Select Committee on European Union Minutes of Evidence

Examination of Witnesses (Questions 1-19)




  1. Welcome. It would probably be helpful if you could, for perhaps two, three or four minutes, give a brief introduction to the subject and to your views. We can then get them together, as it were, and it might help us in our questions.
  (Mr Smith) Good morning. I am Andrew Smith, Chief Economist at KPMG. Prior to that I was the Chief Economist and Investment Strategist at Credit Lyonnais (which is now called Credit Lyonnais Euro Securities in London) looking at the financial markets from an investment point of view. I suppose the start of my interest in the European Central Bank came with what is known as the "communications problem": basically the fact that the ECB insists it is totally transparent whereas in fact a lot of the time the markets just do not seem to get what is happening as far as the ECB's policy actions are concerned. I published a paper towards the end of 2001 called "Too much independence, not enough transparency . . ." and, very briefly, the argument in that was that central banks' currency, if you like, is credibility. This can be buttressed by independence, accountability and transparency in various different measures. There is no a priori correct mix of these various . . . pillars, I was going to say . . . I will say pillars, for the bank's credibility but I think the fact that this "communications problem" does exist does suggest that the ECB may not have it right yet. I must admit I was rather confirmed in this view when the ECB's response to my paper was just to reiterate effectively that it was highly transparent and highly accountable. I would like to make one broad point: I see that you are looking at this from a European perspective, and it does seem to me that we do have to take into account the fact that central banks in different countries and different areas come about with different histories, from different cultures and with different structures of the economy, so the sort of discussion we are having now might not seem particularly appropriate in various of the European countries where they have the example of a highly independent, highly secretive, some would say very low accountability, banking past, in the persona, of the Bundesbank. A lot of the sort of discussions we have over here about what is happening to short-term interest rates, how is the MPC functioning and so forth, are not really topics of hot debate in a lot of European countries, partly because, of course, the power, of short-term interest rates is not so great in some of those other economies. I think we just need to bear that in mind if we are trying to understand why the ECB appears to behave in some strange ways to us.

  (Mr Walton) Good morning. I am David Walton, Chief European Economist at Goldman Sachs. At the outset I would say that I have no particular problems with much of the way that monetary policy is conducted by the European Central Bank but, I agree with Andrew, I do think the ECB's main problem has been one of communicating effectively its strategy to financial markets and, indeed, to the citizens of the euro zone economy. I think part of that is due to the fact that policy has actually evolved since the introduction of the euro in January 1999 and I do not think the communication strategy has fully caught up with that. I do regard this review that the ECB is undertaking at the moment into its monetary strategy as an opportunity for the ECB to realign its words with its actual actions. I think there are two areas where policy has evolved. The first is the so-called first pillar, the monetary pillar. I think it is pretty clear that M3 is not a very good guide to interest rate decisions in the euro zone economy. I think money and credit are clearly important indicators for the ECB but it is not clear that they merit a particular status over and above everything else at which the ECB looks under the second pillar. Therefore, one good reform, I would suggest, is that the ECB actually downgrades the first pillar and that would make their communication strategy a lot easier. The second area—and more important for me—is that I think their definition of price stability has evolved. When they started out, they talked about price stability being price increases of less than 2 per cent over the medium term. Effectively that meant they adopted an inflation target of zero to 2 per cent. It is pretty clear that one per cent actually represents the floor for their inflation target and Professor Issing, the Chief Economist at the ECB, has indicated this on a number of occasions. It is also pretty clear that the ECB has become more tolerant of inflation above two per cent—a little bit above two per cent. For me, one of the aims of this monetary strategy review should be for the ECB to make it clear that when it says that it is price increases less than two per cent that correspond to price stability, that definition should really be taken as being an average over time and that that average is actually quite close to two per cent, and, ideally, they should actually give the range in which they are tolerant of inflation—something like one to 2.5 per cent, or one to 3 per cent. If you had those two reforms, of the monetary pillar and of the definition of price stability, that would actually make their communication strategy a lot easier and would align their actions with their actual stated words.
  (Mr Weale) I am Martin Weale. I am from the National Institute of Economic and Social Research. I feel that the European Central Bank is somewhat maligned. There is a tendency to blame it or it and the monetary union for the slow growth that the euro area is experiencing at the moment. In fact, as David mentioned, inflation, depending how far back you carry it, has been above the ECB's target—it is still above the ECB's target. It slowed recently, and one can expect it to drop below the figure of 2 per cent, but they have failed to keep inflation in the bounds that they had set. There is a question: Should the inflation target be slightly higher? If they had had an inflation target of 2 per cent with bands of one to 3 per cent on either side—and, given the measure we are using, that is probably broadly comparable with our own 2.5 per cent—even with that measure they might have felt some difficulty in cutting interest rates further than they have. It is often suggested that the European Central Bank is rather inflexible. In fact, if you look at the frequency with which interest rates have changed since they set up shop in 1999, they have changed 16 times and the Bank of England has changed 16 times, so one certainly cannot say that one arrangement finds it harder to change than another. I would like to have more understanding of how they arrive at their decisions but I think the same point can be made about the Bank of England and I think the fundamental obstacle is that when you have a committee coming to a decision of this sort it is difficult to be very precise, in a way, about how you reach your decisions. I would like to see greater explanation about why they do what they do with a view to making it easier to anticipate their future moves, but I would not say that the Bank of England is an ideal model on which no improvement is possible. I do think that clarification of the inflation target would be desirable. It is easy to say, in periods of economic weakness, faster inflation is always the solution—and it is always the solution until you try it for too long and then it starts to be a problem instead of a solution—but there might be a case for, at the very least, clarifying their target—say, 1.5 per cent, with a one per cent range either side. On the question of the first pillar, I have argued that money GDP would make a more sensible first pillar than the monetary measures they have and I would be happy to elaborate on that.

