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



CHAPTER 5: THE RELATIONSHIP BETWEEN MONETARY AND FISCAL POLICY

How does the MPC take account of fiscal policy?

5.1  Before the current arrangements for monetary policy were set in place, the Chancellor, through the Treasury, had direct control of both monetary and fiscal policy. Now, although the Chancellor has ultimate responsibility for both monetary and fiscal policy, operational control has been divided between an independent MPC that has sole responsibility for monetary policy, and the Treasury which retains its responsibility for fiscal policy. Separation of responsibility does not, however, entail that monetary and fiscal policy can be formulated independently of each other. Both can affect inflation in the short run, and also growth and the exchange rate. So how does the MPC take account of the Government's fiscal stance? What information about fiscal policy changes does the Treasury give the MPC?

5.2  The ultimate responsibility of the Chancellor was put as clearly as possible to this committee by Sir Andrew Turnbull, Permanent Secretary to the Treasury, when he gave his interpretation of the balance of responsibilities. He said that "In some fundamental sense nothing has changed. He (the Chancellor) is still responsible to Parliament." (Q 359) This is not to say that the MPC must be protected from critical scrutiny. It is to say that ultimately, if things go wrong, the Chancellor must be in the firing line. Even if things go right, in the sense that the MPC regularly hits the inflation target, but there are undesirable real consequences, the person to blame is the Chancellor, not the Governor.

5.3  Explaining the division of responsibilities, Sir Andrew said that "The objective of the Treasury is to pursue sustainable growth for the economy as a whole." The Bank has been set "a specific objective, which is to deliver inflation" (Q 370). He also claimed a limitation in the Chancellor's responsibilities when he stated that "Apart from when things go badly wrong, he is not responsible for the level of interest rates that the MPC has chosen" (Q 369).

5.4  The Government has introduced a new stance for fiscal policy as well as new arrangements for monetary policy. This new stance recognises the limitations of fiscal policy as a short-term instrument and focuses on the medium and long terms. The aim is for budget balance in the medium term. Tax rates are set for the medium term and revenues are smoothed in the short term by borrowing. Longer term borrowing is constrained by the Government's golden rule to be only for investment expenditures. Referring to the MPC, Mr O'Donnell told the committee that "I think that leaves them free to operate in the best possible way so that they are not having to adjust for big swings in the economy caused by big stimuli and cutbacks in the fiscal side" (Q 178).

5.5  Mr O'Donnell explained the relation between monetary and fiscal policy to this committee in the following terms. "We certainly use fiscal policy to help the Monetary Policy Committee to deliver their job, most certainly, and the best way we can help the Monetary Policy Committee is through having a very predicable fiscal policy that adheres to rules that we have laid down". (Q 176)

5.6  Despite these good intentions, there is still concern that monetary policy might find itself counterbalancing, and hence negating, fiscal policy. In the new system, the MPC must try to maintain inflation at 2.5 per cent. In order to do so, it will have to react to any aspect of fiscal policy which threatens to throw inflation off target. As a result, a Budget which is inflationary might require the MPC to increase interest rates and a Budget which is deflationary might cause it to decrease interest rates. As Lloyds TSB point out, this is not a matter of "punishing" or "rewarding" the Government: "it is an automatic policy response" (p 216), or, as put by M Trichet, "If a fiscal policy is no good, then you cannot help countering the bad influence which is coming in a fiscal policy." (Q 1380) Such an example nearly occurred this year: in the words of Professor Bean:

5.7  There is no point in denying that monetary and fiscal policy could theoretically be in conflict, and clearly, it helps if there is some co-ordination between the two. But we are obliged to say immediately that there is wide gap between the possibility of conflict and the actuality. Lord Desai told us "I remain to be convinced that monetary and fiscal issues can, even in theory, be separated" (p 266) and added "I see no other way of running the economy" (Q 1187). The Governor assured us that such co-ordination does take place: "The Committee as a whole before a Budget and during the Budget planning process will discuss whether it feels there is a message that it would like to convey to the Chancellor and typically I would expect that there would be a message they would want to be made to the Chancellor and that is conveyed through the Treasury Representative to the Chancellor." (Q 1591) In addition, the Treasury briefs the MPC before the Budget on its contents. But there remains a degree of scepticism that although the mechanisms so far are working quite well, they may not always do so: according to Gerard Lyons, "When things are going well everything seems great. Currently the Treasury briefs and keeps the MPC informed of fiscal policy. This is good, and according to reports the Treasury carries out this role very well. Yet this a second best solution." (p 241)

What is the role for fiscal policy?

