V Wider Policy Issues
56. During the course of this Parliament the monetary
framework and developments in the economy have raised wider questions
about the best way to manage the economy. It has been argued that
monetary and fiscal policy may be less well co-ordinated with
an independent central bank. Some commentators have also expressed
concern that a statutory inflation target has led to too much
emphasis being placed on the need to control inflation at a time
when the strength of the exchange rate has caused imbalances in
the economy. Looking at more long term economic issues there has
been considerable debate about whether the "new economy"
developments, which have been seen in the US, are also beginning
to be picked up in the UK and, if so, how they will affect the
future conduct of monetary policy. We discuss these issues in
the following section.
CO-ORDINATION OF MONETARY AND FISCAL POLICY
57. Separating the control of monetary and fiscal
policy runs the risk that overall economic policy will be poorly
co-ordinated. The IMF raised this concern in their 1999 selected
issues paper on the UK noting that "most analyses of central
bank independence ... do not take due account of the possibility
that policy coordination may weaken, thus potentially offsetting
the benefits of lower inflation bias."
When we examined this issue in our last report two years ago we
concluded that "the framework has so far avoided potentially
serious conflict between monetary and fiscal policy."
However Mr Weale cautioned that "just because policy had
worked well to date did not mean that there would never be any
problems arising from the separation of the two policy setting
Our experts had differing views. Mr Barrell pointed out to the
Committee that the framework had perhaps "made monetary policy
more reactive to fiscal policy ... so in terms of the short-term
reactions we have probably got less coordination of monetary and
However, Professor Buiter thought that "there is clearly
no conflict ... one learns the reactions of the other party, and
through a process of repetition and reputation building ... one
ends up with something which is pretty much like a co-operative
58. The co-ordination of policy is heavily dependent
on the clarity of information being provided by the Treasury representative
on the MPC. His job is to "ensure that they [the MPC] know
everything they can about what is happening to the economy and
to fiscal policy in general."
If the clarity of the information provided is insufficient then
there is a risk that policy may be set erroneously. In our inquiry
into the 2000 Budget we took evidence from Mr David Walton, Director
of UK Economic Research at Goldman Sachs, who thought that the
Treasury exposition of the fiscal stance caused "a great
deal of confusion about the tightness of the Budget."
This opacity seems to have puzzled some members of the MPC, who
concluded in their first analysis of the Budget figures in March
2000 that "the Budget suggested a tighter fiscal stance than
previously anticipated by households and companies."
But in April, after a more detailed analysis, they qualified their
position noting that "the impact on future activity and inflation
from the Budget seemed unlikely to be large over the next two
Mr Kohn however told us that the people he had talked to thought
that "the Treasury was careful not to try and steer the Committee's
monetary policy decision" and that "the Treasury representative
was very useful in giving the Committee a view on where fiscal
policy was going, what the budget was likely to be like."
59. The Governor has emphasised to this Committee
that he would be willing to change policy irrespective of the
timing of the Budget or an election.
There may therefore be an incentive for the Treasury to muddy
the waters in its presentation of the fiscal position in order
to avoid policy being tightened at an inappropriate political
moment. We believe that the responsibility is on us to continue
to probe the advice which the Treasury gives the MPC by questioning
the Chancellor and the Treasury Representative.
THE EXCHANGE RATE
60. One of the major policy problems which the MPC
have faced over the last four years has been the strength of the
exchange rate. Sterling appreciated, on a trade weighted basis,
by approximately 14 per cent between Autumn 1996 and Summer 1997
and has fluctuated at or above this level
throughout the last four years. The strength of sterling has
had a disproportionately severe effect on the manufacturing sector
of the UK economy, with many companies finding it difficult to
remain competitive, particularly in European markets. The
Governor acknowledged this telling us "we recognise that
the impact of monetary policy, and particularly the impact of
the strong exchange rate, have differential impacts on different
sectors of the economy and that in turn can have differential
impacts on regions in which those sectors are concentrated."
61. The MPC have struggled to deal directly with
this issue. They are mandated to target inflation, as the Governor
has frequently emphasised to us: "the responsibility of the
MPC is absolutely clear and that is to deliver inflation around
In any case it would not make economic sense (in addition to being
against the provisions of the Act) to target the exchange rate
as well as inflation because, as Dr Wadhwani told us at his confirmation
hearing, "all the economic text books always say ... you
cannot attempt to hit two targets at the same time with only one
instrument. For that reason I do not think ... the MPC can attempt
to go down the route of exchange rate targeting in any sense."
62. Nevertheless, whilst not explicitly targeting
the exchange rate, the MPC do, as the Governor told us, "take
account of the exchange rate in setting monetary policy,"
although, as Mr King emphasised, the MPC do not "single out
any one factor ... it is the net effect of all the factors and
all the data that determine what changes we make in interest rates."
The Governor explained that the MPC's approach is "if we
are confident that we are on track in terms of inflation, if we
think that there are alternative interest paths which could actually
be consistent with that result, then we can take account of that
[the exchange rate] in determining which of those interest rate
paths it would be most sensible to pursue." The MPC's problem
had been that "it is not at all clear how particular decisions
on interest rates would necessarily influence the exchange rate."
63. For the first two and a half years of its existence
the MPC's inflation forecast assumed, incorrectly, that the exchange
rate appreciation was temporary, and that sterling would fall
in line with relative interest rates. The MPC were not alone in
this error but it has given the impression, as Mr Bootle told
us, that "the Bank look appallingly incompetent," although
he emphasised that such an impression was "unfair and misleading."
