Select Committee on Treasury Minutes of Evidence



  Inflation in the UK dropped down to the centre of the target range (2.5 per cent) in the middle of 1998. It dipped below 2.5 per cent by the end of that year, and in the two years since then inflation has moved down to, and then stayed around, 2 per cent. Given the historical track record, keeping inflation close to, and generally slightly below, a figure of 2.5 per cent is a major achievement. Expected future inflation also remains low. Chart 6.8 on Page 68 of the February 2001 Inflation Report shows the results of a survey of 27 forecasts of inflation (these are made by independent research institutes and City institutions). The range of forecast is remarkably narrow. The overwhelming majority of forecasts are that inflation falls within the range 2.1 per cent to 2.7 per cent. In other words, the MPC has succeeded in persuading almost all outside forecasters that two years ahead the most likely result is that inflation will be fairly close to the centre of the target range. Medium and longer dated government bond yields in the UK are now under 5 per cent. These prices strongly suggest that investors in the UK do not expect inflation to be significantly above the centre of the target range for the foreseeable future.

  Judged by what has happened to inflation over the period since the Bank was given operational independence over monetary policy, and by the influence this has had upon expectations of inflation, the performance of the MPC looks extremely favourable. But macroeconomic policy in the UK has been undertaken in a relatively favourable environment—inflation has fallen to very low levels in most European countries and in the US; in Japan it has been negative for much of the last three or four years. Over the past four years output has risen steadily in the UK, but has risen far more rapidly in the US. Unemployment has fallen to historically low levels, but the same is true in the US and unemployment is now moving down in Europe.

  Overall, the inflation and real economy performance of the UK since 1997 has been very good, but not substantially out of line with that of other industrial countries.

  The greater achievement of the new arrangements is not so much the macroeconomic outcomes but rather the dramatic increase in the transparency with which monetary policy is formed in the UK. Although members of the Monetary Policy Committee clearly have reached different judgements on what policy is most appropriate (though the scale of those disagreements is easy to exaggerate and usually the debate is about whether interest rates should move by 25 basis points or not move at all), there is admirable clarity about the objectives of policy. Differences in opinion are the result of inevitable differences in interpretation of the facts, rather than differences over the objectives.

  Many of the criticisms that one sees levelled against the MPC strike me as unfair and often quite bizarre. For example, it is common to hear it said that because inflation has moved under the 2.5 per cent level and remained there for several quarters, that the MPC is clearly failing in its responsibilities. This criticism is unconvincing because the scale of the undershoot is small and has been significantly influenced by events which could not have been known at the time (for example the sustained period of unusually strong sterling; the relatively benign inflation environment in which most commodity prices have been weak; the surprising degree of wage moderation given low levels of unemployment).

  Had low inflation, and low expected inflation, been achieved at the expense of high and rising unemployment and falling output, that would have made the criticism of the MPC carry some weight. But overall output has increased steadily, unemployment continued to fall, employment continued to rise and there have been no financial crises. It is very hard, I think, to complain much about the way in which monetary policy has been set given these facts.


  The major change between the February Inflation Report and that produced last November is that in the intervening period there has been a marked reduction in prospects of US economic growth which prompted substantial monetary policy easing from the US Fed. This has led the MPC to conclude that although its central estimate of growth and inflation pressures are not substantially different, the risks are now predominantly on the downside. The inflation outcome chart on page 67 shows that whilst there is little change in the expected level of inflation two years ahead (compared with November), there is now a significantly higher chance that inflation will undershoot. The big question is whether what is clearly a slowdown in the US might become a recession and, if it does, what the knock-on impacts on the UK might be. There is major uncertainty on both factors. But looking at trade patterns does reveal that what happens in Europe is significantly more important for the UK economy than what happens in the US. Furthermore, although all the European countries are open to trade, the importance of developments within Europe for each country are consistently far more important than what happens in the United States. Even if output were to slow markedly in the US the direct knock-on impact upon the UK is probably rather limited. Much less clear is the impact on the UK were a recession in the US to trigger a major downward adjustment in asset prices (most obviously in equity prices). All this is discussed clearly in the Inflation Report and it is what lies behind the asymmetric risks to the projections for inflation and GDP growth.

  The big question is "Should the MPC ease monetary policy much more significantly now, so as to guard against a substantial downward shock to demand stemming from a recession in the US?" On the basis of figures 6.2 and 6.6 the answer to this question is clearly No. Figure 6.2 shows that two years from now inflation is rising: the MPC's central guess as to inflation then is that is should have risen to the 2.5 per cent level and be heading up. Chart 6.6 shows what the MPC's projections are if interest rates were to be cut by another 50 basis points or so over the next few quarters. If that were to happen the central estimate of inflation is that it should be about 2.7 per cent two years from now, and apparently rising.

  There are enough uncertainties about what is happening to demand pressures and inflationary pressures in the UK to mean that a pre-emptive substantial further easing in monetary policy now, to head off the effects of a US recession that quite probably will not materialise, would surely be a mistake. As ever, different indicators of economic pressures in the UK point in different directions. The labour market clearly remains very tight, with headline unemployment falling and labour shortages, especially amongst skilled labourers, at high levels. Vacancies relative to the unemployed are at high levels and recent data on wage settlements suggests they picked up. The picture in the housing market is particularly murky with the Halifax and Nationwide house price indices suggesting very different trends in prices. The exchange rate has also moved down by around 3 per cent relative to where the Bank thought it would be in November.

  Finally, it is clear that unless the spare capacity in the UK economy is higher than a reasonable viewing of the data would imply, then there needs to be a slowdown in the rate of private demand in order to provide for the transfer of resources to meet increases in public spending. There are very powerful reasons why that spending is desirable given the high proportion of it which is on infrastructure, or more generally on investment. But unless it is to generate some overheating private sector demand will need to grow less rapidly than in the recent past. Given all these factors a powerful case can be made that any significant further easing of monetary policy—unless it is triggered by some clear signs of a recession in the US—is unwarranted.

19 February 2001

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