Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 142-159)


20 MARCH 2007

  Q142 Chairman: Good morning and welcome to the second session this morning of our inquiry into the MPC ten years on. As with Lord George, we are privileged to have the benefit of your experience. We hope to finish at about half-past 11. We shall ask crisp questions and I am sure you will give very crisp answers to them. To what extent do you think that the record of the Bank of England and the MPC over the past 10 years has been the result of the institutional reform since 1997? I asked Lord George how much of a watershed it was.

  Ms Bell: Perhaps less 1997, but the overall inflation targeting framework has been a big contributor. One must remember that lots of developed economies have had similarly favourable experiences, though perhaps not as favourable as ours, because there has been a global consensus about the way to run macro-economic policy, in particular monetary policy. We have been part of that. Having said that, I think it would have been quite easy for the MPC to get it wrong at different stages and notably it has not. I think it is quite wrong to think that it has been plain sailing and there have not been any risks. There have been big structural changes in the world economy and the UK economy and also a considerable number of shocks. The MPC has dealt with that extremely well.

  Dr Julius: I would agree. It has certainly been a mixture of international factors and improvements in policies here and some pretty good judgments by the various people who have been on the committee.

  Dr Wadhwani: I would certainly endorse that. It has been a mixture, but I would not underestimate the significance of the change in 1997. What it did markedly was to bring down inflation expectations, as one sees in a variety of measures. It also gave one much greater confidence that inflation expectations would stay anchored. I believe that that has made a significant difference to the way in which the economy has responded to shocks. For example, it has made it much easier for the economy to handle the fluctuations in oil and commodity prices that we have seen. I believe that the anchoring has been very important.

  Q143  Chairman: Professor Goodhart, in your submission to us you mentioned that the stability of inflation since 1992, particularly since 1997, has been extraordinary in comparison with previous eras, but it could be taken for granted by the younger generation and maybe down the line the MPC will be blamed for things which it really should not be blamed for.

  Professor Goodhart: Absolutely. I believe there is great danger that because the past 15 years have been so incredibly stable people now think that if inflation varies by 0.3% in a month things are going wrong. One used to have variations of 1% or 2% a month quite regularly. The stability has been quite remarkable. I think that now people take it rather too much for granted. There could be occasions when there are greater shocks—other countries get into difficulties and all kinds of things could happen—and it might not be possible in future to repeat the stability of the past 10 to 15 years.

  Q144  Ms Keeble: How supportive is each of you of the CPI as a measure of inflation, especially in view of the fact that the RIP is used in wage bargaining? What do you think about the current discrepancies in the public debate between the public's perception of inflation and the measures which the MPC is using?

  Ms Bell: I do not think it matters so much what measure of inflation one takes. I think what matters is that it is consistent and credible, and to achieve that it should not change around too much. As long as it is fairly representative of the cost of living—perhaps one can argue about whether or not house prices should be included—I believe that it is fine and for statistical reasons CPI has superior properties. It would be nice if it included house prices. I do not believe that RPI itself is particularly useful—the previous target was not RPI but RPI excluding mortgage interest payments—because interest rates themselves should not be directly included in the targeted measure of inflation.

  Dr Julius: Of the measures currently available the CPI is the best one to target. There are advantages in having a geometric mean and various reasons why RPI would be the wrong measure to target because it includes mortgage interest rates. Having said that, one has to look at the practicalities of how one can include the impact on inflation of house prices. It is not a clean-cut exercise and that is part of the reason the European Commission has not so far succeeded in coming up with a way to do that. Unless a good way to do it can be found, I think it is better to leave the clean-cut measure—CPI—as we have it. When we were looking at RPIX, which includes a measure of house price inflation with the owner occupied equivalent of rental costs, it was not a very good element and it destabilised that particular measure. I add that in times like the present when commodity prices are quite volatile it is useful to look at a core measure. The MPC does not currently pay a lot of attention to core measures of CPI, but I think that that can also add knowledge about where inflation is going in future.

  Q145  Ms Keeble: I can see the point of having a fairly stable measure that is reliable as a statistical tool, but there is an issue about the public perception being completely out of kilter. You may think it does not matter whether or not the public thinks that the Government and MPC use credible measures. Nonetheless, there is a credibility issue especially when the use of interest rates can widen the perception because increases have a knock-on effect on mortgages.