Despite the poor record of the exchange rate assumption it was
not until November 1999 that the MPC, at the instigation of Dr
Wadhwani, changed their exchange rate assumption to splitting
the difference between a constant exchange rate assumption and
uncovered interest parity (UIP).
Professor Goodhart implied in answer to our questions, that this
assumption would, other things being equal, feed through into
lower import prices and lower inflation than would have been the
case under the old assumption.
64. At present the exchange rate assumption is less
of a cause for concern, and indeed in the last quarter the Bank
have reported on, their assumption was undershot. Nevertheless
the concerns arising from the recent past highlight the pressures
which can be placed upon the new framework. We support the
MPC's stance on how it accounts for exchange rate movements in
its policy deliberations but we also question whether the MPC
are learning from developments in the economy as quickly as they
should. If they had changed their exchange rate forecast assumption
earlier, it is possible that interest rates would have been cut
earlier and inflation might not now be undershooting the target.
THE NEW ECONOMY
65. The "new economic paradigm" is a concept
which has been developed in recent years to help explain developments
in the United States economy which, until the recent slowdown,
had seen a remarkable period of sustained growth supported by
low inflation. Professor Buiter summarised the structural transformations
associated with the new economy as "increasing openness;
financial innovation; lower global inflation; lower profit margins,
reflecting stronger competitive pressures; buoyant stock markets
defying conventional valuation methods; a lower natural rate of
unemployment; and a higher trend rate of growth of productivity."
U.S. proponents of the new economy have argued that their economy
is benefiting from structural gains in productivity, a fact acknowledged
by Alan Greenspan, Chairman of the Federal Reserve, in a speech
in June 2000; "... most of the gains in the level and the
growth rate of productivity in the United States since 1995 appear
to have been structural, largely driven by irreversible advances
in technology and its application."
However, the productivity improvements witnessed in the US have
yet to be mirrored in the UK, although the Treasury claimed in
their "Productivity in the UK" paper that "there
are early signs that productivity growth is beginning to increase."
66. There are a range of views amongst MPC members
as to the likely impact of the new economy developments in the
UK. Dr Wadhwani has argued that "productivity growth is likely
to be above average over the next two years" and expressed
concern that "to 'wait and see' for a statistically significant
change in the actual measured productivity growth might be to
miss an economically significant change in the true productivity
However, the Bank's official line, set out in February 2000 for
the Committee, was more cautious: "... there is little evidence
to suggest that these recent advances [in Information and Communication
Technology (ICT)] has so far increased trend productivity growth
in the UK, though they may of course do so in the years ahead.
It is generally agreed that the NAIRU
is now lower than it was say a decade ago, and possibly that ICT
advances may have contributed to this apparent fall. But other
explanations are equally plausible."
67. Analysis of the implications of the new economy
is more than just an academic argument. For MPC members their
interpretation of its effects will play an important part in policy
decisions. As the November 2000 MPC meeting minutes highlight,
new economy issues frequently play a part in the immediate policy
decision; "... some members pointed to the possibility that
GDP growth might have been increasingly understated in recent
years because of the possible mis-measurement of the ICT sector.
This might have an effect, in their view, of imparting an upward
bias to the inflation forecast."
We believe that the "new economy" and its developments
are one of the key issues facing economic policy makers over the
next few years and we expect the Bank to monitor the issue carefully.
Our successor Committee may wish to pursue this issue further
in the next Parliament.
Staff Country Report No 99/44 United Kingdom Selected Issues,
para 44, p 17. Back
Report, Session 1998-99, The Monetary Policy Committee-Two
years on, HC 505, para 60. Back
112 Ibid. Back
of Evidence, 15 March 2000, The 2001 Budget, HC (2000-01)
326-i to iii, Q 212. Back
Report, Session 1999-2000, The 2000 Budget, HC 379, Appendix
4, first paragraph. Back
meeting minutes March 2000, para 34. Back
meeting minutes April 2000, para 5. Back
Exchange Rate Index (ERI) rose from 86.1 in September 1996 to
100.4 by June 97 (1990=100). Back
Report, Session 1999-2000, Research Assistance for Monetary
Policy Committee Members, HC 43, Q 129. Back
2000 Inflation Report hearing, HC (1999-2000) 286-i & ii,
Q 108. Back
Report, Session 1998-99, The Monetary Policy Committee of the
Bank of England: Confirmation Hearings, Volume II, HC 476-II,
Q 26. Back
2000 Inflation Report Hearing, HC (1999-2000) 523-I & ii,
Q 193. Back
2000 Inflation Report Hearing, HC (1999-2000) 286-i & ii,
Q 88. Back
Q 108. Back
basic theory of uncovered interest parity (UIP) says that on average
the exchange rate will evolve in line with interest rate differentials. Back
Report, Session 1999-2000, Research Assistance for Monetary
Policy Committee Members, HC 43, Q 173. Back
New Economy and the Old Monetary Economics, paper by Willem Buiter. Back
Greenspan, speech to New York Association for Business Economics,
13 June 2000. Back
in the UK: Progress towards a productive economy.
HM Treasury, March 2001, para 1.3. Back
Challenges in a New economy, speech to HSBC Global Investment
Seminar, 12 October 2000. Back
Non Accelerating Inflation Rate of Unemployment (NAIRU) is the
unemployment rate when output is just at its potential. Back
2000 Inflation report hearing, HC (1999-2000) 286-i & ii,
annex to evidence. Back
2000 MPC meeting minutes para 30. Back