Select Committee on Monetary Policy Committee of the Bank of England Report



1.1  The purpose of this chapter is to examine the objectives of monetary policy as set out in the Bank of England Act 1998, and to relate them to the operational independence of the Bank and its Monetary Policy Committee. We shall be looking at the subject in general terms. While that involves an appreciation of the decisions the MPC has taken, and the arguments expressed in their minutes, we shall not comment on a specific decision taken in any month. In other words, we have refrained from "second guessing" the choices made by the MPC or duplicating its work. That does not mean that members of this Committee have no views on actual decisions that have been taken, but simply that we have taken the view that such comment lies outside our remit on this occasion.

1.2  The Act gives priority to price stability[1] as an objective of short-term macroeconomic policy, and sees the relevant instrument as monetary policy. The MPC has one instrument under its command, the short term interest rate. It can use it to control one target. As laid down by law that is a price stability as determined by the Chancellor. At the moment that is set as a rate of 2.5 per cent, with the Governor obliged to write a letter to the Chancellor in the event of the inflation rate straying 1 per cent either side of the target. We discuss the significance of inflation deviating from 2.5 per cent by more than 1 per cent in this Chapter and in Chapters 3 and 4. In addition, the Act supplements the primary objective to bring into play in some circumstances other objectives of the Government's economic policy.

1.3  We propose in this chapter to discuss the reasons for giving priority to controlling inflation over other possible objectives. We review the evidence on what that objective means, and what its consequences might be. We also interpret the precise form of the objectives of policy as set out in the legislation, both with regard to meaning and practical application. We must say right away that there is not universal agreement on the main objective itself, the precise way in which it is expressed, how it is to be interpreted, and what its effects on the real economy are likely to be. For our part, we regard it as a matter of the utmost significance that short-term monetary policy has a statutory basis for the first time in our modern history. We do not believe that what is embodied in statute can or should be approached in a casual way.

The reasons for giving priority to controlling inflation over other possible objectives, costs and benefits

1.4  Five days after the general election, the new Chancellor of the Exchequer, the Rt Hon Gordon Brown MP, announced that he had decided to give the Bank of England operational responsibility for setting interest rates, with immediate effect. In making his statement, he explained his rationale for such a move, which had not been widely anticipated. The Labour Party's manifesto had said:

The Chancellor stated on 6 May 1997 that "The central economic objectives of the new Government are high and stable levels of growth and employment."[2] He criticised the interest rate regime he had inherited, claiming that "the present arrangements for policy-making are not generating the confidence that is necessary" and that "the perception that monetary policy decisions have been dominated by short-term political considerations has grown." Setting out his proposals, he said that they would "ensure that decisions are taken for the long-term interests of the economy and not on the basis of short-term political pressures. This is the way to create the stability we need for higher investment and high levels of growth and employment." The Committee notes the distinction here between short-term political aims and the long-run performance of the economy. Monetary policy, however, is a short-term implement, although its impact is of a dynamic kind with a profile in excess of two years. It is, perhaps, also worth noting that the basic decision, operational independence, is itself meant to be a long-term one, changing the basic nature of policy making. Quite separate from the actual decisions of the MPC, operational independence may in itself have a long run influence on the way financial markets and markets in the real economy work. One important aspect of this, on which we comment below, is a possible change in expectations, both as to inflation and real economic stability.

1.5  The new regime was quickly put in place: the Chancellor conducted only one monthly monetary meeting with the Governor of the Bank under the old system, whereby the Chancellor and Governor would meet to discuss whether to raise interest rates and the Chancellor would make the decision. Since June 1997, interest rates have been set at a monthly meeting conducted by the new Monetary Policy Committee, consisting initially of eight but now of nine voting members, including the Governor, plus a non-voting representative from the Treasury. Having given them the task of controlling inflation, in his letter to the Governor, the Rt Hon Edward (Eddie) George, which immediately preceded his policy statement of 6 May 1997, the Chancellor defined the new Government's objectives for the Bank:

    "Price stability is a precondition for high and stable levels of growth and employment, which in turn will help to create the conditions for price stability on a sustainable basis. To that end, the monetary policy objective of the Bank of England will be to deliver price stability (as defined by the Government's economic policy) and, without prejudice to this objective, to support the Government's economic policy, including its objectives for growth and employment."

