The Interest Rate Decisions of
the MPC
13. In August 2005 the official interest rate
was cut by 25 basis points to 4.5 percent. For the previous year
rates had stood at 4.75 per cent. Five members of the MPC voted
in favour of the cut (Kate Barker, Charles Bean, Richard Lambert,
Stephen Nickell and) David Walton) and four voted to maintain
rates (the Governor, Sir Andrew Large, Rachel Lomax and Paul Tucker).
Thus all four external members of the MPC voted to cut rates and
only "internal" Bank members voted against. There is
no doubt, therefore, of a division of opinion between the Bank
and the external members of the MPC.
14. The Minutes of the August meeting explained
that the main factor influencing the vote in favour of a cut in
rates was the slackening of demand pressure on supply capacity.
This, together with survey information of a sharp fall in prices,
created a need to reduce rates to avoid damaging confidence and
to support the path of market interest rates. The Minutes noted
that early action would reduce the risk that greater changes would
be needed at some point in the future, but this would not preclude
a rise in rates in the future if the data warranted it. It is
difficult for us to interpret this explanation in any other way
than that the cut was designed to boost demand. We presume this
was in order to avoid future inflation falling too far, but this
was not stated explicitly in the Minutes.
15. Those who voted to maintain rates had a more
cautious view of the prospects for inflation. Although demand
had slowed, the Minutes explained, the economy was still operating
close to full capacity, and survey data indicated a stronger economy
in the future. With oil prices remaining strong, producer prices
rising sharply and an acceleration in unit labour costs, it was
thought too early to conclude that inflationary pressures had
abated. Adding to the strength of demand while costs were still
working their way through the supply chain was said to risk increasing
inflation.
16. In September and October 2005 all members
of the MPC voted for an interest rate of 4.5 percent. The September
Minutes stated that the MPC were in broad agreement about the
nature of the risks to the outlook for inflation, but they attached
slightly different weights to them. Pressure on demand was thought
to be still downwards and could deliver a lower inflation outturn
than envisaged in August. However, in the past year inflation
had been higher than expected. This was said to reflect more than
just the impact of oil prices. Nonetheless, inflation expectations
appeared to the MPC to be well-anchored.
17. These Minutes also showed that the MPC had
considered how best to respond to oil price increases. They could
be accommodated temporarily and headline CPI inflation would be
allowed to rise. Monetary policy could be tightened later if there
was a subsequent increase in inflation expectations that caused
higher wage settlements. This seems to have been the main basis
of the agreement by the MPC to confirm a rate of 4.5 percent.
18. The October Minutes noted that the official
four-quarter output growth rate had been revised still lower.
This prompted the MPC to wonder whether the official data were
correct. Business surveys indicated that service sector growth
was not as weak as the official statistics suggested and weaker
growth was not evident in the employment data.
19. Mervyn King told the Committee that he did
not think that the MPC had been unusually divided. He said that
the MPC ought normally to be in a position where some individuals
were taking marginally different views from others. He remarked
that the MPC had been criticised for being overly unanimous in
the last year.
20. We agree with the Governor on this. Members
of the MPC should individually make up their own minds about interest
rates. Differences of opinion are to be expected on occasion and
should not undermine the authority of the MPC provided the reasons
for them are fully explained to the public. The last year has
been an unusual one for the MPC. It experienced its first serious
supply shock to inflation. In the absence of a well-rehearsed
monetary policy response to substantial supply shocks, it is not
surprising that there were differences of opinion among MPC members.
This is part of the process of learning how best to formulate
policy. We accept that any differences of opinion have in practice
been small and that the MPC has not departed from its inflation
remit. The fact that differences of view were largely a division
between external and internal members of the MPC might be said
to illustrate the benefits of having external input into the decision.
Nevertheless, we believe that it is important for the credibility
of the Bank that occasions when the Governor is outvoted should
be few and far-between.
21. We share the fears of the MPC about the accuracy
of official statistics. Following an analysis of official data
revisions in our last report on monetary policy, we expressed
our concern about the accuracy both of the preliminary estimates
and the final data, even though we were partly re-assured by the
Governor's denial that they had been a problem for the MPC. In
his latest evidence to the Committee, Mr King noted the problems
mentioned in the October Minutes. We also record that the MPC
were sufficiently worried about data revisions to national accounts
that they included a special analysis in the August Inflation
Report. Between the third quarter of 2003, and the second quarter
of 2004, economic growth was under-estimated by 1 percentage point
compared with the revised figure. In the first quarter of 2005
growth was over-estimated by 0.7 of a percentage point compared
with the May revision. In our view, these are major discrepancies
and are too large for any complacency about the accuracy of official
estimates of economic growth.
How Effective is Monetary Policy
22. This question arises from recent findings
by the Bank about the response of inflation to changes in interest
rates. These findings are reported in its description of its new
quarterly model[5]. The
Committee noted that the Bank had estimated that a 100 basis point
increase in interest rates sustained for a year might reduce inflation
by a maximum of only 0.3 of a percentage point. If correct, this
weak reaction of inflation to interest rates would seem to undermine
the effectiveness of monetary policy.
23. In response, Mr Bean told the Committee that
the impact of a change in interest rates depended a lot on why
the change had occurred and how it was interpreted by markets.
A crucial factor was whether the change was expected to be temporary
or permanent. He said that the response was probably nearly twice
as big if it was thought to be permanent. This response underlines
the crucial importance the Bank attaches to the role of expectations
in the conduct of monetary policy, with which we concur.
24. In practice, we observe that only once has
the MPC held the interest rate unchanged for more than four quarters
(from November 2001 to January 2003), and the largest change has
been 50 basis points. We appreciate that these are only estimates
of the response of inflation to interest rates, and there may
be a considerable margin of error. We applaud the Bank's openness
in publishing this information. Nonetheless, these results seem
to offer strong support for the Governor's warning against expecting
the MPC to be able to fine-tune the economy.
Conclusion
25. This report is provided for the information
of the House. We expect to invite the Governor, with other members
of the MPC, to give oral evidence to the Committee again next
year.
1 Select Committee on Economic Affairs, 1st Report
(2001-02, HL 5); 2nd Report (2002-03, HL 66): 3rd Report (2003-04,
HL 176). Back
2
Select Committee on the Monetary Policy Committee of the Bank
of England (1998-99, HL 96-I);
(2000-01, HL 34-I). Back
3
Ms Kate Barker, Mr Charles Bean, Mr Richard Lambert and Sir Andrew
Large. Back
4
The Retail Prices Index excluding mortgage interest payments. Back
5
The Bank of England Quarterly Model, 2005 Back