  2. David Walton and Martin Weale, do you have anything to say about the transparency/accountability issue mentioned by Andrew Smith at the beginning?
  (Mr Walton) I would go back to my opening remarks, really, that they would be a lot more transparent if they actually—

  3. You do not have anything specific reforms?
  (Mr Walton) Not really. I think if they say what they do, that would make them a lot more transparent.
  (Mr Weale) I do not think I have anything to add, thank you.

Lord Taverne

  4. First of all, may I apologise, but I am going to have to leave during this session. I have only one or two questions. First, all right, they have not specifically adopted symmetry or stated their targets of one to 3 per cent, but are you saying that it is a matter of presentation rather than substance? Because, in practice, is it not right to say that they have been as concerned about undershooting as they have about overshooting, and—as, indeed, the result has shown: relatively high inflation, on the whole above the target they have set—they have been as concerned with stimulating growth as they have been with suppressing inflation?—not that they are necessarily alternatives. Would you agree that it is really a question of presentation rather than practice? The question I have for Mr Smith is this: Is it fair to say, as you suggest in your paper, that the markets are completely baffled by what the central bank has done, that they do not understand the plot? Has the picture that has emerged not been, to a certain extent, a fairly clear one, that in practice they have really been quite sensible, and more or less adopting symmetry although it is not explicitly stated?
  (Mr Smith) I will try to link your two questions together, if I may do so. It seems to me that for transparency and for accountability the central bank needs to be very clear about what it is doing. The ECB has said it has a ceiling of 2 per cent for inflation. If it starts implicitly rather than explicitly playing with that target, I think it is heading for potential problems, in that the market will not always be able to understand why it is doing it and therefore might start to wonder about the credibility of the bank and whether it is really firm in its purpose of stabilising prices in some sense. I think that is an issue, just in the sense of: How can we measure the bank's actions if we are not quite sure what it is actually getting at? Having said that, I am tempted to move towards the money GDP issue, if that is all right. It seems to me that central banks do have an eye on growth. You cannot get away from that. In the case of the UK, the Bank of England gets over this problem by having the output gap model explicitly, which basically says that the best way of keeping inflation stable is to have output kept as close as possible to target. In the UK's case you could say that the inflation target under most circumstances becomes a growth target and you could also say that there is an implicit money GDP target because you take the view that there is an underlying trend rate of growth and you add your inflation target to that and effectively you have a nominal GDP target for the longer term. I think the problem with the ECB is that it is just very unclear what actually it is targeting still. I think I have probably not really answered the second part of your question.

