Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

PROFESSOR ANTON MUSCATELLI, PROFESSOR SIMON WREN-LEWIS, MR RAY BARRELL AND PROFESSOR TIM CONGDON CBE

6 MARCH 2007

  Q20  Ms Keeble: Ray, what do you think about that?

  Mr Barrell: I think you can see that in the discussion on which index we should be using is an indication of the success—

  Q21  Ms Keeble: I am sorry, I cannot hear you.

  Mr Barrell: Even discussing which index we should use is an indication of the success that we have had, because the indices all tend to move together in the medium term. Consumer prices, retail prices, producer prices—there are reasons why they might move apart which we can understand but they all tend to move within 2% or 3% or so together and therefore any of them will actually do, and in 1992 anything would have done when we had inflation running at 10%. Stabilising anything would have been a good idea. One could argue that perhaps we should either include more things in the CPI (but that has got to be a Europe-wide decision because we use a common index) or we should move to a producer price index, which is harder than it might look to get more exact control over inflation. I think those are secondary issues and we have to stabilise something. The CPI will do; the CPI as measured will do, as long as we know what is missing from it and what the problems are with it.

  Q22  Ms Keeble: The question was about credibility. Obviously what Professor Congdon referred to as the debate about inflation has been missing for quite some time and it is around the current public sector pay rises. Do you think that it remains credible for the MPC to retain a very rigid definition of inflation at a time when there is divergence in the public debate and when there is pressure to look at perhaps including house prices, one of the effects to which Ray referred. Professor Congdon, I know you think that it is not the MPC's job to worry about these things but there is obviously an issue about the public perception of inflation.

  Professor Congdon: As far as one can tell, there has been some deterioration (or some rise at any rate) in pay settlements, but it is not that dramatic, in fact rather less than one might have expected given that the Retail Price Index has gone over 4%. I do not think house prices should be included in a large way in any measure of goods price inflation. They do come in in various ways in the indices and I have not much to add, frankly. The present situation is very interesting. May I just make one point, and it may seem slightly political? In my view there is a link between money growth and asset prices and that then affects the incomes of people involved in   trading assets—stockbrokers and chartered surveyors and people like that—and at the moment they are doing very well. Then you have got public sector workers being told they are going to get 1.9%. This is a classic situation where you get trouble. There have been many cycles like this in the past.

  Q23  Ms Keeble: Ray, is there not a slight problem of "ivory tower-ishness" if this definition of inflation is far adrift from the public perception?

  Mr Barrell: I think public perception is not always the thing that really matters in pay bargaining. Outside the public sector one can go along and say, "I want RPI as my wage increase," and the employer has to say whether he can afford it or not. That is a wage bargain. Inside the public sector there is also a bargain and the public sector employee can go along and say, "I want RPI," and the Chancellor's response might well be to say, "The public sector has been expanding; I want it to stop expanding and in order for it to do that, my side of the bargain is not to give you RPI." Pay bargaining is not just about fairness; it is about demand and supply in the market, and it is demand and supply in the market which will determine wages.

  Q24  Ms Keeble: I know that the other people wish to say something. Professor Muscatelli, you said in your evidence that you thought one potential inflation target measure was domestic output price inflation. I wondered if you wanted to say some more about that.

  Professor Muscatelli: Essentially one of the arguments there is that there is a feedback effect from the exchange rate on to consumer prices and essentially by focusing on the domestic price index you can avoid some of these issues. In the written evidence that Professor Wren-Lewis provided, [1]he expands on that quite a bit. The other point I would add just to follow up on the discussion which I think is important is I think CPI is a narrow index. Obviously if housing costs can be incorporated that would be a positive step although, as Ray said, it has to be done at European level. If that does not happen, I think it could ultimately have an impact on the credibility of monetary policy. Going back to what we were discussing earlier about anchoring expectations, if you start targeting an index which is a million miles from what people perceive to be the inflation they are experiencing, then I think (especially at a time when inflation is higher) that can have a big impact on expectations. I think there is an issue there to confront in the medium term—if not now then quite soon—in terms of incorporating at least housing costs into CPI.

  Professor Wren-Lewis: I just want to make three points. The first is I think the Bank of England has to stick to one index for a long period of time. It cannot keep changing the index that it is targeting because that would destroy credibility. That is the first thing to say. Secondly, however, it is wrong to believe there is one right index or price inflation measure to look at. I think the Bank should be looking at a range of price indices, not just consumer prices but also producer price indices and also wage inflation, so I think it needs to be looking at all of those and if it is the case that the CPI inflation is an outlier and all these others are rising then I think it should act. That is the second thing I want to say. The third thing is I am 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. I think that is an interesting debate to have and it is not obvious which way the answer would come.

  Q25  Ms Keeble: I just have one further question for Professor Muscatelli. You suggested that there may be evidence that although the target is symmetrical there is an anti-inflationary bias and I wonder if you could say a little bit more about that.