  Dr Wadhwani: I wonder whether it is a matter of attempting to educate the public, because it is quite dangerous to endorse public views that they deserve wage rises in line with RPI. Ultimately, in an idealised labour market wages should be going up in line with what a competitive business can afford and that need not be RPI. In the specific instance where RPI is boosted by interest rate increases that may not be something that businesses can afford to pay. If in the labour market people insist on getting RPI-style wage increases they may just end up boosting unemployment. Therefore, it seems to me that it is our duty and, with the greatest respect, possibly your duty to help educate the public about this issue. I also strongly suspect that in periods when RPI is running below CPI—that was certainly part of my experience when I was on the committee—there was not much heat from the public about the issue.

  Q146  Ms Keeble: Do you believe there is any bias, particularly anti-inflationary bias, by the MPC despite the fact that the target is symmetrical?

  Professor Goodhart: There was certainly no bias of which I was ever aware. I think the reason why inflation came out at a tiny bit below target was essentially that we all expected the exchange rate to come down a bit. It rose enormously in 1997 and the general expectation was that it would decline slightly from then on, but it never happened. 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.

  Q147  Ms Keeble: Do you think that the interest rate should be the only tool used by the MPC, or should it have other tools at its disposal?

  Professor Goodhart: The central bank has other functions as well. It is concerned with financial stability and it has to consider what kinds of instruments it might want to use for that purpose. There is also a question of whether the central bank should ever intervene in the foreign exchange markets. You probably are aware of issues in France about what the ECB should do. The question of whether there should ever be intervention in the foreign exchange markets is a very lively one.

  Q148  Ms Keeble: I do not believe you agree that letter-writing is a form of sanction?

  Professor Goodhart: Certainly not. Letter-writing is usually an explanation of what has happened. The MPC is always trying to achieve the inflation target. Shocks are bound to occur from time to time and they will drive inflation up or below the limit. At that point the MPC must explain why it has happened and what it intends to do. It is a form of explanation, and it also gives the Chancellor a chance to reply so that if inflation has deviated from what the MPC is trying to achieve the Chancellor can say that it should try to return quicker or more slowly than the bank suggests in its letter.

  Q149  Ms Keeble: I was interested to hear Lord George say that he wished he had perhaps used it when inflation went too low. Do you believe that it is differently perceived?

  Professor Goodhart: My belief is that every central bank governor and most members of the MPC are looking forward to the first occasion of letter-writing. Obviously, they do not want a deviation from target to occur, but they are quite looking forward to getting this part of the institutional instrumentation in operation and showing how it ought to work.

  Q150  Ms Keeble: But it has not been used in 10 years and is seen almost as a tool of last resort.

  Professor Goodhart: It is not a tool of last resort. When the MPC was founded in 1997 the historical experience and expectations were that there would probably be about two or three letters written per year. The decline in the volatility of inflation over the past 10 years has been quite extraordinary. If one went back to the kind of normal variations in inflation that occurred in all historical experience one would certainly expect letters to be written fairly frequently. Stability has been so great that it is almost unimaginable. It was not imagined that there would be anything like this when the MPC was established in 1997.

  Q151  Chairman: Are there any other comments on  letter-writing to be added to Professor Goodhart's view?

  Ms Bell: I agree that it is not a sanction and should not be seen as such. It is definitely part of the communication process. I also agree it is disappointing that we have not had a letter yet. I wonder whether perhaps the bounds should be narrowed or the committee should start writing letters when they get towards the end of it just to make use of that communication tool.

  Dr Wadhwani: It would be dangerous if it was seen as a sanction. If it was seen as a sanction by the committee it would stop it doing the correct thing which is occasionally to allow inflation to stray outside and to bring it back only gradually.

  Q152  Mr Love: We are all pining for a letter, and maybe we will get it one day. I move on to the characteristics of a good external member. Who better to answer that question than former external members. Perhaps I may start with Professor Goodhart who in his submission wrote a detailed spec as to who should be external members. 2[2] Perhaps he would elaborate.

  Professor Goodhart: The MPC is a remarkable institution which is charged by Parliament and the Chancellor with the job of changing interest rates in such a way as to hit an inflation target. That is a technical requirement. Effectively, the specification ought to be that the person involved is capable of achieving within a reasonably short time the ability to make a sensible and informed choice.

  Q153  Mr Love: Do any of the witnesses believe that in trying to reach a balance of the external members there is a role for non-technical persons? You have had one such person on the committee.