  5. Really if you could say how far this has unsettled markets.
  (Mr Smith) The bafflement of markets is particularly on a month-to-month basis. We have quite a few examples of the ECB saying one thing one day effectively—their spokesman, normally Duisenberg—and a day or two later we find the ECB making an interest rate decision which appears totally to contradict what has just been said. We had that back in December. Just before they cut interest rates, Duisenberg effectively seemed to be saying that stagflation, with the emphasis on the `flation' bit, was more of a worry than deflation and then either the following day or two days later the ECB cut rates. So we get the markets being, in a sense, wrong-footed all the time, which is not happening if you look at what is happening in the US and it is not really happening in the UK—although I guess the markets did seem to think that the February cut over here was a surprise. But, generally speaking, it is a kind of month-to-month problem with the ECB.
  (Mr Walton) I do not really agree with Andrew actually. I think they used to have a problem of the presentation from month to month, not least because each of the various national central bankers and the ECB executive board would quite often say things and they would not appear to be that coordinated, but I would say that at least over the last 12 months they have made a deliberate and conscious effort actually to make sure that they do not surprise markets unduly. I cannot recall every interest rate decision but certainly the last two moves, the December and the March moves, I think were very well telegraphed by Duisenberg, and Duisenberg has effectively become the spokesman for the committee, the person to whom you listen, in the same way that you listen to Alan Greenspan in the United States, and some of the other Fed governors can say things which are not necessarily that relevant to the actual interest rate decisions. So I think they have improved in the way they have presented but I do think they should be more up front. I also agree that they are very responsive to economic activity. The main reasons why they cut in December and March, despite the fact that inflation was above 2 per cent, was because they were concerned about the weakness of economic activity and they could see that that would lead to an improvement in inflation looking over the next year or two. In many ways the ECB has evolved into a central bank which broadly has a symmetric inflation target close to 2 per cent. My only plea would be that if that is the way they are operating then that is what they should actually say they are doing, rather than maintaining a pretence that, if you like, zero per cent inflation or 0.1 per cent inflation is the same to them as inflation at 1.9 when in fact they are really indifferent between inflation at one per cent and inflation of close to 3 per cent.
  (Mr Weale) I agree with David that they have had inflation above 2 per cent for quite a long time and it does not seem to have exercised them in the way we imagined. Because it is untested that the Monetary Policy Committee would be exercised at least in writing letters if inflation were above their upper limit of 3.5 per cent. It seems reasonably plain that breaching their 2 per cent target is not equivalent to breaching the Monetary Policy Committee's 3.5 per cent target in this country. There is a question: What are they actually doing? What target do they actually have in mind? I think it would be helpful to know more about this. On the question of sensitivity to activity, the point about the first pillar is that at the moment, I think I am correct in saying, it is still true that M3 is still growing fairly rapidly. To have a demand, a target, a pillar which reflects real activity and allows them to respond to that in a way that the monetary targets do not would I think be rather helpful to them. If they are to have a two-pillar strategy then it is a much more sensible pillar than monetary target that they have at the moment. There is a separate question, not much discussed, and that is whether it is desirable to build any element of clawback into the system; in other words, any element of price stabilisation rather than just inflation stabilisation. Our arrangements do not have that: bygones are bygones. The advantage of stabilising or having some sort of reference to the level of prices and not just the inflation rate is that it does mean that long-term monetary contracts have much less uncertainty to them than if it is simply inflation which is stabilised. The downside, of course, is that you may find it difficult to meet those sorts of targets and you may worry about the effects of the sustained inflation undershoot that might be needed on occasion should you pursue that sort of policy, but there is a real issue there that merits serious discussion and we should not simply assume that all targets should be defined in terms of growth rates and bygones should always be bygones.