1.6  This objective was formalised with the passage of the Bank of England Act 1998[3], section 11 of which reads as follows:

    "In relation to monetary policy, the objectives of the Bank of England shall be:

    (a)  to maintain price stability, and

    1. subject to that, to support the economic policy of Her Majesty's Government, including its objectives for growth and employment."

1.7  One might assume that the meaning of this section of the Act ought to be what was said in the earlier letter. Our difficulty with that is the result of the wording being so different in the two cases. It must also be remarked that the Chancellor said a precondition, not the only precondition, and added that achieving the real aims would in turn help to sustain price stability. This problem of interpretation is returned to several times in our Report.

1.8  What cannot be disputed is that the new system of monetary policy is clearly intended to underline the Chancellor's commitment to creating a low and stable rate of inflation. What he meant by price stability is inflation stability at a rate above zero. On 6 May 1997, he set out some of the reasons for this: as well as the arguments already cited above, he called inflation "the enemy of investment", a view reflected in his evidence to this Committee, that "What manufacturing wants most of all is low inflation, low long-term interest rates that allow higher levels of long-term investment." (Q 5) He did not say whether these were real or nominal rates. To appreciate the significance of the distinction it is of value to look at the paths of short and long-term rates as set out in the graphs in Appendix 5.

1.9  The Chancellor is not alone in his dislike of inflation. One merely has to examine the objectives of the United States Federal Reserve ("the Fed") or of the European Central Bank (ECB) as expressed in the Maastricht Treaty, under which it was set up. It is also a commonplace that the past two decades have been dominated by a low inflation objective in much the same way as the previous three decades were seen as the era of full employment.

1.10  The United Kingdom, which has by G7 standards been a country of higher than average inflation over the last three decades, has since the war also been perceived as being an under-performer in terms of economic growth. The two are often linked; for example, the (until recent) excellent performance of the German economy has been attributed to (at least in part) its record of low inflation. Most notable of all, recent US economic performance has been one which combines low inflation with rapid job creation. We are well aware, however, that there is not universal agreement among the experts as to what is cause and what effect.

1.11  The broad aim of monetary policy is to provide what is called a nominal anchor, in order to keep inflation under control. Theoretically this can take several forms: a rate of growth for the money supply, an exchange rate target or an inflation target. All of these have been advocated at one time or another. What have also been advocated are specific policy rules. We emphasise here that the target approach being used in the United Kingdom is discretionary. The MPC does not follow a specified policy rule to achieve the target, as if they themselves were the human equivalent of a computer programme. One of our witnesses (Professor Minford (Q 1143)) did say that, while central banks gave the appearance of making policy in a discretionary fashion, they did in fact follow a simple policy rule.

1.12  Before the breakdown of the Bretton Woods system in the period 1969-1973 the anchor was provided by the sterling-US dollar exchange rate. Since floating the exchange rate in 1973 the United Kingdom has tried all three nominal anchors, and has now adopted inflation targeting because of the apparent lack of success of the first two. Under Bretton Woods United Kingdom inflation was tied institutionally to that of the United States. After floating the United Kingdom within limits determined its own inflation rate.

1.13  On the adverse effects of continuously rising prices the general opinion seems to be that while very high inflation damages the market mechanism, there is little clear economic evidence that mild inflation is very harmful, and may be helpful. There has been an estimate for the US that a one percentage point increase in inflation may cost more than one-tenth of a percentage point in its growth rate. Nonetheless the balance of opinion is that low, but not zero, inflation is to be preferred. What is more definitely agreed is that inflation uncertainty is especially harmful. Putting the two aspects together, high and uncertain inflation makes it more difficult for individuals and organisations to make correct economic decisions. It also results in higher interest rates attributable to an inflation risk premium. As Sir Brian Pitman, Chairman of Lloyds TSB, told us, "We have had years and years of stop-go, boom and bust and we have felt that inflation really has been a cause of an awful lot of it." (Q 915)

