Price Stability and the Policy Framework

9.  The broad objective set by the Chancellor for the Monetary Policy Committee is price stability which, as we have previously remarked, is to be interpreted as inflation stability. The Chancellor of the Exchequer has defined[8] the Bank's remit as:

The operational target for monetary policy remains an underlying inflation rate (measured by the 12-month increase in the RPI excluding mortgage interest payments) of 2.5 per cent. The inflation target is 2.5 per cent at all times: that is the rate which the MPC is required to achieve and for which it is accountable.

10.  A further requirement of the Chancellor is that, should inflation be more than one percentage point above or below the 2.5 per cent target, the Governor of the Bank of England must write a letter to the Chancellor to explain why this happened, and what steps he proposes to take to return inflation to the target. This type of objective is often referred to as a symmetric inflation target. It is designed to avoid a conservative policy of preferring to err on the low side, and this is why the Chancellor regards symmetry as an important feature of inflation policy.

11.  A key feature of monetary policy is the focus on inflation. Section 11 of the Bank of England Act 1998 instructs the Bank "to support the economic policy of Her Majesty's Government, including its objectives for growth and employment" subject to maintaining price stability. The clear implication of this is that it is not for the Bank to try to resolve any conflict there might be between inflation and other macroeconomic objectives. There was a detailed discussion of the objectives of monetary policy and this remit in Chapter 3 of our previous report, which there is no need to repeat. In this report, we provide a brief update of opinion about whether this is still the appropriate objective for monetary policy, but our focus is more on the implementation of policy, on the role of symmetry and how successful the MPC has been in achieving the inflation target. We shall also comment on a neglected aspect of the remit, namely, that if the Bank were to keep close to the target at all times, this might entail such high interest rates that the consequences for output and employment might be politically unacceptable, even for a short time.

12.  In describing the objective of Government macroeconomic policy, the Chancellor said that it was still the attainment of high and stable levels of growth in employment. He stated that it was his belief that there was no "long run trade-off between low inflation and those high and stable levels of growth in employment that we seek". He said that to avoid stop-go, an inflation target seemed the right thing to have, and that should be a symmetric target. In his view what was required was "a period of constancy in economic objectives that allows both credibility to be built up and allows people to see that we are determined to escape from that stop-go experience" (Q 1188). Of course, constancy of objectives itself says nothing about what those objectives should be.

13.  Ed Balls, Chief Economic Adviser, HM Treasury elaborated on the importance the Government attaches to symmetry. He said that "the Government remains absolutely committed_to having a clear and symmetric inflation target as a sole objective of monetary policy". The Government's view was that this was the best way to deliver stability in the medium term and thus meet the underlying objective of high and stable levels of growth and employment (QQ 283, 327). The Chancellor has confirmed that he thought it a key element of the success of the Monetary Policy Committee's remit that "the objective of monetary policy is clear and unambiguous"[9]. Mervyn King, a Deputy Governor of the Bank of England and a member of the MPC, among others, welcomed this point of view (Q 747) and Dr Donald Brash, Governor of the Reserve Bank of New Zealand, told us that monetary policy in New Zealand had a similar objective. Legislation had decreed without qualification that "monetary policy should be used to achieve and maintain stability in the general level of prices" (Q 404).

14.  There was broad support from other witnesses for adopting an inflation target for monetary policy. The Bank of England Commission[10] is of the view that the Bank should look only at inflation. Martin Temple, Director General of the Engineering Employers Federation, said that the remit was "basically_.. the right one", while Sir David Lees, Chairman of Tate & Lyle, thought that "price stability as defined by the Chancellor was the key and overriding issue" (QQ 461, 467). Sir George Mathewson, Chief Executive, Royal Bank of Scotland, thought that this was "the most practical thing to be done at this point" (Q 1002), while Mr Terry Scuoler, Managing Director, Ferranti Technologies Limited thought that price stabilisation and control was critical, "having lived through the difficult days of the late 1970s and 1980s" (Q 466).

