Select Committee on Treasury Ninth Report

III Assessing the Monetary Framework

19. The various components of the monetary framework are intended to ensure the transparency and accountability necessary to maintain the credibility of the MPC. This credibility is important because, if the policy framework is to succeed in the long term then, as the Chancellor told us in our previous inquiry, it is necessary to get "an all party consensus on the importance of the change that was made in monetary policy."[29]As Professor Minford explained to us at the time, "having an independent central bank is not sufficient condition for inflation control unless it is underpinned by political consensus."[30] It is perhaps a measure of the success of the monetary framework that there is now broad political acceptance of it.


20. The monetary framework set up the Chancellor is extremely open and transparent; indeed Sir Alan Budd told us that he believed it was "possibly the best system in the world for setting monetary policy."[31] Outside of periods when inflation is overshot or undershot by more than a percentage point (necessitating a letter from the Governor to the Chancellor), the main vehicles for explaining monetary policy are the minutes of the monthly meetings, the quarterly Inflation Report and the subsequent hearings held by this Committee. Professor Minford summarised the general perception on the transparency of the framework in his evidence to our last inquiry. He "welcomed the extreme transparency whereby you get individual members of the [MPC] along, they can say where they stand, you get a well informed public debate where all the participants who have a vote can be assessed and therefore it reduces the uncertainty surrounding monetary policy."[32]

MPC meeting minutes

21. The MPC meeting minutes are notable for the clarity with which they explain potentially complicated policy decisions. Nevertheless a number of witnesses, in particular Professor Buiter, advocated greater individual accountability in the minutes. He suggested inserting "at the end of the minutes where the votes are recorded a short paragraph written on the day the vote is taken ... explaining why each individual member voted that way."[33] However, when we put this idea to the Governor he said he was concerned that "there is a real danger" in such an approach "that you do get into a situation where the individual personality impedes what I believe is a very well working process ...You would focus the thing on personalities rather than on the elements in the debate."[34] We do not see the need for individually attributable explanatory paragraphs. We believe that differences of view between MPC members, and their wider thinking, can be explained in public, including in our evidence sessions. We return to this issue in paragraph 43.

22. The Bank has also taken additional measures to heighten public awareness about monetary policy and to explain the decisions of the MPC. In April 1999, following a recommendation of this Committee, the Bank published a paper on the transmission mechanism[35] and its suite of forecasting models. Members of the MPC also make numerous speeches around the country. In addition, the Bank has introduced more innovative measures such as a monetary policy competition for schools in conjunction with the Times newspaper. We commend the Bank on the way in which it has sought to disseminate information on the policy and actions of the monetary policy committee. However, as we noted in paragraph 10, public expectations of the inflation rate remain approximately a percentage point above the target and hence we would encourage the Bank to continue to think of ways in which they can broaden the reach of their information campaign.

The Inflation Report and forecast

23. When the Inflation Report was first introduced by the then Chancellor Norman (now Lord) Lamont, its aim was to "produce a wholly objective and comprehensive analysis of inflationary trends and pressures."[36] The Bank of England Act set out more specific guidance for the Report stating that for each quarter it should contain "a review of monetary policy decisions published by the Bank ... an assessment of the developments in inflation in the economy of the United Kingdom and an indication of the expected approach to meeting the Bank's objectives."[37] The Act also states that "No report under this section shall be published without the approval of the Monetary Policy Committee."[38] The Inflation Report has thus become the main vehicle for explaining the underlying thinking of the MPC in depth.