  Lord Sheldon: Transparency. The great advantage of transparency is that it enables people to understand the way the mind of the European Central Bank is proceeding. In so far as it does that, it offers the opportunity of the two, the markets and the bank, working pretty well in line with each other and it gives a better understanding as to what is happening. How far can we go in transparency? Revealed votes is the extreme one, I suppose. Another one would be to have all the arguments that have been presented at the discussions in the European Central Bank, to get a flavour of the kind of arguments that are going backwards and forwards. Then there is the other aspect about the inflation targets. Undoubtedly the European Central Bank were concerned much more about inflation than anything else. Although I have heard what has been said by the people here, I am a bit concerned that there is still that element there that underneath it all they are still very worried about at some future time, or perhaps their past history affects them very much in the way that they are still very frightened about inflation. And the situation has changed, it has changed quite dramatically, with the unemployment rates and so on we are seeing in Europe. Although there has been some move in the direction which you, Mr Walton, and your colleagues have said, I am not sure it has gone far enough. Finally, the one about removing M3. I am very worried about these targets that you set because they are never that precise. Things change and people's attitudes to them change. I have seen monetary policies of M1, M2, M3, M4 and M5—and I have derided them all—in my time. It should be one of the considerations—I am not disputing that—but to set it as a target I think is a dangerous thing.

  Chairman: To whom are you putting those three questions?

Lord Sheldon

  6. Andrew Smith talked about "not enough transparency".
  (Mr Smith) My starting point is that there is still a puzzle in that the European Central Bank insists it is highly transparent. Although I agree they have made some progress towards improving communications over the last year, it still seems to me to be an issue that we do not understand the ECB in the way that we understand, or think we understand anyway, the Bank of England and even, these days, the Federal Reserve, which I think has changed quite a lot as well. So the question is: where is it going wrong? If the ECB says, "We are highly transparent" but a lot of us sit here and do not really understand what they are doing, where is it going wrong? They do a lot of the things which other central banks do: they give us monthly reports, annual reports, they testify to parliament—Duisenberg and a couple of the others do anyway. The one thing they do not do is publish the minutes. They claim that the press conferences they give are a substitute for those minutes. The way I perceive this problem is that they are actually giving us ex post transparency. They tell us what they have done and why they have done it, and sometimes the reasons they give are more plausible than at other times, but that is rather different from that which we get from the Monetary Policy Committee and the Federal Reserve, where we get, if you like, ex ante discussions, so we get discussions of what might happen under various contingencies, what they think the risks are, all these things. In my paper I give the analogy of a detective story where the strategy—about which the ECB is supposedly very transparent—does not actually tell us a lot. The strategy of a detective story is that there is a murder, there are various characters, we have the odd red herring and then the detective unveils the murderer, but, if you just know that, that does not really give you any help understanding the storyline; you need to understand the chapters. To me it is the minutes, if they are given willingly, which give us the chapters and allow us to understand the plot. We are really getting ex post transparency, not the ex ante transparency, the discussions and so forth, which would give us a clue as to what is really going on.


  7. I wonder if Lord Sheldon would mind me asking the other two about this idea of publishing things. What do you feel about that?
  (Mr Walton) I have no particular issue about whether the minutes should be published or not. I think they would be helpful on balance but I think the key thing is that they could reflect to a greater extent than they do the shades of opinion within the Council. The press conference and the editorial of the ECB bulletin largely present the picture as being very black and white—you know, interest rates are where they are because these are the appropriate circumstances and they are appropriate until they change again—whereas from the UK MPC minutes and also from the Fed you do tend to get more of an indication of balance of risks and the way the arguments are going. And to a degree that is summed up by the vote: if the vote is a majority vote, then that tells you something—as opposed to, say, a 5:4 vote. So you are lacking that dimension at the moment. But you do not necessarily need to publish complete minutes to get that, you just need to have within the editorial, within the press conference, "Some of us basically felt there was a case for cutting interest rates even though the majority decision was that we kept rates on hold." I think a little bit of that flavour of the argument would be quite helpful.

