To what extent
is this due to the MPC?
6.4 Since the decline of the inflation rate and
the period of stability antedate the work of the MPC, it cannot
be said that they are solely or even mainly responsible for any
of that. The point holds a fortiori when it is appreciated
that operational independence of the Bank of England was not predicted,
especially in this form. In addition, the Bank itself has laid
particular emphasis on the importance of time lags in the monetary
policy process. It is only recently that the direct impact of
the work of the MPC is being felt. It may not be difficult to
agree with the Governor's statement that "the fact is that
it has been close to target nonetheless, so we could not have
fouled up completely" (Q 1551). This may be unduly modest,
since within the historical record the capacity for error within
the realm of macroeconomic policy making appears limitless. Some
weight must also be given to the MPC being new to the job. They,
and the Treasury, for that matter, are still in the business of
learning how to operate within the new structure.
6.5 We have already noted that when assessing
the success of the MPC there is the delay between their decisions
and the affect on inflation. The consensus view, from all our
witnesses, backed by econometric evidence, is that this delay
appears to amount to between 18 months and two years, and, as
we have said, this would suggest that only the earliest of the
MPC's decisions are now having an effect.
6.6 Thus, the time lag must lead some to the
conclusion that the real credit must, in whole or part, go to
the predecessors of the MPC. Even though Gerard Lyons, for example,
admitted that "It would be wrong to attribute all of the
improvement to making the Bank of England independent but certainly
I am sure there has been some influence there" (Q 1112),
his opinion was that "the fact that the Bank assumes it takes
two years for policy changes to affect inflation shows that the
previous Chancellor Ken Clarke was taking the right policies because
two years after he left office we did hit 2.5 per cent inflation."
(Q 1119) Roger Bootle felt likewise: he said that
"On the face of it the
MPC has done very well. … However, the regime is predicated
on the assumption that the full effect of monetary policy changes
takes between 18 months and two years to come through. You could
go so far as to regard the closeness of the actual inflation rate
to the target as a tribute to the previous regime under the former
Chancellor, Mr Kenneth Clarke." (p 255)
6.7 Nevertheless, the MPC is still given due
credit by other witnesses. Martin Weale believed "the new
monetary policy arrangements have been responsible for holding
the average rate of inflation at something very close to 2.5 per
cent" (Q 1055). Sir Ronald Hampel's view was that "we
look as though we are going to have a smoother period this time
around. If that turns out to be the case I think the MPC deserves
to take some of the credit." (Q 1257)
6.8 Where the MPC may have made a more substantial
difference is in the area of inflationary expectations. The Governor
told us that "What I am sure it has done is to reduce inflationary
expectations." (Q 1616) and Mervyn King has noted that such
expectations fell by about 0.5 percentage points on the day of
the announcement of the new arrangements.[23]
He went further, and suggested that "part of the improved
performance of the last two or three years can be attributed to
… the "credibility windfall" resulting from the
new monetary policy framework".[24]
Sir Ronald Hampel told us "we reduced our inflationary expectations
over the last couple of years from five per cent to three per
cent" (Q 1255), and in written evidence ICI noted that "inflationary
expectations and long term interest rates in the United Kingdom
have now come down to match those in the US, and this might be
seen as a success for the MPC" (p 275). Sir Brian Moffat
went further, and stated that British Steel now planned on the
2.5 per cent target figure. There is some doubt, however, whether
any of these improved expectations are yet reflected in the actual
rate of inflation. There are indications that the decline in
earnings growth is a reflection to some extent of the fall in
the expected rate of inflation. The City of London and many businesses
employ more economists, and, presumably, take notice of what they
say. (Whether we can go further than that and state that the
wider public has become more economically sophisticated, especially
in regard to inflation, is more doubtful.)
6.9 An independent, although still imperfect,
measure of the extent to which the fall in inflation may be attributed
to the MPC, and one not mentioned by witnesses, is the behaviour
of the term structure. A rising yield curve (long yields exceeding
short rates) is a reflection of either expectations of higher
inflation in the future or the higher risk premia on long bonds,
but an inverted (or falling) yield curve can only be due to expectations
of lower future inflation. Until 1997 the term structure sloped
upwards; long yields on 5-year and 15-year gilts exceeded 1-year
yields. But from 1997 onwards the term structure started to turn
downwards, and until very recently, has been inverted throughout
most of 1998 and all of 1999. This strongly suggests that market
expectations of future inflation have been marked down since the
MPC began. A rough estimate is that inflation expectations are
nearly 3 per cent lower than in 1996 and over 2 per cent lower
than in 1997.
6.10 It could be argued that this is all due
to an expectation that sterling will join EMU and that therefore
the United Kingdom will have the same long rates as the euro-zone.
To some extent this is supported by the humped-shape of the yield
curve at the time of writing. This probably reflects the increased
uncertainty about entry to the euro as a result of the May European
elections, and hence the possibility that United Kingdom inflation
will be higher than euro-zone inflation in the medium term. If
so, this would not be a vote of confidence in the MPC by financial
markets. To set against that interpretation is the fact that under
the MPC inflation has been brought down to levels where long-term
rates are comparable to those in the euro-zone.