5.8  In the past fiscal policy was used to stimulate or suppress demand according to the circumstances of the time, and was regarded as the short-term policy instrument. Used properly, which was not what always happened, its purpose would have been to keep the economy on a non-inflationary full employment track. Monetary policy was then set, sometimes in the form of money supply targets, to maintain or reinforce the non-inflationary position. Apart from the objection that fiscal policy was used sometimes to over-stimulate the economy, it was also objected that many fiscal changes were rather clumsy as short-term instruments. That is what has led to the current approach to these matters. It then becomes inevitable that if a policy of short-term fiscal stimulation were to be pursued, unless they were instructed otherwise, the MPC would react to it, in ways similar to those noted above.

5.9  We have to assume that the Treasury is not unaware of this, and finds it acceptable in the sense of eschewing short-term fiscal intervention other than in exceptional circumstances. So, as pointed out by Lloyds TSB, "one consequence of giving an independent Monetary Policy Committee responsibility for maintaining stable low inflation is effectively to rule out the use of activist fiscal policy." (p 216) We also note Professor Minford's view that "If you then from time to time say "We are going to boost the roads programme because the economy is in a mess," you then lose all control over public spending" (Q 1170), which is reflected in the Governor's statement (in referring to the Chancellor) that "I am very reluctant to encourage him to try and engage in short-term fiscal management because we have been down that path many times before and it has typically proved to be a considerable disaster." (Q 1608) We have also been told by Lloyds Bank that:

5.10  Not surprisingly, that is not the end of the matter. Monetary policy cannot target anything but the whole economy, and this is where fiscal policy might step into the breach. To use a crude example, if one sector of the economy were doing very badly and needed an export boost, but in the economy as a whole the pressures were largely inflationary, two things could be done. First, the MPC could lower interest rates. This might help the sector in need, but it would be inflationary and would damage the rest of the economy. Alternatively, the Government could tailor a specific package for the sector in need. This would be more appropriate and would have little effect on inflation and the economy as a whole. We have to say, however, that such fiscal intervention, desirable or otherwise, is not at all the same as the fiscal activism that the coordination debate has been about.

5.11  The problems of relying on monetary policy are articulated by Professor Bean:

    "monetary policy, whilst easy to operate is blunt and relatively unpredictable in its effects compared to some types of fiscal action. Moreover it ignores the burdens that are placed on the tradeables sector if sole reliance is placed on interest rates. I think it is time for the re-emergence of at least sorts of fiscal action as a complement, or even on occasion a substitute for monetary policy, depending on the nature of the shocks impinging on the economy." (p 305)

5.12  This is a valid comment, but it does not lead to the conclusion that fiscal and monetary policy necessarily tend to work against each other in a contradictory fashion. Turning to a specific example, according to many of our witnesses, a strong example of where fiscal policy should have been changed was immediately after the election. Their claim is that a tougher budget would have lessened the need for a tighter monetary policy in 1997 and 1998 and would have hurt exporters less. According to Lloyds TSB:

    "a sharper tightening of fiscal policy in 1997-98 would have reduced the need to raise interest rates at that time. This would be likely to have resulted in slower consumer spending growth than otherwise, but faster growth of investment and exports - given the likely exchange rate decline that would follow. It should also boost manufacturing's contribution to growth relative to that of services. Tightening policy would therefore have rebalanced growth towards exports and investment and away from consumer spending, and towards manufacturing and away from services." (p 217)

5.13  Lord Desai, referring to the same example, told us that "small increases in interest rates only prolonged the agony by raising expectations of further interest rate increases and hence sterling overvaluation. An appropriate response would have been a much tougher budget in July 1997 than was the case." (p 267) Had the Chancellor followed such a course, according to Martin Weale, "one would have had perhaps less of manufacturing complaining about high interest rates and a high exchange rate if interest rates had been used less to control inflation and an increase in the general level of taxation had been used a bit more" (Q 1062).

