Select Committee on Monetary Policy Committee of the Bank of England First Report


41.  This chapter looks at how the MPC implements monetary policy, and assesses how successful it has been in achieving the objectives it has been set. We begin by looking at the inflation target. We then discuss the time-scale for monetary policy and the inflation forecasts.

The 2.5 per cent symmetric target

42.  As noted in Chapter 2, although not stated explicitly in the Bank of England Act, the Bank's inflation remit has been implemented in the form of a symmetric inflation target: inflation within one percentage point either side of a central target of 2.5 per cent. The symmetry is in order to avoid a too conservative monetary policy. In practice, the Bank of England has more often undershot the 2.5 per cent target than overshot it, whilst its inflation forecast has tended in the last two years to exceed the target. We probed with MPC members and other witnesses whether the MPC was in fact operating a symmetrical target or whether they were indeed happier, as it might appear, to undershoot rather than overshoot.

43.  The members of the MPC confirmed that the target was symmetrical. Professor Charles Goodhart told us "we have consistently remained symmetrical about trying to achieve, over the horizon to which we give most weight, that it should be exactly 2.5, neither an iota above, if we can help it nor an iota below" (Q 13). Mervyn King spoke of "the importance of the symmetric nature of the inflation target" and said that, while there were always shocks which moved the committee away from the target, they were always trying to get back onto the target (Q 151). The Governor said that it was the tendency of all nine individuals to "recognise the fact that the target is symmetrical" (Q 152). Professor Stephen Nickell thought that the "symmetry of our remit is incredibly important", not least because it facilitated explanation of why interest rates were lowered. The symmetry provided a clear way of focussing on the work of the MPC. Mervyn King added that adopting an inflation target ensured the remit was absolutely clear both internally and to the world and to the financial market and was a helpful tool in explaining what the MPC was trying to do and thus gaining credibility (QQ 747—8).

44.  For the Treasury, Sir Andrew Turnbull and Ed Balls confirmed that the target was a point objective of 2.5 per cent. Ed Balls was quite clear that although the Governor is required to write to the Chancellor if inflation goes above 3.5 per cent or below 1.5 per cent, "this does not define a range" for inflation (Q 355). Ed Balls suggested that it was an important consequence of the symmetric target that deviations below the target were taken just as seriously as those above. This would have the effect of removing deflationary bias from the MPC's decisions and consequently encouraging a longer-term view (Q 283). The Chancellor told us that avoiding inflation significantly below the target was a sign of commitment to growth (Q 1188). Governor Brash too thought "there is a great deal of merit" in having any central bank as keen to avoid deflation as inflation (Q 419). As already noted, Paul Ormerod expressed a preference for just having a range for inflation, from zero to four or five per cent and ignoring month by month fluctuations (Q 707). He was, however, alone in this.

45.  In practice, inflation has more often been below the target than above it. If symmetry is important, and the aim is to hit the target, the fact that in practice the outcome appears to be a downwards bias needs further investigation. There appear to be two possibilities: either the MPC is in fact operating an asymmetric target, or the undershoot is due to circumstances outside the control of the MPC. We accept that, as the MPC members themselves have told us, they are working on a symmetric target. We also accept the Bank of England's explanation that this has been because of a need to deal with a number of transitory effects, of which we consider a prime example to be the fact, as pointed out to us by Gus O'Donnell, that the exchange rate has been firmer than the Bank had forecast (Q 359). A symmetric target in our view not only allows the MPC stability in its operations but also, as suggested by the Bank of England Commission encourages transparency, by giving the MPC an unambiguous goal; and supports accountability by requiring an explanation from the Committee if inflation strays too far from the target[26]. We accordingly recommend further study, perhaps by the new Economic Affairs Committee, of why inflation has more often been below the target than above it. Such investigation could also examine in detail the reasons why the MPC has been so successful in keeping inflation down; whether there are lessons to be learned in case economic conditions change for the worse in the future; and whether there are any issues of significance arising from the transmission mechanism. Such a study could also examine how the MPC takes account of the Government's wider economic policy (including whether the "subject to that" proviso in section 11 of the Act in fact has any significance).

The Time-scale for Inflation Control and the Inflation/Output Trade-off

46.  The remit is to hit the inflation target always, and there is an obligation to stay within one percentage point of the central target in the sense that, if the end points are breached, a letter must be written to explain why. Nevertheless, differences in how to interpret the remit of the MPC have emerged amongst its members. Some, including the Governor, interpret it as meaning that inflation should always be within one percentage point of the 2.5 per cent target and that a letter to the Chancellor is required if it is not. Other members of the MPC, noting that it takes about two years for changes in interest rates to be fully transmitted to inflation, interpret the remit as aiming to control inflation over a horizon of two years. We say more on forecasting in Chapter 5.

