Select Committee on Economic Affairs Second Report


SECOND REPORT


28 FEBRUARY 2003

By the Select Committee on Economic Affairs

ORDERED TO REPORT

THE MPC AND RECENT DEVELOPMENTS IN MONETARY POLICY

Introduction

1.  In 1998, the House of Lords established the Select Committee on the Monetary Policy Committee (MPC) of the Bank of England to provide a mechanism for parliamentary scrutiny of the work of the MPC.

2.  In early 2001 its successor, the Economic Affairs Committee, was established with a remit "to consider economic affairs". Given that broad remit, the Economic Affairs Committee has decided from time to time to continue its scrutiny of current economic policy and the role and performance of the MPC in particular. The membership of the Committee is given in Appendix 1, and a list of Members' relevant interests is given in Appendix 2. In the present short inquiry, the Committee took evidence from the witnesses set out in the Appendix 3.

3.  We had hoped that the Chancellor of the Exchequer would appear before us to comment on the matters we raise here and to answer our questions about the current state of the economy and economic policy. We have always found him helpful and willing to give us evidence. Unfortunately, although we gave him several months' notice, he was unable to find time to do so on this occasion. We therefore call upon the Government to support the view that when a Lords Committee asks a Minister to attend, that Minister should come.

Remit of the Monetary Policy Committee of the Bank of England

4.  The remit of the Monetary Policy Committee of the Bank of England, which was established by the Bank of England Act 1998, is:

(a)   to maintain price stability; and

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

5.  The Act requires that the Government specify at least every 12 months its economic policy objectives, including what price stability consists of. The MPC's remit is to hit the inflation target set by the Chancellor of the Exchequer, which since the establishment of the MPC has been 2.5 per cent for the RPIX.[1]

6.  The target is symmetric in that deviations above and below it are of equal significance. All deviations matter, but a special explanation is called for only when the deviation is more than 1 percentage point.

7.  Our predecessor Committee has discussed the MPC's remit several times in the past, in relation to both the formal remit and how it is interpreted.[2] The formal remit is defined very narrowly, which has always troubled us. We have increasingly come to appreciate that in practice the remit is interpreted more flexibly.

8.  The MPC's policy instrument is the short-term interest rate. Obviously, if the MPC has only one instrument at its disposal, it can aim at only one target.[3] Equally important, a single target is compatible with the proposition that, if the outcome deviates from the target (in this case the inflation rate) or is expected to do so, there is still room for manoeuvre in establishing the best path back to the ultimately desired position. Too abrupt a change may cause instability and damage the real economy. Too slow a change may take the inflation rate too far away from the desired level and incur associated costs. There is also likely to be a connection between the short-term inflation outcome and the long-term ability to hit the target. Such a trade-off was mentioned by Mr Geoffrey Dicks of The Times Shadow Monetary Policy Committee (Q189).

9.  One Deputy Governor of the Bank of England, Mr Mervyn King, said: "The point of bringing inflation back to target over a horizon longer than two years in some circumstances is solely in order to reduce the risk of being further away from the target at other times" (Q113). He referred to volatility of demand (Q90). The Governor, the Rt Hon Sir Edward George, also referred to undesirable volatility of output which "would have implications for future inflation as well as output" (Q113). Mr King also mentioned "undesirable volatility in outputs" in his answer to Q136.

