MEMORANDUM BY PROFESSOR ANDREW SCOTT,
SPECIALIST ADVISER TO THE COMMITTEE
The Inflation Report declares UK GDP as being
close to trend growth (although the trend growth is left unstated
and there is disagreement of around 0.5 per cent in the level
of trend growth amongst MPC members). If this is the case a
simplistic analysis suggests neither rising nor falling inflationary
Three factors dominate the discussion of the
current inflationary environment: a) the current low level of
inflation, by all measures b) the strength of consumption, with
some credence being given to another bout of financial liberalisation
and c) a tight labour market and strong earnings growth, albeit
matched by productivity growth. Crudely put, the first suggests
lowering interest rates while the second and third suggest maintaining
or even increasing rates. The balance between these factors explains
the consensus view of the MPC. The 5-4 vote however reveals how
finely balanced the factors are with a) being sufficient to persuade
some MPC members to vote for a cut and those members believing
in supply side changes would point to b) and c) as being supporting
evidence for their view.
There seems little that is controversial
in the MPCs views on the US and the impact of a US decline
on the UK economy. That a slowdown is occurring is beyond question
and the aggressive action by the Fed should prevent a hard landing
and credit crunch that some fear. This does however, exist as
a downside risk. The simulations quoted on p.19 are from conventional
models and reveal conventional resultsUK-US trade is relatively
small and spillover effects through equity markets do not have
a big impact on the economy. If these predictions are wrong then
at the very least they will have been wrong through good reasoning.
However, if the US follows Japan into a lengthy
period of slow growth which is followed by continental Europe
then clearly the UK will suffer. Monitoring developments in the
US over the next six months will be critical but as yet developments
in the US alone are not sufficient to warrant an effect on UK
interest rates. They do however, add to a growing background
of downside risk to UK GDP which is reflected in the GDP fan
Is the MPC setting policy to offset the risks
shown in the forecast?
Economists spend a good deal of time analysing
decision making under uncertainty. Two different models are often
utilisedcertainty equivalence in which the individual
simply targets the expected outcome and ignores the possible range
of outcomes or precautionary behaviour where the target reflects
both the desired average outcome and considerations over the likely
range and volatility. In the case of inflation targeting certainty
equivalence would result in targeting just 2.5 per cent inflation
while precautionary behaviour might involve targeting less than
2.5 per cent inflation so that if mistakes are made the official
target is not threatened.
I think that the current policy stance and
events over most recent periods suggest that the MPC is following
a precautionary policy model. This would help explain the
RPIX undershoot as well as the most recent interest rate decision.
It also explains the minority view of those who emphasise the
supply side developments. If you are following a precautionary
policy you will give little weight to these developments.
Given how sluggish inflation is to change and
given its recent trajectory I feel the MPC is being cautious in
its pace of lowering interest rates. I would go further and say
that I am surprised how swift a turnaround in inflation they are
expecting in order for inflation to reach 2.5 per cent by the
end of the fan chart horizon. Inflation moves slowly and in a
lagged response to GDP changes. However, the fan charts show an
almost contemporaneous response.
While I believe that the majority of the MPC
is following a prudential approach I do not think this warrants
criticism. For credibility purposes it is crucial that the MPC
succeeds in lowering UK inflation and so long as the precautionary
behaviour implies only modest variations in the inflation outcome,
e.g 2 per cent rather than 2.5 per cent, the median outcome I
think it is entirely appropriate.
Does the forecast have any value given the disparate
views of the MPC?
As currently produced the impression of the
forecast is that it is the view of the majority which given current
voting patterns is almost equivalent to the Bank staff. Table
6b on page 67 gives useful information regarding alternative views
of MPC members of key variables. I think that some elaboration
and development of this table is increasingly called for.
THE RPIX UNDERSHOOT
The fact that inflation has been predictably
below 2.5 per cent for an extended period of time can be explained
in three ways: (I) precautionary policy behaviour (see above)
(II) predictable forecast mistakes due to not incorporating supply
side developments (III) delayed revelation of information about
turning points in the economy which lead many meetings of MPC
to make mistakes before they can be corrected.
As explained above I feel that the MPC has been
somewhat cautious in setting policy and this probably explains
the modest RPIX undershoot. However, I would also argue that this
is justifiable and also encourage the Committee not to view the
inflation rate as a variable over which the MPC has precision
control. To date the undershoot has been modest, well within
standard error bands and has not been accompanied by weak growth.