47.  Gus O'Donnell said that the use of the two-year period did not mean that a change in interest rates now would mean that in two years time "boom-something happens": the position could better be described as "when we change an interest rate we know on average over the past the path that has had to affecting inflation and we then tend to look at the effect coming through all of it by about the end of two years" (Q 290). Governor Brash said that no one could be very confident in looking two years ahead, as anything could happen, but there was no alternative to proceeding in such a way (QQ 428—9). Mervyn King told us that a demand shock would tend to push inflation and output growth up in the same direction, whereas a supply shock would push them in different directions. The two-year horizon was therefore important to allow the MPC to look ahead and see if short-term inflation would go away (Q 822).

48.  The point to be emphasised here is that a lot can happen in a two-year horizon. For example, in the next two years, an election is unavoidable. The outcome and consequences of this are something that markets will try to anticipate and evaluate. It is also possible that, two years from the publication of this report, a referendum on the United Kingdom joining the euro may have been held or be about to be held. It follows that unless short-term interest rates and inflation converge to euro levels, the possibility of the United Kingdom joining the euro would have an effect on the MPC's decisions over that two-year period. However, the CBI told us they do not see any need to change the 2.5 per cent target against the possibility of euro entry (Q 255). The Governor told us that the MPC would not speculate on the possibility of euro entry although the MPC would have to take into account market developments arising from, for example, people's expectations of the exchange rate (QQ 1330—1335). The possibility of joining would be treated like any other short-term external shock (QQ 1358—9).

49.  This is not a report about the euro and we are not intending to comment further on this possibility. We do, however, draw it to the attention of our successor Committee. The question of how the behaviour of the economy will change after the general election, should a party committed to a referendum on joining the euro win, will be a significant one for our successor Committee to consider over the coming years. The reaction in the markets and market speculation to the various possibilities will also be of importance. We note the possibility of serious effects should the markets begin to anticipate that the UK will join the euro.

50.  Another very important point that arises from the time-scale for inflation control is often ignored. Despite the requirement of the Bank of England Act that, subject to achieving the inflation target, monetary policy should support Government policy on growth and employment, we have already noted that there is little scope for the Bank to do this. We cannot discern any examples where this has so far occurred. One way in which the Bank could do so, however, relates to the letter it must write to the Chancellor when inflation is more than one percentage point from the central 2.5 per cent target. If a shock occurs to inflation that is forecast to breach the limits, the Bank may have a choice to make. It could attempt to keep inflation close to the target no matter how large the required change in interest rates, and no matter how much that might affect growth and employment. Or, on the grounds that the cost in terms of growth and employment would be too high, it could choose to send the letter. In effect, therefore, the shocks to inflation would be passed on to other variables so that they do not affect inflation. So far this situation has not arisen, but there is a non-negligible chance that it could. The Bank's remit is not clear on what the Bank's decision should be in such a case.

51.  The situation is further exacerbated by the dynamics of the transmission mechanism of monetary policy which take time to work themselves out fully. Initially the impact of a change in interest rates on inflation is small, and it is generally assumed that it takes about two years for the virtually full effect to be transmitted. As a result of the effect on inflation of changes in interest rates being so small in the short term, the interest rate change might need to be all the larger to keep inflation very closely on track. Moreover, as shown in our previous Report, it would be mainly the exchange rate channel through which the interest rate change would initially work. This is because the exchange rate, being an asset-price, is very volatile. In the first instance, therefore, the impact of anti-inflation policy would fall much more on tradeable goods sectors of the economy than other sectors.

52.  It remains unclear whether all members of the MPC believe that it is possible or desirable to try to keep inflation within the symmetric target it has been given. Further, although, as the Chancellor says and is widely agreed by witnesses, there may not be a long-run trade-off between inflation and output, our conclusion is that keeping strict control over inflation at all times is likely to create a short-term trade-off. We also note that, if it takes time for interest rates to affect inflation, any letter to the Chancellor might be better sent in anticipation of breach of the limits, instead of after the event.

What is the Appropriate Index to Measure Inflation?

53.  In our previous report, we analysed at some length various indices used to measure inflation[27]. The MPC targets RPIX, which is the rate of retail price inflation excluding mortgage interest payments. Several other central banks that conduct monetary policy by targeting inflation use a similar measure, but many use a different target. While there is general agreement that it is desirable to stabilise a broad measure of inflation, such as consumer prices, the differences between central banks arise largely from the components that were excluded from this measure and to a lesser degree the method of construction of the index.