5.14  This may turn out to be a correct assessment, but it does not lead to any conclusion about the need for better coordination. The need would be for better policy altogether. It also does not mean in itself that fiscal policy is an appropriate means for short-term boosts to the economy in general. While we may still be less than fully convinced, the Chancellor can rightly say he is for the moment entitled to the benefit of the doubt. He has put a new structure in place, and we can wait until it has been subject to the hardest tests.

5.15  Subject to that, long term fiscal measures are worth encouraging: Lloyds TSB told us that "changes to taxes and government spending can have important effects on long-term growth by encouraging higher rates of saving and investment, by improving education and training and by increasing work incentives." (p 217)

To what extent can the side effects of monetary policy be mitigated by fiscal policy?

5.16  The MPC by necessity operates on a "one size fits all" basis: interest rate decisions apply to spender and borrower, manufacturer and service-provider, importer and exporter, rich region and poor region alike. Yet the needs of each is unlikely to remain the same in any circumstance, never mind at all times. Somehow, the different priorities must be accommodated. Of course, that is true of monetary policy in general, quite independent of the decision making structure. It must be added that it is also true of fiscal policy viewed as a macroeconomic control instrument. Thus, while entirely accepting that the two parts of policy must not contradict each other, it does not follow that even in a perfect world the problems of differential effects disappear. If, however, monetary policy is successful in achieving price stability, and, together with the overall fiscal position, policy is set to achieve over time the Government's objectives with regard to growth and employment, there remains room for detailed fiscal intervention to help particular markets or regions. It is not within our remit to explore public expenditure proposals or tax incentives which influence business decision making or the market mechanism in this form. We simply point out that there is nothing in the new approach to policy which prevents this. Indeed, the Treasury's pronouncements on investment in the public sector and the golden rule shows they are well aware of this. The whole subject would increase in relevance were Britain to join EMU.

Should there be an exchange rate policy?

5.17  We have already discussed the fact that, prior to the use of inflation targeting, there was exchange rate targeting. This went very badly wrong when the market decided that, even with the imminent prospect of 15 per cent interest rates the pound was overvalued[20], and when the dust settled after the expulsion from the ERM the pound was closer to 2DM than to 3DM. Ironically, the pound is now back at the 3DM level.

5.18  This level is perceived by many to be too high. For example, many manufacturers complain that the increase in the value of sterling from a low level of around 2.20DM is pricing them out of the market. Sir Brian Moffatt, Chairman of British Steel, told us that "When currency was weaker at around 2.50 we were the lowest cost producer in the world. Nowadays I cannot sell a tonne of steel in an export market and make a profit" (Q 1302). The British Chambers of Commerce have provided us with anecdotal examples of how the high cost of Sterling has led to job losses (pp 117-118). In turn, those who have complained about the high value of sterling have begun to argue that once again there should be a target rate of exchange. Not all of those who are keen to see sterling at a particular level are motivated primarily by making the value of their products cheaper in export markets. Some just want stability. As far as Sir Ronald Hampel - who does not advocate an exchange rate policy but who would nonetheless like a lower exchange rate - is concerned, "the worst thing is fluctuating exchange rates" (Q 1266).