15.  There was less support from witnesses for including other objectives in the Bank's remit than we found when we took evidence for our First Report. Among those who advocated including other objectives was John Monks, General Secretary of the TUC, who said that the MPC remit should be changed to be in line with that of the Federal Reserve in the United States[11], although noting that the Treasury judged this to be impossible in the United Kingdom (Q 521). Robert Rowthorn, Professor of Economics, University of Cambridge, also thought that the system in America was better, requiring account to be taken both of inflation and of the real economy. Paul Ormerod agreed that the remit of the MPC could be broadened to be more like that of the Federal Reserve (QQ 711—2, 727).

16.  In our previous inquiry several witnesses expressed concern about the consequences for their business of monetary policy focusing exclusively on inflation control, and in particular that higher interest rates lead to a strong exchange rate and a loss of competitiveness. During the present inquiry, Dr Nick Boucher, Director, Planning and Communications, Glynwed International plc, told us that "effectively the interest rate weapon works through the exchange rate by battering the traded sector of the economy" and added that the effect of this, and a variable exchange rate, was "to drive public companies away from the traded sector and to some extent out of the United Kingdom". He wanted policy makers to be aware of this, but he still accepted that it was part of the price to be paid for price stability (QQ 478—9).

Is 2.5 per cent the right target?

17.  The answer from the Treasury on whether there was any case for changing the 2.5 per cent inflation target was "no". The Chancellor told us that it was not only important to meet a target but to sustain doing so in order to build up credibility (Q 1190). The Permanent Secretary, Sir Andrew Turnbull, said that the present target was not out of line with our major trading partners and any gains from a slightly lower rate would be "pretty minor" when set against damage that would be done to the clarity of the target (QQ 354—5). Douglas Godden, Head of Economic Policy and Enterprise at the CBI, also thought that the current target should be maintained (Q 254). Paul Ormerod expressed a different view, that the target should be expressed solely as a range for inflation - from zero to four or five per cent - with no attention paid to month-by-month fluctuations within that range (QQ 707, 716).

18.  We agree that it is desirable for the objectives of monetary policy, and how this is implemented, to be consistent over time. We therefore support the symmetric inflation target and agree with the view that the Chancellor should for the moment retain the current central inflation objective of 2.5 per cent. We also recommend, however, that given the repeated instances of inflation below the target, the Chancellor gives consideration to setting the target at a lower level, and that he reports his conclusions to both Houses of Parliament. We are supported in this by the conclusion of the Treasury Select Committee in the House of Commons, that "keeping to the same inflation target for a period of time makes it clear that the Government is pursuing a consistent aim and adds to the credibility of its anti—inflation policy"[12]. We note that, whatever the arguments for or against joining EMU, should the UK join, this would, in effect, entail a change in the monetary policy objective. The European Central Bank does not have an inflation target in the same sense as we have. There are "two pillars" to its monetary objectives: a reference value for monetary growth of 4.5 per cent and inflation below 2 per cent, as measured by the HICP index. There is also pressure from the European Parliament for the European Central Bank to take account of the output and employment consequences of monetary policy. These numbers are averages for the euro area countries and inflation in individual countries usually differs from this, sometimes considerably, as in the case of Ireland.

Co-ordination between monetary and fiscal policy

19.  We have considered again the role of fiscal policy in price stability and the control of inflation, and whether the co-ordination between fiscal policy and monetary policy had in fact suffered, given that it was no longer the case that the two policies were in the hands of the single individual, the Chancellor. Some of our witnesses thought that co-ordination between fiscal and monetary policy was of little importance. Professor Robert Rowthorn was of this view provided that the MPC "operates in a reasonably co-operative way with the Treasury" (Q 725). Sir David Lees, who regarded the MPC as a technical agency, thought that as the Chancellor set the objective, he should make the Bank aware of the direction of fiscal policy, and this in turn argued for very "close co-ordination" of the two policies (Q 508). He suggested that when monetary policy squeezed manufacturing, for example, fiscal measures could be taken. Martin Temple of the Engineering Employers Federation thought that fiscal policy should focus on complementing monetary policy (Q 508). The TUC thought that there would need to be "sophistication" in fiscal policy (QQ 545—6). In New Zealand, those conducting monetary policy had "a reasonably well informed view of what fiscal policy will do" and the Governor of their Central Bank, Dr Donald Brash, gave examples (QQ 433—439).

