Select Committee on Treasury Minutes of Evidence

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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