Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 120-139)



  120. This Committee spoke to the Congressional Budget Office in Washington and the Federal Reserve in Washington. They are quite clearly making forecasts ten years out. You may argue that they are not terribly reliable but nevertheless they are making those forecasts of trillion dollar surpluses. The driver to all of that is quite clearly the fairly heroic assumptions in the US about productivity. I am trying to get a sense from you of the extent of that mode of thinking as adopted by the researchers to the MPC and the kind of work they are doing.
  (Professor Buiter) I hope not very far because these numbers are clearly crazy.

  121. They are clearly crazy. That is very helpful. We will send a note to Alan Greenspan on that.
  (Mr Flemming) I would like to pick up one hypothesis that Professor Buiter overlooked and was alluded to, but only tangentially, by Sir Alan. You may recall that he stressed "as recorded" in looking at the comparisons. The fact is that the statistical conventions differ somewhat on the two sides of the Atlantic. That is relevant, for instance, to the proposition that Professor Buiter made that there has not been a great boom in the quantity of investment of the relevant kind, particularly in the UK. That is partly a statistical matter. For a given change in expenditure, particularly in IT, the US would allocate a larger proportion to an increase in quantity and a small proportion to an increase in price. That may be one reason, and also because the US and the Fed are projecting figures that are going to be generated by their conventions and not our conventions. That is one important caveat. Then there is a question about comparison, not only with the United States but across the Channel too, where you find a pattern much more similar to ours and where, incidentally, the statistical conventions are more similar. The Germans in particular have done quite a lot of work on the impact of those conventions. The other question is: given that there is a puzzle here, whose job is it to address it? It is certainly true that the Monetary Policy Committee should be thinking about it and should be monitoring research and perhaps commissioning some. As you mentioned in your question, the particular peg you have chosen to hang your question on was an expression of puzzlement by the Treasury and that would suggest that the Treasury might do it. It is also, of course, very important to the Treasury's own policies and judgments on fiscal policies. Equally, I do not think that the question ought to be: should the Bank of England and the Monetary Policy Committee be doing it or should the Treasury be doing it? What we want is an open discussion and an open debate to encourage people everywhere to address this problem and to try to work, to some extent competitively, and to some extent collaboratively on narrowing the range of uncertainty. As Professor Buiter said, this is not something where there is going to be a clear answer. Even the economic historians still debate what was happening 100 years ago, and that will be true in 100 years' time.
  (Mr Barrell) May I give a slightly more simplistic view of the policy making process? Of course we should be doing research on the new economy. It is very difficult to put a handle on it but, as practical forecasters, we can look at what happened in the US over the last six years and what happened in the UK. In the UK on average recently inflation has been about or very slightly below target and about or very slightly below forecast. That is interesting information because if, for reasons that we cannot get at, productivity was growing more rapidly, output would grow more rapidly, and therefore inflation would probably be well below target. In the US over the same period, since about 1995/96, in each year from 1995 through to 2000 our forecast of US inflation was 1 per cent too high year after year and so was that of almost everybody else. It has taken us some time to acknowledge that there has been a genuine change in productivity growth in the US over those five years. One of the ways you can read that in is by saying: "We were wrong on our growth and inflation forecasts and perhaps there has been something going on in the US." Conversely we can say: "We were round about right on our inflation and growth forecasts for the UK, and therefore not much seems to be happening that we were not anticipating." The US has seen very different things with very much lower inflation than anticipated, which is a signal something is happening temporarily in productivity. The amount organisations can produce is suddenly jacked up. Probably it has stopped moving up now but they have suddenly gone through this rearrangement of the way they do things. As a result, their inflation is lower and their growth higher. The Monetary Policy Committee can read that into existing inflation and forecast serious mistakes, like we were all making for the US.

  Mr Ruffley: That is very helpful.