6.11 Overall, insofar as it can be judged, at
all the MPC has delivered on its basic priority of price stability,
but witnesses for the most part have suggested to us that it is
too early to come to a definitive conclusion. Professor Bean's
recommendation that "until there is evidence that the system
is not working, the best advice seems to be: Don't try to fix
it!" (p 306) appears to be the most appropriate.
Has this
been an unusually benign period for inflation?[25]
6.12 The counterpart to the reasonably good heritage
bequeathed to the MPC is that so far they have not been severely
tested. Without a seriously adverse demand shock, let alone a
large supply shock, it is very difficult to see whether the new
approach is working well. It is not easy to see how inflation
targeting might have coped with an oil shock, a flight from the
currency or a world environment of rising prices. Martin Weale
said to us that "The studies we have done have looked at
inflationary shocks and what the economy has experienced in the
past, both positive and negative, and they just have not been
there in the last five years." (Q 1056) One other aspect
of all this was noted by the Governor. Serious supply shocks may
be rare in any case. He stated that "The classic supply shock
was the oil price rise in the early 1970s and the fact that people
have to point back to that shows they are pretty unusual events."
(Q 1610)
6.13 We do not look forward to such tests, and
would rather live in an automatically stable and successful world!
But in our sort of economy such tests to the system must eventually
occur. They will prove the system's usefulness (or worthlessness),
but we have to emphasise the argument that severe tests have been
lacking is a general feature of the evidence to our Committee.
As put to us by Sir Brian Pitman, "I think they have been
tremendously helped by a benign environment. There is no doubt
whatsoever about that." (Q 935)
6.14 The 1990s have seen inflation at low levels
not just in Britain, but throughout the world. The European Union
weighted average for 1998 was 1.8 per cent, and for the G7 it
was 1.5 per cent[26].
This compares very favourably with the past, as we have already
noted, and inflation policy is now played according to different
rules. There are plenty of reasons why, and we turn to the former
Chancellor, Mr Clarke, for some of them: he told us:
"I got utterly fed up
listening to people make comparisons with the late 1980s and I
continue to get fed up with the present Chancellor of the Exchequer
making comparisons with the late 1980s because the economic rules
internationally have changed since then. If you look around the
world the old relationship between monetary aggregates and inflation
has certainly changed and even monetarists admit they do not know
quite how. As a layman, what I think has happened is we have
global competition as never before. We have a pace of technological
change as never before. The ability to raise productivity in
some sectors is quite immense. The ability to hand on price increases
to restore margins is very, very limited, so that one sees around
the world prices confined, earnings confined and expectations
changing." (Q 607)
6.15 Or, as put by Gerard Lyons, "the global
environment has become very competitive and that has forced the
corporate sector to keep costs down, wages have been kept down
and in turn consumers have become very price resistant."
(Q 1102)
6.16 The Governor, however, does not share the
view that he has been given an easy task: he told us that "We
have had elements of good fortune in being precisely around 2.5
per cent but I have to tell you that the situation in the last
two and a half years has been as difficult as I can ever remember
and I do not think people appreciate the impact that that has
had on trying to steer this economy." (Q 1552) His view
is that during the existence of the MPC there have been significant
inflationary pressures: first upward, and then downward. In the
Bank's 1999 Annual Report, he states that "it was apparent,
certainly from early 1997, that overall demand and output growth
needed to moderate if we were to avoid capacity restraints and
a rise in inflation."[27]
He goes on to explain that in late 1998, after the financial collapse
in Russia and the losses incurred by the LTCM hedge fund, and
the weakening of business confidence at home, "The prospect
of a necessary slowdown in overall demand growth to keep inflation
on track risked turning into an unnecessary downturn with a prospective
undershooting of the inflation target."[28]
6.17 Others have taken a different view. Mr
Clarke, for example, said of the 1998 monetary targeting that:
"the only reason we
went above the target last year, 1998, was because of the tax
changes that the Chancellor made. If you look at RPI whatever
it is called, Y, excluding tax and mortgages it never went above
the target at all so there were not any inflationary pressures
waiting to explode inside the economy so long as you made some
adequate movement in time, to keep it at that level." (Q
614)
Others were sceptical about the downturn of late
1998. Lord Desai's view of the Asian crisis was that:
"If I was giving this
evidence a year ago, then the MPC was not a very popular body.
People were complaining about the MPC. It had gone through successive
interest rate rises and people were wondering "How soon are
we going to run into recession?" and "What kind of recession
will it be and will it be a hard landing?" and so on. All
that has been averted thanks to this nice external shock."
(Q 1199)
6.18 But not all have been critical. In respect
of the monetary tightening, Lloyds TSB offer another opinion.
They considered that:
"The MPC then had to
perform a delicate balancing act between growth and inflation.
