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


General comments

7.1  The central theme of this report is one of learning from experience. The arrangements under which macroeconomic policy, in general, and monetary policy, in particular, are carried out are new. This is so, even though we view them as emerging from earlier policies and procedures. This Committee too regard their enquiry as experimental, in that nothing of precisely the same kind has been carried out by their Lordships before. What follows immediately, therefore, is that the MPC and the Government itself must be prepared to make changes if they are demanded by economic events. It may well be, for example, that the problem we have emphasised on the apparent differences between the wording of the Act, the remit set out by the Chancellor, and the recent interpretation by the Governor as described in Chapter 1 is best interpreted as indicative of such a response. Equally, any conclusions reached by this Committee are tentative in that they may well be shown to be incomplete as new shocks hit the economy and policy makers react to them.

7.2  Our approach to our remit has been strongly evidence-based. By this we mean two things. We have called before us a wide variety of witnesses. Some of them are economic experts; others have a deep knowledge of the world of business and finance; the Bank of England have set out before us their interpretation of what they are obliged to do, and how they have done it; and, of course, the Treasury have explained the basis of the new policy. All of our witnesses have presented serious analyses of the problems we have to investigate. In addition, their contributions have been enhanced by reference to real-world experience. We have also been kept in touch with the academic research which throws light on the problems of monetary policy. Not surprisingly, it is too early to mount the sort of studies which would give a definitive answer to the questions, What have been the consequences of the new arrangements, and have their benefits outweighed their costs? We take it for granted that both the Bank and the Treasury are monitoring the performance of the MPC to date, and will continue to do so. We hope such work will be placed in the public domain, sooner rather than later.

Operational independence

7.3  It is certainly our view on the basis of what we have heard so far that the Government was right to give operational independence for monetary policy to the Bank of England. (Many of us had come to this conclusion before or while the 1998 Act was passing through Parliament.) We are also persuaded that giving the new policy a statutory basis, despite being a radical new departure in economic policy making, was a sensible step forward. If it does nothing else, it ought to persuade the public of how seriously the Government takes economic policy making, and what a central role the control of inflation has.

Section 11 and the MPC's remit

7.4  It is probably also a good thing to place the objectives of the new policy in the Act. But this does lead to two concerns. One which we have discussed in Chapter 1 is that in addition to what is in the Act (essentially section 11) there is also the remit to the MPC as set out in the Chancellor's letter. The latter must be a valid interpretation of the former. We are unable to say at this stage of our deliberations whether it is the only possible valid interpretation. Our second, and related worry, is whether, if a future Chancellor wished to change the form of the objectives of monetary policy, that would require further primary legislation.

7.5  Our view is that if any remit set out by the Chancellor were to have as its aim price stability, itself interpreted by the Chancellor, then no amendment to the Act would be required. Only if some other aim were to be designated which could be regarded as downgrading price stability, or imperilling it, would an amendment to the Act be required. We have said, therefore, that in principle the Chancellor could ask the MPC to focus on the exchange rate insofar as that helped the inflation target to be reached. He could not, however, ask them to balance price stability against growth and employment, the so-called dual mandate, without going back to Parliament.

7.6  The Act states that it lies within the hands of the Chancellor to say what is meant by price stability. He has set a target of 2.5 per cent in terms of RPIX. We regard this as sensible and feasible in the prevailing circumstances. It certainly lies within the range of targets that any reasonable commentator would wish to take seriously. In setting that target, the imperfections of any policy mechanism must be recognised. Thus, while in a sense a loss occurs when there is a small deviation from the target, there is no need for any headline response until the deviation gets as large as 1 per cent. This is not to say that 2.6 per cent or 2.4 per cent are as good as 2.5 per cent, but rather that in those circumstances the MPC can be assumed to be able on its own to get back on target fairly quickly. The 1 per cent points demand, at least, an explanation, but deviating that far does not necessarily imply serious policy error, rather than unforeseen circumstances that need responding to.