54.  There are a number of reasons why certain components might be excluded from the measure, even though it is generally agreed that a broad measure should in fact be used. RPIX, for example, excludes interest rate payments as it is agreed that the measure of inflation should not itself be directly affected by changes in the monetary policy instrument. Excluding the direct effects of interest rate decisions also means that the MPC does not itself have to assess how much of the change of inflation is in fact due to its own actions in changing interest rates. It could, however, also be argued that excluding mortgage interest payments, for example, gives a distorted cost of living, given the large part that such payments play in many household budgets. Furthermore, the argument for excluding mortgage interest payments equally applies to other interest payments, such as credit cards. A case could also be made for excluding the direct inflationary impact of other Government measures such higher indirect or consumption taxes. These are in fact excluded from the index RPIY.

55.  The Bank of England's Annual Inflation Report charts the behaviour of inflation as measured by three indices (RPI, RPIX and RPIY) and these are often very different. In any broad measure of inflation, the individual components are likely to behave differently from each other, which can make interpretation of broad measures problematic and complicate the MPC's choice of interest rates. This is because many individual items may move in opposite directions or have different volatilities. Some components will vary differently over different time—scales (for example food prices are more volatile in the short term than household goods prices) and these variations have important implications for the control of inflation. Because of the time it takes for interest rate changes to be fully transmitted to inflation — between 18 months and 2 years — the MPC is unable to do very much about short-term fluctuations in inflation unless, as we have argued above, it is willing to raise interest rates sharply. There is, therefore, a case for excluding highly volatile components from the index targeted. If such components were to remain in the index, the MPC would not wish to respond to such temporary shocks, unless they had long lasting second round effects on other components and thus on the inflation being targeted. We consider in paragraphs 84-87 the effect of outside shocks on the inflation rates though it should be noted here that movements in, for example, oil prices or other imported goods are foreign in origin and beyond the control of the Bank. Many central banks accordingly exclude such items, and target core inflation (the rate of domestically produced output in services) instead. The Bank of England did stress that it controls inflation through demand management via interest rates and it follows that it would be much easier for the MPC to control core inflation than RPIX. There are, however, a number of second round effects on core inflation as many of its components are not in fact controllable by the Bank. The MPC would still need to respond to inflationary pressure arising from these components and indeed, as indirect tax increases are outside of the control of the monetary authority, there might also be a case for the measure of core inflation to be net of taxes too.

56.  In our First Report[28]we compared the two different ways of constructing an index number as a weighted average of the individual components. RPIX is an arithmetic average. Other indices, like HICP, would be a geometric average. The Bank's quarterly inflation report published both these indices and explained in individual cases why they differ. Our First Report showed that if the inflation rates of the component items were the same then the two measures would be identical, but if they differed the arithmetic average would be greater than the geometric average, such differences being most notable in periods of high inflation. Other situations that would cause a difference between the two types of index are when one component, such as oil price inflation, dominates the scene, or when there is imported goods price inflation due to the depreciation of the exchange rate, or where some items, such as food, have strong seasonal effects. It is important to appreciate, therefore, that the index is a measure of the underlying reality. Using a geometric as opposed to an arithmetic mean does not change the underlying reality. If HICP comes up with a lower number than RPIX, it does not follow that switching to the former means that there is less inflation in the economy.

57.  Professor Charles Goodhart told us that it was his view that it would be "wrong-headed simply because there are technical difficulties" with RPIX to shift away from it. Professor Willem Buiter confirmed that one would not change the index, or even the numerical target for the index, unless there were very good and exceptional reasons for doing so, because without a clearly defined major event to justify the change, "the whole process [would] look suspicious" (QQ 75—80). Dr Sushil Wadhwani noted that biases in the RPI were "an important problem" but would only be significant if they were growing significantly over time. He suggested that the Office of National Statistics should give priority to doing more work on this question, a view with which we strongly agree (QQ 601—2).

58.  There are, however, arguments for using a different measure of inflation from RPIX. We are not clear how much research the Bank of England have undertaken on this issue. Our conclusion, however, is that, even if it were to emerge from any such investigation that a change from RPIX was warranted on technical grounds, there remains a strong argument for not making a change at this stage. It is crucial to the MPC's work in delivering low inflation that inflation expectations remain low. A significant element of this is public acceptance of the choice of the inflation measure to target. If there were to be a change, any switch would run the risk of creating a loss of public confidence in monetary policy, unless the public could be persuaded to understand the merits of the new system. It is our view that the dangers of any such move significantly outweigh the technical merits of moving to a different inflation measure at this time.

A Monetary Conditions Index

59.  An alternative to targeting inflation is to target an index consisting of several different items such as inflation, the exchange rate, money growth and interest rates. This is known as a monetary conditions index and has been used in Canada and New Zealand. We do not wish to go into too much detail on what is fundamentally a technical question. Governor Brash explained to us in some detail how a monetary conditions index works in New Zealand: his answer is printed in full in Q 416. We note however that both Canada and New Zealand have now abandoned the use of such an index as it tended to produce counter-productive interest rate responses to exchange rate shocks.