10.  In evidence, Mr Matthew Taylor MP, Treasury Spokesman for the Liberal Democrat Party, stated clearly his opposition to a dual mandate[4] (Q204). He recognised that the MPC considers gross domestic product because it affects volatility and inflation. He also said that according to the Federal Reserve Act 1913, the goals of Unites States monetary policy did not actually give more weight to growth (Q204). The Treasury Spokesman for the Conservative Party, the Rt Hon Mr Michael Howard QC MP, was also happy with the mandate specified in the Bank of England Act 1998. He referred to the second limb — "to support the economic policy of [the] Government, including its objectives for growth and employment" (Q244). His view of the House of Commons Treasury Select Committee's recommendation that the mandate be re-examined was clear: "There is no harm in re-examining things, but my personal view is that the case for changing the mandate has not been made" (Q245). Mr Dicks and Ms Diane Coyle, both of The Times shadow Monetary Policy Committee, were also content with the present remit. Indeed, Ms Coyle said that "differences between the Bank of England and the Fed are more apparent than real" (Q196). She added, in terms similar to those of Mr Taylor: "It is a very long time since the Fed sacrificed its simple inflation target for the sake of the economy". Mr Martin Weale and Mr Anatole Kaletsky, both of The Times shadow Monetary Policy Committee, took a similarly broad view.

11.  Differences in policy approaches can be illustrated as follows. In the event of a recession, or when a recession is anticipated, most economists would say that the correct monetary policy response would be to cut interest rates. One explanation of this is because recession is associated with a lowering of inflation rates; therefore, hitting the inflation target requires an easing of monetary policy. Another explanation is that a recession is undesirable and it is safe to ease monetary conditions because there is no danger of exceeding the inflation target. In practice, the two lines of reasoning result in the same conclusion - that interest rates should be cut. The MPC adopts the former reasoning; others, including the Federal Reserve Bank, the latter.

12.  For example, following the February cut in the interest rate, the MPC explained that "over the next few years the prospects for demand, both globally and domestically, are somewhat weaker than anticipated."[5] This can be interpreted as meaning: (a) that inflation is predicted to be below target, so monetary policy has been eased; (b) that inflation is predicted to be below target, so it is safe to intervene to stimulate demand for output and labour; or (c) that demand prospects are poor, and priority must be given to stimulating them. The MPC rejects the third view, but we consider that this rejection involves an element of semantics rather than economics.

13.  Although the operation of the MPC has mostly been satisfactory, we reiterate our earlier view that something like the formulation of the remit of the Federal Reserve Bank[6] would benefit the United Kingdom economy. In practice, the MPC has been successful both because it has interpreted its remit in a more sophisticated way than its strict remit might appear to suggest, and also because the economy has not been hit by a major demand shock and (until now) no significant supply shock at all.

14.  Although the operation of the MPC has been satisfactory so far, we conclude that a re-examination of its remit to include broader concerns than inflation alone might benefit the United Kingdom economy. We will carry out such an examination in a later report on the MPC.

Appointment and Transparency

15.  At the moment, the MPC has nine members - the Governor of the Bank of England; the two Deputy Governors; two Executive Directors of the Bank; and four independent experts appointed by the Chancellor of the Exchequer.

16.  Our predecessor committee has in the past expressed concern about how independent members are appointed.[7] We favour a more open process, conducted in accordance with a Code of Practice analogous to the Code of Practice for Public Appointments published by the Office of the Commissioner for Public Appointments. We favour such an approach, partly as a matter of principle and partly as a way of enlarging and deepening the pool of people who might be considered for membership. The Chancellor has always rejected our view on the matter.

17.  Similar considerations apply to the appointment of staff of the Bank of England who become members of the MPC. It is difficult to discern any formal appointment procedures. As far as we can ascertain, posts are not advertised, and we do not know whether references are required.

18.  Mr Howard suggested that Parliament should approve the appointment of members to the MPC. We have never considered that to be part of our job, especially as the Bank of England Act 1998 makes it clear that neither House has a role in the appointment of MPC members. It has never seemed to us to be a useful contribution on our part to suggest that a particular person was below standard or that another was satisfactory. Mr Howard referred to a Joint Committee. Although we do not reject such a proposal out of hand, we are not persuaded by its feasibility or the value of the likely outcome.