  Dr Julius: With the current structure, particularly the central role of the forecast in the MPC process, it is quite difficult for a non-technical person to participate fully in that exercise. It depends exactly on how one defines "non-technical". I do not believe it means that one needs a huge amount of econometric model-building in order to be an MPC member. I note that one of the submissions suggests that at least one of the external members should have substantial experience in model creation.

  Q154  Mr Love: What is your view of that?

  Dr Julius: My view is that certainly one or more should have real experience in using and interpreting forecasting models of the economy. I am not persuaded that experience of building models is required, but every external and internal member needs to be professionally competent in interpreting models, asking the right questions about them and so forth. Without that the internal functioning of the MPC process and communication of the output is compromised.

  Q155  Mr Love: Dr Wadhwani, Professor Goodhart says that it can take six months for the non-specialist to become comfortable with the forecasting procedures. The outside experts said to us that in order to keep the bank on its toes at least one member needed to be thoroughly acquainted with it. Do you support that view?

  Dr Wadhwani: Yes. It certainly takes time to adjust to the model and to be on the committee. That is why I now feel that terms should be longer; instead of three years perhaps the term should be five or six years. Members should be given the option of perhaps serving a somewhat shorter term, but certainly should be encouraged to serve a longer term.

  Q156  Mr Love: I want to come to that. I hope to seek a consensus among the four of you. First, for how long do you think members should be appointed? Should members be eligible for reappointment? There seems to be a broad consensus developing.

  Ms Bell: If I may comment on the external member who is a modeller, I am not sure there is a need for somebody who is able to be hands on and run his or her own model, because the external members do not work as a block, or should not do so; they should all be there as individuals. I am not sure one gains anything by having one person who can go through the nuts and bolts of the model. What one needs is that all the members understand the broad properties of the model and how it is put together and can hold the bank to account. There is plenty of technical expertise within the bank.

  Q157  Mr Love: You appear to suggest in your evidence that four years without reappointment is the correct way to go forward.

  Ms Bell: I agree that perhaps terms should be a little longer. I also think there should not be reappointment. The suggestion of four years arose because with four external members one would have a very neat roll over. We had a problem a few years ago when there were big internal changes going on at the bank and two external members came to the end of their term at the same time. I think that potentially it causes difficulties. Were we to have a committee with five external members and four internal members perhaps we would have rolling five-year terms.

  Dr Julius: Reading everyone's evidence, it seemed to me that most if not all of the former members of the MPC felt that there should be longer periods and more protection for the independence of external members. There was a difference in terms of length of appointment. My own view is that a three-year term is quite a good length for the first time and a second term should be permitted if both sides feel it is appropriate, but that the six-year total limit should be applied to both internal and external members so there would be an equality of historical experience and continuity on the committee. The reason I am not in favour of a single five or six-year term is that it has two disadvantages. One is that it may well be somebody is appointed who is not really competent for the job, and to be stuck with that person, as it were, for five or six years is not particularly helpful. In the public or private sector often one does not know that. Someone can look very good on paper and do very well at interview and in the job it just does not work out. I think there is a risk in having a long-term appointment like that. The second issue is that if it is an appropriate, good person a five or six-year appointment is quite a long commitment to a rather cloistered job that may be out of the mainstream of the individual's own career path, particularly if he or she is not from academia and comes from the private sector or financial markets. Although that person could resign, say, four years into a six-year term it would be something of a political issue; it would be in the newspapers and there would need to be a good reason. It might be difficult to attract that sort of person to a job for which the term was, say, six years.

  Q158  Mr Love: Professor Goodhart, you talked of the possible danger that internal Bank members could become subject to "group-think".[3] Do you think there are any dangers of a herd mentality among external members; if so, how would you guard against it? How do you ensure that all the external members do not think similarly?

  Professor Goodhart: They certainly have never had a herd mentality.

  Q159  Mr Love: That is reassuring.

  Professor Goodhart: One of my colleagues, Willem Buiter, was particularly individualistic. How do you guard against group think? I would encourage some of the externals to keep a foot outside the Bank. The kinds of people who would be appointed are at a sufficiently mature stage of their careers that they are unlikely to be subject to excessive pressure. I do not believe that this is likely to be a danger, and there certainly never has been any kind of danger.

2   Ev 15-19 Back

3   Ev 15-19 Back

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