Judy Mallaber

  122. Do you think the transparency of the current monetary framework could be improved and, if so, how? We can start with Sir Alan, as you already have some views on record.
  (Sir Alan Budd) These are my views and they are only added to what I believe is an excellent system, possibly the best system in the world for setting monetary policy. I had expected there to be rather more in the way of individual accountability by the nine members of the Monetary Policy Committee. Their votes are recorded. The reasons why they vote in the way they do are reported in the minutes. They are reported in fairly general terms and they are reported anonymously. I have no particular problem with these views being anonymous in the minutes but I think it is perfectly reasonable that subsequently individual members should be asked to explain why they voted in the way they did at a particular meeting, and even more importantly, at a sequence of meetings, so that we can test the extent to which they are acting consistently and coherently. There was a time when I think the lack of transparency became quite serious but that has got better since then. This was in May of last year when there was an inflation report which published a forecast in the usual way. The fan charts and what is known as the best collective judgment gave a path for inflation which had inflation at the end of the two-year period at the target level of 2.5 per cent. But there was also a table 6B published in the inflation report which showed how individual members, with their own views, differed from that central view because they differed about the path of the exchange rate, or they differed about the path of productivity, or they differed about what was going to happen to retail margins. These are perfectly reasonable disagreements but if you summed these disagreements and could believe that some people were at one extreme and some at another, there appeared to be at the May meeting some people who thought that inflation in two years' time would be 3 per cent and some who thought that inflation in two years' time would be 2 per cent. In policy-making terms, even given the uncertainty, that is a very wide range of views of where inflation is going to be, yet there was a unanimous vote not to change interest rates. That puzzled me greatly. I had no way of explaining this myself and I think it would have been helpful if individual members had been asked which of those views they themselves held and why, despite holding those views, they had decided that the appropriate policy response was no change. In fact we know rather more about this than we did then because the most recent inflation report has a rather helpful box in it which explains how the forecasts relate to policy decisions. It may well have been that the individuals would have given the explanations at the time but at the time I was simply confused about why the Monetary Policy Committee was behaving in the way that it was.
  (Professor Buiter) It is certainly possible for somebody to be in the box twice. With inflation there could be one deviation from the norm which would cause inflation to be higher and another to be lower, more optimistic about productivity and more pessimistic about the exchange rate. I do not think there is a logical problem at all necessarily.
  (Sir Alan Budd) No, but again I do not think there is any reason why we should not have been told that.
  (Professor Buiter) I agree but there are two aspects to that. First, I think we could have at the end of the minutes where the votes are recorded a short paragraph written on the day the vote is taken because you do not want people to re-rationalise their positions with the benefit of several weeks' hindsight. There could be a short paragraph explaining why each individual member voted that way. The Japanese do that to a certain extent. They ask the dissenting members to write an account of the reasons for their dissent at the end of the minutes. The second option, of course, is to be very open. When I joined the MPC I always expected the first question to be: Explain why you voted the way you did. I was never asked that question. That really staggered me.
  (Sir Alan Budd) That was really the point I wanted to make.

  123. Did you think it would be good for us to do these things?
  (Professor Buiter) Yes.


  124. To be honest, I am not sure that is correct. We have asked individual members why they vote a particular way.
  (Professor Buiter) You did not ask me.

