The reasons
for giving priority to controlling inflation over other possible
objectives, costs and benefits
1.4 Five days after the general election, the
new Chancellor of the Exchequer, the Rt Hon Gordon Brown MP, announced
that he had decided to give the Bank of England operational responsibility
for setting interest rates, with immediate effect. In making
his statement, he explained his rationale for such a move, which
had not been widely anticipated. The Labour Party's manifesto
had said:
"We will reform the
Bank of England to ensure that decision-making on monetary policy
is more effective, open, accountable and free from short-term
political manipulation"
The Chancellor stated on 6 May 1997 that "The
central economic objectives of the new Government are high and
stable levels of growth and employment."[2]
He criticised the interest rate regime he had inherited, claiming
that "the present arrangements for policy-making are not
generating the confidence that is necessary" and that "the
perception that monetary policy decisions have been dominated
by short-term political considerations has grown." Setting
out his proposals, he said that they would "ensure that decisions
are taken for the long-term interests of the economy and not on
the basis of short-term political pressures. This is the way
to create the stability we need for higher investment and high
levels of growth and employment." The Committee notes the
distinction here between short-term political aims and the long-run
performance of the economy. Monetary policy, however, is a short-term
implement, although its impact is of a dynamic kind with a profile
in excess of two years. It is, perhaps, also worth noting that
the basic decision, operational independence, is itself meant
to be a long-term one, changing the basic nature of policy making.
Quite separate from the actual decisions of the MPC, operational
independence may in itself have a long run influence on the way
financial markets and markets in the real economy work. One important
aspect of this, on which we comment below, is a possible change
in expectations, both as to inflation and real economic stability.
1.5 The new regime was quickly put in place:
the Chancellor conducted only one monthly monetary meeting with
the Governor of the Bank under the old system, whereby the Chancellor
and Governor would meet to discuss whether to raise interest rates
and the Chancellor would make the decision. Since June 1997,
interest rates have been set at a monthly meeting conducted by
the new Monetary Policy Committee, consisting initially of eight
but now of nine voting members, including the Governor, plus a
non-voting representative from the Treasury. Having given them
the task of controlling inflation, in his letter to the Governor,
the Rt Hon Edward (Eddie) George, which immediately preceded his
policy statement of 6 May 1997, the Chancellor defined the new
Government's objectives for the Bank:
"Price stability is
a precondition for high and stable levels of growth and employment,
which in turn will help to create the conditions for price stability
on a sustainable basis. To that end, the monetary policy objective
of the Bank of England will be to deliver price stability (as
defined by the Government's economic policy) and, without prejudice
to this objective, to support the Government's economic policy,
including its objectives for growth and employment."
1.6 This objective was formalised with the passage
of the Bank of England Act 1998[3],
section 11 of which reads as follows:
"In relation to monetary
policy, the objectives of the Bank of England shall be:
(a) to maintain price stability, and
- subject to that, to support the economic policy
of Her Majesty's Government, including its objectives for growth
and employment."
1.7 One might assume that the meaning of this
section of the Act ought to be what was said in the earlier letter.
Our difficulty with that is the result of the wording being so
different in the two cases. It must also be remarked that the
Chancellor said a precondition, not the only precondition,
and added that achieving the real aims would in turn help to sustain
price stability. This problem of interpretation is returned to
several times in our Report.
1.8 What cannot be disputed is that the new system
of monetary policy is clearly intended to underline the Chancellor's
commitment to creating a low and stable rate of inflation. What
he meant by price stability is inflation stability at a rate above
zero. On 6 May 1997, he set out some of the reasons for this:
as well as the arguments already cited above, he called inflation
"the enemy of investment", a view reflected in his evidence
to this Committee, that "What manufacturing wants most of
all is low inflation, low long-term interest rates that allow
higher levels of long-term investment." (Q 5) He did not
say whether these were real or nominal rates. To appreciate the
significance of the distinction it is of value to look at the
paths of short and long-term rates as set out in the graphs in
Appendix 5.
