Select Committee on Treasury Ninth Report

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.


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."[110] 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."[111] 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 instruments."[112] 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 fiscal policy."[113] 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 outcome."[114]

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."[115] 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."[116] 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."[117] 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 years."[118] 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."[119]

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.[120] 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.


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[121] 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."[122]

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 the target."[123] 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."[124]

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,"[125] 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."[126] 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."[127]

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."[128] 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).[129] 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.[130]

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.


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."[131] 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."[132] 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."[133]

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 growth rate."[134] 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[135] 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."[136]

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."[137] 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.

110  IMF Staff Country Report No 99/44 United Kingdom Selected Issues, para 44, p 17. Back

111  Eighth Report, Session 1998-99, The Monetary Policy Committee-Two years on, HC 505, para 60. Back

112  IbidBack

113  Q 167. Back

114  Q 168. Back

115  Minutes of Evidence, 15 March 2000, The 2001 Budget, HC (2000-01) 326-i to iii, Q 212. Back

116  Fifth Report, Session 1999-2000, The 2000 Budget, HC 379, Appendix 4, first paragraph. Back

117  MPC meeting minutes March 2000, para 34. Back

118  MPC meeting minutes April 2000, para 5. Back

119  Q 233. Back

120  Q 336. Back

121  Sterling Exchange Rate Index (ERI) rose from 86.1 in September 1996 to 100.4 by June 97 (1990=100). Back

122  First Report, Session 1999-2000, Research Assistance for Monetary Policy Committee Members, HC 43, Q 129. Back

123  February 2000 Inflation Report hearing, HC (1999-2000) 286-i & ii, Q 108. Back

124  Fifth Report, Session 1998-99, The Monetary Policy Committee of the Bank of England: Confirmation Hearings, Volume II, HC 476-II, Q 26. Back

125  May 2000 Inflation Report Hearing, HC (1999-2000) 523-I & ii, Q 193. Back

126  February 2000 Inflation Report Hearing, HC (1999-2000) 286-i & ii, Q 88. Back

127  Ibid, Q 108. Back

128  Appendix 2. Back

129  The basic theory of uncovered interest parity (UIP) says that on average the exchange rate will evolve in line with interest rate differentials. Back

130  First Report, Session 1999-2000, Research Assistance for Monetary Policy Committee Members, HC 43, Q 173. Back

131  Abstract-The New Economy and the Old Monetary Economics, paper by Willem Buiter. Back

132  Alan Greenspan, speech to New York Association for Business Economics, 13 June 2000. Back

133  Productivity in the UK: Progress towards a productive economy. HM Treasury, March 2001, para 1.3. Back

134  Monetary Challenges in a New economy, speech to HSBC Global Investment Seminar, 12 October 2000. Back

135  The Non Accelerating Inflation Rate of Unemployment (NAIRU) is the unemployment rate when output is just at its potential. Back

136  February 2000 Inflation report hearing, HC (1999-2000) 286-i & ii, annex to evidence. Back

137  November 2000 MPC meeting minutes para 30. Back

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