However, I suspect that the economic climate of the next 12-18
months will not be so forgivingan inflation undershoot
during this time period may well be accompanied by below trend
Supply side developments may have helped to
explain some of the undershoot as well, and if the MPC deny behaving
in a precautionary manner is the only rational explanation left.
However, if this does explain the RPIX undershoot then the decision
to hold interest rates is puzzling. Supply side developments would
lead one to be less concerned over wage growth matched by productivity
growth and by strong consumption (as this would be backed up by
higher productivity growth).
Delays in information about turning points could
explain some extended periods of RPIX undershoot but not I feel
what has currently occurred.
I have listed above a number of my current concerns.
The main forecast issues I have are:
(a) the inflation fan chart suggests a sharp
turning point and strong contemporaneous correlation with GDP.
Although not unreasonable it is a little unusual.
(b) The forecast is for strong consumption
growth, strong government expenditure and weak private sector
investment. Is this seen as a good mix?
(c ) In discussing the strength of consumption
appeal is made to a new bout of financial innovation. It is also
claimed that consumption may be becoming less sensitive to official
interest rates. I am not sure that this is theoretically correct
but ignoring that what implications does this have for how monetary
policy is operated?
THE MPC SINCE
In broad terms the MPC must be considered a
huge success. Inflation has fallen dramatically, the level of
debate about UK interest rates has improved significantly and
the structure and operational details of the MPC have been the
source of much international praise. There have been some minor
problems and difficulties but a good institution has been successfully
launched by the good efforts of numerous individuals.
The MPC has undoubtedly been fortunate in beginning
its operations in a period of quiescent world inflation which
has done much to help it establish its reputationboth by
reducing inflation and enabling the MPC to avoid too many conflictual
decisions between lower inflation and higher output. However,
merely waving away the lowering of inflation as a global event
would be unfair to the MPC. In the past the rest of the world
has had low inflation but poor UK monetary policy has achieved
a worse outcome for us. Further, even during the last five years
other central banks have come under far more criticism than the
MPC in how they operate monetary policy.
The government should also be complimented on
their appointments to the MPC. To achieve credibility it is crucial
to appoint experts whose sole focus is to achieve 2.5 per cent
inflation. The background of MPC members should therefore be those
who have spent considerable time studying how interest rates affect
inflation and how inflation is generated in an economy. It is
a mistake to appoint businessmen or trade unionist to the MPC.
If the goal of the MPC is to achieve a fixed inflation target
that is their ultimate aim. The metaphor I use in teaching is
of a famous football player who requires drastic surgery on a
knee. It is irrelevant if the surgeon has ever played football
before, you simply require an expert who has devoted their professional
career to mending knees. Appointment of non-economists would simply
confuse that the ultimate aim of the MPC is. I also think that
a bias towards academic economists is also commendable (although
the reader may not be surprised at this). The Bank has a huge
staff who provide numbers and data, what is much more scarce are
individuals who can interpret these numbers in a flexible way.
A small group of academic or City economists fit the bill.
There are however some minor criticisms:
(a) The Inflation Report is beginning to
look rather tired. It does of course have to go through all the
most recent statistics but it lacks the accessibility of earlier
issues. In particular, I think that the numbers could be arranged
in a more conceptual way to reflect debates within the MPC eg
over supply side developments, forecast uncertainties, etc. Currently
it is more a presentation of numbers and less a reflection of
the values of the MPC.
(b) The 5-4 balance between Bank and external
MPC members is understandable and overall desirable. There remains
however, a strong feeling that the publications reflect more the
views of Bank members. I think that individual reports by the
external members or quotes of each individuals forecast are undesirable
and would weaken the authority of the MPC. However, I do feel
that a stronger platform is needed for the externals' views. An
elaboration of the table which shows divergence of views amongst
MPC members would be useful. I also think that a page summarising
the external MPC members' view of the forecast, unedited by Bank
staff, would add significantly to their voice and avoid too much
(c ) Appointments to the MPC are a somewhat
mysterious process. I do not think this is a fatal flaw but wonder
if there might not be some role for a professional body (for instance,
the Royal Economic Society) to avoid too much the appearance of
political issues becoming involved in selecting the MPC members.
21 February 2001