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


Giving the Bank independent control of monetary policy via the MPC

1.26  Several reasons have been offered for the difference between Britain's experience and that of its major competitors. The most frequent comparisons are made between Britain and Germany. The German post-war experience of high growth and low unemployment has changed to one of high unemployment and a low growth rate. This has been caused in general by the costs of reunification and possibly the burden of a costly social system in need of repair. (Germany continues to experience low rates of inflation.) Among the other reasons cited for the post-war Wirtschaftswunder (economic miracle), are the inventiveness of its people, the strength of its Mittelstand (medium-sized business sector), and good relations between management and unions. But the success of the independent central bank, the Bundesbank, is dominant amongst the reasons given for the successful control of inflation and its beneficial effect on the economy. Another important reason is the structure of the trade union movement in that country, and their support for the inflation objective and participation in the policy making process.

1.27  The success of the Bundesbank in controlling inflation has in turn often been attributed to its independence from political control. It is not alone in this respect: in recent years, the Federal Reserve Board of the United States has been similarly praised. Together these two central banks have been cited in comparisons which contrast the long-term success of the United States and Germany with the relative poor inflation performance of the British economy. This comparison has been made by those who have now successfully argued for the Bank of England's independence. Looking back on the Chancellor's decision, Lord Desai, though not a supporter of an independent Bank of England, told our Committee that "I think we were driven by two things. First of all, the persistent good performance of the Bundesbank, and Alan Greenspan happened to be the Chairman [of the Federal Reserve Board of America] and he was very, very successful" (Q 1182). Lloyds TSB, among others, have looked beyond the two main examples: according to them, "Research we have carried out shows that independent central banks have presided over more stable, and less inflationary, economies." (p 202) Other economists such as Barro[11] are more doubtful of what can be inferred from the empirical evidence.

1.28  Alan Greenspan's success at the Fed is legendary. According to Gerard Lyons, another critic of independence, "there is little doubt that the central bank which currently has achieved the best results has been the US central bank, the Fed." (Q 1107). Lord Desai's view is that "previous Fed chairmen were not necessarily that successful" (Q 1182). Lord Desai denies "any scientific basis for the idea that central bank independence is a good thing" (Q 1183) and contends that "The academic literature which is cited in its support though fashionable is, in my view, of dubious quality." (p 266) We ourselves have no doubt that operational independence for the MPC will and must be judged by results, probably more broadly interpreted than inflation performance.

1.29  These doubts apart, the Chancellor has been much praised for his move. Sir Brian Pitman told us that "I think you would find most of the banks in London great supporters of what has happened because we believe this will lead to greater stability and that will ultimately lead to more sustainable growth." (Q 915). The TUC stated that "The TUC believes that the new arrangements have proved broadly successful, albeit with room for improvements"(p 120). Martin Weale called the new arrangements "much better than the old" (Q 1043).

1.30  Whether the Chancellor, in making his decision to grant independence to the Bank, was following sound economic theory or simply fashion can, of course, be debated. The answer is probably both. It is worth marking out the principal mechanisms of the policy. The first point to note is that the Chancellor has followed a degree of precedent in forming the body to undertake the Bank's work, ie the Monetary Policy Committee. It has been formed in such a way as to provide a monetary policy which is, following the wording of the Labour Party's manifesto, "more effective, open, accountable and free from short-term political manipulation." Its membership and procedures will be examined in more detail in the next chapter. It is worth stating now that, in most of the independent central banks the decisions are also made by a Committee rather than by a powerful chairman. Alan Greenspan, Hans Tietmeyer (the outgoing President of the Bundesbank) and Wim Duisenberg (the President of the European Central Bank) are influential figures in their own right but they are all chairmen of powerful Committees.