7.7  Given other parts of the Act, which enable the Chancellor to intervene in the presence of a major crisis, it can be concluded that theoretically the new form of policy making can lead to a satisfactory outcome both for inflation, and for employment and growth. We say this although we remain puzzled by the meaning of section 11 read in association with the Chancellor's letter. Being aware of the experience of other monetary authorities it might be thought that the Act could have been better worded. The wording is certainly different from that of the remit of the Federal Reserve[29]. This means that those who interpret the two as much the same must be mistaken. As we have said several times, the way the Act is written implies there can be no balancing of the price target against a real target even in the short term. But if we concentrate on the wording of the Act, which as legislators we must do, the expression "subject to that" in section 11 must have a meaning. We would welcome a definitive statement from the Chancellor on what precisely that meaning is.

7.8  We do feel obliged, moreover, to add the following comment or word of warning. The Chancellor's policy has at least two strands. One is that stable prices are good for the real economy. This is so whether one interprets them as a precondition for improved real economic performance or as leading to that end. The second is that so-called supply-side measures, to improve the working of markets, to make the labour force more employable, and to encourage investment will be in place and will succeed. The Government has put substantial emphasis on its supply-side measures, many of which received widespread support. It has, however, been criticised by business for some of the things it has done, in terms of placing additional burdens on them. The Chancellor is entitled to demand that he is not judged before enough time has elapsed for the new measures overall to work. We agree, especially as it remains our view (a) that the overall scenario within which the MPC has operated so far has been relatively benign, (b) that monetary policy has effects with a time lag, and (c) that supply-side policies also operate with a long time lag. But while one to two years may be too short a test period for the MPC, three to four years begins to be long enough. In that period output is likely to get close to its sustainable growth rate and unemployment may continue to fall. The question, which we ourselves are in no position to answer, is will inflation start to rise again, and if it does will the MPC's response be such as to hold back the real recovery?

Art or science?

7.9  We turn next to the actual operations of the MPC. We are extremely impressed by the wide range of statistical and other data which they examine in the process of coming to their decisions. We have also said how pleased we are with the transparency of their Minutes, and with the speed with which they appear in public. It is not easy, however, for anyone to appreciate how the decision which is taken is precisely related to the MPC's analysis of the economy. We are aware that there are those who believe that the relationship is minimal. The way for the MPC to rebut that is to make the decision procedure clearer still. Since it is always possible to take the right decision for the wrong reasons, it is important that, without naming names, more emphasis is placed on the following, (a) what was decisive in coming to the particular decision taken, and was that decisive for all members? and (b) what caused any member of the MPC who, quite properly, changed his or her mind in the course of discussion to do so? Such additional information would also help when the relevant consideration was one of a right decision turning out badly.

The level of interest rates

7.10  On their precise choices of interest rates so far, we regard all the decisions of the MPC as lying within what might be called the reasonable range. This does not mean that their decisions on some occasions also cannot be subject to reasonable criticism both as to scale and timing. We are fully aware of the level of nominal and real interest rates being above that of our competitors. We would welcome a statement by the MPC, possibly in the Inflation Report, as to why the interest rate in this country is considered low at 5 per cent while that set by the ECB is 2.5 per cent. Is there still a serious risk premium to be attached to sterling and to British inflation and to other features of the economy? The lack of direct concern with an apparently overvalued exchange rate and a trading deficit are equally apparent. But we have not felt that more detailed appraisal of those and similar matters lay within the remit of this committee at this stage of our deliberations.

Voting on the MPC

7.11  We are also rather intrigued by what we have gleaned about the voting process on the MPC. This seems to occur in two stages; a trial run of individuals expressing a preference, followed by the actual voting. All of this occurs sequentially so that later voters, so to speak, know what their predecessors have done. On the face of it this is not a satisfactory voting procedure. We strongly recommend that the MPC examine their methods with a view to removing any possible bias in the decision making mechanism.