  125. Perhaps we just thought we knew about you!
  (Mr Barrell) Can I make the main distinction that Sir Alan made between transparently and clarity? Something that is transparent is not necessarily clear. For instance, a Swatch watch is transparent but, I think, extremely difficult to read. Clarity is much more important than transparency. Why the final decision was made and what the reaction would be to situations, like for instance the collapse in the US, are much more important to know than individual votes and comments during the process of decision-making. It is rather like the Cabinet taking collective responsibility for their decisions. It may be that no individual member of the Cabinet actually supported the final decision but there is a reason for the decision the Committee makes. Committees do different things from individuals. I think, rather than at the bottom of the minutes having a paragraph, at the top of the minutes have a page explaining the collective decision, why a decision was made collectively and what would have happened if different information had been available. Then, if anybody wishes to go on and read what individuals said and what they voted on, that may be of interest but it is the collective view that matters. You have to remember that the UK framework is very distinct. It is largely a panel of experts. These are people who do not have separate interests. For instance, the Bundesbank operated quite successfully for some years but one could never say that its operations were transparent. You hardly ever found out what people thought—there was a committee making decision—partly because they had regional interests. However, the Bundesbank's response function was largely clear. People knew what it might do and that is very important in a monetary policy framework, knowing what you might do rather than knowing who voted for it. One might say the same with the Fed. It is clearer what the Fed might do because of its experience. Although we have needed perhaps some transparency in the early stages of the Monetary Policy Committee, perhaps it and other people should concentrate on the clarity of its responses and the reasons for its responses rather than how each individual contributed to a joint decision.
  (Sir Alan Budd) Can I just say that that may be what has happened but it is not what was intended. These are not committee decisions in the normal sense of committee decisions, and they are certainly not Cabinet decisions in which there may be dissent in the course of reaching the decision, but there is not supposed to be dissent thereafter. These are quite clearly individual votes. They are added up to give a majority result and this is very distinct for me from the way in which one might take committee decisions, and they were intended to be.
  (Professor Buiter) The reason the collective decision comes out that way is because the Governor puts the proposition that demands a majority—end of story—so there are at least five in favour.

  126. Mr Barrell has made various comments about how it compares with other countries. Can you make more comments about the transparency and clarity compared with those other countries and whether it makes our system more or less effective than the framework in other regimes around the world?
  (Mr Barrell) One has to think of the institutional setting in which something is constructed like the European Central Bank, which I think would find it difficult to have an independent panel of experts. I think also that it would be politically difficult to publish the votes because the individual members of councils have regional or country interests. They represent in some sense their country. Publishing their vote might influence their behaviour in ways that would be unwise. We are not in that situation. We do not have representatives of Yorkshire and of Scotland and so on, and therefore there is no regional pressure. In the US it is the same. To an extent, governors have a regional interest. One has to be a little more cautious in the US system. In the UK one can be distinctive. We do not have to copy the ECB or the Federal Reserve. We can build our own institutions and we can have dissent because it is an academic panel. That is also quite distinctive. If one has an academic panel, one can have all sorts of decisions. It is harder when it is a political panel. We have built a different institution. It may not be the best institution we could build but it is definitely not the worst. It does seem to be doing a great deal better than the institutions we have had for the previous 25 years.
  (Professor Buiter) It is not of course true that the national governors on the ECB board represent regional interests. They are mandated by the Treaty only to look at the EU-wide interests. If they do represent national interests, they are violating the constitutional mandate. Secondly, they do not vote. They could vote but they do not. They have a consensus, a collective way of taking decisions. I think the procedure is bad and unnecessary. The argument that it would be awkward because of national political pressures I think could be put the other way round. If there were to be votes—and of course there are not—the governments of the capitals would know in five minutes of the vote. The pressure would be there. The effect of accountability would not be there because you could hide behind the fig leaf of formal responsibility. I think the system, from the point of view of accountability and openness, is worse than it need be.

  127. That is in the European Cental Bank?
  (Professor Buiter) Yes. The American system is a one-man show. That is its weakness.

Judy Mallaber

  128. Does that make it transparent?
  (Professor Buiter) Certainly it is pretty transparent, though of course the chair is extremely opaque in his statements. Yes, it is pretty predictable.

  Chairman: We have discovered that for ourselves.