The clarity and feasibility of the emphasis on inflation and the subsidiary role of supporting the Government's other objectives

1.31  We have already mentioned the objectives of the MPC as set out in section 11 of the Act. The MPC has been given the task of maintaining price stability and, subject to that, supporting the Government's wider economic policy. In the ordering of the objectives the first objective appears to be over-riding, and even the one by which the MPC will be judged. The second objective is certainly there, but it is not the top priority. But there are complications. While we have in the remit from the Chancellor a well specified inflation objective, we are not offered numerical targets for growth and unemployment. But it is impossible to believe that ultimately economic performance will not be judged in real terms.

1.32  The argument that low, stable inflation leads to better economic performance has already been described. What has not is the argument that the two section 11 objectives are incompatible, or at least difficult to juggle. Also still to be described are two other arguments: that the first objective must be all-important, and on the other hand, that the two objectives are compatible (and indeed, are in practice equal). This issue appears to divide observers of the new regime more than any other issue.

1.33  Section 11(a) reflects the Government's belief that low inflation is essential for strong and sustained growth, and gives the MPC the task of creating low inflation. This priority has many supporters. For example, Professor Tim Congdon told us that "it is important, in the way that their statute is set up, that they should be looking exclusively at inflation." (Q 1145) The CBI agree: among their arguments, they claim that "it is not possible to achieve two targets with one instrument" (p 148). The priority given to inflation is thus clear, and the concentration on it is likely to lead to greater success in achieving the target. It is a matter of elementary logic that except in rather special cases the number of achievable targets is limited by the number of instruments. But there remains the question, why was subject to that written into the Act?

1.34  There are those who argue that the MPC should not, in its pursuit of the first objective, neglect the second. Some (see CBI above) argue that the two objectives are incompatible, and that the MPC will naturally be concerned about the inflation objective and will only rarely be bothered about growth and employment. Roger Bootle argues that "the greater risk is not that they would be slow to increase interest rates in potentially inflationary circumstances, but rather that they would delay unnecessarily in circumstances when the pressures on inflation were decidedly downwards and when there was actually an inflationary danger." (Q 1139) Others would prefer a "dual mandate" similar to that enjoyed by the Fed: Gerard Lyons claimed that "Independence can result in monetary overkill, especially if a central bank is aiming to prove its anti-inflationary credibility." (p 241). According to Lyons, this has already happened with the monetary tightening that took place in the first half of 1998, and he would prefer the MPC to be given the task of achieving the inflation target and stable employment conditions (p 240).

1.35  Others are not so worried, either because they believe that if the Bank can create low inflation, it will automatically bring benefits to growth and employment; or because they feel that it is very difficult for a central bank to be so concerned with inflation that it will wilfully neglect the other objective. In the first camp are the Chancellor, and such witnesses as Wim Duisenberg, who told that Committee that "the best contribution that monetary policy can give to output and employment is price stability" (Q 853), and Dr König of the Bundesbank, who said that "by achieving price stability and maintaining price stability we promote and we are conducive to growth and employment as well." (Q 907) In the second are such witnesses as Gerard Lyons, whose opinion is "that they are now increasingly operating as if they had a dual mandate, which is sensible" (Q 1118). What complicates this further is that the mechanism of monetary policy works partly through the exchange rate with effects that are not transitory and easily reversed. Some clarification of this topic appears in a memorandum from the Treasury printed in Volume II (pp 387-388). Since we have received this during the very final stages of our deliberation, we have been unable to take it fully into account.

