Select Committee on Treasury Twelfth Report

4  The monetary policy framework


36. Section 11 of the Bank of England Act 1998 sets out the objectives of the MPC of the Bank of England:

In relation to monetary policy, the objectives of the Bank of England shall be—

(a) to maintain price stability, and

(b) subject to that, to support the economic policy of Her Majesty's Government, including its objectives for growth and employment.

Price stability, and the economic policy of Her Majesty's Government are then defined by the Treasury on an annual basis, in a remit letter from the Chancellor of the Exchequer to the Governor of the Bank of England.[97]

37. The type of monetary policy mandate set for the Bank of England is generally characterised as 'hierarchical', in that the primary aim of monetary policy is to maintain price stability, while support of the Government's economic policy is secondary to that. On our visit to the United States, we discussed the US monetary policy dual mandate:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.[98]

Here, price stability and maximum employment share equal ranking. However, observers in the US suggested to us that the definition of 'maximum employment' was treated by the Federal Reserve as meaning the level of employment that would lead to price stability.

38. Mr Brendan Barber, General Secretary of the TUC, touched upon the remit of the MPC, telling us that:

the remit to the MPC is a remit relating to monetary stability but taking account of the implications for growth in the economy more generally. As an element of that slightly wider description of the remit, the needs of the manufacturing sector and the pressure of the manufacturing sector need to be taken into account.[99]

Mr Lambert was quick to rebuff the suggestion that the MPC should have such a wide remit, telling us that:

the Monetary Policy Committee has a single instrument, which is interest rates, and that it has a single target, which is a symmetric target - which is really important. Within that, it is very difficult - and I do not think it would be advised to be trying, as it were - for it to deconstruct the economy and aim at particular sectors of it within its forecasting work.[100]

39. We questioned the then Chancellor of the Exchequer about the desirability of a dual mandate, with price stability and full employment equally weighted. He told us that the Federal Reserve's objectives were written many decades ago, and were "a creature of their times".[101] He went on to say that the UK monetary policy objectives were set against a previous backdrop of high levels of inflation, and that the UK framework had achieved, as well as low inflation, low levels of unemployment.[102] He then went on to argue that modern economic theory suggested that there was no long-term trade-off between employment and inflation, and that therefore a dual mandate was not a worthwhile objective.[103] With only a single policy instrument of interest rates available, we agree that the Bank should have as its primary objective price stability. However, subject to that, we will continue to monitor the Monetary Policy Committee's compliance with the secondary objective of meeting the Government's intention of high and stable levels of growth and employment.

Setting the target

40. The inflation target—currently a central target inflation rate of 2%, measured on the Consumer Prices Index, with a letter to be written to the Chancellor of the Exchequer if inflation on the CPI index moves more than one percentage point either side of that central target—is set by the Treasury, through a letter once a year from the Chancellor of the Exchequer to the Governor of the Bank of England, as required by the Bank of England Act 1998.[104] Since the inception of the MPC, there has only been one change in the target, in December 2003, when both the target and measure of inflation changed, from 2.5% on the Retail Prices Index, to the current 2% on the Consumer Prices Index.

41. During our visit to Canada, we discussed their system for setting the inflation target. In Canada, the target, the inflation measure via which the target will be assessed, and the next time the target will be agreed, are all set by an agreement between the Bank of Canada and the Canadian finance ministry. These agreements are for five years, as opposed to the annual remit in the United Kingdom.[105] A consistent theme in evidence was that changes to the target had to be infrequent. Mr Saunders said it was too easy to change the target under the current system, and that "if you have a target you should stick to it and to me the cost is more changing the target rather than what the particular target is".[106]

42. Lord George thought it was right that the Chancellor of the Exchequer, as an elected politician, set the target, but also thought that changes ought be minimised, and suggested that any politician making a change "would have a hell of a job explaining why he was doing it unless the argument was fairly convincing".[107] Lord George was also keen to keep the Bank out of the decision-making process around setting the target, because that "would draw the Bank into a political process".[108] He was unsurprised that there had been little discussion of the target level, because there was broad consensus behind it.[109] Dr Sentance considered that it would make the job of the MPC harder if the target moved, either by changing the actual target amount, or the inflation measure used in the target.[110] Ms Lomax called for there to be more consultation when the target was changed.[111] The then Chancellor of the Exchequer confirmed that he believed the target should not change repeatedly.[112] It is appropriate for the inflation target to be set by the Chancellor of the Exchequer. We consider that it would be valuable to maximise certainty about the target going forward. To that end, we recommend that the Government give consideration as to how this might be achieved.