1.14  In the past the "Phillips curve" was formulated to support the proposition that there is a trade-off in at least the short and medium term between wage inflation and unemployment, and that higher inflation will reduce the level of unemployment. This theory was undermined by the experience of the 1970s, a period which saw a combination of increasing unemployment and inflation (known as "stagflation"). Current opinion is that such a trade-off is at best a short-run phenomenon, and does not exist in the long run. Unemployment may be temporarily reduced following a burst of demand inflation, but will be unaffected, or even made worse, in the long run. A later re-formulation of the inflation-unemployment trade-off argued that the long-run rate of unemployment is fixed at its "natural rate", and attempts to reduce the unemployment rate below the natural rate would result in permanently accelerating inflation. As a result the natural rate also became known as the non-accelerating rate of unemployment, or NAIRU. In recent years the level of unemployment in Britain, and in other industrial countries, has been below some estimates of what was thought to be the NAIRU without producing accelerating inflation. It may be noted that empirical estimates of the NAIRU have also changed at regular intervals. Majority opinion is now that while there may be an inflation-unemployment trade-off in the short run, inflation and unemployment are unrelated in the long run. This implies that the long-run inflation rate will be the Government's target, and the long-run level of unemployment can be improved by, inter alia, reducing labour market rigidities. Happily, this Committee does not have to pronounce on the current state of economics, but it is struck by certain lacunae in an area of such great importance to policy makers!

1.15  The Chancellor summed up his lack of faith in Phillips' original theory, by telling us that "We now know there is no long-run trade-off between inflation and growth and employment." (Q 3) The Chancellor told this Committee that the Government's policy is to help improve unemployment by supply-side measures through the use of fiscal policies designed to increase competitiveness. We may anticipate our later discussion by emphasising that the Chancellor does not see fiscal policy as a short-term instrument of macro-economic policy, except possibly in response to a major crisis. He sets the fiscal instrument over the medium term to achieve certain real objectives, but not so as to undermine monetary policy. Thus, in principle, he does not expect there to be a conflict between monetary policy and fiscal policy in the way he approaches it.

The choice of inflation targeting as the means of conducting monetary policy as opposed to previous monetary policies and that of the ECB

1.16  As we have noted the Chancellor is not alone in his enthusiasm for reducing inflation: inflation has been treated as a serious problem for a long time, and different methods have been used by successive Chancellors to control it. In the last twenty years, there have been several distinctive policies. The first of these was the targeting of the money supply based on a philosophy commonly known as monetarism. This only lasted until the early 1980s although a target for the growth of broad money continued until the mid-1980s. It was followed by a period of judging interest rates on the basis of a general assessment of monetary conditions, including the exchange rate. This lasted until the United Kingdom joined the Exchange Rate Mechanism towards the end of 1990, although during the second half of 1987 and the early months of 1988, policy was evidently directed towards an informal shadowing of the deutschmark. Membership of the Exchange Rate Mechanism only lasted for two years, until September 1992. The final stage of policy, which was introduced after sterling was ejected from the mechanism and is still used today, is the targeting of the inflation rate itself. This approach has been refined over the years to reach its present state, and we have no doubt, will be further refined in future.

1.17  In simple terms, inflation targeting is the setting of a desired inflation rate and the use of a monetary tool or tools to achieve that target. The Chancellor, in establishing the MPC, set the target at 2.5 per cent on the RPIX[4] measurement. The theory behind inflation targeting is that when inflation is in danger of rising, interest rates are increased by the amount thought necessary to dampen inflationary pressures and inflationary expectations. Conversely, interest rates will be lowered when inflation is in danger of going below its target.

1.18  It is obvious that the form of the target which this country has chosen is not the only one possible. An alternative form could be a maximum with no lower limit. Another possibility would be a desired mean over some suitably long period of (say) two to three years, with no explicit attention paid to its variance. And, of course, the target could be extended to include variables other than inflation, a theme to which we return.

1.19  Inflation targeting is now widely used by central banks as their method of controlling inflation. According to Martin Weale, Director of the National Institute for Economic and Social Research, "several countries have now tried inflation targeting and concluded it works." (Q 1050) Its simplicity is a reason for its popularity: as put by Gerard Lyons, Chief Economist of DKB International, "the benefit of an inflation target is that it is easy to understand" (Q 1112). The policy is conducted with slight variations as to how the target is designed and as to the number of tools available. For example, the ECB defines price stability as a year-on-year increase in inflation in the euro area of below 2 per cent, and attempts to maintain this stability over the medium term. The ECB, unlike the Bank of England, has the power to set its own target, and such a freedom is the norm in independent central banking systems. We say here and now that we favour a target which is simple and easily checked.

