Memorandum submitted by Professor Sheila
Dow, University of Stirling
1. The February Inflation Report
provided crucial insight into the thinking of the MPC at a time
when markets had been taken by surprise by the rise in repo rate
in January. This was all the more surprising since changes tend
to occur more in Inflation Report months, when the MPC
has completed and made public a thorough updating of information
and analysis. Uncertainty was also fuelled by the unusual extent
of division of opinion within the MPC (the vote for a rise being
5 to 4). There had been speculation that there would be a further
rise in February, which in fact did not take place. The Inflation
Report appeared ahead of the Minutes which explained that
decision.
2. It seems that it was pivotal to the decision
to raise the rate in January that increases in wage settlements
be discouraged which might make it more difficult to achieve the
inflation target. The channel for monetary policy was thus to
directly affect expectations. The concern was that rising retail
price inflation might "dislodge inflation expectations"
(p 10), and indeed the Bank of England stated explicitly in its
evidence to the Treasury Committee Review that "Inflation
expectations are therefore central in determining inflation today.
Indeed, the most potent effect of monetary policy is not so much
through the consequences of individual monthly interest rate decisions,
but rather through the ability of the policy framework to condition
those expectations" (Evidence, page 3). As well as
conditioning financial market expectations, there is a concern
with the influence of inflation expectations on wage bargaining,
but also directly on price setting itself (such that expectations
of rising inflation could be self-fulfilling). To influence expectations
by a deliberate surprise move on monetary policy is itself surprising,
given the emphasis in recent years on influencing expectations
by means of analysis, such that any rate change is expected. Having
judged the January increase to have had the desired shock effect
(nothing fundamental having changed in the meantime) the decision
was taken to keep rates on hold in February.
3. In light of this emphasis on expectations
as the primary mechanism of monetary policy, it is interesting
that it should be repeated through the Inflation Report
that "in the medium-to-long-run, inflation is determined
by monetary policy". The MPC's record on inflation targeting
over the last 10 years has certainly been good. It is nevertheless
a strong statement, that monetary policy determines inflation.
The statement reflects much of the particular theory behind inflation
targeting by an independent central bank, and the credibility
of monetary policy. But there are other views which suggest that,
while monetary policy is an important influence on inflation (through
its effects on effective demand, borrowing costs and inflation
expectations), it cannot fully determine inflation. Indeed the
Governor has been very open in speeches about the uncertainties
faced by the MPC in forming monetary policy, and the difficulties
in controlling inflation. Indeed it was further stated in the
Bank's evidence to the Treasury Committee Review of the MPC that
"there remain important unanswered questions about how expectations
are formed and how credibility is gained and lost" (Evidence,
page 4). It is not clear how consistent this is with the confident
statements about inflation being controlled in the medium-to-long-run.
One operative point is whether the medium-to-long-run is a notional
time-frame within which inflation would be controlled, if nothing
else changed, or whether it refers to real time, when other things
do keep changing. Another is that, if the theoretical framework
behind monetary policy is that it is designed to correct deviations
from a long-term norm (particularly specified in terms of a natural
real rate of interest), then uncertainty as to how to correct
those deviations within a two-year time horizon may be material
to whether any long-term norm is reached.
4. One of the arguments framed in the long
term is the monetarist argument that there is a strong correlation
between monetary aggregates and inflation in the long term. The
MPC has joined in the recent revival of interest in monetary aggregates.
But the argument is repeated here (p 14) that growth in M4 in
the UK is driven by money holdings of non-bank financial companies.
It is important to note that the big rise in liquidity is not
being held by households and firms, which monetarist theory would
predict to spill over directly into expenditure. It is explained
(p 4) why it is difficult to predict the effect of this rise in
liquidity on inflation—it is possible for this liquidity
to remain within the financial sector, rather than financing expenditure.
Lending to these companies has also been increasing very rapidly
so one interpretation is that, among other things, the sector
has been seeking more liquidity, financed by borrowing which could
be unwound when conditions change, with no consequence for inflation.
On the other hand, if the purpose of the liquidity is to purchase
financial assets when conditions look more favourable, then the
consequent rise in asset prices could encourage consumption expenditure
through the wealth effect. The rise in liquidity may or may not
lead to inflationary pressures.
5. There is a special analysis of asset
prices on pages 12-3, which explains why the effect of rising
asset prices itself is difficult to predict. The scale of the
increase is illustrated by the statement that the growth in global
equity values over the last four years has been twice that of
global GDP. But it is explained that the likely consequences for
inflation are unclear. The rise in equity prices could have little
effect on inflation if it reflects a warranted decline in risk
premia, it could increase inflation if it is due to high levels
of liquidity (interpreted as upward pressure on demand), or decrease
it if equity values are due for a correction. (The latter if anything
appears the more likely, given the instability in stock markets
subsequent to the Report.)
6. Given the centrality of expectations,
the Report seems surprisingly sanguine about the upturn
in inflation expectations shown in Chart 4.3 (from the two surveys
which ask for responses in terms of expected rates of inflation).
Also worrying is the rise in RPI, which is often employed in wage
bargaining. Like CPI, it fell back in January, but was still running
at 4.2%, and the latest figures show an increase to 4.6% in February
(compared to only a slight increase in CPI inflation to 2.8%).
These headline rates are important if they form the basis for
wage negotiations and for firms estimating future input costs.
However, the monthly changes in inflation statistics should be
treated with caution. Since they measure the percentage increase
in the index from the same month one year back, the change in
the annual rate from one month to the next is affected not only
by how prices changed over the last month, but also by how they
changed between the corresponding months one year earlier. For
example CPI inflation is 2.8% for February compared to 2.0% a
year earlier, yet the increase in the index during February was
only slightly higher than the increase during February 2006. The
annual rate is sensitive to the new month being picked up as well
as the old month being dropped from the calculation. We may well
see a significant drop in the annual rate in April, for example,
simply since there was such a jump in the index in March of last
year.
7. In conclusion, expectations, according
to the MPC, are key to monetary policy. Yet the MPC itself faces
uncertainty on a range of issues feeding into their forecasts.
They conclude that "there was considerable uncertainty about
the path of inflation, both in the nearer term and further ahead"
(p 47). And further we have discussed above important issues,
at a variety of levels, which agents themselves face in forming
expectations: these concern in turn statistical representation,
the institutional arrangements of wage bargaining, and the perception
of actual inflation experience.
March 2007
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