Select Committee on Treasury Ninth Report

II Assessing the performance of the MPC


5. To assess the performance of the MPC it is necessary to judge the actions both of the MPC as a whole and of individual members. Judging the actions of the MPC is more complex than just comparing inflation outturns against the target, as Professor Charlie Bean, then a specialist adviser to this Committee, and now Chief Economist at the Bank of England and member of the MPC, explained in a memorandum to the Committee in 1998.[2] Professor Bean gave two reasons for this: first, the level of inflation today is, amongst other things, the result of policy decisions taken 18 months to two years ago; second, unanticipated shocks to the economy may cause inflation to deviate significantly from the target as a result of events which are beyond the policy makers' control and which they cannot offset. Hence, whilst ultimately the performance of MPC will be judged on how close inflation has been to the target of 2½ per cent, we have made our assessment bearing in mind the economic environment in which they have been working and the time period for which they can be considered fully accountable for the inflation outturn.


The economic conditions

6. Looking at the global economic conditions within which the MPC has been working, we asked our expert advisers whether the MPC had been properly tested. They were divided: Mr Ray Barrell, of the National Institute for Economic and Social Research, told us "the world environment has been very stable over the last three years," which "would help any monetary policy decision maker."[3] However, Professor Buiter, chief economist at the European Bank for Reconstruction and Development and former member of the MPC, disagreed, citing a number of instances where the MPC had been tested including the "incipient financial crisis"[4] of 1998. Mr Roger Bootle, Managing Director of Capital Economics, did not think this episode had been a "proper test" but noted that at the time "the Committee was able to convey the idea that if world conditions worsened further they would act still more vigorously to forestall a recession in the UK." As a result "the MPC contributed greatly to the subsequent recovery of confidence."[5] We note that since their inception the MPC have been working in a relatively benign economic environment; however, we also recognise that they have played a part in helping achieve these conditions.

Performance against target

7. As we noted above, the primary test of how well the MPC has performed is the actual rate of inflation relative to the inflation target of 2½ per cent (see Figure 1). Since the inception of the MPC the RPIX inflation measure has remained within 0.7 percentage points of the target and averaged 2.4 per cent. This, as our expert advisers agreed, is a highly creditable performance, although the average rate of RPIX inflation in the previous four years (1993-1997) was only 2.8 per cent, so it could be argued that the MPC has simply maintained low inflation. Mr Bootle said that "the sharp change in the inflation regime in this country came not with the establishment of the MPC, but rather in the aftermath of Britain's exit from the ERM"[6] and the introduction of inflation targeting.[7] Historically, however, inflation has been far more volatile, as Mr Barrell pointed out: in "the past 25 years in the UK inflation has varied between two and 20 [per cent]."[8] Given the volatility of inflation in the UK over the last 25 years, the MPC's record, as measured by their performance against target, is impressive.


Undershooting the target

8. If we look solely at the inflation outturns for which the MPC can be considered directly accountable, roughly speaking since the beginning of 1999, RPIX inflation has averaged 2.2 per cent, and for the past 23 months it has been below target. In addition the MPC has forecast RPIX to remain below target for the next year and a half. This points towards monetary policy having been set too tight, a view with which Sir Alan Budd, Provost of Queen's College Oxford and a former member of the MPC, agreed, telling us that "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."[9] He did not intend this as a criticism of the MPC, pointing out that "the correct way to judge this is whether they [the MPC] were making the best possible decision given all the information available at the time."[10]