20.  The Chancellor took the view that co-ordination of fiscal and monetary policy was important and this involved a flow of information so that the monetary authority and the fiscal authority each understood what the other was doing. He did not think, however, that having the Chancellor take both fiscal and monetary decisions necessarily resulted in better policy. He cited previous occasions where a Budget was accompanied the next day by an interest rate cut not justified by events, but simply the monetary reaction that the Chancellor thought necessary to justify his actions (Q 1225). Ed Balls thought that the fact that the MPC will now meet one or two weeks after the Budget to announce their decision and give public comment on the fiscal policy, and how fiscal policy is helping or hindering them in meeting the inflation target, was an extremely effective way to ensure that monetary and fiscal policy were co-ordinated (Q 1225). Gus O'Donnell, (Managing Director, Macroeconomic Policy and International Finance, HM Treasury) said that "fiscal policy is essentially a medium term tool" as it is specified in the medium term, and is "subject to meeting the golden rule and the sustainable investment rule" (Q 332). He added that the MPC found "co-ordination very useful" and that the medium term fiscal framework helped their two-year ahead forecast by allowing them "to be clear where they think fiscal policy is going"(Q 1225).

21.  The Chancellor told us that it was one of the duties of the Treasury representative who attends the MPC meeting[13] to keep the MPC informed of the Government's fiscal policy (Q 1203). The Governor told us: "I do not seek to tell [the Chancellor] what to do on the fiscal side and he does not seek to tell me what to do on the monetary side" (QQ 1304—5). He added that it was for the Treasury representative, usually Gus O'Donnell, to brief the MPC on fiscal decisions before meetings (QQ 1294—8). We find it surprising, however, that there should be no discussion between the Governor and the Chancellor of the balance between fiscal and monetary policy.

22.  The Chancellor also said that there were clearly implications for the MPC from changes in fiscal policy. If, for example, the public sector were expanding, the MPC would aim to keep aggregate demand in line with supply through its interest rate policy (Q 1299). The Governor was very comfortable with using short-term interest rates as the instrument for achieving this, as it had a direct bearing on aggregate demand and a reasonably direct relationship with inflation. An alternative such as direct control of the money supply could not be so reliable, as broad money could not be controlled and as the relationship between money growth and inflation was unstable (Q 421).

23.  We note the conclusion of the Treasury Committee in the Commons that the framework for monetary policy has "so far avoided potentially serious conflict between monetary and fiscal policy"[14]. We conclude that the two-way provision of information must be maintained to ensure effective co-ordination. It is unclear, however, whether the system of co-ordination will be as effective in all conceivable circumstances. The Governor's understandable reluctance to make recommendations to the Chancellor on fiscal policy (which is coupled with the Chancellor's equally laudable reluctance to tell the Governor what to do on the monetary side) may well need to be revised should a Chancellor in future propose fiscal measures that could have an material effect on the operation of monetary policy. It remains a matter of simple economics that if fiscal policy is more expansionary, to the extent that the inflation outlook is affected, the MPC will need to tighten monetary policy; similarly, if fiscal policy is tightened, it may be possible to reduce interest rates.

9   Op. cit. note 8 above Back

10   This Commission was appointed by the Rt. Hon Francis Maude MP, then Shadow Chancellor of the Exchequer, to investigate the monetary policy regime. The Commission met between September 1999 and March 2000 and in February 2000 the Rt. Hon Michael Portillo became Chairman following his appointment as Shadow Chancellor of the Exchequer. The reference is to recommendation 8.6. Back

11   One of the general duties of the Federal Reserve has been "conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of maximum employment and stable prices". Back

12   Op.cit. n8 above: Paragraph 46. Back

13   Under Schedule 3(13) of the Bank of England Act, a Treasury representative may attend and speak at every formal meeting of the MPC. This role usually falls to Gus O'Donnell, but has on occasion been taken by Sir Andrew Turnbull. Back

14   Op.cit. n8 above: recommendation P Paragraph 60. Back