Target symmetry

43. One important aspect of the current inflation targeting regime in the United Kingdom is its symmetry. Inflation undershooting the target is considered to be as undesirable as inflation over-shooting the target. Professor Muscatelli, however, argued in his written evidence that empirical evidence suggested that the "Bank [had been] apparently putting greater weight on inflation control than one might have expected with a symmetric target".[113] When questioned about this research, Professor Muscatelli suggested that the possibility "that, as the Bank was trying to build up its credibility it might have been quite cautious and therefore inflation stayed below its target". He stressed that these results were based on macroeconomic models, to which some uncertainty was attached.[114] Mr Barber said there had been an earlier period where the Trade Unions had also feared an anti-inflationary bias on the part of the MPC, but pointed out that inflation was now overshooting the target.[115]

44. Professor Congdon suggested that the appearance of downward bias might have been due to the MPC being surprised by the unanticipated strength of the exchange rate.[116] Professor Goodhart supported this, telling us that, "Because the exchange rate was always somewhat higher than we expected, inflation turned out to be just a tiny bit lower, but the deviations were minute".[117] Lord George discounted the view that the MPC had been trying to win credibility at the start of its work by having an anti-inflationary bias, telling us that "Symmetry was accepted by the MPC from the beginning and was a fundamental characteristic".[118] He said that the MPC had undershot on the inflation target early on because they knew that stimulating the domestic side of the economy was not a sustainable option and were thus cautious, rather than this being a deliberate action to gain credibility at fighting inflation.[119] We strongly support the symmetry of the inflation target. We will remain vigilant for any signs that there appears to be either anti- or pro-inflationary bias by the Monetary Policy Committee, and should such signs appear, we will ask for an explanation during our regular hearings on Inflation Reports.

Measuring inflation


45. The only change to the inflation target since the reforms of 1997 was in December 2003 when the target was revised from 2.5% to 2%, and the measure of inflation used for the purposes of the target moved from RPIX to CPI.[120] The Retail Prices Index had traditionally been used for wage bargaining. Concern was expressed about the change from the RPIX to the CPI because wage increases might still be linked to RPI. As a consequence of this, if RPI were higher than CPI, wage expectations, and thus inflationary pressure, could be higher than if the target had been based on RPI. Mr Barber confirmed that the RPI remained the measure used in wage bargaining.[121] Mr Barrell pointed out that wages were determined by the conditions in the labour market, not the RPI, and therefore even if worker demands related to RPI, it was up to employers whether or not they agreed to that level of increase in salary.[122] Mr Lambert noted that wage bargaining was conducted within a market, and that market would determine the overall level of wage settlements, which the MPC would then monitor.[123] Dr Wadhwani impressed upon us the need to inform the public that RPI-linked wage settlements were not for the good of the economy, should not be expected as of right, and could lead to higher unemployment.[124] We do not believe that the move from the Retail Prices Index (excluding mortgage interest payments) to the Consumer Price Index has adversely affected the work of the Bank of England in anchoring inflation expectations. While the Retail Prices Index may be the dominant index for wage negotiation, and thus of interest to the Bank, wages are, in the main, set by market forces.


46. The Consumer Price Index does not contain an element relating to house prices, unlike the Retail Prices Index. In evidence to the House of Lords Economic Affairs Committee, the Governor of the Bank of England outlined the problem:

CPI ignores housing costs, which is unfortunate. It has rental housing but not owner-occupied housing. For some time we have been hoping that housing costs would come back in to CPI and indeed EUROSTAT is conducting an experiment to see how they could bring housing into different national measures and they control the definition of this harmonised measure across Europe. The latest date now for progress on this front has been pushed out to 2010, but frankly I doubt it will be in my lifetime. That is one of the downsides to CPI, that it is very hard to see now when housing costs will come back in to the index.[125]

