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


What has happened to inflation?

6.1  In June 1997, when the MPC met for the first time, RPIX stood at 2.7 per cent. It rose to 3.0 per cent the next month and then declined to 2.5 per cent by January 1998. By May 1998, it had risen to 3.2 per cent before falling to 2.5 per cent in September, hitting the target for the first of four consecutive months. Since then it has fluctuated around the target by no more than 0.2 per cent until May 1999 when it fell to 2.1 per cent. In all, since the establishment of the MPC it has fluctuated within a 1.1 per cent range: the closest inflation has come to triggering the open letter mechanism was in May 1998, when it hit 3.2 per cent.

6.2  By way of comparison, RPIX averaged 4.7 per cent in 1992, when inflation targeting began, and between then and the establishment of the MPC it reached a maximum of 3.5 per cent in March 1993 and fell to its lowest level of 2.0 per cent in September 1994. What is vital to appreciate is that inflation reached a peak of about 8 per cent at an annual rate in 1990, and fell steadily after that. The stable period has been approximately from 1993 to the present day. Any attempt to assess the value of the new arrangements, which inevitably involves addressing the question of what otherwise might have happened, must be within that perspective. It must also be placed in a world perspective inasmuch as inflation rates of many other leading countries have also been lower than in the past. (Countries which already had low and stable inflation, of course, had less scope to lower it further.)

6.3  On the face of it, it appears that the 1990s have been a success as far as inflation is concerned. Comparing the 1990s (average annual inflation rate: 4 per cent; and since the establishment of inflation targeting: 2.8 per cent) with the 1970s and 1980s (13 per cent and 7 per cent), Mervyn King recently said that "Inflation has been remarkably stable during the six years since an inflation target was introduced. Indeed, it has been more stable than in any period since monthly RPI figures were first collected in 1947."[22]

To what extent is this due to the MPC?

6.4  Since the decline of the inflation rate and the period of stability antedate the work of the MPC, it cannot be said that they are solely or even mainly responsible for any of that. The point holds a fortiori when it is appreciated that operational independence of the Bank of England was not predicted, especially in this form. In addition, the Bank itself has laid particular emphasis on the importance of time lags in the monetary policy process. It is only recently that the direct impact of the work of the MPC is being felt. It may not be difficult to agree with the Governor's statement that "the fact is that it has been close to target nonetheless, so we could not have fouled up completely" (Q 1551). This may be unduly modest, since within the historical record the capacity for error within the realm of macroeconomic policy making appears limitless. Some weight must also be given to the MPC being new to the job. They, and the Treasury, for that matter, are still in the business of learning how to operate within the new structure.

6.5  We have already noted that when assessing the success of the MPC there is the delay between their decisions and the affect on inflation. The consensus view, from all our witnesses, backed by econometric evidence, is that this delay appears to amount to between 18 months and two years, and, as we have said, this would suggest that only the earliest of the MPC's decisions are now having an effect.

6.6  Thus, the time lag must lead some to the conclusion that the real credit must, in whole or part, go to the predecessors of the MPC. Even though Gerard Lyons, for example, admitted that "It would be wrong to attribute all of the improvement to making the Bank of England independent but certainly I am sure there has been some influence there" (Q 1112), his opinion was that "the fact that the Bank assumes it takes two years for policy changes to affect inflation shows that the previous Chancellor Ken Clarke was taking the right policies because two years after he left office we did hit 2.5 per cent inflation." (Q 1119) Roger Bootle felt likewise: he said that

6.7  Nevertheless, the MPC is still given due credit by other witnesses. Martin Weale believed "the new monetary policy arrangements have been responsible for holding the average rate of inflation at something very close to 2.5 per cent" (Q 1055). Sir Ronald Hampel's view was that "we look as though we are going to have a smoother period this time around. If that turns out to be the case I think the MPC deserves to take some of the credit." (Q 1257)

6.8  Where the MPC may have made a more substantial difference is in the area of inflationary expectations. The Governor told us that "What I am sure it has done is to reduce inflationary expectations." (Q 1616) and Mervyn King has noted that such expectations fell by about 0.5 percentage points on the day of the announcement of the new arrangements.[23] He went further, and suggested that "part of the improved performance of the last two or three years can be attributed to … the "credibility windfall" resulting from the new monetary policy framework".[24] Sir Ronald Hampel told us "we reduced our inflationary expectations over the last couple of years from five per cent to three per cent" (Q 1255), and in written evidence ICI noted that "inflationary expectations and long term interest rates in the United Kingdom have now come down to match those in the US, and this might be seen as a success for the MPC" (p 275). Sir Brian Moffat went further, and stated that British Steel now planned on the 2.5 per cent target figure. There is some doubt, however, whether any of these improved expectations are yet reflected in the actual rate of inflation. There are indications that the decline in earnings growth is a reflection to some extent of the fall in the expected rate of inflation. The City of London and many businesses employ more economists, and, presumably, take notice of what they say. (Whether we can go further than that and state that the wider public has become more economically sophisticated, especially in regard to inflation, is more doubtful.)