The MPC's members

7.12  On the membership of the MPC, discussed in Chapter 2, we entirely accept that all of them must have the expertise and background to make a contribution. We do not regard that as meaning that each of them must be an expert in monetary economics. Indeed, we note that the committee as present constituted contains some experts, but they are in a minority. We do not go to the other extreme, and seek to have a so-called representative committee. Nonetheless, we are struck by the limited range of experience of the present MPC, both the academics and the Banks' members. This is true of their work experience, and the sorts of organisations which have employed them. It is also true of the parts of the country they have worked in. Finally, it is true of their academic backgrounds. We hope this is borne in mind when the next appointments are made.

7.13  Our comment relates especially to the way the "independent" members are appointed. It is to be desired that such appointments should be made as openly as possible, and certainly more openly than at present. At the very least something closer to "the Nolan principles" should be adopted. For our purposes we define that as involving openness and objectivity in the method of appointment. The existence of a vacancy should be known. People should be encouraged to apply on their own behalf, or should be able to write in recommendation a candidate whom they fear the Treasury may have missed. Having said that, we also agree that it is right for the Chancellor to have the final say. He must be happy with those he appoints to the MPC. While not doubting for one moment the quality of the latest appointment, for example, we have not the faintest idea how it was made. The potential field of good candidates is not vast, but it must be larger than one. We are convinced that the Treasury can devise a more open method, enabling good candidates to put their names forward for consideration, and knowledgeable people to make suggestions.

7.14  Another concern of ours is with the length of appointment. Too short a period means that expertise acquired on the MPC will be wasted. Too long a period means that the committee gets set in its ways, and everybody becomes a Bank of England person. Our view is an appointment period of five years will be efficient enabling new ideas to be brought in regularly without infringing the need for independence. Renewal should be rare if not impossible, and appointments should continue to be staggered.

7.15  Lastly, there is the question of full-time versus part-time. We were surprised at the start of our investigation that some independent members were full-time. Since all the internal members have other responsibilities within the Bank, for this purpose they are part-time. Thus, we have the paradox that the only full-time members of the MPC are the outsiders! We accept that some potential members' personal circumstances may be such that they could not accept a part-time appointment. This may be true of any employee of firms in industry or commerce, if for no other reason than the possibility arises of conflict of interest. The field of part-time members, (other than the independently wealthy) would be academics, employees of some charities and similar bodies, and businesses, if there are any, where no possible conflict of interest could arise. Since we do not wish to see the membership limited in this way, we now accept that some full-time appointments must be made, but we would not care to see all the independent members being full-time. We can also see that a person may switch from full-time to part-time, or vice versa.

The Court

7.16  The 16 outside members of the Court are all part-time. Our interpretation of the Act is that they are involved with the accountability process. We are concerned with the way in which they have undertaken this task so far. On the face of it, they have an important role in setting the parameters under which the Bank itself and the MPC operate. It was also our impression that they would play a central part in the preparation of the Annual Report, and in assessing the work of the MPC. While accepting on this as on everything that these are early days, we are surprised at the reluctance shown by the Court in exercising their functions in relation to the MPC. We would expect their role to be stronger in future, not least in connection with the quality of data made available to the MPC.

The measurement of inflation

7.17  Central to the work of the MPC is price stability or the control of inflation. It follows (especially from what we say in Chapter 3) that the correct measurement of inflation must be given the highest priority. On the evidence we received we are not convinced that ONS is sufficiently seized by its importance. Their stance has been that they would respond to requests from relevant bodies, but did not seem to see it as their task to take a lead. We believe that they should be more prepared to take the initiative.

7.18  To target an index which is itself regarded as unsatisfactory could lead to real economic harm. There are several problems connected with RPIX which we have mentioned in Chapter 3. An example arises with respect to once for all effects, such as indirect tax increases. They may distort the index, but we assume the MPC can allow for this in its decision making. What is vital is that the general public understands that. There is the usual difficulty to do with coverage, namely, what the index covers. This applies to every index, and is easily dealt with as long as it is recognised. It is our hope that in its regular scrutiny of the subject ONS is especially sensitive to this.