  Professor Muscatelli: Essentially I cited some work which we had done to look at the extent to which the Bank had reacted symmetrically to deviations of output from trend and of inflation from the inflation target. We seemed to find some evidence, certainly from 1997, that there seemed to be some bias towards being more cautious, if you like, on inflation control. [2]However, that is subject to the same caveats which a number of commentators have made, which is that there is a limited span of data, all of this conditional on the economic models. I think the evidence we have produced is intriguing because it might suggest that as the Bank was trying to build up its credibility it might have been quite cautious and therefore inflation stayed below its target but you cannot be 100% sure for the reasons that we were discussing earlier about the uncertainty of macroeconomic models.

  Q26 Ms Keeble: Is that not just historical experience that is telling people to be cautious?

  Professor Muscatelli: The historical data seems to tell us that they were being cautious.

  Professor Congdon: Can I just say something? I think the Bank was very surprised at that time by how strong the exchange rate was. They were surprised by that and that is what kept inflation lower than expected. I think that is fair.

  Q27  Jim Cousins: Professor Wren-Lewis, You have argued in favour of giving the Bank control over short-term fiscal instruments to achieve stabilisation. Could you give the Committee some idea of what sort of instruments you had in mind and in what sort of circumstances they would be used?

  Professor Wren-Lewis: Thank you, yes, I have for a number of years argued that certainly the question of whether the Bank should be given additional instruments is something that should be looked at. This is an issue for the long term. I am not suggesting that this is something that should happen overnight, but I think it is something that should be considered. The essential argument is that we have been through quite a benign period where moving interest rates around seems to have been enough and has not caused serious difficulties but there may well come a time when the Bank would like another instrument to do its job effectively, and particular tax instruments could be appropriate in certain circumstances. So one might think about the VAT rate for example or perhaps some instrument particularly targeted on the housing sector. If you believe that a serious problem—a shock to the housing sector—and using interest rates to deal with this is rather difficult, then you might think about having an instrument that is more targeted to that sector. This is something, in a sense, to think about in the long term and one would certainly want to do a lot of research on what the best instruments to be used were and whether they could be moved in a quick fashion, etc. I think this is something for long-term discussion about how things might move on.

  Q28  Jim Cousins: Clearly the rest of the people do want to comment.

  Professor Muscatelli: I would disagree with that approach, I have to say. I worry a bit about the democratic deficit issue here because it is one thing to argue that interest rates should be under the control of the Bank because ultimately it is affecting a variable which everybody agrees should come under control, which is inflation; it is another to give taxation control to an unelected body. I think there may be ways however to try and tackle this issue of co-ordination. I do not disagree that that is an issue. I think there may be an issue of co-ordination at a time when in more turbulent macroeconomic times than at present when there is simply an observer of the Treasury in the Bank, there is very close communication on what the Budget implications are for fiscal policy, but there may need to be closer liaison between the Bank of England and the Government of the day if there is more of a disjuncture between fiscal and monetary policy, but I do not think handing fiscal policy to the Bank is the answer.

  Q29  Jim Cousins: Should that liaison be transparent?

  Professor Muscatelli: My intuitive answer is yes but it would be interesting to do some research on it.

  Professor Congdon: This is where the doctrinal disputes really become quite—In effect, what has happened in the last 10 or 15 years—

  Q30  Jim Cousins: —You did not say what doctrinal disputes became.

  Professor Congdon: I will elaborate. In the last 10 or 15 years macro policy has in effect become monetary policy. This is why we are having a discussion about the performance of the MPC in its first 10 years. For heaven's sake, we did not have the MPC in the 1940s, 1950s, 1960s or 1970s because that was not the way macro policy was conducted and, as Professor Muscatelli has said, you cannot have the Bank of England deciding fiscal policy. What has made this framework possible is the neutralisation of fiscal policy by the medium-term rules, which goes back in a way to the late 1970s but actually to the early 1980s. I think that has been a good thing. Then we get Professor Wren-Lewis saying that we should bring fiscal policy back. I do not deny fiscal policy can have some short-run effects on the economy. I am however strongly opposed to reactivating fiscal policy and I think that there are very fundamental disputes about what causes the economy to move. Can I just try and explain where I am coming from? I believe that in the long run there is a link between money, asset prices and goods prices, so when the quantity of money rises by 1% so also does equilibrium wealth. Since wealth is about £6 trillion, this means wealth rises by £60 billion and when money rises by 5% wealth rises by £300 billion. Some of that is consumed, which affects behaviour. That is far more powerful than anything fiscal policy can do. Monetary policy is the effective instrument and recognising that has been crucial to the success of the MPC. This is where you get to the really big doctrinal debates, because obviously my colleagues do not agree with me.

  Professor Wren-Lewis: No I agree with you 100% that the interest rate is the instrument, but 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. That is all I was suggesting.

  Chairman: I think we will have the Bank of England Governor standing as an MP so that he is down in the House of Commons explaining why he is doing all these things. How about that?

  Jim Cousins: I think he should stand on a list and be elected for 15 years.

  John Thurso: Hear, hear.