1.9 The Chancellor is not alone in his dislike
of inflation. One merely has to examine the objectives of the
United States Federal Reserve ("the Fed") or of the
European Central Bank (ECB) as expressed in the Maastricht Treaty,
under which it was set up. It is also a commonplace that the past
two decades have been dominated by a low inflation objective in
much the same way as the previous three decades were seen as the
era of full employment.
1.10 The United Kingdom, which has by G7 standards
been a country of higher than average inflation over the last
three decades, has since the war also been perceived as being
an under-performer in terms of economic growth. The two are often
linked; for example, the (until recent) excellent performance
of the German economy has been attributed to (at least in part)
its record of low inflation. Most notable of all, recent US economic
performance has been one which combines low inflation with rapid
job creation. We are well aware, however, that there is not universal
agreement among the experts as to what is cause and what effect.
1.11 The broad aim of monetary policy is to provide
what is called a nominal anchor, in order to keep inflation under
control. Theoretically this can take several forms: a rate of
growth for the money supply, an exchange rate target or an inflation
target. All of these have been advocated at one time or another.
What have also been advocated are specific policy rules. We emphasise
here that the target approach being used in the United Kingdom
is discretionary. The MPC does not follow a specified policy
rule to achieve the target, as if they themselves were the human
equivalent of a computer programme. One of our witnesses (Professor
Minford (Q 1143)) did say that, while central banks gave the appearance
of making policy in a discretionary fashion, they did in fact
follow a simple policy rule.
1.12 Before the breakdown of the Bretton Woods
system in the period 1969-1973 the anchor was provided by the
sterling-US dollar exchange rate. Since floating the exchange
rate in 1973 the United Kingdom has tried all three nominal anchors,
and has now adopted inflation targeting because of the apparent
lack of success of the first two. Under Bretton Woods United Kingdom
inflation was tied institutionally to that of the United States.
After floating the United Kingdom within limits determined its
own inflation rate.
1.13 On the adverse effects of continuously rising
prices the general opinion seems to be that while very high inflation
damages the market mechanism, there is little clear economic evidence
that mild inflation is very harmful, and may be helpful. There
has been an estimate for the US that a one percentage point increase
in inflation may cost more than one-tenth of a percentage point
in its growth rate. Nonetheless the balance of opinion is that
low, but not zero, inflation is to be preferred. What is more
definitely agreed is that inflation uncertainty is especially
harmful. Putting the two aspects together, high and uncertain
inflation makes it more difficult for individuals and organisations
to make correct economic decisions. It also results in higher
interest rates attributable to an inflation risk premium. As Sir
Brian Pitman, Chairman of Lloyds TSB, told us, "We have had
years and years of stop-go, boom and bust and we have felt that
inflation really has been a cause of an awful lot of it."
(Q 915)
1.14 In the past the "Phillips curve"
was formulated to support the proposition that there is a trade-off
in at least the short and medium term between wage inflation and
unemployment, and that higher inflation will reduce the level
of unemployment. This theory was undermined by the experience
of the 1970s, a period which saw a combination of increasing unemployment
and inflation (known as "stagflation"). Current opinion
is that such a trade-off is at best a short-run phenomenon, and
does not exist in the long run. Unemployment may be temporarily
reduced following a burst of demand inflation, but will be unaffected,
or even made worse, in the long run. A later re-formulation of
the inflation-unemployment trade-off argued that the long-run
rate of unemployment is fixed at its "natural rate",
and attempts to reduce the unemployment rate below the natural
rate would result in permanently accelerating inflation. As a
result the natural rate also became known as the non-accelerating
rate of unemployment, or NAIRU. In recent years the level of
unemployment in Britain, and in other industrial countries, has
been below some estimates of what was thought to be the NAIRU
without producing accelerating inflation. It may be noted that
empirical estimates of the NAIRU have also changed at regular
intervals. Majority opinion is now that while there may be an
inflation-unemployment trade-off in the short run, inflation and
unemployment are unrelated in the long run. This implies that
the long-run inflation rate will be the Government's target, and
the long-run level of unemployment can be improved by, inter
alia, reducing labour market rigidities. Happily, this Committee
does not have to pronounce on the current state of economics,
but it is struck by certain lacunae in an area of such great importance
to policy makers!
