Examination of witnesses (Questions 89-99)|
TUESDAY 6 FEBRUARY 2001
89. Welcome and thank you very much for coming.
As you know, we are doing some hearings and a report on the MPC
three years on, if you like. The Treasury Committee was set the
task of holding accountable the MPC. We are going to look at our
performance later on. Could we start off with how you would assess
the record of the MPC and by what criteria do you judge them?
Maybe that would be a useful opening question.
(Sir Alan Budd) I think their record
in achieving the objective that was set them is about as good
as mere mortals could have achieved. In terms of how you judge
them, this, as you know, is not a straightforward matter. Professor
Charlie Bean gave excellent evidence to you on this matter a year
or so back. Judging by outcomes is not ideal. We know that the
rate of inflation has, for some time now, been below the target.
In some sense that indicates the policy could have been more relaxed
two years ago. The correct way to judge this is whether they were
making the best possible decision, given all the information available
to them at the time, I believe that, by and large, they were.
(Mr Flemming) I would share that but I would add the
qualification that, if one is speaking of the system as a whole,
I do not really believe it has really been very severely tested
yet. Indeed, it would take quite a long time to generate the amount
of data and experience that would be needed to draw a firm conclusion
about the robustness of the system. In particular, I think it
might well be buffeted more than it has been by exchange rates,
exchange market events, and also from stock market changes, possibly
even commodity prices. If one looks back at the things that have
disrupted macroeconomic policy over the last four decades or so,
those are where the shocks come from. If those shocks materialise,
then one gets into uncharted waters about estimating the response,
and therefore the inflation forecasts on which the MPC relies
become very widely dispersed and there is a distinct possibility
of errors being made, again through no fault of the Committee.
It is simply that one does not know; none of us knew in 1987 what
the response of the world system was going to be of the stock
market correction. That can create problems which I would perhaps
rather come back to if you were to ask an appropriate question
(Professor Buiter) I would like to address first the
record on the procedural side, which I think is as important as
the outcome on performance. There has been great success in terms
of the accountability of the procedures. That is a demonstration
of the fact that you can have an operationally independent central
bank which, nevertheless, can justify and explain its actions
to the elected Members of Parliament and to the public at large.
That is as much an achievement as whatever comes out in terms
of inflation performance. In terms of inflation performance, by
and large, I agree with the previous speakers. I would not quite
say that there has been no test. We had in 1998 an incipient financial
crisis. We have lived with an asset boom. That is not easy monetary
management. We have lived for a long time with inexplicably strong
sterling, which has not been easy. Furthermore, there is likely
to be a test just on the horizon with the US economy slowing down
rapidly. I think, so far so good, and very good indeed.
(Mr Barrell) I would agree with my colleagues except
to say that we have to recognise that the world environment has
been very stable over the last three years. That would help any
monetary policy decision-maker. It has been surprisingly stable
because there was an incipient crisis in 1998 with the collapse
of Russian bonds and so on, but that crisis did not emerge, partly
because the Americans stepped in to prevent it. The Monetary Policy
Committee was not particularly tried; it stood ready to do its
part but did not really have to do so. Over the last three years
we have had success with an easy trial. I would say, however,
in the first year or so of the Monetary Policy Committee's activities
it was finding its feet and that it was probably reactive to events.
It probably changed interest rates slightly more often too than
was really needed. It is very difficult to know these things because
it is very difficult to measure credibility. The MPC may have
seen itself as building credibility and therefore it needed to
react. It is interesting to note that activity was significant
until the autumn of 1999 when the Institute commented that activity
was excessive, and since then interest rates have hardly changed.
Perhaps the MPC took account of our advice.
90. Is it a legitimate question to consider
the track record of individual members of the MPC? It might be
interesting to have one answer from those who were actually on
the MPC and then perhaps the outsiders putting in a view as well.
(Professor Buiter) It certainly is legitimate. That
is the point of having individual accountability, as well as the
collective task of setting interest rates. Clearly that is something
that not only graduate students looking for a dissertation topic
should do, but also bodies like the Treasury Select Committee.