47. Professor Muscatelli thought that it would be a "positive step" to include house prices in the CPI, because the danger was that people's perceptions of inflation differed from the official measure.[126] Professor Goodhart was also keen to include house prices in CPI, saying "It is a major issue, because the question of what inflation is will vary quite a lot if housing prices move quite differently from the price of other goods and services, as they have very frequently over the past 10 years".[127] While he acknowledged the difficulties of including house prices in the CPI, he stated "It is a complicated, technical issue but a very important one".[128] Mr Lambert also thought that house prices should be included in CPI, but acknowledged the difficulties, especially considering the European context, in so doing.[129]

48. Others did not support the inclusion of house price inflation in the CPI. Professor Congdon did not see any reason to include house prices in a measure of goods price inflation.[130] Mr Barrell pointed out that it would take a European-wide decision to change the CPI coverage, and that, as long as the MPC knew the effects of the items that were missing from the CPI basket, "the CPI will do".[131] Professor Wren-Lewis was also "far from convinced that some measure of housing costs should play a very big role in the Consumer Price Index. It is not obvious to me why movements in house prices have an affect on people's welfare."[132] Dr Julius was also committed to the CPI and thought that the house price element of the RPIX "was not a very good element and it destabilised that particular measure".[133] She encouraged the MPC to pay more attention to the core measures of CPI.[134]

49. Professor Chadha noted that, while the RPI did have a housing cost element, the indices did not diverge over the long-run.[135] He urged the Bank to explain how, by meeting its CPI target, it expected the RPI measure to become more stable.[136] Lord George said that he had not been keen at the time to change from RPI, but thought that "A 2% target for CPI is a good benchmark for the kind of broad balance and stability that is the big picture here".[137] Lord George felt that "One can have endless debate about precisely what one should and should not include", but that "the overall objective will be undermined if too much attention is paid to particular measures which reflect the expressed opinions of particular groups of people in society".[138] Ms Bell thought that the measure used was unimportant, as long as it was "consistent and credible".[139] The then Chancellor of the Exchequer strongly defended the use of the CPI, telling us that "CPI is the internationally accepted measure of inflation and I believe it is right to continue to work through the CPI".[140] He also thought that it was best "for us to follow the general trend of what is happening in other countries" when determining what should be included within the CPI.[141] He went on to say that, when the change from RPIX to CPI occurred, his view was that the new inflation target was "a little tougher".[142] We do not, at the present time, recommend changing the Consumer Prices Index to reflect housing costs, before a pan-European consensus has been achieved. However, we recommend that the Government and the Office for National Statistics (with assistance from the Bank of England if required) work with their European partners in bringing about such consensus as quickly as possible.

Monetary policy and fiscal policy


50. The changes in the monetary policy framework in 1997 meant that fiscal policy and monetary policy were no longer set by the same institution. The Bank of England received one main policy instrument—raising or lowering the interest rate. Fiscal policy remained a Treasury responsibility.[143] Much evidence received related to the nature of coordination between fiscal and monetary policy since that functional separation.

51. Mr Sanders told us that he had long argued "that fiscal and monetary policy must be compatible".[144] But he thought that the MPC had "quite sensibly taken the view that they will keep out of fiscal policy discussions unless fiscal policy starts to affect inflation prospects, and at the moment it does not".[145] Lord George told us that the Bank would monitor fiscal policy, and would provide a warning to the Treasury if it were concerned about the effects of fiscal policy. He thought "the kind of advice the Bank would give would be, 'If you do this it will cause that to happen and interest rates will rocket. Is that really what you want?'".[146]

52. Mr McCafferty told us:

I think there is an argument to say that we have not yet achieved the optimal balance between fiscal and monetary policy and that fiscal policy has been somewhat loose over the course of recent years, with very rapid rates of public expenditure and a rising budget deficit, and this has led to interest rates being slightly higher than would have been the case. That suggests that there is room for further discussions between the two bodies in order to try to achieve that optimum balance between the two sets of policies.[147]

He believed that, if required, the Bank should be vocal if fiscal policy posed a risk.[148] Mr Lambert cautioned the Bank to keep out of politics, but told us "If, however, it thought fiscal policy was seriously and adversely affecting monetary policy, it should say so".[149]

53. The Governor of the Bank of England indicated that, "if fiscal policy were set in a way that would lead to a prospect of very large budget deficits, then I think it would be extremely difficult for us to manage inflation expectations which have been the anchor of the framework for monetary policy".[150] He told us "The Treasury itself knows when making its budget that we will take offsetting action if that appears necessary".[151] Given the influence that fiscal policy can have on the Monetary Policy Committee's primary objective of maintaining price stability, it is right that the Monetary Policy Committee should monitor the Government's fiscal plans, and, if necessary, provide a public warning about the potential effects of changes to fiscal policy.