60.  The CBI explained to us the arguments for using a monetary conditions index in the United Kingdom, an index which would take into account not only exchange rates but also other asset prices such as housing and equity. They cited three possible reasons for moving to such an index:

·  Such an index would contain useful information about broad inflationary conditions and this would in turn help to pin-point the future trend in the narrower target and measure of consumer price inflation.

·  Monetary policy should target broad inflationary conditions, rather than just a particular measure of consumer prices because stability of the exchange rate and equity prices, for example, along with stability and the price of goods and services should also be seen as goals for monetary policy in their own right.

·  Monetary policy should be concerned with stability in the real economy as well as price stability and also with targeting asset prices, for example by using interest rates to burst a share-price bubble.

61.  The CBI concluded, however, that even if the MPC could devise a monetary conditions index that allowed them to achieve greater stability in the real economy without upsetting the primary objective of consumer price stability, the primary objective of policy should remain as is, for the reasons of clarity, credibility and public understanding (pp 43—4). We agree.

62.  In our previous report, we said that there is not one correct way to measure the price level or inflation. That is still our view. If the index targeted has more volatile elements that do not offset each other, there may be a temptation to ignore them when setting policy on the grounds that their effects on the index are transitory. The alternative, which has much the same consequence, is to target an index that excludes them in the first place. More research should be undertaken on these issues. In the meantime, in the absence of an overwhelming case for a particular alternative, and for reasons of public confidence and given the role of the RPI in various contracts and in index-linking, we re-iterate our view that the MPC should continue to target RPIX.

Forecasting Inflation

63.  Since the interest rate has effects over approximately a two-year horizon, the MPC needs to take a view of what is likely to happen over that period. This involves at least two aspects; a forecast of what is likely to happen if there is no change, and a forecast of the consequences of any proposed change. This is also complicated by the knowledge that policy itself can change month to month.

64.  Mervyn King told us that the MPC needs to forecast inflation because of the period of up to two years it takes for interest rate changes to be fully transmitted to inflation (QQ 746—7). In an attempt to quantify this, in our First Report[29], we showed that, based on the Bank of England's model, after one year only half the full response of inflation had occurred. We also showed that 80% of this was via the exchange rate channel and that the longer the interest differential with other countries is expected to last, the greater would be the initial impact on the exchange rate. As a result of the need to look ahead the MPC devotes a large share of its resources to inflation forecasting. Our previous estimates also show what a critical role expectations of future interest rates and the exchange rate have in the inflation forecast. This is an area where we have some concern over what the MPC does.

65.  A second reason why forecasting is important is because of the range of matters the MPC takes into account. These are reflected in the Minutes which, before discussing the implications of the latest data that have led the MPC to reach an immediate policy decision, normally set out a whole catalogue of issues arising across a range of economic factors. These are usually in a standard format and include demand, output, prices and costs, prices of assets and money, labour market conditions, world economic conditions and the impact of any recent or forthcoming Budget. Interest in these factors arises from what they might reveal about inflation, as the Bank of England Act does not include them as targets in their own right.

66.   We asked MPC members to explain how they reached an amalgam of all these factors to focus on the target rate of inflation over the next two years and to arrive at a decision on short-term interest rates. Professor Charles Goodhart told us that, once a quarter, they have a forecasting session which aimed "to take account of all these factors in a framework of a coherent model" (Q 40). This raises the question of the differences that must inevitably arise when so many distinguished people such as the nine MPC members come together, but first we probe a little more what the forecast actually is.

Inflation forecasts or projections?

67.  We note that there is an important distinction to draw between a forecast and a projection. A forecast is an attempt to predict the actual outcome. A projection is a forecast constrained to satisfy certain assumptions. If the constraints were not satisfied then the projection would differ from the forecast. Another way of expressing the difference is that between an unconditional and conditional forecast. The MPC forms projections of future inflation based on the assumption that the official interest rate will remain constant and possibly on assumptions about unchanged future policy in other areas such as fiscal policy. It also makes assumptions about economic variables such as the exchange rate and the world economic outlook. Since, in the past, interest rates have always been changed at least once a year, projections of inflation two years ahead based on an assumption of a constant interest rate must be expected to differ from the inflation outturn. Unfortunately, the distinction between forecasts and projections is often lost in what the MPC says. For example, the Inflation Report[30], which describes the difference between the two, refers to the forecast process. Members of the MPC in their evidence also speak of the inflation forecast. Whatever word is used, it is important to keep in mind that it is in fact a projection, or forecast conditional on certain assumptions.