Yes, individual performance does matter and of course evaluating
it causes the same problems as that of the Committee performamce
as a whole.
(Sir Alan Budd) I agree with that. As it has happened,
of course, people have not had their appointments renewed. That
is entirely for the Chancellor. Were they to be renewed, then
I think there is a perfectly reasonable question about how well
have individuals performed. Three years is rather a short time
in which to judge this. When the system was being set up, if I
may say so, there was a feeling that there would be questions
of renewal and that people would try as best they could to judge
the performance of individuals. I have made comments about how
easy it is to do that. That is a different matter.
(Mr Flemming) It is certainly legitimate but I think
it is very difficult to identify the performance of an individual.
Were I a member and if I thought there was some inflation nutter
on the other extreme, I might vote consistently for very low interest
rates, not because I thought very low interest rates were desirable
but in order to neutralise the lunatic at the other end of the
spectrum. I am not sure you could allow for that. The performance
is a collective performance when it comes to the point. On the
other point that Sir Alan has raised, I do believe, particularly
if it is not in practice going to be a pattern of reappointment,
that it would probably be best to remove the option, in order
to enhance the perception of independence on the part of the members,
at the same time as possibly lengthening their term.
91. What do you mean by that last point?
(Mr Flemming) That when each member is appointed there
should be some discussion with a term of about six years as a
maximum but many people, particularly coming from academic life,
might not be able to do that. There should be a discussion which
would fix the term of their appointment, and that would then not
92. What you are arguing for is longer terms?
(Mr Flemming) Preferably longer terms and reviewing
the question of renewability.
93. Therefore individual responsibility would,
in a sense, not be operable?
(Mr Flemming) They would be publicly accountable but
it would not be, as it were, enforceable by having the carrot
(Mr Barrell) If you have a panel of independent experts
making monetary policy decisions, it is probably useful to keep
a record of their voting and they should be answerable to somebody
on the record for their voting. I personally do not consider that
record particularly interesting, partly because it is a committee
and people make decisions on a committee in relation to the other
members. I think we have probably paid too much attention to voting
records and less to the actual reasons for the decisions being
made by the committee.
94. For 22 months now we have had inflation
on the chosen target or well below that target. Can I ask each
of you what you deduce from that and do you think you can fairly
conclude that the policy is set too tightly?
(Sir Alan Budd) May I start by saying it is a tribute
to how successful the Monetary Policy Committee has been. You
say that the inflation outcome has been well below the target.
In fact, it has been up to half a per cent; that is a margin of
error we would have thought quite outstandingly successful in
times gone past. Certainly it has been clear that it has been
persistently below. As I said earlier, this does suggest that
when they were making the interest rate decisions about two years
ago, they set policy tighter than after the event it needed to
be. The single most important reason for this is the one alluded
to by Professor Buiter, namely a persistent, high level of the
exchange rate. In general, at the time those decisions were being
made, there was a market perception that the exchange rate would
fall. This was embodied in the Monetary Policy Committee's assumptions
at that time. The exchange rate did not fall as expected and inflation
has been lower than was predicted. I think there have been other
difficulties. It is possible that there have been more favourable
relationships between the level of unemployment and the rate of
inflation in this country, independent of what was happening to
the exchange rate. In that sense, there had been a structural
improvement in the economy which was not possible to detect at
95. Would you not say, however, that the 22
months run of inflation well below that target should invite the
MPC to re-visit some of those assumptions it was making about
the exchange rate, for example two years ago, and challenge whether
that is still accurate? Do you think they have done that?
(Sir Alan Budd) They have done it because there was
a body of members who believed that it was more sensible to predict
inflation on the assumption that the exchange rate would stay
at its current level rather than be guided by the forward market
indicators. The central forecast is based on an average of the
exchange rate not falling and the exchange rate falling, as indicated
by forward interest rates. So they have shifted; they have shifted
their central assumption. I am sure they have thought a great
deal about why they were wrong in their forecast of the exchange
rate. Certainly, they are learning from their experience and from
their mistakes all the time.