The experience of the past and of other countries

1.20  Historically, Britain has not been a country of high inflation—there has never been a period of hyperinflation—but there have been periods where inflation has been excessive. In this century there have been two periods of inflationary pressure caused by wars, but in peacetime the major period of inflationary concern was from the early 1970s to the early 1980s. In the 1970s the average annual increase in the Retail Price Index was 13.2 per cent, with annual peaks of up to 24.2 per cent[5]. Since 1993, however, the inflation rate has been relatively low, with the (seasonally adjusted) RPIX at or below 3.5 per cent at all times. The figure is now 1.3 per cent for the RPI, and 2.2 per cent for the RPIX.

1.21  By contrast, other major countries often have a better recent record than Britain. The United States has only rarely suffered from double-digit inflation, and Japan and Germany have both been very successful in maintaining very low levels of inflation. Germany, of course, suffered from hyperinflation in 1923 at a rate reaching 500 per cent per month with appalling political consequences.

1.22   Not all of Britain's inflation can be attributed to domestic forces. According to Gerard Lyons, "The 1970s were a decade of high inflation and as we moved through the 1980s, whatever country you were in, not just the United Kingdom, inflation remained a problem." (Q 1102) The most notable inflationary bursts were in the mid 1970s (reaching 26.9 per cent in August 1975.) and again at the end of the decade (reaching 21.9 per cent in May 1980), following oil price shocks[6]. But such supply shocks tended to affect Britain more than other countries: average inflation for the 1970s was 13.2 per cent in Britain but during the same period the corresponding figures for the United States, Japan, Germany and France were 7.2 per cent, 9.1 per cent, 5.0 per cent and 9.2 per cent respectively.[7] In the 1970s in Britain, the inflationary spiral was exacerbated by, among other factors, high wage demands associated with industrial unrest.

1.23  Britain's record in the 1980s was better than it had been in the 1970s, but despite the decreasing power of the unions to demand higher wages, inflation was still a problem from time to time, most notably at the end of the decade, 1990, when the RPI peaked at 10.9 per cent. Again, other countries fared better: in 1990, for example, average G7 inflation was 5.0 per cent.[8]

1.24  The 1990s have seen a period of low inflation throughout the world. In Britain, the inflation rate has been lowered to levels last experienced in the 1960s, and this is true of other countries: even some countries with poor records, such as Argentina, have moved from hyerinflationary to lower and more stable inflationary environments. Britain's inflation rate is, however, still higher than that of most other G7 countries: inflation (including mortgage interest payments) in Britain in 1998 was 3.4 per cent, compared with 0.6 per cent in France, 0.9 per cent in Germany, 1.6 per cent in the United States and 0.6 per cent in Japan[9].

1.25  Throughout the last three decades, we can see inflationary trends reflected to a degree in interest rates. The relationship between inflation and interest rates is complicated and will be discussed at a later point. It is not always worth comparing the two at an immediate point. But in respect of longer-term relationships comparisons are often useful. For example, in the last ten years, when United Kingdom inflation has been higher than in most other G7 countries, so too have our interest rates been higher, and since 1988 they have never fallen below G7 averages. Today, interest rates stand at 5 per cent in Britain, 5.24 per cent in the United States, 2.66 per cent in France and Germany and 0.13 per cent in Japan.[10]

1   In this Report, price stability and low inflation are mainly interchangeable terms. This is how they have been seen by all the witnesses. Back

2   Statement by the Chancellor of the Exchequer, 6 May 1997. Back

3   The Bank of England Act 1998 received Royal Assent on 23 April 1998 and came into effect on 1 June 1998. Back

4   We define RPIX in Appendix 3. Back

5   Source: OECD. Back

6   RPI figures; source: ONS. Back

7   Source: OECD. Back

8   Source: OECD. Back

9   Source: Treasury. Back

10   Source: Treasury. Back

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