9. The Governor has explained the undershoot as being due to the unexpected strength of sterling's effective exchange rate.[11] This is a view with which our expert witnesses agreed. Mr John Flemming, Warden of Wadham College Oxford and a former Chief Economist at the Bank of England, told us "with hindsight the MPC made a mistake, but its assumptions about the exchange rate movements were perfectly reasonable assumptions."[12] Professor Buiter agreed that there had been exchange rate surprises but also raised two other factors: firstly that the MPC might have underestimated the "extent to which the non-inflationary rate of unemployment might have fallen," and secondly, that there could be some policy bias, arguing that the MPC "are not really targeting the 2.5 per cent symmetrically."[13] Mr Bootle shared this view, suggesting that "if the target had been overshot this consistently, then the Committee would have been more vigorous in seeking to bring it back."[14] However, Mervyn King, the Deputy Governor of the Bank of England responsible for monetary policy, denied that there was any bias to policy setting, assuring us that it "is not the view of any member of the Committee, and it is not the remit we have been given." He pointed out that whilst "it is true that we have been below target for 22 months ... we were at or above the target for 21 months before that."[15] It is debatable however how much influence the MPC had on the inflation outturns for the preceding 21 months as much of this period was before the actions of the MPC would have had their full effect on inflation outturns, as explained in paragraph 5.

Performance against expectations

10. An alternative method of assessing the performance of the MPC, and the wider monetary framework, is to look at forward expectations of inflation. Such expectations are a measure of the credibility of the MPC and will be based both on their performance against target and on the transparency of the framework as a whole. Looking at market expectations, the MPC has performed very well: 10 year government bonds have essentially converged with those of our European neighbours, while longer bond yields have undershot them. According to Mr Bootle "this is arguably one of the most important indicators of the MPC's success—dispelling the long-held market view that the UK is an inflation-prone country."[16] A similar conclusion can be drawn from survey evidence. The most recent Barclays Bank "Basix" survey shows that inflation expectations of a range of experts have fallen to around the target level, although the expectations of the general public remain stuck at 1-1.5 percentage points above the target.

11. The credibility of the MPC is in part a result of the actions which it has taken. Looking at the interest rate path followed by the MPC (see Figure 2), we observe that the frequency with which they have altered policy has slowed during the course of this Parliament, as Mr King noted when introducing the November 2000 inflation report "... interest rates have been unchanged for nine months. So suggestions that the MPC is excessively 'activist' will no doubt shortly be replaced by the view that we are excessively passive."[17] Mr King claimed that the interest rate path was simply a result of the MPC responding to economic conditions. However, whilst to a large degree this may be true, a number of our expert witnesses, including Mr Flemming, thought that the MPC's initial policy responses "showed a willingness to be pro-active in order to establish a reputation." He explained that "once the reputation is built and if the markets believe that the MPC is capable of keeping inflation within a very narrow band around the target then ... it [is] easier for the MPC to achieve it [the inflation target] without being so fidgety."[18]

UK base rates

12. We commend the MPC on establishing a high level of credibility; however we are concerned that in an effort to establish such credibility the MPC may have biased policy towards undershooting the target. We would therefore remind the Governor of his assurance to us, in November 1998, that the MPC will be "just as active, rigorous [and] aggressive in pursuing inflation at 2.5 per cent if there is a balance of risks on the downside as we had been on the upside."[19]

Performance against secondary objectives

13. The Bank of England Act states that, subject to maintaining price stability, the Bank shall "support the economic policy of Her Majesty's Government, including its objectives for growth and employment."[20] The Treasury interpreted this objective more explicitly to be "achieving the highest level of economic growth consistent with keeping inflation at 2½ per cent."[21]

14. We can assess the achievements of the MPC against its secondary objectives by looking at the outturns of growth and employment over the last four years. Since the MPC was set up, in June 1997, the economy has grown by an average of 0.65 per cent per quarter and unemployment (based on the claimant count) has fallen by a third from 1.5 million in the third quarter of 1997 to just under one million today. Our experts were agreed that from the perspective of developments in the real economy the MPC had a pretty good record. As Mr Bootle told us "It is noteworthy that the MPC's inflation record has not been achieved at the expense of weak growth, or even of considerable instability in the real economy ... Accordingly ... the MPC has also achieved a remarkable record with regard to its secondary objectives."[22] However, our experts again emphasised that macroeconomic policy had been undertaken in a relatively favourable environment; Professor David Miles, of Imperial College Business School, pointed out that, although the "real economy performance of the UK since 1997 has been very good",[23] it was not substantially out of line with that of other industrial countries. Mr Bootle also cautioned that, in his view, this performance should not "be taken as an endorsement of the MPC ... for we do not know what would have happened in the absence of the MPC, nor if one or more interest rate decisions had been taken differently."[24]