24. Possibly the most important analysis used in the Inflation Report to elucidate the future approach of the MPC to meeting its objectives is the inflation forecast. The Bank recently published an explanation of the forecast process in the Inflation Report. The Bank explained that "forecasts are central to the conduct of monetary policy given that it takes time for interest rates to affect inflation."[39] The inflation forecast fan charts show "the best judgement of the Committee as a whole about inflation and growth prospects, conditional on assumed interest rates." However, the article cautions that "this may not be the best judgement of each individual member of the Committee." It also emphasises that the link between the fan chart and policy is "not mechanical."[40]

25. As the arrangements for the MPC have bedded down and the economic environment has changed, the increasingly disparate views among MPC members have meant there have been occasions when opinions on the future outlook for inflation have differed significantly. Sir Alan Budd highlighted such an occasion in May 2000, when "the fan charts and what is known as the best collective judgement gave a path for inflation which had inflation at the end of the two year period at the target of 2.5 per cent. But ... individual members ... differed from that central view ... [and] if you summed these disagreements ... there appeared to be ... some people who thought that inflation in two years time would be three per cent and some who thought inflation in two years time would be two per cent."[41] This difference of views amongst MPC members has up to now been accommodated in the form of a table in the Inflation Report. However, as Mr Bootle told the Committee "increasingly it is becoming clear how difficult it is to present a single view of the future in this way."[42] There must therefore be a concern that the central view of the inflation forecast (illustrated by a deep red middle band in the fan chart) in fact represents the views of a minority (or possibly even none) of the MPC members. It is doubtful that such an outcome enhances the transparency of monetary policy, a point Mr Kohn noted in his report to the Court of the Bank on the monetary policy processes of the Bank of England: "the forecast round and Inflation Report perhaps may not be as helpful as they might be to the Committee, or to the public, the Parliament, and the markets in understanding, predicting, and judging policy actions."[43]

26. Our witnesses had a number of possible solutions to this problem. Mr Bootle suggested "having a forecast of the future from the Bank staff and it being quite open and clear that this is not necessarily, as it were, the central view of the Committee as a whole."[44] Mr Kohn set out five possible alternatives in his report, but recommended only two to us: "a majority forecast and a median forecast."[45] He did not, however, choose between the two, but thought that, following his recommendations, the Bank now used "a little of both now and that is not a bad way to go."[46] Professor Charles Goodhart, a former MPC member, has also considered this problem in a recent paper.[47] He concluded that the best solution was "to make the Governor the sole author of the Inflation Report, but approved by the MPC."[48] However, the Governor rejected this proposal, arguing: "I do not think a Governor's forecast would be worth anything. It would certainly be worth no more than a staff forecast in terms of its impact on the policy."[49]

27. We agree with Mr Kohn that "the inflation forecast and Inflation Report are key elements in making policy under the inflation target set by the government and in explaining the policy to the public."[50] We also note Mr Kohn's point that "the forecast round and Inflation Report may not be as helpful as they might be". We recommend the MPC review the current arrangements.

The unchanged interest rate assumption

28. The inflation forecast makes the assumption, as Professor Bean told us, that "interest rates stay unchanged over the forecast horizon."[51] This assumption has been criticised by the IMF who noted in a working paper in December 1999 that the Inflation Report "appears to lack transparency and credibility in relation to its inflation forecast."[52] Our expert witnesses also questioned whether such an assumption was credible. Mr Flemming explained to us there have been occasions when the "chart of inflation expectations was on target for two years out but ... it was fairly clear that the next ... quarter's forecast was going to show the inflation rate being considerably above target. Therefore it would be natural for someone to draw the conclusion that interest rates were going to have to change within the next quarter."[53] Such a position clearly calls into question the credibility of the assumption of unchanged rates.

29. Mr Flemming's solution to this problem was to assume that inflation would be at the target range and then require the MPC to "publish with wide dispersement probably a trajectory of short-term interest rates which we think is compatible with delivery."[54] However Sir Alan Budd warned that the difficulty with this approach would be "getting the Monetary Policy Committee to agree on the path [for interest rates.]"[55] Mr Barrell also pointed out that the Bank of England as a central bank was working under different constraints from independent economic forecasters. They therefore faced the problem that "if the central bank says interest rates will go up in six months' time everybody will say, 'Why don't you do it now?'" Mr Barrell thought that was "a very difficult question to answer."[56]

30. Professor Bean explained that the MPC's interest rate assumption was a "benchmark" and that the MPC undertook "an extensive examination of the alternative interest rate profiles that might generate particular inflation profiles."[57] Mr King added that the MPC "look at the fan charts and the different levels of interest rates ... [and] set interest rates at a level such that the fan chart looks as if the central projection is coming back to 2.5 per cent." He emphasised that "what matters to most members of the Committee is the balance of risk."[58] We recognise that there are a number of theoretical criticisms of the MPC's forecast assumption of unchanged interest rates. However we think that it provides the most easily understood framework for assessing future policy developments.