Mr Fallon

  129. To return to forecasting, John Flemming, if the Bank no longer assumes the inflation targets to be unchanged at the end of the two-year horizon, is it right to continue with its policy of assuming that interest rates are also unchanged from the forecast?
  (Mr Flemming) As you probably know, this is an issue that has concerned me considerably, It has not been easy. I do not think it is one on which this group will necessarily agree. I am not sure the problem is so much with a prospective change, although I did suggest that there might be a change in the inflation target. I do think that there is a problem, occasionally at least, with the internal coherence of the formal assumption that the forecast is generated by assuming unchanged interest rates. I do not have the date in my head as well as Alan did with his problems. There was an occasion when the famous chart of inflation expectations was on target for two years out but it was essentially a crash landing. Given what one knows about the sort of inertia in the system, it was fairly clear that the next month or the next quarter's forecast was going to show the inflation rate being considerably above target. Therefore, it would be natural for someone to draw the conclusion that interest rates were going to have to change within the next quarter. It should have been natural for the members of the MPC to make that assumption and to build in that in some way. I do believe that there might be some advantage and that it could be done. The traditional central banking view is that we never make any statements implicit or explicit about prospective movements in interest rates. I think that, in the context of a structured arrangement with explicit forecasts and assumptions for them, it might well be possible to do that. Indeed, I actually argued this when the MPC was launched. I think their success in holding inflation very close to the centre of the target range reinforces it, that actually publishing inflation forecasts is not very helpful. The natural assumption for someone to make now is that inflation will be at the target rate. The thing that people want to know about, and might want to know what the experts on the Monetary Policy Committee think, is what the trajectory of interest rates will have to be to deliver that. One could actually turn the whole process upside down and abandon the inflation forecasts and say: "We are going to assume that we are going to meet our target"—it would not be a bad assumption, actually—"and we will publish, with wide dispersement probably, a trajectory of short-term interest rates which we think is compatible with that delivery." That is an extreme position that I have taken up from time to time. You will probably hear from my neighbours why it is not a sensible way to go.

  130. If I could press you a little on that, in your article you point out that publishing an interest rate forecast is not a statement necessarily of intent. How would you deal with the problem of market perception that it might be seen almost inevitably as a statement of bias?
  (Mr Flemming) Of course, as you indicate, the Americans have from time to time made a statement of bias. That did not prove fatal. So if it were so interpreted, it would not matter very much. Again, this is going back some time, but I did suggest that with the dispersement that you would have in there, you would actually be able to make some comparisons between the uncertainty reflected in the MPC's forecast done on this basis and the uncertainty about future interest rates reflected in certain derivative products and options over future Treasury Bill contracts or whatever. Therefore it would be impossible to see whether or not there was alignment between the MPC's estimates of bias, as it were, or expression of bias, and the expectations of the market. You may recall, again in the early days of the MPC, that Deputy Governor Mervyn King did take some satisfaction from the fact that most of the MPC's policy changes, or rather interest rate changes, had been correctly anticipated by the markets. If one did this, one would also be able to see whether that was true not only in the primary market but also in the markets for these derivative option instruments. Coming back to what he said and I said then, the MPC could prove to be boring to the second degree.