68.  We inquired into how this forecast was made. It is a quarterly forecast and is described in some detail in the August 2000 Inflation Report. The following description is given. The projection is based on a number of uncertain assumptions on which members of the MPC may hold different views. After identifying the main economic developments since the previous Inflation Report, the MPC reviews the individual assumptions in turn. A central projection is built up in the light of these assumptions and represents the best collective judgement, the centre of gravity of opinion on the Committee. A fan chart is then constructed to illustrate the Committee's collective assessment of the degree of uncertainty — the variance of the distribution of the likely outcomes — and the balance or risks or skew. An outcome in the tail of the chart is to be regarded as very unlikely. Although the central projection is revised each quarter, the variance is estimated on the basis of the past ten years of forecast errors. It would appear from this description that the central forecast that emerges is one that the whole Committee is required to sign up to, even though they may differ in the assessment of some of the assumptions (QQ 1314—1321).

69.  Charlie Bean (appointed as an Executive Director of the Bank, and as a member of the MPC in October 2000) said that "the forecast represents the centre of gravity for the Committee but everybody does not necessarily sign up exactly to the forecast, and that is the whole purpose of Table 6B of the Inflation Report, to indicate the extent to which different individuals might diverge from that" (Q 1319). The Governor said that the published forecast is "the centre of gravity, the collective best judgement", but an individual member may differ a little from this on the basis of their assessment of the particular factors: "Those things are reflected in Table 6B" (Q 1321). Mervyn King confirmed that this was "ambitious undertaking, which no other Central Bank does with a Committee". There were two good reasons for proceeding in this way: transparency and allowing an explanation of interest rate decisions to be given in terms of the outlook for inflation. Mechanisms existed to deal with individuals' unwillingness to sign up to the forecast (Q 803). Dr Sushil Wadhwani thought disagreements were "healthy and entirely normal" (QQ 598—600).

70.  Professor Willem Buiter stressed that they tried to predict a whole range of factors, such as world trade, world prices and the price of oil, as well as the actions of the US Federal Reserve and the European Central Bank, because each such "is part of the environment within which we operate. It is like the weather. We try to predict it presumably because it influences our environment but that is about it" (QQ 96—98). A forward view was taken of all these factors in the external environment and judgement sometimes overrode even market yields (QQ 99—103) although John Vickers described what went on as not betting but rather "trying to think through what the real forces are in the world economy" (QQ 104—106).

71.  Another key factor in the forecast is the MPC's analysis of the state of the labour markets, and of individuals' expectations for inflation. Professor Stephen Nickell told us that shocks from the labour market did affect monetary policy. Upward pressure on wages could either lead to continuing inflation, if the monetary policy response to it was relaxed, or to only a short-term inflationary pressure if there was a relatively tight response. The labour market remained pretty tight so signs of inflationary pressure would be taken very seriously. Current expectations for wages seemed to be assuming that inflation would remain around 2.5% (partly due to the work of the MPC in stabilising inflationary expectations) but if the labour market were to tighten further and employers began to compete for employees huge wage increase could follow (Q 794).

72.  The uncertainty surrounding the forecast has led to various suggestions: that it should not be published; that it should be solely a staff forecast; that it should be an independent forecast; that each member should make their own forecast. The Bank of England Commission[31] has recommended that responsibility for the inflation forecast be taken by those MPC members who are employees of the Bank. The Commission's Report argues that transparency will be improved if there is "open publication of any conflicting projections upon which the external members of the MPC have relied in coming to their voting decision"[32]. A staff forecast as such, however, has been rejected by the Bank because it would create divisions between the internal and external members; because the markets would not treat it as a forecast of the way in which the MPC itself was thinking; and because of sensitivities about publishing it (QQ 603, 802). There are other arguments against each MPC member making their own forecast. First, some individuals would find it easier to make forecasts than others. Second, there would be speculation about the reasons for differences. Third, presentation and communication with the public would be weakened if a general message of agreement on the broad outlook was complicated by the publication of "small technical differences among the Committee" (Q801). Finally, the notion that the MPC works as a team would be lost. While we can see some force in these arguments, however, we consider that the case is still open. We recommend in paragraph 94 below that the new Economic Affairs Committee considers the alternatives to the present system of forecasting.

73.  In commenting on the fact that members of the MPC may have the same broad outlook for inflation but very different views on the choice of interest rate, Mervyn King told us that "It is the level of interest rates that matters. I think those differences [in interest rates] will show up in small differences in the forecasts but the differences between members of the Committee and their outlook for inflation are tiny in comparison with the uncertainties about the outlook for inflation around the central projection that we might all share. Those uncertainties are very much bigger than the sorts of differences between members that one might find" (Q 805). Mervyn King's comments prompt us to wonder how the MPC can have such a consensus on the interest rate when there is so much uncertainty about future inflation. One reason why this might be possible is if interest rates have little effect on inflation. But this would then undermine the whole rationale for using interest rates to control inflation.

How good is the forecasting record of the MPC?