  8. Is there not a problem about the fact that they are not there as representatives of their countries and you do not necessarily want to reveal how each one voted?
  (Mr Walton) You do not need to reveal how each person voted. You could just say, "We have a committee of 18"—or however many—"and within that a sizeable minority thought that there was a strong case for cutting interest rates," even if the decision in the end was that rates were left unchanged. I think all too often they have tried to present it as one of collective responsibility, whereby once they agree on the decision then that is it and everybody is signed up to it. To reflect shades of grey sometimes can be quite a useful tool, and, as I say, does not require necessarily for the minutes to be published.
  (Mr Weale) I think the minutes should be published. They should be anonymised, as Andrew suggested in his paper. One of the difficulties of course is that if an anonymous speaker is talking at length about the situation in German or the situation in France there might be obvious conclusions people would jump to as to who was making those comments, so some thought would need to be given as to how to do it maintaining the substance of anonymity as well as the form of anonymity, but I think the minutes could talk about the situations in particular countries in a way that obscured the identities of those making the points and I think for that to be done would be a very valuable contribution to transparency.

Lord Hannay of Chiswick

  9. I read your paper, Andrew Smith, and I had a lot of sympathy with the balance you tried to strike. I do think it is quite unwise for anyone to be pushing them towards identifying individual votes. I think it is too new an institution, and the risks of pressure being put on people if their votes can be identified is a real one which they feel and I think you were right to avoid that. I do think that if this idea of achieving greater transparency by publication of minutes and so on is to get anywhere, some greater account will have to be taken than has been in previous criticisms of the very real feeling that they have that they could be put under pressure by too close identification of who said what. The question I would like to ask you really is this: To what extent do all the criticisms add up to extreme frustration by journalists and analysts that these people do not have English as their mother tongue and therefore do not express themselves in the language of Milton and Shakespeare and are less skilful than Alan Greenspan or Eddie George at getting the precise and exact nuances of the English language quite right? If that is the problem, we are not going to solve it, so we had better get used to it, frankly. In a sense, that is what will happen: people will get used to it. They will discover that the ECB has a different house style in its statements and that you have to allow for the fact that they do not always express themselves in pluperfect English. The second question is slightly less trivial. It is to ask you to what extent most of the points you are making could be met if the ECB more consciously did what the Fed do, which is to indicate a bias (that is, to indicate a direction in which they believe they were leaning for the future) and to what extent that is the missing element. It is of course missing also, I think I am right in saying, from the MCP's statement.
  (Mr Smith) On your first point, I myself often wonder whether we have a linguistic problem at times, and I also sometimes wonder whether you have not only frustrated journalists but also frustrated city economists who guessed wrong one month arguing that it is the fault of the ECB for not being transparent. But I think really there is an issue which is much broader than that; it is this whole issue about how much is the ECB really prepared to tell us about what it is doing. This might be jumping ahead a bit, but we have already referred to it, there is a peculiarity in the sense that the ECB is setting a numerical inflation target itself. I would argue that setting a numerical inflation target does have some political angles to it. How much growth and how much inflation might you want or what sort of trade-off do you want? Of course, in the UK the MCP is actually just handed an inflation target which is decided politically or by politicians and it then has, in that sense, just a technical job of trying to reach the target, whereas the ECB sets its own inflation target, which is sensitive. One reason why they might be reluctant to reveal more about their workings might be a fear that they might actually open up the inflation target they have set. They might actually open that itself up to discussion, which would actually be extremely problematic for them. So I do think the transparency issue is more than just the day-to-day communication. Your question about bias . . .?


  10. The Fed—
  (Mr Smith) Yes. My view on this, again going back to my detective story analogy, is that the more information you get, the easier it is to follow the plot. From the markets' point of view, one way they can understand more how the central banks are thinking is if they give indications of their bias as well, because then you know from month to month what you are looking for if you have the context of the minutes as to why there is that bias in the first place. If they just said, "We have not cut rates this month, but we will probably be thinking about it next month," I am not sure it would actually help an awful lot. May I just go back as well to this question on revelation of national identities. I am not convinced. I suspect this might be somewhat overdone. I accept that there could be pressures on individual central bank governors, but equally at the ECB itself there is a lot of peer pressure presumably going on there as well, so I am not totally convinced that it is such a big issue as people suspect it might be. Also, I do think if you do actually start publishing minutes and even the balance of the vote, it is not actually going to be very difficult for people to find out who has voted which way anyway. I just think it is maybe not such a big issue and, once you start being more transparent, I am not sure there is an awful lot you can do about keeping identities secret anyway.