6.9  An independent, although still imperfect, measure of the extent to which the fall in inflation may be attributed to the MPC, and one not mentioned by witnesses, is the behaviour of the term structure. A rising yield curve (long yields exceeding short rates) is a reflection of either expectations of higher inflation in the future or the higher risk premia on long bonds, but an inverted (or falling) yield curve can only be due to expectations of lower future inflation. Until 1997 the term structure sloped upwards; long yields on 5-year and 15-year gilts exceeded 1-year yields. But from 1997 onwards the term structure started to turn downwards, and until very recently, has been inverted throughout most of 1998 and all of 1999. This strongly suggests that market expectations of future inflation have been marked down since the MPC began. A rough estimate is that inflation expectations are nearly 3 per cent lower than in 1996 and over 2 per cent lower than in 1997.

6.10  It could be argued that this is all due to an expectation that sterling will join EMU and that therefore the United Kingdom will have the same long rates as the euro-zone. To some extent this is supported by the humped-shape of the yield curve at the time of writing. This probably reflects the increased uncertainty about entry to the euro as a result of the May European elections, and hence the possibility that United Kingdom inflation will be higher than euro-zone inflation in the medium term. If so, this would not be a vote of confidence in the MPC by financial markets. To set against that interpretation is the fact that under the MPC inflation has been brought down to levels where long-term rates are comparable to those in the euro-zone.

6.11  Overall, insofar as it can be judged, at all the MPC has delivered on its basic priority of price stability, but witnesses for the most part have suggested to us that it is too early to come to a definitive conclusion. Professor Bean's recommendation that "until there is evidence that the system is not working, the best advice seems to be: Don't try to fix it!" (p 306) appears to be the most appropriate.

Has this been an unusually benign period for inflation?[25]

6.12  The counterpart to the reasonably good heritage bequeathed to the MPC is that so far they have not been severely tested. Without a seriously adverse demand shock, let alone a large supply shock, it is very difficult to see whether the new approach is working well. It is not easy to see how inflation targeting might have coped with an oil shock, a flight from the currency or a world environment of rising prices. Martin Weale said to us that "The studies we have done have looked at inflationary shocks and what the economy has experienced in the past, both positive and negative, and they just have not been there in the last five years." (Q 1056) One other aspect of all this was noted by the Governor. Serious supply shocks may be rare in any case. He stated that "The classic supply shock was the oil price rise in the early 1970s and the fact that people have to point back to that shows they are pretty unusual events." (Q 1610)

6.13  We do not look forward to such tests, and would rather live in an automatically stable and successful world! But in our sort of economy such tests to the system must eventually occur. They will prove the system's usefulness (or worthlessness), but we have to emphasise the argument that severe tests have been lacking is a general feature of the evidence to our Committee. As put to us by Sir Brian Pitman, "I think they have been tremendously helped by a benign environment. There is no doubt whatsoever about that." (Q 935)

6.14  The 1990s have seen inflation at low levels not just in Britain, but throughout the world. The European Union weighted average for 1998 was 1.8 per cent, and for the G7 it was 1.5 per cent[26]. This compares very favourably with the past, as we have already noted, and inflation policy is now played according to different rules. There are plenty of reasons why, and we turn to the former Chancellor, Mr Clarke, for some of them: he told us:

    "I got utterly fed up listening to people make comparisons with the late 1980s and I continue to get fed up with the present Chancellor of the Exchequer making comparisons with the late 1980s because the economic rules internationally have changed since then. If you look around the world the old relationship between monetary aggregates and inflation has certainly changed and even monetarists admit they do not know quite how. As a layman, what I think has happened is we have global competition as never before. We have a pace of technological change as never before. The ability to raise productivity in some sectors is quite immense. The ability to hand on price increases to restore margins is very, very limited, so that one sees around the world prices confined, earnings confined and expectations changing." (Q 607)