54. Earlier in this Report the possibility of 'leaning against the wind' and keeping interest rates higher than might otherwise be needed in order to stem the growth in asset prices. However, as Mr Barrell stated, this would come at a cost, in that "Holding interest rates higher than they otherwise would have been in order to deal with debt and to deal with asset prices and those risks means holding them higher than they really need to be to hit full employment immediately, so there is a choice, a trade-off".[152] To counter this trade-off, Professor Wren-Lewis suggested to us that the Bank be given control of certain fiscal policy instruments in order to target certain sectors of the economy, such as housing, where imbalances have built-up. He stressed that this policy proposal was "for the long term. I am not suggesting that this is something that should happen overnight."[153] Professor Wren-Lewis acknowledged that "the interest rate is the instrument", but went on to say that "the question is whether you might want to supplement it on quite rare but important occasions by giving limited temporary control of certain fiscal instruments to the Bank".[154]

55. The reaction to this policy suggestion was not positive. Professor Congdon disagreed with the notion of handing elements of fiscal policy to the Bank, telling us he was "strongly opposed to reactivating fiscal policy and I think that there are very fundamental disputes about what causes the economy to move". He went on to say "Monetary policy is the effective instrument and recognising that has been crucial to the success of the MPC".[155] Professor Muscatelli did not agree with the policy proposal of allocating certain fiscal measures to the Bank on the grounds that that he was worried about the "democratic deficit" created by such a move. He thought closer cooperation between the Bank and the Treasury ought to be the answer.[156]

56. When asked whether the Bank ought to be given control of fiscal policy instruments, Lord George replied:

I certainly would not want to put the bank in the position of managing fiscal policy as well because the considerations go way beyond economics. They have to balance social as well as economic concerns and that is the job of elected politicians. It is not a technical job like that of the Bank of England, so one must have much more input into that.[157]

He highlighted the lack of a democratic deficit for such a move, telling us the Bank "should certainly not be able to veto decisions or insist that politicians behave in a certain way. I should like to point out that we live in a democracy."[158] We see no merit in the case for the Bank of England being given control of any elements of fiscal policy, which should properly remain the province of elected politicians accountable to the House of Commons.

97   Section 12, Bank of England Act 1998 Back

98   Section 2A, Federal Reserve Act 1913, as amended Back

99   Q 370 Back

100   Q 372 Back

101   Q 410 Back

102   Ibid. Back

103   Q 439 Back

104   Section 12, Bank of England Act 1998 Back

105   Bank of Canada press release, 23 November 2006 Back

106   Q 78 Back

107   Q 131 Back

108   Q 132 Back

109   Q 133 Back

110   Q 200 Back

111   Q 289 Back

112   Q 444 Back

113   Ev 65 Back

114   Q 25 Back

115   Q 374 Back

116   Q 26 Back

117   Q 146 Back

118   Q 129 Back

119   Ibid. Back

120   Remit letter from the Chancellor of the Exchequer to the Governor of the Bank of England, 10 December 2003 Back

121   Q 357 Back

122   Q 23 Back

123   Q 360 Back

124   Q 145 Back

125   Oral evidence to the House of Lords Economic Affairs Committee, 31 October 2006, by the Governor of the Bank of England, Qq 15-16 Back

126   Q 24 Back

127   Q 171 Back

128   Qq 171-172 Back

129   Q 361 Back

130   Q 22 Back

131   Q 21 Back

132   Q 24 Back

133   Q 144 Back

134   Ibid. Back

135   Q 72 Back

136   Q 73 Back

137   Q 112 Back

138   Q 115 Back

139   Q 144 Back

140   Q 434 Back

141   Ibid. Back

142   Q 446 Back

143   Q 11 Back

144   Q 64 Back

145   Ibid. Back

146   Q 125 Back

147   Q 366 Back

148   Q 367 Back

149   Q 368 Back

150   Q 249 Back

151   Ibid. Back

152   Q 11 Back

153   Q 27 Back

154   Q 30 Back

155   Ibid. Back

156   Q 28 Back

157   Q 121 Back

158   Q 125 Back

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