96. Can I ask others what they think of that?
What would you deduce from the fact that we have had inflation
below target for so long?
(Mr Flemming) I think that Sir Alan has covered much
of the ground, but if the question is, as indeed you put it, has
policy been too tight, I would not look only at the indicator
of the inflation performance. If monetary policy were too tight,
we would be paying a price in something else, as well as actually
getting perhaps an unexpected bonus in terms of inflation. After
all, the overriding statutory target or obligation is price stability
and many people would argue that 2.5 per cent a year is not really
price stability, although it is not for the Monetary Policy Committee
to debate that.
97. They are told what the target is.
(Mr Flemming) Yes, and their job is to deliver it.
One of the people who might re-think under these circumstances
is actually the Chancellor of the Exchequer, since there has not
been a high price paid, as it turns out. As Sir Alan mentioned,
some labour market developments have been favourable as well.
Therefore, one conclusion one might draw is that it would in fact
be possible to ratchet the target down at some point to get closer
to price stability without paying a high price in terms of output
98. Your conclusion from the 22 months is that
it is nothing to do with the MPC's policy-setting but perhaps
the target is the wrong target?
(Mr Flemming) Not the wrong target, no; what I am
saying, as Sir Alan did, is that with hindsight the MPC made a
mistake, but its assumptions about the exchange rate movements
were perfectly reasonable assumptions. They were actually backed
up by the markets and it was a very widespread mistake and not
one for which they can easily be blamed. As a consequence, we
have learnt some things about the behaviour of the economy. Because
of other changes that have taken place, we have learnt that we
can actually live with a lower rate of inflation than had been
thought with as high a level of activity as had previously been
(Professor Buiter) I re-emphasise, as Sir Alan did,
just how small the bias actually is. Over the last year, inflation
has averaged 2.1 per cent. The fact that not once as a committee
did we have to write a letter to the Chancellor is very surprising.
We are talking about small under-performance of the target. If
it happens for 22 months, then it has to be for one of three reasons:
either a systematic bias in the shocks that it faces, systematic
surprises; or working with the wrong model, the wrong view of
the economy; or a policy bias, that you are not really targeting
the 2.5 per cent symmetrically. It may be a bit of two or all
three. There certainly was in the period I was there, for me a
persistent series of exchange rate surprises. We are probably
still feeling the effect of that. That should now reverse in six
months or a year from now, as sterling has weakened. I think we
also probably underestimate the extent to which the non-inflationary
rate of unemployment might have fallen. I think there may have
been some other bias. There may be a view that, if one had to
write a letter to the Chancellor, inflation having, say, fallen
below 1.5 per cent, that said, "Dear Chancellor, the economy
is booming, unemployment is at an all-time low. However, inflation
is 1.4 per cent, we are sorry", that would not be a terribly
difficult thing to write. It might be more difficult to write
the same letter saying that inflation is 3.6 per cent. I do not
know but I think it is a mixture of the three.
(Mr Barrell) In terms of the structure of the economy
we live in, I would say that it is quite remarkable how close
to 2.5 per cent inflation has been. If we look at the past 25
years in the UK, inflation has varied between 2 and 20 per cent.
The fact that we kept inflation within a very narrow band means
one of two things: either the sequence of shocks we faced have
been very much smaller than we experienced in the past; or the
new policy framework is very much more effective than we would
have expected three years ago. Monetary policy may have turned
out to be very marginally tighter than might have been anticipated
but that margin is very small indeed, given the degree of control
we can have on an economy like that of the UK.
99. I want to come on to the shocks now. One
interpretation is that it has been a benign climate and therefore
relatively easy to get it right. I think Mr Flemming, in your
introductory comments, you said it has not really been tested
yet. On the other hand, some of your colleagues have mentioned
testing conditions: the oil price shock, the slow-down in America
and the Russian bond situation. There have been tests around.