6.15  Or, as put by Gerard Lyons, "the global environment has become very competitive and that has forced the corporate sector to keep costs down, wages have been kept down and in turn consumers have become very price resistant." (Q 1102)

6.16  The Governor, however, does not share the view that he has been given an easy task: he told us that "We have had elements of good fortune in being precisely around 2.5 per cent but I have to tell you that the situation in the last two and a half years has been as difficult as I can ever remember and I do not think people appreciate the impact that that has had on trying to steer this economy." (Q 1552) His view is that during the existence of the MPC there have been significant inflationary pressures: first upward, and then downward. In the Bank's 1999 Annual Report, he states that "it was apparent, certainly from early 1997, that overall demand and output growth needed to moderate if we were to avoid capacity restraints and a rise in inflation."[27] He goes on to explain that in late 1998, after the financial collapse in Russia and the losses incurred by the LTCM hedge fund, and the weakening of business confidence at home, "The prospect of a necessary slowdown in overall demand growth to keep inflation on track risked turning into an unnecessary downturn with a prospective undershooting of the inflation target."[28]

6.17  Others have taken a different view. Mr Clarke, for example, said of the 1998 monetary targeting that:

    "the only reason we went above the target last year, 1998, was because of the tax changes that the Chancellor made. If you look at RPI whatever it is called, Y, excluding tax and mortgages it never went above the target at all so there were not any inflationary pressures waiting to explode inside the economy so long as you made some adequate movement in time, to keep it at that level." (Q 614)

Others were sceptical about the downturn of late 1998. Lord Desai's view of the Asian crisis was that:

    "If I was giving this evidence a year ago, then the MPC was not a very popular body. People were complaining about the MPC. It had gone through successive interest rate rises and people were wondering "How soon are we going to run into recession?" and "What kind of recession will it be and will it be a hard landing?" and so on. All that has been averted thanks to this nice external shock." (Q 1199)

6.18  But not all have been critical. In respect of the monetary tightening, Lloyds TSB offer another opinion. They considered that:

    "The MPC then had to perform a delicate balancing act between growth and inflation. The economic stakes were big. Simulations on our model of the United Kingdom economy at the time suggested that a soft landing could easily be turned into outright recession if interest rates were only marginally too high" (p 204).

6.19  And in respect of the Asian crisis, Professor Bean, though considering that "these shocks have come at what has turned out to be quite a convenient time for the Monetary Policy Committee" (Q 1446), said that "the way they reacted relatively promptly to the Asian crisis—or rather the second leg of the Asian crisis following the Russian default—by reducing rates swiftly during the first half of this year has been an object lesson in how central banks should behave." (Q 1407)

6.20  To place all this in a wider perspective, GDP was rising above its trend growth rate in 1997. It has been somewhat below trend since then. This may explain the early tightening of monetary policy, and the subsequent easing. The obvious drawback to such an interpretation is that policy is meant to be forward looking. What matters, therefore is not whether GDP is rising above trend at some time, but, given the Act and the remit of the MPC, what this implies for future inflation rates. (Interpretation of what inflationary pressures were inherited by the MPC is made even more complicated by the fact that the unemployment percentage has been falling steadily since 1993.) Professor Bean told us that "the MPC has been dealt a good hand and played it well." (Q 1446). That is a conclusion with which we are inclined to agree.

How much of the exchange rate changes have been due to United Kingdom monetary policy?

6.21  We have already noted the difficulties which some parts of industry say they have been experiencing as a result of the high value of Sterling. We have also discussed the problems the experts have had in explaining what has happened to sterling, and especially of evaluating the relationship between interest rates and exchange rates.

6.22  It is important not to exaggerate the rise in the value of sterling. Over the past two decades the pound has lost some 40 per cent of its value against the DM (which could be looked at as a proxy for the euro.) It has risen more recently, but is still below where it was ten years ago. Against the US dollar sterling has fluctuated for some time in the range of US$1.5 to $1.8. It has risen from a trough in 1993, but is still below its earlier peak. More to the point, it has risen steadily since 1993, a trend certainly not initiated by the decisions of the MPC. Sterling's effective exchange rate was on a downward trend from the beginning of the 1980s until the mid 1990s. There has been a 20 per cent revaluation since then, possibly due to better control of inflation, but not altogether, if at all, attributable to the MPC. It is probably this last figure commentators have in mind when saying sterling is overvalued.

6.23  It is worth adding in connection with that, the balance of payments on current account was in deficit from the mid 1980s to the mid 1990s. The move into surplus started in 1996, and coincides with the rise in the value of the pound. Any causal connection is difficult to discern, especially considering the more recent move back towards deficit.