74.  Mervyn King also cautioned against thinking of forecasts as estimates, which can be either right or wrong. There was, he said, a sense in which no forecast can be right, as unexpected shocks prevent you predicting the future. Hence a forecast is not a number, and the fan charts, which were presented as a contribution to transparency and public discussion, tried to show that it was "the balance of risks_the uncertainty about inflation" which determined policy. Hence an analysis of the forecasting record of the MPC would not take the form of assessing whether the MPC had got things right or wrong but of professional judgement of where the balance of risk lay. The MPC accordingly produced an annual review of its track record (Q 800). Whilst we accept that the MPC's inflation forecasts should not be judged purely as point estimates, this is not the same as accepting that a class of forecasts cannot be assessed as right or wrong. An example would be a systematic tendency to over-predict or under-predict inflation (or output, for that matter). Another relevant consideration is the speed at which the MPC identifies a change in the inflation trend or the broader economic environment. This has relevance for our analysis of the MPC's forecasting record below.

75.  Much of the error in forecasting inflation has been attributed to the exchange rate. As discussed in the our First Report, the MPC has in the past used uncovered interest parity (UIP) to forecast the exchange rate according to which the exchange rate is determined by interest differentials. In Appendix 4 of that Report we discussed in detail how difficult it is to forecast the exchange rate with any certainty using this approach, even though it may well be the correct way to do so. Given the importance of the exchange rate in forecasting and controlling inflation it is worth adding that in a recent paper Dr Sushil Wadhwani, then a new member of the MPC, has expressed dissatisfaction with this approach to forecasting exchange rates[33]. Several major problems with this method were also examined in our First Report[34]. The assumption of a constant interest rate for the projections can only be expected to add to the role of the exchange rate in causing errors in the inflation forecast.

76.  A detailed assessment of the MPC's inflation forecasting record is published in the Bank's August 2000 Inflation Report[35]. The forecasts are for one and two years ahead. The assessment period begins with August 1997; the last available for one year ahead was made in May 1999. Charts A and B show that there has been a persistent tendency for the projections to exceed the outturn of inflation. According to the Inflation Report, the one-year-ahead projections of the mean made between August 1997 and May 1999 were on average 0.3 percentage points above the inflation outturn. The two-year-ahead projections of the mean made between August 1997 and May 1998 were on average 0.7 percentage points above the inflation outturn. The Inflation Report attributes these forecast errors mainly to the exchange rate being stronger than was assumed. It is also noted that interest rates tended to be lower than assumed in the projection. This was because the MPC responded to weakening external pressure on inflation (caused by lower world growth rates) by reducing interest rates. Chart D shows that the MPC's one-year-ahead output projections made between August 1998 and May 1999 were persistently below the outturn, sometimes by as much as 1.5 percentage points. Thus the record shows that more recently the MPC has been persistently too pessimistic about both future inflation and output.

77.  The Governor said that he was "rather proud of our forecasting record", and that it had been "remarkably accurate". He added that "if you can produce a forecast which has got a better track record than that, I shall be absolutely delighted". He also said that the persistence in the errors was the result of looking two years ahead, and that there were still only a few observations on which to make a judgement (Q 1307). Charlie Bean told the Committee that the forecast performance had been better than expected, that the errors had been small and that the inflation performance had been surprisingly good. He attributed the output forecast errors in part to the unexpected strength of sterling (QQ 1307—1308).

78.  We tried to probe further with individual members the case for more self-analysis of the forecast. Professor Willem Buiter said that the most unexpected factor had been the exchange rate and as he could not explain after the event why sterling was where it was, the fact that he had not predicted it correctly in advance was not too serious (Q 14). Professor Charles Goodhart took comfort from the fact that the Bank had not had to write a letter of explanation, even though statistically one might have expected that two such letters would have had to have been written, while John Vickers welcomed the idea of periodic review (Q 15). Dr Sushil Wadwhani told us that the staff regularly present the MPC with a comparison of their forecasts against external forecasts, both showing what such forecasts were saying and trying to explain why there were differences (Q 606).

Uncertainties surrounding the inflation forecast

79.  In his evidence, Mervyn King stressed that the MPC's forecasts of inflation were subject to considerable uncertainty (Q 800). This is the reason why the MPC publishes its fan charts. The shading around the central projection decreases further away from the centre to reflect the lower probability the MPC attaches to inflation taking such extreme values. The bands widen the further ahead the projection. For two years ahead the band-width is on average about two percentage points—about one percentage point either side of the central projection. This implies there is about a 10% probability that inflation will be one percentage point above or below the central projection. The corresponding figure for one year ahead is about 0.75 of a percentage point.

