Select Committee on Economic Affairs Second Report


The Interest Rate Cut of 6 February 2003

47.  Since the Committee finished taking evidence, the Bank of England has cut interest rates by 0.25 of a percentage point.[15] It has also published the Minutes of the MPC meeting of 6 February, and the February issue of its Inflation Report, which provides the background for the decision. As this decision, and the reasons given for it, are so striking and apparently at variance with the recent past, we make a few brief observations about it. These observations are based on the material found in the Inflation Report and in the MPC Minutes, but we are fully aware that we have not had a chance to take evidence from the Bank of England on this subject.

48.  The Repo rate has been held constant at 4% since 8 November 2001, a period when inflation has been almost continually below the 2.5% target. The first striking aspect of the cut is that it has coincided with a rise in inflation to 2.7%. Given the MPC's remit to target inflation, the cut comes as a surprise. It has also surprised markets and commentators. This too must be set against the MPC's previously stated wish not to take markets by surprise. So what has occurred that has brought this unanticipated move about?

49.  The February Inflation Report, which was published after the interest rate cut and refers to it, notes three main factors. All three relate to rising costs: higher housing depreciation costs, increases in oil prices and rising import prices. The MPC believes that the first two will be temporary and not long-lived. The import price rise is ascribed to a falling exchange rate. The highly significant aspect of this is that these are supply shocks to the economy, and not demand shocks. This is probably the first time that the MPC has been faced with a supply shock to which it felt the need to make an interest rate response.

50.  We draw attention to the fact that the MPC has responded to these supply shocks by cutting interest rates. This is despite the increase in inflation, and the fact that an interest rate cut may be expected to cause a further depreciation of the pound, and hence increase in import prices and inflation.

51.  Previous statements by the MPC to the Committee refer to the use of interest rates to control inflation via their effect on aggregate demand. This would seem to imply that the source of the shock was not of relevance to the MPC. To be consistent with the MPC's remit, and its previous evidence to the Committee, in the absence of any identified long-term negative demand shock in the Inflation Report, we would therefore have expected that the rise in inflation would have triggered a rise in interest rates, or at least keeping them constant. We can only speculate on whether the MPC is reacting to unidentified long-term demand factors, is giving greater weight to a loss of output in its interest rate decision, or has not recognised that it is in new territory. We look forward to discussing these issues with the MPC at an early opportunity.

The Pagan Report

52.  Finally, we note that Professor Adrian Pagan's Report on Modelling and Forecasting at the Bank of England has now been published. It is, unfortunately, too late for it to be taken into account in this Report. We hope to take evidence on the Pagan Report and on the Bank of England's Response to it in due course, with a view to publishing a separate Report on that subject.

15   Two of the members of the MPC voted against this cut: they were Andrew Large and Paul Tucker. Back

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