  131. Sir Alan Budd, do you see any difficulty with that?
  (Sir Alan Budd) The difficulty that has always been given when this sort of discussion is held about the recognised problems of having a fixed interest rate assumption throughout the forecast period is that of getting the Monetary Policy Committee to agree on the path. I think what John Flemming has suggested is that this, too, should be a fan chart. It would completely change the way in which the Monetary Policy Committee conducts its discussions compared with what it was when I was there, which was about the path for inflation and the unchanged interest rate, which would achieve a satisfactory inflation outcome. They would have to somewhat re-think it. I am not saying this is impractical but it would be a very different process I think from the one that I shared. Perhaps it was changing at the time Professor Buiter left.
  (Professor Buiter) First of all, I think it is important, and it seems to be impossible to get this across, that the two-year horizon is neither here nor there. The target is not aiming to hit the inflation target two years from now. Two years is just part of monetary folklore, that monetary policy will have its maximal effect. I do not think that is true for the British economy, if it ever was. So two years is just where the paper runs out. It has no significance apart from that. I do agree that the constant interest rate assumption is not a forecast, not a prediction, not a commitment. It is at best simply a conditional projection. It is one that makes very little sense because if we really stuck to a constant interest rate, we know that the model would blow up. All these models have this problem. At some point you have to start responding to inflation in order to stabilise the economy. Any constant or any exogenous path of nominal interest rates is likely to lead to explosive behaviour. I would favour making explicit what is implicit beyond the horizon the fact that we do respond to deviation from the inflation target or of output from where we think its capacity level or of unemployment from the natural rate and produce inflation forecasts using a rule. It is hard to get the Committee to agree on the rule but the current agreement I think is largely illusory. We do not agree on the constant interest assumption; it is just there for obvious reasons. Central bankers do get wet feet about appearing to make a commitment. That is something one has to get around because clearly you do not want to commit yourself to any path or, even to any particular rule. A best collective judgment type fudge can be very helpful. It is just a question of educating the markets, and indeed also our political masters, about what these forecasts mean, so you do not get shot with the petard of your own forecast.
  (Mr Barrell) Of course, I cannot know how the Monetary Policy Committee or the Bank of England produces a forecast but, as a practitioner, if I was asked to produce a forecast for constant interest rates for two years, I could do it. In order to hit the target, as Professor Buiter says, after two years and one quarter, I have interest rates adjusting to get to the target but I do not have to publish that. Everybody in my forecast is expecting it and therefore it works. It works because it is something beyond the forecast horizon and the Policy Committee, if it is using models, may have done something like that, to have a sudden jump in interest rates after the forecast. It might be better to take the leap and smooth that jump in interest rates over the forecast horizon we publish, with some degree of uncertainty and all the normal caveats about our not knowing what is going to happen. The problem for a central bank is that if the central bank says the interest rate will go up in six months' time, everybody else will say, "Why don't you do it now?" That is a very difficult question to answer. I do accept they have constraints that are different from the constraints that I as a forecaster face, but the uncertainty bounds around the interest rate would help them disguise their embarrassment about not moving now if they thought it was necessary.
  (Mr Flemming) Although I said it could turn everything upside down, I am not sure that it need do so. One of the points that emerged from my colleagues' comments is the importance of emphasising the dispersement. In fact the question that I would like to put to each member of the MPC, and then have an algorithm that produced the fan chart, would be to give, say, at six-monthly intervals over the two-year forecasting horizon their best estimates of the quartile points, to get away from the central line, which might indicate the bias. So you would ask each person: what is the interest rate that is so high that there is only a 25 per cent chance of its being higher than that and what is the one that is so low that there is only a 25 per cent chance of its being lower than that? Then you can combine the nine sets of figures. I do not think it would be very difficult using an algorithm. If it were explained, I think that would minimise any kind of commitment or damage that would be done by what I believe would be a practical procedure.

Mr Plaskitt

  132. Could I ask each of you if you think it is time for the Chancellor to reconsider the current definition of price stability?
  (Mr Flemming) I suggested that you might earlier. It seems to me a slightly curious use of language. I believe that the 2.5 per cent target when it was set was a very sensible level at which to set it. A number of the developments which might make it appropriate to consider lowering it now were then not reliably to be anticipated. I think that it is slightly curious to define 2.5 per cent as price stability, but that is purely a linguistic matter. The other issue that you may be alluding to is the question of whether RPIX is the ideal indicator.