80.  We accept entirely Mervyn King's emphasis on uncertainty and acknowledge the attempt to represent this in the fan charts. Nonetheless, it is instructive to relate the uncertainties in projected inflation reflected in the fan charts to the forecasting record. As noted, the mean forecast error one year ahead has been in the range 0.5—0.7 percentage points. Although this is large in relative terms, however, we accept that these errors are still small in absolute terms.

81.  One of the factors that is said to have caused a difference of opinion in the MPC about the interest rate decision is the impact of technology gains on inflation. According to one view, buoyant domestic demand is likely to have less impact on future inflation because productivity gains have reduced unit costs. To have a permanent, and not just a temporary, effect on inflation, however, such productivity gains would need to be repeated frequently. A one-time productivity improvement would have a permanent effect on the price level, not the inflation rate.

Uncertainties surrounding the interest rate decision

82.  Members of the MPC have told this Committee that they attempt to control inflation by demand management. By reducing aggregate demand, inflation is decreased. It is worth observing, therefore, that the projections for output growth since August 1998 have been repeatedly lower than the outturn - by roughly 1.5 percentage points. This is attributed to stronger domestic demand than expected due to the lower interest rates, and to wealth effects arising from equity capital gains. Thus at the same time that GDP growth has been greater than expected, inflation has been lower. This raises a strong concern about the interest rate decision. If the MPC had forecast inflation more accurately, interest rates would presumably have been lower than they were. But given the relation supposed to exist between demand and inflation, if the higher output growth had been forecast accurately then interest rates should have been higher than they were.

83.  Another puzzle about the interest rate decision is that in the months from July to September 2000 the MPC central inflation projection two years ahead has been about 2.75%, yet interest rates have remained unchanged. If it takes about two years for interest rates to have their full effect on inflation then one might have expected an immediate increase in the interest rate. In fact, only four of the nine members of the MPC have voted for an increase.

Is the current approach suitable for supply shocks?

84.  Since its inception the focus of the MPC has been on the control of inflation by demand management through interest rate policy. As long as only demand shocks are affecting inflation this will almost certainly remain a viable approach. We are also concerned by how the Bank responds to supply shocks, such as imported inflation due to, for example, oil price shocks, and the gains to inflation due to technological improvements that reduce unit costs. The evidence we have received appears to indicate that supply shocks would be treated in the same way as demand shocks, but we are not convinced that this would necessarily be appropriate. This is one area where, to date, the environment has not been too difficult for the MPC, especially when compared with the severe problems of the past. The current approach might be sorely tested in less favourable situations.

85.  The Bank of England Commission suggested that "in the case of a large systemic shock, it might be inappropriate for the Chancellor to allow the MPC to continue setting interest rates designed to restore the level of inflation compatible with the pre-existing target range". They suggest that, under such circumstances, the Chancellor announces a path of targets and ranges leading back towards low inflation at a speed he judged appropriate[36]. In New Zealand, however, Governor Brash is directed to ignore the immediate effect of supply shocks, at least in the first round of inflationary consideration, although there would be a tightening of policy if, for example, higher oil prices tended to lead to higher wages, (QQ 424—6).

86.  We asked our witnesses about a number of different supply shocks. As far as oil prices were concerned, John Vickers told us that they were not a special factor (Q 33) whereas Professor Willem Buiter said that they remained "a big component" because they were set by a cabal. Mervyn King was more dismissive, however, of the importance of equity prices, as these could not be predicted anyway. He questioned whether there was such a thing as a "bubble" in terms of the level of asset prices but he did note that central banks had to be modest in forming a judgement on whether a valuation was right or wrong. The MPC would of course look at any risks arising from asset prices (QQ 813—6). The Governor told us that the significance of the housing market, too, was over-exaggerated and the MPC did not take much account of it (QQ 205, 213). Chris Allsopp said that asset prices were indeed less important than looking at the overall picture (QQ 809—810). Professor Stephen Nickell told us that there had also been fewer shocks arising from the labour market, as the structure had changed due to changes in unemployment benefits and union activity (QQ 790—91).

87.  More generally, in their evidence to the Committee, members of the MPC were less clear how they would respond to higher inflation due to a supply shock, as opposed to a demand shock. It remains unclear whether they would take action to keep inflation on target, or take the view that this might be an occasion when a letter to the Chancellor would be more appropriate. Perhaps there is a clue in the recent increase in the oil price which appeared for a time to be a possible threat to inflation. The central forecast of inflation in August 2000 rose to 2.75 per cent, but interest rates were kept unchanged. In general it may be asked whether an interest rate increase is the right reaction to a supply shock. Arguably, the correct response to an oil price shock is to allow the price level to rise and then to re-base future inflation at the higher price level. This argument reflects the fact that demand has not increased, that the oil price shock is already deflationary and the required response is a substitution away from the use of oil. Notwithstanding our previous discussion of the choice facing the MPC between keeping inflation on track and safeguarding growth and employment when inflation is likely to breach the one percentage point limits, this response to a supply shock would imply temporarily higher inflation, and might possibly necessitate a letter from the Governor to the Chancellor.