15. On this point, the corollary to the criticism that policy has been run too tightly is that the level of growth has been less than it might otherwise have been. Sir Alan Budd told us that "there has been a remarkably low level of unemployment but ... since inflation has been lower than was expected or it was required to be ... there would be an alternative state of the world in which presumably unemployment would have been slightly lower and inflation would have been high." However, he emphasised that "the margins ... are extremely small" noting that "the extraordinary thing is that they [the MPC] have kept so close to their target while unemployment has been so encouragingly low."[25] Our experts were therefore agreed, as Mr Barrell put it, that given the ability of policymakers to affect real economic variables, whilst theoretically it was true to say that we might have had a little more employment if monetary policy had been slightly looser, "to the degree we can control things nobody would say that the gains would be significant."[26] We note that the MPC has performed well in meeting its secondary objectives of supporting the Government's policies for growth and employment.


16. The Bank of England Act requires that the MPC meeting minutes record "the voting preferences of members who took part in the vote on the decision."[27] This published voting record enables our Committee to question each MPC member about their decision and thereby hold them individually to account. However, we cannot hold hearings with every member of the MPC every month, and we consider this issue further in paragraphs 21 and 43 below.

17. The correct way to judge each individual member, as with the MPC as a whole, is to assess whether they were making the best possible decision given all the information available at the time. However, it may not always be clear in the record of any given meeting why each member voted in the way they did. In addition for those members who voted differently from the majority it will be almost impossible to know the "counterfactual"—the path that inflation would have taken had their policy decision been enacted—and therefore make an assessment of whether their favoured policy decision would have resulted in an outcome closer to target than that achieved by the majority view.

18. Analysing the voting record of individual MPC members it is noticeable how little discrepancy there has been between members so far. As Mr King told the Committee, to date there have only been "four occasions out of 45 meetings with differences of view ... bigger than 25 basis points." In his view the only differences between members had been about the timing of an interest rate move: overall there had been "broad unanimity on the Committee of everyone who served on it ... that these broad pattern of interest rates ... served the economy well."[28] An examination of the Committee's voting record confirms Mr King's point. Looking at the situation two years ago when, as we noted in paragraph 8, current inflation outturns point towards policy having then been set too tightly, the difference in policy stance was mainly one of timing: one member of the Committee (Dr Julius) advocated a loosening of policy for two months before the Committee decided unanimously to cut rates. We believe it was correct to require each individual vote to be recorded but note that so far differences in the broad voting patterns are minor.

2  First Report, Session 1997-98, Accountability of the Bank of England, HC 282, Appendix 12. Back

3  Q 89. Back

4  Q 89. Back

5  Appendix 2. Back

6  Appendix 2. Back

7  An inflation target range of 1-4% was introduced in October 1992. Back

8  Q 98. Back

9  Q 89. Back

10  Q 89. Back

11  Governor's speech, Yorkshire Forward, Bank of England Regional Dinner, 16 January 2001. Back

12  Q 98. Back

13  Q 98. Back

14  Appendix 2. Back

15  Q 320. Back

16  Appendix 2. Back

17  Inflation Report Press Conference, 16 November 2000, opening remarks by Mr Mervyn King. Back

18  Q 103. Back

19  November 1998 Inflation Report hearing, HC (1998-99) 37-i & ii, Q 81. Back

20  Bank of England Act 1998, section 11. Back

21  HM Treasury, Background notes, 13 June 1997: The Inflation Target and Remit for the Monetary Policy Committee, para 34. Back

22  Appendix 2. Back

23  Evidence p 46. Back

24  Appendix 2. Back

25  Q 179. Back

26  Q 183. Back

27  Bank of England Act, section 15(4). Back

28  Q 424. Back

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