31. The Bank of England Act states that the Treasury shall define "what price stability is taken to consist of."[59] To date the Chancellor has defined price stability as an annual increase in RPIX of 2½ per cent. However, looking ahead it is possible that the Chancellor may wish to change either the level or measure of the inflation target. Our expert witnesses were divided on whether he should do this. Mr Flemming thought that developments in the economy "might make it appropriate to consider lowering it now."[60] Mr Barrell agreed telling us that "2.5 per cent cannot really be described as price stability in the medium term and there would be a strong case for reducing it to 1-ish for the next parliament without there being a significant tightening of monetary policy during that process."[61] Professor Buiter, however, did not think it would be a good idea to reduce the target; he warned that "changing the target should only be done very infrequently; otherwise the Chancellor by repeated changes in the target can regain discretionary power over monetary policy."[62] He therefore preferred to wait to "revise the target when Britain joins EMU," if that were to occur. Sir Alan Budd shared Professor Buiter's view "about the desirability of stability in this inflation targeting activity," but pointed out that "we know from experience that 2.5 per cent on the retail price index excluding mortgage interest payments seems to be equivalent to about 1.5 per cent on the harmonised index of consumer prices ... so we are not far from the 1 per cent the European Central Bank has in mind."[63] We would like to see more commentary in the Inflation Report on UK inflation as measured by the Harmonised Index of Consumer Prices.

32. The Governor agreed with Professor Buiter that if the target "were changed too often, that would actually damage the process," although he acknowledged that "there would come a time when it would be sensible to review it seriously."[64] He thought it would be "premature"[65] to change the target at the moment because "the arrangements are still bedding down."[66] We do not think that at present it would be appropriate to change the level or measure of the inflation target.


Representation on the MPC

33. Throughout the existence of the MPC there have been suggestions in the media, and elsewhere, that monetary policy is being set to offset inflationary pressures in the South East at the expense of the real economy in the rest of the country. This has led to calls by commentators, including the TUC in their written submission to our previous inquiry, that "there should be a stronger voice for industry to influence the setting of interest rate policy."[67] However the Governor has refuted this suggestion on a number of occasions stating, in 1999, for example, that "the point ... about the membership of the MPC is that they have to be experts in monetary policy ... I would be very happy if we could find experts of the same calibre and I do not mind where they come from, but my concern simply is that they should be experts in this very technical subject."[68] We agree that MPC members should be chosen as experts in monetary policy. However, we believe that there is an advantage in these experts coming from different backgrounds; and we note that one member of the MPC has a business background and another is a well known labour market economist.

Provision of Regional Information

34. The Non-executive Directors of the Court of the Bank of England are mandated by the Bank of England Act to determine "whether the Committee has collected the regional, sectoral and other information necessary for the purpose of formulating monetary policy."[69] Baroness Noakes, Chairman of NEDCo, explained that NEDCo looked "at the work of the regional agents ... what kinds of ... regional and sectoral information flows, are going to the MPC ... [and] make sure ... that they [the MPC] themselves keep under review how they do things."[70] In addition NEDCo occasionally hold their meeting in different regions of the country. Sir Alan Budd confirmed that the MPC "listen with great attention to what the [regional] agents say, because it is very up to date information ... [we] find them extremely valuable, because here these people are talking to the businesses and to the firms and to the unions in the regions."[71] We welcome the consideration the MPC give to reports from the regional agents and emphasise their importance.