1.15 The Chancellor summed up his lack of faith
in Phillips' original theory, by telling us that "We now
know there is no long-run trade-off between inflation and growth
and employment." (Q 3) The Chancellor told this Committee
that the Government's policy is to help improve unemployment by
supply-side measures through the use of fiscal policies designed
to increase competitiveness. We may anticipate our later discussion
by emphasising that the Chancellor does not see fiscal policy
as a short-term instrument of macro-economic policy, except possibly
in response to a major crisis. He sets the fiscal instrument over
the medium term to achieve certain real objectives, but not so
as to undermine monetary policy. Thus, in principle, he does not
expect there to be a conflict between monetary policy and fiscal
policy in the way he approaches it.
The choice
of inflation targeting as the means of conducting monetary policy
as opposed to previous monetary policies and that of the ECB
1.16 As we have noted the Chancellor is not alone
in his enthusiasm for reducing inflation: inflation has been treated
as a serious problem for a long time, and different methods have
been used by successive Chancellors to control it. In the last
twenty years, there have been several distinctive policies. The
first of these was the targeting of the money supply based on
a philosophy commonly known as monetarism. This only lasted until
the early 1980s although a target for the growth of broad money
continued until the mid-1980s. It was followed by a period of
judging interest rates on the basis of a general assessment of
monetary conditions, including the exchange rate. This lasted
until the United Kingdom joined the Exchange Rate Mechanism towards
the end of 1990, although during the second half of 1987 and the
early months of 1988, policy was evidently directed towards an
informal shadowing of the deutschmark. Membership of the Exchange
Rate Mechanism only lasted for two years, until September 1992.
The final stage of policy, which was introduced after sterling
was ejected from the mechanism and is still used today, is the
targeting of the inflation rate itself. This approach has been
refined over the years to reach its present state, and we have
no doubt, will be further refined in future.
1.17 In simple terms, inflation targeting is
the setting of a desired inflation rate and the use of a monetary
tool or tools to achieve that target. The Chancellor, in establishing
the MPC, set the target at 2.5 per cent on the RPIX[4]
measurement. The theory behind inflation targeting is that when
inflation is in danger of rising, interest rates are increased
by the amount thought necessary to dampen inflationary pressures
and inflationary expectations. Conversely, interest rates will
be lowered when inflation is in danger of going below its target.
1.18 It is obvious that the form of the target
which this country has chosen is not the only one possible. An
alternative form could be a maximum with no lower limit. Another
possibility would be a desired mean over some suitably long period
of (say) two to three years, with no explicit attention paid to
its variance. And, of course, the target could be extended to
include variables other than inflation, a theme to which we return.
1.19 Inflation targeting is now widely used by
central banks as their method of controlling inflation. According
to Martin Weale, Director of the National Institute for Economic
and Social Research, "several countries have now tried inflation
targeting and concluded it works." (Q 1050) Its simplicity
is a reason for its popularity: as put by Gerard Lyons, Chief
Economist of DKB International, "the benefit of an inflation
target is that it is easy to understand" (Q 1112). The policy
is conducted with slight variations as to how the target is designed
and as to the number of tools available. For example, the ECB
defines price stability as a year-on-year increase in inflation
in the euro area of below 2 per cent, and attempts to maintain
this stability over the medium term. The ECB, unlike the Bank
of England, has the power to set its own target, and such a freedom
is the norm in independent central banking systems. We say here
and now that we favour a target which is simple and easily checked.