7.19  On the technical side, there is a choice between indices like RPIX and HICP—both of which are published in this country. In practical terms for the moment only a small group of experts take note of the latter. For inflation targeting we can see some good reasons for switching to HICP, especially as it is the form preferred by the European Central Bank. Given the extent to which so many contracts of all forms are written in RPI terms, there could be serious implications in moving to HICP for one purpose, inflation targeting, and leaving the RPI for the rest. To move over entirely without additional research and preparation would be hazardous. We strongly recommend that further examination of all this coupled with appropriate action needs to be undertaken without delay. A useful comment full of insight is the following from the US Bureau of Labor Statistics, who state:

7.20  It is a widespread feeling that there is a variation in inflation rates between different regions of the country. It is connected with, but not the same as, the distinction raised by the Bank between domestically generated inflation and imported inflation. Neither of these breakdowns of the RPI is mentioned in the Act or in the remit letter, but they are both important. It is our view that, without prejudice to the outcome, ONS ought to undertake or commission research to determine (a) whether there are significant regional differences in inflation rates, and (b) how important in quantitative terms normally is the distinction between domestically caused inflation and imported inflation.

The MPC's achievements

7.21  We have said at the very outset that we support operational independence for the Bank of England with respect to monetary policy. Despite all the caveats that have been expressed, the policy so far has been a success. It is right to be cautious about the precise causality, and not to be over confident about the future. But the central objective should not be forgotten. The MPC was told to hit a precise inflation target, and they have hit it. They must be congratulated for that.

The exchange rate

7.22  What we have also to return to is another of our concerns, the value of sterling. The exchange rate is an important part of the transmission mechanism. It has a varying effect on different parts of the real economy. Above all no one is able to say with confidence what determines it. This is worrying in itself. But given the possibility that the United Kingdom might enter EMU some time in the next few years, attention must be paid to the vexed questions of whether there is a right rate for the pound, and, if so, how do we get to it. We also have to ask what is the role in the MPC in all this.

7.23  There is one aspect of the exchange rate problem which the Committee has found especially intriguing at the time this Report is written. The objective of the ECB is, no less than that of the MPC, the control of inflation. It is of interest to note, therefore, with the value of the euro falling, how the emphasis of interested commentators has switched to the effect of the policy on the exchange rate!


7.24  We have congratulated the MPC on the quality and timeliness of their Minutes. We have indicated how the Minutes could be improved, but we do not wish such a comment to be interpreted as suggesting what we are already offered is not first-class. Both the Chancellor and the Governor have committed themselves fully to a policy of transparency which is unprecedented in this country or, as far as we know, elsewhere. That makes the task of those involved in the accountability process much easier. It is our view that the bias at all times must be to make things public rather than to keep them secret. Since those inside, both Bank and Treasury, by definition know what we do not know, that places a heavy burden on them to reveal data and analysis. To take one example, mentioned in Chapter 4, the Bank may be looking into the usefulness of other instruments of monetary control such as those used by the Fed. If they are, it is their duty to let that be known, and not wait for a Committee such as ours to ask.

7.25  One particular reason for this is that one effect of the existence of the MPC could well be to change the way the economy works. Apart from the change in inflationary expectations, firms are requiring expertise both to anticipate MPC decisions and to interpret them. It would aid private business in particular, if the experts were kept fully informed of how MPC thinking in matters within its remit was emerging.

Our role

7.26  Our final comment concerns the role of a Committee such as this. We have seen our task as one of critical interpretation. We are certainly supportive of the new procedures, but are convinced that a questioning approach is the best way of helping to influence the process of policy-making. We ourselves, although not without views, are not policy makers. We are part of a broader process, helping to educate and inform the public, and assuring them that those who take the biggest decisions that influence our everyday lives are held to account.

29   It might be helpful if we state precisely what the mandate of the Federal Reserve system is. The Humphrey-Hawkins Act passed by Congress in 1978 requires the Fed to:

"Maintain long-run growth of monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Back

30   Katharine G Abraham, John S Greenlees and Brent R Moulton, Working to improve the Consumer Price Index, in Journal of Economic Perspectives, American Economic Association, Winter 1998. Back

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