35. We note that the Bank has had difficulty getting across the message that "the influences which determine where interest rates go are the overall outlook for inflation ... it is a national outlook ... not a regional one ... and not a sectoral one."[72] We believe that this must in part be due to the perception that the MPC does not completely incorporate developments in the different regions of the country into its deliberations. Hence, in our previous report, we "encourage[d] the MPC to hold meetings and hearings outside London."[73] The Governor told us that there were two reasons why the Bank had not held MPC meetings outside London: "One is that the preparatory phase, the pre-MPC process, actually involves huge numbers of Bank staff and it would not be realistic to take them around the country. The other is that we are actually in purdah during this period ... [so] none of us could speak to the public and get our message across."[74] However, we also note that the European Central Bank hold policy meetings away from Frankfurt twice a year.[75] We think that the MPC should take further steps to eradicate the perception that it is not taking account of regional economic factors when setting policy. We therefore recommend that the MPC should reconsider its decision not to hold meetings outside London, as we think the symbolic benefits would more than compensate the logistical inconveniences involved.


36. The membership of the MPC consists of the Governor and Deputy Governors of the Bank, two members appointed by the Governor of the Bank after consultation with the Chancellor (the executives responsible for monetary policy analysis and monetary policy operations) and four "external" members appointed by the Chancellor of the Exchequer. All the members of the committee, except the Governor and two deputy governors, are appointed on three year renewable contracts.

37. Our expert witnesses raised concerns about the length of contract. Sir Alan Budd pointed out that "three years is a rather short time in which to judge"[76] the performance of an individual member when their contract is up for renewal. Mr Flemming advocated removing "the option [of reappointment] in order to enhance the perception of independence on the part of the members [and] at the same time possibly lengthening their term ... with a term of about six years as a maximum."[77] In addition, Professor Buiter, in his resignation letter to the Chancellor, concluded that "... both the appearance and the substance of independence of the external members of the MPC are best served by restricting their membership to a single term."[78] Short tenure renewable appointments run the risk that the members' votes are influenced, towards the end of their tenure, by a desire to gain re-selection to the Committee. We therefore repeat the recommendation made in our report on the Accountability of the Bank of England that the duration of the terms be increased.

38. It is also very unclear how the Chancellor chooses the external members of the MPC. The criteria set out in the Act are that "the person has knowledge or experience which is likely to be relevant to the Committee's functions."[79] This is a broad definition and currently the recruitment procedure and specific criteria the Treasury use are extremely opaque. This is in stark contrast to the "openness, transparency and accountability"[80] the Treasury claims for the framework as a whole. As a counter balance to this opacity, and a necessary part of the accountability of the MPC, we have held public meetings to confirm the suitability of appointments to the MPC. We discuss the confirmation hearings in paragraphs 49 to 55 below.


39. The external members of the MPC may work full or part time at the Bank. At present two of the external members, DeAnne Julius and Sushil Wadhwani, who came from commercial organisations, work full-time at the Bank and two, Stephen Nickell and Christopher Allsopp, who have academic backgrounds, work part-time at the Bank and part-time at the London School of Economics and New College, Oxford, respectively. As the "externals" are not bank officials they do not have the same access to the full range of Bank staff as the "internal" members. This led to newspaper reports of a disagreement, in October 1999, between the external members (particularly those without access to outside academic researchers), and the senior management of the Bank, as to the level of support which should be provided. The Governor explained to us at our next hearing that this had been resolved by allocating to each externally appointed MPC member, when required, "a dedicated resource in the form of one post-graduate economist and one graduate economist." He also explained that the Bank had formalised its procedures for setting research objectives "we ... now have six regular meetings each year to determine the priorities ... four of them in the context of the quarterly forecasting round ... two meetings ... to discuss longer term research projects."[81]