The experience
of the past and of other countries
1.20 Historically, Britain has not been a country
of high inflation—there has never been a period of hyperinflation—but
there have been periods where inflation has been excessive. In
this century there have been two periods of inflationary pressure
caused by wars, but in peacetime the major period of inflationary
concern was from the early 1970s to the early 1980s. In the 1970s
the average annual increase in the Retail Price Index was 13.2
per cent, with annual peaks of up to 24.2 per cent[5].
Since 1993, however, the inflation rate has been relatively low,
with the (seasonally adjusted) RPIX at or below 3.5 per cent at
all times. The figure is now 1.3 per cent for the RPI, and 2.2
per cent for the RPIX.
1.21 By contrast, other major countries often
have a better recent record than Britain. The United States has
only rarely suffered from double-digit inflation, and Japan and
Germany have both been very successful in maintaining very low
levels of inflation. Germany, of course, suffered from hyperinflation
in 1923 at a rate reaching 500 per cent per month with appalling
political consequences.
1.22 Not all of Britain's inflation can be attributed
to domestic forces. According to Gerard Lyons, "The 1970s
were a decade of high inflation and as we moved through the 1980s,
whatever country you were in, not just the United Kingdom, inflation
remained a problem." (Q 1102) The most notable inflationary
bursts were in the mid 1970s (reaching 26.9 per cent in August
1975.) and again at the end of the decade (reaching 21.9 per cent
in May 1980), following oil price shocks[6].
But such supply shocks tended to affect Britain more than other
countries: average inflation for the 1970s was 13.2 per cent in
Britain but during the same period the corresponding figures for
the United States, Japan, Germany and France were 7.2 per cent,
9.1 per cent, 5.0 per cent and 9.2 per cent respectively.[7]
In the 1970s in Britain, the inflationary spiral was exacerbated
by, among other factors, high wage demands associated with industrial
unrest.
1.23 Britain's record in the 1980s was better
than it had been in the 1970s, but despite the decreasing power
of the unions to demand higher wages, inflation was still a problem
from time to time, most notably at the end of the decade, 1990,
when the RPI peaked at 10.9 per cent. Again, other countries
fared better: in 1990, for example, average G7 inflation was 5.0
per cent.[8]
1.24 The 1990s have seen a period of low inflation
throughout the world. In Britain, the inflation rate has been
lowered to levels last experienced in the 1960s, and this is true
of other countries: even some countries with poor records, such
as Argentina, have moved from hyerinflationary to lower and more
stable inflationary environments. Britain's inflation rate is,
however, still higher than that of most other G7 countries: inflation
(including mortgage interest payments) in Britain in 1998 was
3.4 per cent, compared with 0.6 per cent in France, 0.9 per cent
in Germany, 1.6 per cent in the United States and 0.6 per cent
in Japan[9].
1.25 Throughout the last three decades, we can
see inflationary trends reflected to a degree in interest rates.
The relationship between inflation and interest rates is complicated
and will be discussed at a later point. It is not always worth
comparing the two at an immediate point. But in respect of longer-term
relationships comparisons are often useful. For example, in the
last ten years, when United Kingdom inflation has been higher
than in most other G7 countries, so too have our interest rates
been higher, and since 1988 they have never fallen below G7 averages.
Today, interest rates stand at 5 per cent in Britain, 5.24 per
cent in the United States, 2.66 per cent in France and Germany
and 0.13 per cent in Japan.[10]
1 In this Report, price stability and low inflation
are mainly interchangeable terms. This is how they have been
seen by all the witnesses. Back
2
Statement by the Chancellor of the Exchequer, 6 May 1997. Back
3
The Bank of England Act 1998 received Royal Assent on 23 April
1998 and came into effect on 1 June 1998. Back
4
We define RPIX in Appendix 3. Back
5
Source: OECD. Back
6
RPI figures; source: ONS. Back
7
Source: OECD. Back
8
Source: OECD. Back
9
Source: Treasury. Back
10
Source: Treasury. Back