  11. Does anybody else have anything to say? Am I not right in saying that recently Duisenberg actually has talked about the bias, the way they are looking.
  (Mr Walton) Duisenberg has certainly said . . .For instance, at the press conference after the March cut they said they had debated between a 25 and a 50 basis point move, so there is a bit more of a revelation of their thinking. To answer the two questions that Lord Hannay put, I think English as a first language is an irrelevance to this. Whether you have a first pillar is a pretty fundamental thing in any language. Indeed, whether an inflation target is zero to 2 or one to 3 is a fairly fundamental thing. This has nothing to do with nuances; this has a lot to do with explicit recognition of what they actually do. On the bias, I actually am not particularly in favour of a bias. I think in the US system the bias creates all manner of difficulties—as we are probably about to find out today if the Fed does not actually cut rates. Indeed, in the US the bias typically has not been that good a guide to what the central bank actually does. I think that if they feel strongly enough actually to have a bias then that sort of suggests that they should have done something. If they do not feel so strongly, then can still reflect the way that some members are thinking, but, as we know from the UK MPC, just because a couple of members think that rates ought to come down that does not necessarily provide a very good guide to the way the whole committee will actually think going forward. I think you should reflect opinion but I personally do not think you should have an actual bias as to what you might do in the next month or two because circumstances change.
  (Mr Weale) Could I say rather more strongly that I am actually against a bias, for the obvious reason that if you think it is likely that interest rates should be lower next month than they are today then why have you not reduced them today already. It must in some sense be saying that the interest rate setting authority does not think it has done the thorough job: it does not think it has set the interest rate yet at the appropriate level. The only reason for doing that would be if you thought that changes in interest rates of more than a quarter of a percentage point were something to be avoided at almost all costs. Well, we can all remember that interests rate changes in Britain used to be larger than a quarter of a percentage point and the heavens did not fall on us, so I would certainly avoid the idea of a bias. On the concept of English as a first language, possibly I do not read enough in the French and German newspapers, so I would not have picked it up, but I have a suspicion that the complaint about the communication from the ECB seemed to stem mainly from London—at least, I have not noticed them as much in other European countries.

Lord Sheldon

  12. On the two questions I put, I am sorry it has lasted so long, and I am a bit concerned about time, but the other two questions I have are these. Is there really symmetry in inflation targets? Is there really a symmetry or is there not some residue of the concern about inflation being higher than it should be? Removing M3, the whole of the first pillar. Using monetarism, of course, is one of the considerations, but should it be quantified in this way or in any way?
  (Mr Walton) Could I just say on the inflation targets that I think they have changed. One evidence for this is that the last time interest rates in the euro zone were down at 2.5 per cent was back in April 1999 and inflation at that time was at one per cent. This time round they have been prepared to cut rates down to this level when inflation has still been running above 2 per cent, so I think that does provide some evidence, if you like, that they are prepared to move more aggressively than perhaps they would have done when the ECB first came into existence.

  13. Taking into account the whole of the economy and the way the economy is moving, is there not still some feeling that the pressure should still be down, even by comparison with the state of the economy at any particular time?
  (Mr Walton) I think you can argue that interest rates of 2.5 per cent are pretty low. Certainly, if you look at most euro zone countries, inflation in most euro zone countries is at or higher than the level of interest rates set by the ECB. It is only really Germany which has much lower inflation. So, for most countries they are seeing an easier set of monetary conditions than they have really seen at any time in the past 20 years or so. I think they have been quite appreciative of the fact that they have needed to ease monetary conditions because activity is so weak. On your question about M3, I fully subscribe to the notion that the first pillar should be downgraded. I am a little bit concerned that the ECB is actually going to retain the first pillar. They will drop the reference value and they will say the reason they are retaining it is because they want to guard against asset price bubbles. You can see this in today's FT story. To my mind, the best way to observe whether or not you have an asset price bubble is actually to watch the asset prices themselves rather than to look at it indirectly through some money supply indicator. There will be occasions perhaps where you do want to be concerned about asset prices, in particular if that threatens your ultimate objective of price stability, but to give it some special status, I think, is not really warranted.
  (Mr Weale) Could I say it is not obvious to me that the European Central Bank is too concerned about inflation. I think internationally we are at a phase of the world economy at the moment where a lot of people are saying that a bit more inflation would not matter too much. They are largely people and organisations who had borrowed money in the expectation that things would turn out differently from the way they have and they are now hoping to be bailed out of their difficulties by inflation eroding the values of their debt. This is something that works fine provided it is terribly infrequent but I think the European Central Bank and others are right to remind us that from being something very infrequent it can become sort of the norm, and, in those circumstances, you then face the difficulties that economies did in order to try to bring inflation down in the 1980s and early 1990s. That is not to say that the inflation target needs to be between nought and 2 per cent—it is plain they have let inflation go above it—but I think independent central banks, whose job is to control inflation, need to show that they are taking that job seriously.