Compatibility of low inflation with the Government's other economic objectives

1.36  We have already noted the Chancellors' view that there is no long-run trade-off between inflation and growth and employment. His opinion that low inflation is a prerequisite for growth and employment is supported by, for example, Sir Brian Pitman. He told us that "all over the world there is a conviction that low inflation is the way to achieve sustainable growth." (Q 922) But this view, though rarely disputed, is accepted cautiously by some, and is doubted in particular by those with experience of non-service industries and of areas outside the South. In any country inflation can only be targeted by applying one monetary policy for the whole of the economy. As Professor Dr Hermann Remsperger of the Bundesbank stated, "For monetary policy there is no chance to distinguish between different sectors of the economy and say, "Well, in the light of developments in manufacturing industry a rate cut of 50 basis points but in the service sector just 25", I think that is impossible." (Q 882) In a country as diverse as the United Kingdom, there will always be geographical areas and economic sectors which are not performing as well or as badly as others. In the last two years, for example, the manufacturing sector has been underperforming. At the same time there has been a boom in the service sector; and areas such as the North-East of England have not been growing as fast as the South-East. Added to this, inflation is calculated at the national level: there is no separate figure for inflation in the various parts of the country. The question of whether the inflation rate is the same over all regions of the economy is a serious one. We do not prejudge the answer, but are convinced that the Office for National Statistics ought to give priority to work which will provide it.

1.37  That the interest rate appropriate for one sector may be different from that needed for another may be designated as the "one policy fits all" problem. This was the dilemma that was faced by the MPC when it was raising interest rates in early 1998. It is not unique to Britain: in Germany, the Bundesbank from 1990 until the establishment of the ECB had to set monetary policy for a country which, due to reunification, consisted of a prosperous west and a very depressed east. In their case, however, the view was taken that it was the job of the government (Q 883). This problem arises even more strongly for the ECB itself.

The remit of the MPC

1.38  In "The Inflation Target and Remit for the Monetary Policy Committee: Background notes" published by the Treasury in June 1997 further details of the monetary objective were stated. Principally, these are:

1.39  This remit provides both a long-run objective—a 2.5 per cent growth rate of RPIX—and implicit instructions for the short term. The evidence from the Governor and recent inflation rates show that the MPC is sticking to this remit.

1.40  One aspect of the remit where there is a lack of clarity is in the exact interpretation to be given to the requirement to support the Government's economic policy objectives for growth and employment. If inflation is to be kept very close to its target, then it is not clear what scope there is for using interest rates to achieve other objectives. In his evidence the Governor stated that the MPC achieves the inflation target by using interest rates to control demand for the purpose of controlling inflation. To quote specifically:

"I think I said this to you when I first came before this Committee—you do not address inflation first, get it under control and then turn your mind to something else. You are continuously addressing the inflation objective and through that supporting growth and demand in the economy. That is what I said to you, I think I would have preferred that formulation because I think it would have been easier to understand." (Q 1561).

This would suggest that any consideration given by the MPC to growth and employment must not merely be subordinated to achieving its price stability objectives, but might mean that the former gets no weight at all. The Governor may be right, but we find it impossible to interpret the exact words of the Act in this fashion.

1.41  What is noteworthy both in the minutes of the MPC and in their public statements is the extent to which they focus directly on all sorts of aspects of the real economy. For the most part this is intended to throw light on inflation and its likely path in future. It is not clear, however, whether in the minds of some members of the MPC weight is actually being given to state of the real economy itself. Members of the MPC differ from time to time on what is the right policy decision to take. Since they are all confronted with the same data set, and discuss all aspects of the problem together at considerable length, their differences arise from (a) differing views on how the economy works and what factors determine inflation in general, (b) differing interpretations of the state of the economy at the time the decision has to be taken and its likely development in the foreseeable future, and (c) differing interpretations of the risks involved in a more or less expansionary or contractionary monetary policy. One aspect of policy differences is especially noteworthy. The individual members of the MPC have differed on change versus no change, with the change almost always in the same direction. There have been only two occasions when some members have argued for an interest rate rise while others have wanted an interest rate cut[12]. We deal with various aspects of the decision making system and the voting mechanism later on.

1.42  The remit seems better designed to deal with demand shocks than supply shocks. We do not doubt that the former occur much more frequently than the latter. What would happen if there were a supply shock remains unclear although there is scope within the remit to deal with these as well.