5.19  There is no doubt that many of those who have given evidence to us believe that sterling is overvalued. They are supported in this view by outside commentators. The question that has to be addressed is what meaning is to be attached to overvaluation. There was a time when this was considered in relation to balance or equilibrium in the current account of the balance of payments. In a world of perfect or nearly perfect international capital markets in which deficits are relatively easily financed by a country such as the United Kingdom it is difficult to see this as fundamental in other than the very long run. More narrowly, reference can be made, as it has been, to how competitive the exchange rate leaves particular firms or sectors when it comes to international competition. Too high an exchange rate would be damaging to some firms or even whole sectors the sales of which would decline, and they themselves disappear never to return. Even with a flexible and efficient economy structural (possibly irreversible) damage would be done, and it would be hard for the Government to reach its real targets. If that interpretation is accepted it is still difficult to say by how much the pound is overvalued. 20 per cent, or roughly 2.40-2.50DM is a much quoted figure, but some (for example, Lord Desai, Q 1189-1192) believe that 2.75DM is more realistic. It is not for us to say what the value of the pound ought to be, but we can ask two questions of the MPC. First, can they affect the value of the pound through interest rate decisions? And secondly, should they try?

5.20  Theoretically, interest rates affect the value of currency by making domestic financial assets a better investment. A rise in interest rates makes it cheaper to borrow abroad and lend at home. The net international flow of funds should strengthen the value of sterling. There are, of course, complications, not least to do with exchange risk and expectations[21]. Thus while the interest rate effect has certainly been true at times in the past, at the moment it is hard to discern a simple and reliable relationship between interest rates and the strength of a currency. (There is the further complication of the value, especially the expected changes in the value, of the currency determining interest rates, and not the other way round.)

5.21  The last time a United Kingdom Government tried to use interest rates to manage the value of the pound was in 1992, when increases in rates from 10 per cent to 12 per cent (and even the prospect of a rise to 15 per cent) on a single day failed to stop the markets from forcing the pound well below its ERM floor. This happened despite the massive buying of sterling by European central banks wishing to keep the pound in the ERM. Less dramatically, since then the relationship between interest rates and the value of the pound has been difficult to evaluate, and most recently the fall in interest rates from 7.5 per cent to 5 per cent has failed to have any discernable effect on the value of sterling. Nor would any different policy have produced a different result: as put to us by Roger Bootle, "It is very difficult to tell quite how the exchange rate, in particular, would have behaved under a different regime." (Q 1135) This blunts much of the argument for trying in the first place.

5.22  More generally, in our evidence we are almost presented with a counsel of despair. This may be summarised by the proposition, remarked on above, that nobody, not least the professional economists, has any confidence on what is the main factor determining the exchange rate at any point of time. The exchange rate is what it is as determined by market traders. In that sense, since markets are free, the exchange rate is always right. Furthermore, as we have argued, the authorities are not able to control the exchange rate. This is even more true with monetary policy now geared to a precise target of price stability, and fiscal policy set for the medium term. We are therefore in a double bind, so to speak. The exchange rate is in present circumstances the outcome of myriad factors and not an initial force. If it were a matter of policy to control it, the Treasury and the Bank would not be sure any more what they would have to do. That is not a criticism of them, but an apparent fact of economic life. Even joining EMU would not solve the problem as the euro floats against other currencies.

5.23  Having said that, we are obliged to note that at some point in the future, there may have to be an exchange rate policy, simply because if Britain is to join the single currency there will have to be a convergence. To join EMU at an exchange rate which would lead to unemployment and low output and growth, and with no other tools to offset all that would be foolhardy in the extreme. This is not the same as saying we know what the right rate for joining is or how to get to it. What we can suggest, however, is that our reading of the Bank of England Act leads to the conclusion that it might be compatible with aiming at the exchange rate as long as that can be argued to be part of the path to stability. This surely needs further examination and interpretation.

5.24  For the time being exchange rate targeting is a risky venture. In connection with this, ICI reckon the inflated value of sterling cost them £60m in pre-tax profits in 1998 compared with 1997 (p 275) but their former Chairman, Sir Ronald Hampel, told us "I find it difficult to say they should put as much weight on to it as other things, despite the fact that I think it is the single biggest penalising factor for manufacturing industry." (Q 1267) For him, "to reduce interest rates solely for the purpose of reducing the exchange rate would actually defeat the ultimate purpose of the MPC." (Q 1250)


20   The 15 per cent interest rate was revoked before it came into force. Back

21   See Appendix 4. Back


 
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