  Q31  Jim Cousins: Professor Congdon, in your evidence you have lots of nice things to say about our opposite numbers in the House of Lords and one of the things they say on this very point is that "from time to time monetary policy would have to respond to fiscal policy", paragraph 25 of their report, and they are concerned about what they see as the consistently overoptimistic GDP growth forecasts and over-estimates of tax revenue and under-estimates of the budget deficit and borrowing requirements. Despite that, you see no attraction in either the Bank of England having access to fiscal instruments or perhaps some kind of tax equivalent of the Bank of England?

  Professor Congdon: There has been no fiscal policy in the Keynesian sense in the last 25 years and you could not have the present framework of policy if that were to be restored. That is not to say that what happens to the budget deficit is not relevant to monetary policy. As I said in my own evidence, if there is a large budget deficit which is monetised then that is very important. What I also said in my evidence was that it may be the case that at some future date debt management should again become part of what the Bank of England does—and by the way the Bank was responsible for that until 1997. They had discussions with the Treasury about it, but the responsibility for debt management really lay with the Bank of England, and that is again a subject that the Committee could think about. In my view, debt management policy is part of monetary policy and it should be considered as part of monetary policy, but again one could discuss that.

  Q32  Jim Cousins: Professor Wren-Lewis, to go back to you, in your evidence to the Committee you were arguing in favour of an inflation target that was a "soft target",[3] perhaps to take account of some of the very points that Professor Muscatelli was saying earlier, that people's experience of inflation is not homogenous and different parts of society have their own very different inflation rates. Perhaps you would care to put that point to the Committee.

  Professor Wren-Lewis: I think in a sense it relates to an answer already given and that is if you found that CPI inflation was on target but wage inflation was substantially above target, RPI was above target, producer price inflation was above target, I think then you would want to raise interest rates. In a sense, that is why I think it should be a soft target because you should be looking at other measures of inflation rather than just CPI, and the circumstance I have just given is when you would want to depart from your target.

  Q33  Jim Cousins: Can I ask Professor Wren-Lewis's colleagues whether you would perhaps regard that as muddying the waters?

  Professor Congdon: I rather agree with Professor Wren-Lewis on that. The puzzle—and this is in a way whether it has been benign circumstances or whether it has been policy—is that the last 10 or 15 years has been an extraordinary period because one would have expected far more divergences between the RPI, the CPI, and wages and asset prices than we have seen for most of this period. Obviously at the moment we are getting a bit of a problem with the gap between house prices and consumer prices but it has been an extraordinary period. I would rather agree with you; I think one should not expect this incredible period of over 15 years, basically staying within 2% or 3%, to continue. These years have been extraordinary, really.

  Q34  Angela Eagle: I was just wondering, Professor Wren-Lewis, how on earth you could come to the thought that we should hand over taxation policy to non-elected people without effectively abolishing our democracy? Would you feel happy if your VAT rate went up or down that it was a non-elected person at the Bank of England doing it? Why would you bother voting in general elections if you did that?

  Professor Wren-Lewis: First of all, the Bank does change interest rates, which has a very big effect on a large number of people.

  Q35  Angela Eagle: Within a parameter set by an elected body. It is not a tax rate, though, is it?

  Professor Wren-Lewis: My proposal would be if power was delegated to the Bank of England it would be to change just a few taxes on a temporary basis.

  Q36  Angela Eagle: VAT is a fairly big tax instrument for most people.

  Professor Wren-Lewis: I did not say unimportant, I said a few tax instruments on a temporary basis within set limits, so in that sense it is not very different in terms of the impact on people to changing interest rates.

  Q37  Angela Eagle: So you are one of those people who thinks that fiscal policy should somehow be made independent as well as monetary policy, are you?

  Professor Wren-Lewis: No, I do not actually think that. I think that it is very important that tax rates in the long run are set by a democratically elected government; absolutely I do.

  Q38  Angela Eagle: That is good to hear.

  Professor Wren-Lewis: That is why I very carefully specified that only changing these instruments on a temporary basis should be something that the Bank should be allowed to do within set elements as a way of stabilising the economy.

  Angela Eagle: VAT rates do not go up and down very often though, do they? They tend to go up and stay up.

  Chairman: I think one of your students could get a good PhD in that and then you can come back to us with the findings. Mark?

  Q39  Mr Todd: Can we turn to the MPC as a body and how it works. First, briefly, is it too large? By the silence I take it no, you are happy that it is about right. Professor Wren-Lewis, you have commented flatteringly on the model that the Bank of England uses and suggested that at least one external member of the MPC should have a working knowledge of the model. Are there people available who have that knowledge because I think you later go on to discuss the transparency of the model and its replication outside the Bank, which would suggest that that skill may be extremely rare?

  Professor Wren-Lewis: What I actually suggest is that there should be one external member of the MPC who is familiar with the kind of model that the Bank operates. Obviously they do not need to have knowledge of the particular Bank model before they get appointed because if they know the kind of model that the Bank is using then it is quite quick to be able to look at the particular model the Bank is using and understand it. I think it is very important that there should be someone on the MPC who essentially is involved in producing and using the kinds of models which the Bank's current model is a class of.


1   1 Ev 37-43 Back

2   Ev 64-66 Back

3   Ev 42 Back


 
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