40. NEDCo are mandated to ensure that MPC procedures operate satisfactorily during the year. However on this occasion their procedures clearly failed to work. We therefore asked Baroness Noakes, Chairman of NEDCo, to justify their assessment in the annual report that the Monetary Policy Committee "procedures ... operated satisfactorily."[82] Baroness Noakes explained that NEDCo "looked at [the issue] ... and encouraged the Bank to be quite explicit about how that process had gone on in its review of monetary policy procedures ... in the light of that full explanation and bearing in mind that we found no harm done to the process of monetary policy, we found it relatively straight forward to reach the conclusion that we did."[83] Nevertheless, despite Baroness Noakes' explanation, we note that the issue was only fully resolved after it had been made public and became a focus of one of our public hearings. We believe that the Non-Executive Directors need to be much more pro-active in ensuring that the procedures of the MPC operate fairly with respect to both internal and external members.

29  Eighth Report, Session 1998-99, The Monetary Policy Committee-Two Years On, HC 505, Q 68 (and para 29 of the Report). Back

30  Ibid, Q 2. Back

31  Q 122. Back

32  Eighth Report, Session 1998-99, The Monetary Policy Committee-Two Years On, HC 505, para 31. Back

33  Q 122. Back

34  Q 400, 401. Back

35  Bank Quarterly Bulletin Volume 39 No 2 p 161-176. Back

36  February 1993 Inflation Report, p 3. Back

37  Bank of England Act 1998, section 18(2). Back

38  Ibid, section 18(5). Back

39  August 2000 Inflation Report, p 63. Back

40  Ibid, p 49. Back

41  Q 122. Back

42  Q 243. Back

43  Donald L Kohn, Report to the Non-Executive Directors of the Court of the Bank of England on Monetary Policy Processes and the Work of Monetary Analysis, p 14. Back

44  Q 243. Back

45  Q 212. Back

46  Q 212. Back

47  "The Inflation Forecast", National Institute of Economic and Social Research Review, January 2001. Back

48  Ibid, p 65. Back

49  Q 415. Back

50  Donald L Kohn, Report to the Non-Executive Directors of the Court of the Bank of England on Monetary Policy Processes and the Work of Monetary Analysis, p 13. Back

51  Q 305. Back

52  Central Bank Independence and the Conduct of Monetary Policy in the United Kingdom, IMF Working paper WP/99/170, December 1999, p 15. Back

53  Q 129. Back

54  Q 129. Back

55  Q 131. Back

56  Q 131. Back

57  Q 305. Back

58  Q 306. Back

59  Bank of England Act 1998, section 12(1)(a). Back

60  Q 132. Back

61  Q 133. Back

62  IbidBack

63  IbidBack

64  Q 341. Back

65  Q 346. Back

66  Q 347. Back

67  Eighth Report, Session 1998-99, The Monetary Policy Committee-Two Years On, HC 505, Appendix 9. Back

68  February 1999 Inflation Report hearing, HC (1998-99) 268-i & ii, Q 193. Back

69  Bank of England Act 1998, section 16(2). Back

70  Q 5. Back

71  Q 170. Back

72  February 2000 Inflation Report hearing, HC (1999-2000) 286-i & ii, Q 93. Back

73  Eighth Report, Session 1998-99, The Monetary Policy Committee-Two Years On, HC 505, Conclusion (g). Back

74  First Report, Session 1999-2000, Research Assistance for Monetary Policy Committee Members, HC 43, Q 206. Back

75  European Central Bank Annual Report 1999, Chapter XI, p 135. Back

76  Q 90. Back

77  Q90, 91. Back

78  Letter from Willem Buiter to the Chancellor, 18 January 2000 (reproduced with Treasury News Release 16/00, 11 February 2000). Back

79  Bank of England Act 1998, section 13(4). Back

80  Budget 2001, HC (2000-01) 279, p 18 para 2.4. Back

81  First Report, Session 1999-2000, Research Assistance for Monetary Policy Committee Members, HC 43, Q 74. Back

82  Report by the Non-Executive Directors of the Bank of England, Bank of England Annual Report 2000. Back

83  Q 6. Back

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