Lord Lea of Crondall

  14. I have two questions which arise from things written by Martin Weale. One is an extract from a memorandum submitted to the Treasury Committee and the other is a paper written with Ray Barrell of April this year. On page 7 of the paper, the European set up is described as a "constitutional hybrid". Of course, it is different from America, in the sense that the fiscal policy instruments, subject to Maastricht, are in a sense devolved in a totally different way from America. On the other hand, some people think of the Fed as having not only a twin pillar but almost a triple pillar, that they have obviously money supply and inflation but they also have real economic growth. My first question is this: Does it make any difference whether you have explicit terms of reference to include real economic growth or not?
  (Mr Weale) Could I say on that that if the ECB did have real economic growth explicitly in its terms of reference then my guess is it would be happier about cutting interest rates, or it would have cut interest rates further than it has. I do not know, I would expect it to make a difference.

  15. Would that be a good idea or not?
  (Mr Weale) My judgment is that at the moment interest rates in the euro area could probably be a bit lower and inflation actually would probably also fall to under 2 per cent but I think they would have found it easier had they had real growth mentioned in their reference frame or if they had this money GDP target.
  (Mr Walton) My own view on this is you have to be a little bit careful about how much you ask central banks to do. At the end of the day, central banks have one instrument, which is interest rates, and really they can only achieve one target. You could go for a money GDP thing, which is a kind of compromise between growth and inflation, or you can go for an inflation target, and most central banks these days (the Fed being the notable exception) have gone down the route of adopting an inflation target. I personally think that is the best objective to go for, rather than a money GDP objective. The reason for that is that I fundamentally believe that the way to keep inflation broadly stable through time is largely to keep growth in the economy pretty close to a trend rate of growth, whatever that trend should be. What you tend to find is that inflation-targeting central banks actually become bigger fine tuners than prior to the period when they had inflation targets. The UK is a very good example of that, where the stability and growth compared with earlier periods in time, certainly since the Bank of England independence but even since 1992, has just been very striking. So really the way the ECB behaves, which is the way the Bank of England behaves—some are more explicit about this than others—is essentially to try to keep the economy as close to potential as possible, because that is the best way of trying to ensure that inflation does not deviate too far from target. In other words, the way to get booms and busts in inflation is essentially to have booms and busts in economic activity. I would be pretty happy with just specifying an inflation target for a central bank and allowing them to get on with that job.
  (Mr Smith) I agree very much with what David has said. We always end up anyway going back to the logical problem, that if you have one instrument, you cannot target two things simultaneously. I have just a couple of other points: both the UK and the ECB do have these funny "subject to" clauses appearing somewhere or another. The Bank of England Act says that the Bank of England is to target inflation "subject to that it should support other objectives of Government policy" and, hidden away, there is a similar clause for the ECB. The way I interpret that is to say that if you have an inflation target, there are various paths of interest rate movements and real GDP changes you could go down to get there. I think the "subject to" clauses are really saying that you ought to have an eye to minimising the effects on output when you are progressing towards meeting your inflation target. That brings us also to the time horizon issue. If you have a longer time horizon—or even, you might argue, some banks seem to operate on a variable time horizon, potentially anyway—they are actually making a decision about what effect they want to have on output compared to what effect they want to have on inflation. My own view is that this is fine, and I am very pleased central banks do it, but I am not sure it would help actually to have more explicit targets for either real GDP or nominal GDP. I think it is logically difficult and just confuses the communication of it.