6.24  On the question of the role of interest rates, there are many potentially valid explanations for the lack of a close relation between interest rate and exchange rate movements. Confidence seems to have a strong role: Lord Desai's view was that "the British economy now has higher growth potential and more flexible labour markets than it used to have and therefore to some extent the exchange rate should reflect the higher real strength of the British economy." (Q 1189). This may also explain the strength of the dollar relative to the Euro. But if that is right, we have nothing to fear. A strong economy should improve our export performance, and the external value of sterling. If there is a problem, something else must be driving the pound upwards, more than reflecting increased productivity,and causing problems for the tradeables sector. That is precisely what we have been told in evidence. An example is the very powerful statement from British Steel on its inability to sell profitably abroad despite its high level of efficiency.

Has monetary policy been synchronized more with the US than with the Euro-zone?

6.25  It is notable that while the pound has fluctuated against other currencies, it has stuck close to the dollar. Since inflation targeting began the pound has moved roughly in a band of US$1.50-$1.70, but the corresponding band for the deutschmark has been much wider at DM2.20-DM3. Meanwhile base rates in Britain and America have been much closer to each other than to those in the euro-zone. As noted above, the reverse has been true of long rates.

6.26  It is not clear what the explanation for this is. Is it more a reflection of United Kingdom, euro or US monetary policy? The ECB still uses monetary targets and has set a reference value for money growth of between 4.5 per cent and 5 per cent. This is based on assumptions made about inflation, GDP growth and trend velocity. Unfortunately, the actual values of these variables are different from what is assumed. Moreover money growth has in practice exceeded 5 per cent. Added to this interest rates were cut again in April. One possible, but for the moment tentative, explanation is that the ECB's monetary policy has been unnecessarily slack. We have to add that such a conclusions would be regarded as rather controversial.

6.27  More generally, it may be asked whether the United Kingdom and US economies are closely linked by trade, that being the explanation of relative stability of the £/$ rate. The problem here is twofold. Firstly, United Kingdom trade is nowadays greater with the EU than the US. Secondly, the capital account is far more important in determining the exchange rate than the current account, especially in the short and medium terms. Indeed, in the short term, and probably the medium term too, international capital movements are the dominant force in exchange rate changes. Here too it remains to be demonstrated that the US and United Kingdom capital markets are linked so closely as in themselves to account for what has happened to the £/$ and £/DM rates. More generally on exchange rates, presumably what matters are relative rates of interest, notably those between the US and the United Kingdom. A more careful examination of that may in due course clear up some of the exchange rate puzzles.

6.28  A lack of explanation and a historical perspective tell us not to jump to simple conclusions. We must add that this is not the same as asserting that the problem is not there. Industry's objections are a true reflection of their experience, and are valid. There can be no doubt about the recent pressure felt by the tradeable goods sector. There are problems with the goods section of the balance of payments, although these are of long standing. Either the MPC must pay attention to this as part of its "subject to that" remit, or the Chancellor must find another form of solution.

What have been the costs of the policy to date?

6.29  If interest rate changes are supposed to translate into inflation only after 18 months to two years it will naturally be too early for most individuals and companies to evaluate their personal inflation costs and benefits at this stage. However, because interest rate changes have an immediate effect, and because they may have an effect on exchange rates, there will be many who will have felt a cost already. Sir Brian Moffatt, for example, has felt such a cost, and his view that "a tight monetary policy … has brought big pressures on industry, particularly in manufacturing" (Q 1295) is not an isolated one. Mr Stan Hardy, Chairman of the Yorkshire Ridings Branch of the Institute of Directors, said that "the upward pressure on sterling caused by high interest rates lost export orders" (p 358); the National Farmers' Union claimed that "The high level of interest rates in the United Kingdom in 1998 imposed a large cost on the agricultural industry with the interest bill to agriculture rising by some £100 million when compared to 1997" (p 363); and the UK Steel Associated claimed that:

Generally, many in industry might agree with the MSF Union, who stated:

    "High interest rates—in recent times more than twice those of our major competitors—and an over-valued pound have been important factors in falling output, job losses and the manufacturing trade deficit." (p 362)

Lecture at Queen's University, Belfast, 17 May 1999. Back

23   Ibid. Back

24   Ibid. Back

25   What we mean by "benign period for inflation" is a period when circumstances are conducive for maintaining low inflation. Back

26   Source: Treasury. Back

27   Bank of England Annual Report, p 3. Back

28   Ibid p 4. Back

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