Let us quickly go to each of you: can you comment on whether you
think the system really has been tested and if not, what sort
of test will turn out to be the real test?
(Mr Barrell) Has the system been tested? No, not really.
The world system was tested in 1998 but not particularly the UK's
role in it. The only test that the Monetary Policy Committee has
faced, as has been stressed, is the exchange rate has been rather
stronger than might have been anticipated, but that has helped
in its task. It is a favourable test, pushing inflation down below
what it might otherwise have been. In terms of what tests we might
face, we do have to recognise that the last few years have been
very stable and the sorts of shocks we saw in the late Eighties
and early Nineties would actually cause inflation to vary a great
deal more than we have seen in the last five years. The sort of
shock we might expect to see is a very sharp slow-down in the
US where the dollar depreciated very strongly to absorb that shock,
causing the European economies to slow down. The Monetary Policy
Committee then needs to stand ready to cut interest rates sharply
and rapidly in response to a slow-down in the worlds economy.
We do not know whether it will yet, but I suspect it will, but
it should stand ready to do that very rapidly. The other sorts
of shocks we might meet are sudden movements in the exchange rate,
which we do tend to see in the UK. The exchange rate flutters
about on a ceiling and then suddenly drops through the floor and
flutters about there for a few more years and then suddenly shoots
up again. If suddenly we see the exchange rate drop by 30 per
cent, there is bound to be inflationary implications in that.
We have to see how the Monetary Policy Committee reacts to those
inflationary policies. There are two major shocks, the sterling
exchange rate and the collapse in the US, that we could face.
The Monetary Policy Committee has been very worried about the
sudden collapse of sterling and therefore quite rightly has been
cautious. It has not happened yet. It may never happen. It remains
a possibility while we have a floating exchange rate.
(Professor Buiter) It is true that there have not
been major external shocks. There have been some shocks. We have
not seen a major world recession. We have seen an increase in
the price of oil but one that was reversed, and these tend to
be reversed quite quickly. There has not been a collapse of sterling.
I would like to point out that many of the largest shocks that
made the economy behave badly in the past were internal, self-inflicted
ones that came from the monetary and fiscal framework. We had
decades of very cack-handed monetary and fiscal management in
this country. I think the framework itself probably, both on the
fiscal and monetary side, is somewhat better now. Personally,
I have no doubt at all that if the world economy were to go through
a serious downturn, which I do not think is likely but it may
happen, the MPC and whoever serves on it would respond swiftly
(Mr Flemming) I would like to agree with Professor
Buiter that the environment is not entirely exogenous. It is possible
that our new policy arrangements, not only in the monetary area
but also the structure of policy being pursued on the fiscal side,
contributes to stability. While there have been these persistent
errors in forecasting the exchange rate, and indeed the exchange
rate has been uncomfortably high for quite a long time, there
has not really been any exchange market turbulence of the kind
that has occurred in the past and I do not think we can count
on it not occurring again. On oil prices, although the movement
of oil prices recently has been as big as in the Seventies, the
impact on OECD economies and the UK economy is about half that
because of the lower share of oil in expenditure. It may be that
means that we are diversified and we could not have a shock as
big as we had in the Seventies, but maybe we could. I do not know
how they would cope with that. The other point is the US slow-down
which initially Professor Buiter described as being round the
corner. I am sure that if that materialises, the MPC will respond.
The question as I put it earlier is whether they will respond
by an amount which, in hindsight, would be appropriate. Given
that the consequence of changes that take us into uncharted waters
is that nobody knows what the right thing to do is with foresight
and how useful it is to judge them with hindsight when the events
have unfolded is not clear to me.
(Sir Alan Budd) I can be very brief because my colleagues
have really given all the answers. It has been a relatively stable,
external environment, and that has helped. Also, such shocks as
there have been have tended to bring inflation down rather than
put it up. I very much support what Professor Buiter says, that
we have been perfectly capable of creating our own dramatic instability
while the rest of the world has been quite stable. I think we
must give credit to a system that has so far prevented that from