  16. Paragraph 26 of Martin Weale's extract from a memorandum to the Treasury Select Committee begins, "Is the ECB's inflation objective too low? The target of 0-2 per cent pa is certainly lower than the UK target of 2.5 per cent. The gap is not large given that the UK RPI tends to rise up to 1 per cent faster than the euro area Harmonised Consumer Price Index" etc. I think it is quite an important point. It is emerging here about this Harmonised Consumer Price Index, does that mean that comparing apples with apples we do have a different, as it were, announced result for any given set of price increases? When Martin Weale says that the UK RPI tends to rise up to one per cent faster than the euro area Harmonised Consumer Price Index, is he implying that is for statistical reasons?
  (Mr Weale) Yes, I am.

  17. Could you explain why?
  (Mr Weale) As far as I understand it, there are two reasons. One is the treatment of housing in the UK RPI. Even if you look at the "excluding mortgage tax interest" there is a depreciation charge for the use of housing which I do not think appears in the Harmonised Consumer Price Index, and we for a long time have lived with a situation where house prices tend to rise in fits and starts but tend to rise faster than prices in general. The second factor is that the retail price index looks at a fixed basket of goods and measures the cost of that. When I say "fixed" that is a slight misnomer; the composition of the basket is changed every year, reflecting patterns of the thing that people actually buy, but no assumption is made that if the price of ... I do not know ... cigarettes happens to go up a lot then people will cut back on their spending in cigarettes and buy something else. When you allow for substitution away from things that have risen in price particularly rapidly, the cost of living actually goes up less than if you assume that the basket that people buy is invariant to the way prices are changing. The European Harmonised Consumer Price index has an adjustment for this. It is a rough and ready adjustment but I think the suggestion is that it takes about 0.5 per cent per annum off the inflation rate.

  18. Chairman, I would like to see that fully explained somewhere because I was a member for many years of the Retail Prices Index Advisory Committee and re-weighting (which I think is the term that is used) is done reasonably frequently.
  (Mr Walton) Could I just add one thing on this, because there is a very useful box in the Budget Redbook—because, if you remember, the Chancellor in his speech actually said that the Treasury was looking into whether or not to shift. The way round this—and this was a problem in the United States as well—is that the RPI is basically an arithmetic average of lots of different prices and the Harmonised Index, including the Harmonised Index in the UK, actually averages things geometrically and that tends to dampen the effects of some of these extreme price movements. You find—and it can be proved, although I cannot—that a geometric average will never give you a number which is larger than an arithmetic average and will usually give something smaller. It has been pretty consistent in the UK, since the introduction of the Harmonised Index, that that effect is worth about half of a percentage point and it has been very well documented by the Office for National Statistics. Once you just make that adjustment alone, a 2.5 per cent RPI X target, calculating these data using the same methodology (that is, just using the same statistical averaging) would automatically bring you down to a 2 per cent inflation target in the UK, regardless of the point about housing, which, as Martin says, has quite often been worth quite a bit more. The problem with housing is that it is treated very differently in every European country, and the way that Eurostat has got round that is just to ignore it altogether, which is not necessarily the most appropriate thing to do. I think it is that which is largely there—it is this way the data which are just averaged together which accounts for this bias. In the US they found that this bias was worth just over a quarter percentage point or so, and, indeed, the Boskin Committee did get the statistics authorities to move from an arithmetic weighting to a geometric averaging and that did knock between a quarter and a half per cent off US inflation.
  (Mr Weale) There is an article on this in the ONS publication Economic Trends. I am afraid I cannot remember in which month it was published but they certainly do document this in some considerable detail.

Lord Hannay of Chiswick

  19. It is presumably incontrovertible that if we joined the euro zone the European Central Bank would use the harmonised rate for its work on the UK whatever we chose to use.
  (Mr Weale) Absolutely. Yes.

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