1.43  Supply shocks can arise in many ways. The classic case of this was the oil embargo of 1973, when members of the OPEC cartel restricted the supply of oil in order to raise its world price. Other examples might be through wars or through technological progress that makes existing products and production methods redundant, or by new cheaper sources of supply of existing products. In general the correct response to such shocks is not to seek to completely offset the initial effects on prices and hence the inflation rate but to ensure that they do not have a lasting impact on inflation and inflation expectations. If this means that the Bank were to miss the target it would be called upon to write an open letter to explain why, and to set out the steps it is taking to bring inflation back to target. In the event of a large shock there may even be a need for the Government to revise the inflation target for a while or to take other action, for example through the use of fiscal policy. We have no reason to expect that this would not be fully appreciated by the MPC and the Treasury.

The extent of the discretion available to the MPC in the short term through the letter writing

1.44  From time to time, all economies are subject to external, largely demand, shocks which affect inflation at least in the short run. An example of an economic slump in one region is the recent Asian crisis. In this instance, the fall in the value of far-eastern currencies and the slump in their domestic demand for goods may lead to a recession and the deflationary effect results in cheaper goods originating from those countries (such as electrical equipment) and fewer customers for goods produced in the West (like BMWs).

1.45  In theory, some shocks affect inflation only in the short run. As we have said, a supply shock will cause the inflation rate to rise for only 12 months, a blip, so to speak, and provided there are no knock-on effects, inflation should return to the original rate at the end of this period. In such a circumstance, it may be prudent not to raise interest rates, so as to avoid the risk of damaging the economy. Partly to allow for such shocks the mechanism of the open letter was introduced.

The implications of a letter for government policy more generally

1.46  The letter from the Governor to the Chancellor is a requirement for all circumstances where inflation leaves the target range and is not just for such occasions when direct price shocks occur. In such a letter, the Governor's duty is to explain why in his judgment the target has left the target range as well as external shocks there are many possible reasons to explain the failure to hit the target. Principally, these will fall into two categories: the shortcomings of fiscal policy and the shortcomings of monetary policy. We may distinguish between poor responses to whatever new forces are driving the economy and intrinsic policy errors. Included in the latter would be the kind of policy mistake we have seen in the past, namely a deliberate attempt to drive the economy beyond its longer term supply limits.

1.47  As yet, there has been no need for the Governor to write such a letter to the Chancellor and its potential format can only be speculated upon. However, it is not difficult, as we have just said, to imagine circumstances where even fiscal policy would be in part to blame for excess inflation. It is worth adding that this is meant to be a general note of caution. We have not seen any sign of this kind of mistake occurring either in the latter stages of the previous administration or under the early stages of the present one.

Should the Bank and not the Government choose the inflation target as in other countries?

1.48  As noted above, the Bank does not have the power to set its own target, unlike other central banks like the Bundesbank, the ECB and the Fed. The advantage of the present arrangements is that it allows the Government to ensure that the Bank has in mind the objective of following their economic program in general. The disadvantage is that if this objective is taken seriously it means that the Bank has less freedom of action. The Governor told the Committee, however, that the MPC preferred the Government to set the target than to set it itself. We do not know whether the Governor has been involved in discussions about the feasible or desirable level of the inflation target. Since both Bank and Treasury have discussions at all levels on all aspects of the macroeconomy, it would show remarkable restraint if the Governor and others kept silent in discussions about the remit! Of equal interest is the question of changing the target. The majority view has been that some inflation, certainly as measured by RPIX, helps the market mechanism to work better. A target of zero means that price cuts must be as frequent and as large as price increases, which is not easy to achieve while maintaining full capacity real growth. But that does not imply that 2.5 per cent is the correct target for all time. It is a useful task for serious economic research to elucidate the optimum inflation rate. A fortiori this problem would grow in importance were the United Kingdom to join EMU.

11   R Barro, Inflation and economic growth in Bank of England Quarterly Bulletin, Vol 35, No 2, May 1995. Back

12   May and August 1998, when on each occasion the majority favoured no change, DeAnne Julius favoured a rate cut and Willem Buiter favoured a rate rise. Back

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