How important is forecasting for successful inflation control?

88.  We have been told that forecasting is a pretty uncertain process, almost random in its operation. In such a world, it could be argued that the work of the MPC should be discontinued. We reject this view. If the MPC is to be fully effective, it is crucial for them to have good forecasts of future inflation in making the current interest rate decision. The forecasts are conditional on key assumptions about the interest rate and certain external economic variables and members of the MPC sometimes differ in their opinions about these. There is considerable uncertainty about the forecast, but this uncertainty seems to be unable to account for the much larger forecasting errors that occur in practice. There is good reason to think that this might be due to an inappropriate treatment of future interest rates in forming the forecast. The exchange rate forecasts seem to be a contributory factor, and the method of forecasting is another, and probably related, area of concern.

89.  As the MPC has been in operation for several years, we consider that the Bank should now be in a position to review its performance in general so far. Under section 16(1) of the Bank of England Act, a sub-committee of the Court of Directors of the Bank is required to keep the procedures followed by the MPC under review. Our view is that what they should concentrate on is forecasting performance. We note that the Bank has set out for the Commons Treasury Committee[37] how they would go about assessing the MPC's forecasting performance. We recommend that a review of the method of forecasting inflation used by the MPC should take place, with a view to discerning whether it is state-of-the-art. This review (in effect an audit) should be sponsored and financed by the Court, although they themselves would not be the body which undertook it.

Regional factors

90.   A matter of interest to our witnesses was whether the MPC was sufficiently alert to regional factors. The CBI told us that there were very helpful contacts between business and the Bank, sometimes through the Bank's Agents and sometimes through visits by individual MPC members. Any problem was caused not by a lack of awareness of what was happening in the regions but by the need to set a common interest rate for the country as a whole (QQ 242—3). For the purposes of the narrowly-focused inquiry we are conducting, we have concluded that the MPC is sufficiently alert to regional factors. We recommend, however, that the new Economic Affairs Committee conducts a thorough review of the importance of regional variations in the economy and of the steps necessary to take account of them in the formulation of policy across the board.

How successful has the MPC been?

91.  One of our witnesses, Paul Ormerod, questioned the whole basis on which the MPC works. It was his view that, with inflation low around the world, it would be difficult to claim that any particular central bank had any particular responsibility for low inflation in a particular economy. He also questioned the assumption, on which the operational arrangements for the MPC are based, that it is possible to predict with reasonable accuracy future events in the economy and to exercise reasonably precise control over outcome by actions which are taken today (Q 706). Despite these fears, we note that to date the MPC has been successful in achieving its inflation objectives.

92.  Looking ahead, will the MPC be able to continue to be as effective should economic conditions change? It has been suggested by the Bank of England Commission and others that the recent economic environment has been rather benign for the operation of monetary policy. The Bank of England Commission noted that[38] many of their witnesses had pointed out that "the international inflation background_has been benign_[and] that both inflation and inflation expectations were low at the time when the new arrangement first came into force".

93.  We put this point to Mervyn King and his view was that the MPC could take some credit for what had happened to inflation, because of its response to the economic shocks during its period of operations. He cited the 1997 Asian crisis; the Russian default and devaluation in 1998; and the sharp pick-up in world growth in 1999. He also noted that the exchange rate had risen very sharply immediately before the establishment of the MPC, and had then continued to rise (Q 743). We are inclined to agree with Mr King. Saying that the economic environment has been relatively benign does not mean that it has not been confronted with serious problems. It certainly does not imply that the MPC has not worked well, and has not helped to keep inflation low and stable.

94.  It is our view that this system has worked well in the relatively benign recent economic conditions. It may not be so easy in the future, when conditions get tougher as they surely will, to arrive at and rely on a collective forecast. We recommend that the Bank considers alternatives to the current procedure for preparing the forecast, even if only to satisfy everyone that those procedures will indeed be sufficiently robust in a harsher economic climate. The general question of forecasting is one that the new Economic Affairs Committee may wish to examine.

26   See note 10 above: Paragraph 7.11. Back

27   See Chapter 3 and Appendix C of our First Report. Back

28   Paragraphs 3.17-3.30. Back

29   Chapter 4 of our First Report. Back

30   August 2000, p 49. Back

31   See footnote 10 above. Back

32   Paragraph 7.32. Back

33   Speech to the Senior Business Forum, Centre for Economic Performance "The Exchange Rate and the MPC: what can we do?" (31 May 2000) available at Back

34   Chapter 4. Back

35   Pages 63-66. Back

36   Paragraphs 7.14-7.18. Back

37   Op.cit. n8 above: Appendix 12. Back

38   Paragraph 3.2. Back

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