  133. No, I was thinking about the target.
  (Mr Flemming) In that case, I will stop there.
  (Mr Barrell) In the remit that the Monetary Policy Committee had, it was made clear that the target was set contingently on existing inflation but for this Parliament; in other words, it took account of an existing situation when inflation had been high. I think 2.5 per cent cannot really be described as price stability in the medium term and there would be a very strong case for reducing the target to 1-ish for the next parliament, without there being a significant tightening of monetary policy during that process. There are numbers of reasons for changing the target. Partly if what one wants is to encourage long-term contracting with the knowledge that prices will be stable over, say, a five or ten year contract in any real sense, then, 1 is much better than 2.5 because 1 per cent inflation is round about maybe the upper band of the quality drift one sees in products. So prices are on average stable if we measure inflation to be running at 1 per cent. I think we should be suggesting that there should be some revision of the target at the beginning of the next parliament and that revision should be downwards.
  (Professor Buiter) I would not be in favour of that for the following reason. It is true that 2.5 per cent RPIX is probably a high rate of inflation if you want consistency with price stability, even if you allow for the kind of bias that inevitably creeps into that sort of index. First of all, changing the target should only be done very infrequently; otherwise the Chancellor by repeated changes in the target can regain discretionary power over monetary policy. You do not have the instrument but you just move the target around. I would do it infrequently. If he were going to stick to this regime for the foreseeable future, at some point a change to something lower than 2.5 per cent might be desirable, say to 2 per cent, and not much less in my view because the problem is that there is an asymmetry in the economy as normal interest rates cannot go below zero. I think that is a constraint that we have to respect. The reason I would not do that now is that there will, I hope in the not too distant future, be an opportunity to revise the target when Britain joins EMU. I would save my credibility, my capital, for that day rather then spend it in intermediate target changes will be good only for a few years and try to stick to 2.5 for the next three years or so, however long it takes.
  (Sir Alan Budd) I think I am perhaps slightly closer to Professor Buiter than the other two. We know from experience that 2.5 per cent on the retail price index excluding mortgage interest payments seems to be equivalent to about 1.5 per cent on the harmonised index of consumer prices used around Europe. So we are not far from the 1 per cent that the European Central Bank has in mind. One might at some stage close that gap. I very much take Willem Buiter's view about the desirability of stability in this inflation targeting activity.


  134. As you know, the Treasury Committee has a central role in this accountability process of the MPC. How do you think we can improve our role? Sir Alan Budd I know has views on this, so perhaps you could start.
  (Sir Alan Budd) It is linked to the previous discussion and indeed linked to the comment that Willem Buiter made, that the minutes are the minutes and that is fine. That can be judged as a good account of the way in which the Monetary Policy Committee is making decisions. Individuals have voted individually and it seems to me perfectly reasonable to ask them why they have done so and which of the views expressed in the minutes they happen to hold. The most obvious body to do this is your Committee. I think that it could do this rather more rigorously and indeed regularly than it has done so far. As I have pointed out, you do not have all the members all the time; you take a subset of the members.

  135. It would be impossible to have all the members, given that they are quite a long-winded lot!
  (Sir Alan Budd) I understand. I think that all the members of the Monetary Policy Committee must understand that they are at risk, if you like, of having to explain to you why they did what they did in one month and why they did something else in another month. The obvious place for this to happen is in this Committee.

  136. That is very useful and clear. We will ponder on that one. Does anybody else have views on this?
  (Professor Buiter) First on procedures that could be improved to make it easier for you to call us to account effectively: there are the individual explanations in writing at the end of the minutes by MPC members explaining their votes. Then the possibility—and it would require a change in the law—of having real confirmation hearings. This would only work of course if Parliament somehow could commit itself, this Committee, not to turn it into a three-ring circus. That requires restraint that I do not know is available. It is a real issue because American confirmation hearings sometimes have degenerated into a rather unseemly exercise. I think in principle it would be valuable. For the rest, I think there is a real problem of expertise. Parliament in general, the TSC being no exception, is under-resourced and under-staffed and inevitably you do not have a committee that is staffed by people who are monetary policy experts.

  137. If I may interrupt you there, in fact one of our advisers is now on the Monetary Policy Committee.
  (Professor Buiter) I know but it is still a very small staff compared to what I think is necessary. On the substance of monetary policy decisions, the MPC has been given far too easy a ride by the Committee. We were given a far harder time to explain ourselves by the other place.

Mr Cousins

  138. Why do you think that is?
  (Professor Buiter) They have more expertise.

  139. Than is available to the Committee?
  (Professor Buiter) Yes, and more time to concentrate on it. You people have real jobs.
  (Mr Flemming) May I comment on one of the latter points that Willem Buiter made about real confirmation hearings? I am not sure about that. I think that there is an important question.

  Chairman: We are just coming on to confirmation.

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