Select Committee on Treasury Minutes of Evidence


MEMORANDUM BY PROFESSOR ANDREW SCOTT, SPECIALIST ADVISER TO THE COMMITTEE

THE CURRENT POLICY STANCE

  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 pressures.

  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.

THE OUTLOOK FOR THE US ECONOMY

  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 results—UK-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 chart published.

INFLATION FORECAST AND POLICY SETTING

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 utilised—certainty 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 forgiving—an inflation undershoot during this time period may well be accompanied by below trend growth.

  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.

OTHER ISSUES

  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?

COMMENTS ON THE MPC SINCE INCEPTION

  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 reputation—both 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 fragmentation.

    (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


 
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