19.  Despite the reservations we have expressed about appointment, we consider that the independent members are fulfilling their duty of objectivity. Compared to its counterparts, notably the European Central Bank and the Federal Reserve Bank, the MPC is refreshingly transparent, and its members are not loath to express their own points of view. We have no doubts about the ability of individual members. We note, however, the limited range of backgrounds from which they are appointed. We understand that the Treasury has a list of possible candidates.[8] We have never seen the list and have no idea who is on it, and what their levels of expertise and experience are. Furthermore, as far as we know, the Treasury has never given any public indication of the qualifications and experience prospective candidates are expected to have. In taking evidence, we have not heard any argument that has caused us to change our previous view.

20.  We therefore recommend, as we have done, consistently, before, that members of the MPC should be recruited and appointed in a manner consistent with Nolan principles.

21.  We also draw attention to the length of appointment and reappointment of MPC members. No member has been reappointed[9], although it has been reported that Dr Sushil Wadhwani was invited to continue.[10]

22.  Mr Howard, suggested that the term of appointment of independent members should be four years rather than three and should not be renewable. He believed that five years was too long. On the assumption that the first year is spent learning how the MPC works, the present arrangements leave only two years in which independent members can make an active contribution.

23.  Bearing in mind that independent members tend to be full time, there are limits to how long they can be away from their original jobs — assuming that they retain them — or be out of the labour market if they have left their previous appointment. Extending the length of the term might make it harder to recruit both academics and non-academics.

24.  We conclude that the terms of appointment should be re-examined. A more flexible approach would involve consideration of both length of appointment and whether members should be full or part time.

25.  Although we have raised the issue of lack of transparency in the appointment of members of the MPC, in other respects we consider that the MPC operates transparently. In evidence, Mr Andrew J. Smith from KPMG compared the European Central Bank and the Bundesbank to the MPC. He compared the low transparency of the Bundesbank coupled with its high independence with the high transparency of the MPC (which is equally, if not more, independent). He said: "Five years ago we came as a whole new ball game. We designed our own central bank. There are these cultural differences. So to say whether the model is better or not we have to say that from an Anglo-Saxon point of view, we prefer the ex ante transparency" (Q60). He recommended that the European Central Bank:
·  Publish minutes of meetings in summary form within a reasonable timescale, without attribution of arguments to individuals, as in the UK and US;

·  Institutionalise a formal motion on interest rate policy (that rates be raised by x, lowered by y or remain unchanged) to be proposed by the ECB President and voted on by the Governing Council at each meeting;

·  Publish the result of the vote (although there is no significant advantage from naming the individual voters);

·  Announce the ongoing bias of policy (in the way the Federal Reserve does) when the interest rate decision is announced;

·  Reduce the frequency of meetings from fortnightly to monthly—or lower the status of the mid-month meeting to one of review only, and

·  Publish more frequent forecasts with enhanced explanation of the risks to the forecast and a fuller explanation of their role in decision making.

We believe that these six main recommendations to enhance credibility are sensible and we will consider them further in a later Report.


1   Retail Price Index excluding Mortgages. Back

2   e.g. the Report of the Select Committee on the Monetary Policy Committee of the Bank of England, HL Paper 96, 1998-99, paras 1.38-1.43. Back

3   As a matter of technical economics, the target could anyway be a weighted average of (say) inflation and unemployment. As we point out below in paragraph 29 the inflation rate itself is a weighted average of service price inflation and goods price inflation. Back

4   This refers to a remit such as the remit of the Federal Reserve Bank. The remit of the Federal Reserve Bank was set out in the Humphrey-Hawkins Act, passed by Congress in 1978, as being to "maintain long-run growth of the 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

5   Financial Times, 7 February 2003. Back

6   See footnote 4 to paragraph 10. Back

7   Report of the Select Committee on the Monetary Policy Committee of the Bank of England (HL Paper 34-I, 2000-01, paragraphs 95-111). Back

8   Evidence from the Governor of the Bank of England, given to the Select Committee on the Monetary Policy Committee of the Bank of England, HL Paper 34-II, 2000-01, Q171. Back

9   Since the Committee agreed this report, Professor Stephen Nickell has been reappointed. Back

10   Financial Times, 28 January 2003. Back


 
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