The economic stakes were big. Simulations on our model of the
United Kingdom economy at the time suggested that a soft landing
could easily be turned into outright recession if interest rates
were only marginally too high" (p 204).
6.19 And in respect of the Asian crisis, Professor
Bean, though considering that "these shocks have come at
what has turned out to be quite a convenient time for the Monetary
Policy Committee" (Q 1446), said that "the way they
reacted relatively promptly to the Asian crisis—or rather
the second leg of the Asian crisis following the Russian default—by
reducing rates swiftly during the first half of this year has
been an object lesson in how central banks should behave."
(Q 1407)
6.20 To place all this in a wider perspective,
GDP was rising above its trend growth rate in 1997. It has been
somewhat below trend since then. This may explain the early tightening
of monetary policy, and the subsequent easing. The obvious drawback
to such an interpretation is that policy is meant to be forward
looking. What matters, therefore is not whether GDP is rising
above trend at some time, but, given the Act and the remit of
the MPC, what this implies for future inflation rates. (Interpretation
of what inflationary pressures were inherited by the MPC is made
even more complicated by the fact that the unemployment percentage
has been falling steadily since 1993.) Professor Bean told us
that "the MPC has been dealt a good hand and played it well."
(Q 1446). That is a conclusion with which we are inclined to
agree.
How much
of the exchange rate changes have been due to United Kingdom monetary
policy?
6.21 We have already noted the difficulties which
some parts of industry say they have been experiencing as a result
of the high value of Sterling. We have also discussed the problems
the experts have had in explaining what has happened to sterling,
and especially of evaluating the relationship between interest
rates and exchange rates.
6.22 It is important not to exaggerate the rise
in the value of sterling. Over the past two decades the pound
has lost some 40 per cent of its value against the DM (which could
be looked at as a proxy for the euro.) It has risen more recently,
but is still below where it was ten years ago. Against the US
dollar sterling has fluctuated for some time in the range of US$1.5
to $1.8. It has risen from a trough in 1993, but is still below
its earlier peak. More to the point, it has risen steadily since
1993, a trend certainly not initiated by the decisions of the
MPC. Sterling's effective exchange rate was on a downward trend
from the beginning of the 1980s until the mid 1990s. There has
been a 20 per cent revaluation since then, possibly due to better
control of inflation, but not altogether, if at all, attributable
to the MPC. It is probably this last figure commentators have
in mind when saying sterling is overvalued.
6.23 It is worth adding in connection with that,
the balance of payments on current account was in deficit from
the mid 1980s to the mid 1990s. The move into surplus started
in 1996, and coincides with the rise in the value of the pound.
Any causal connection is difficult to discern, especially considering
the more recent move back towards deficit.
6.24 On the question of the role of interest
rates, there are many potentially valid explanations for the lack
of a close relation between interest rate and exchange rate movements.
Confidence seems to have a strong role: Lord Desai's view was
that "the British economy now has higher growth potential
and more flexible labour markets than it used to have and therefore
to some extent the exchange rate should reflect the higher real
strength of the British economy." (Q 1189). This may also
explain the strength of the dollar relative to the Euro. But
if that is right, we have nothing to fear. A strong economy should
improve our export performance, and the external value of sterling.
If there is a problem, something else must be driving the pound
upwards, more than reflecting increased productivity,and causing
problems for the tradeables sector. That is precisely what we
have been told in evidence. An example is the very powerful statement
from British Steel on its inability to sell profitably abroad
despite its high level of efficiency.
Has monetary
policy been synchronized more with the US than with the Euro-zone?
6.25 It is notable that while the pound has fluctuated
against other currencies, it has stuck close to the dollar. Since
inflation targeting began the pound has moved roughly in a band
of US$1.50-$1.70, but the corresponding band for the deutschmark
has been much wider at DM2.20-DM3. Meanwhile base rates in Britain
and America have been much closer to each other than to those
in the euro-zone. As noted above, the reverse has been true of
long rates.
6.26 It is not clear what the explanation for
this is. Is it more a reflection of United Kingdom, euro or US
monetary policy? The ECB still uses monetary targets and has
set a reference value for money growth of between 4.5 per cent
and 5 per cent. This is based on assumptions made about inflation,
GDP growth and trend velocity. Unfortunately, the actual values
of these variables are different from what is assumed. Moreover
money growth has in practice exceeded 5 per cent. Added to this
interest rates were cut again in April. One possible, but for
the moment tentative, explanation is that the ECB's monetary policy
has been unnecessarily slack. We have to add that such a conclusions
would be regarded as rather controversial.
6.27 More generally, it may be asked whether
the United Kingdom and US economies are closely linked by trade,
that being the explanation of relative stability of the £/$
rate. The problem here is twofold. Firstly, United Kingdom trade
is nowadays greater with the EU than the US. Secondly, the capital
account is far more important in determining the exchange rate
than the current account, especially in the short and medium terms.
Indeed, in the short term, and probably the medium term too,
international capital movements are the dominant force in exchange
rate changes. Here too it remains to be demonstrated that the
US and United Kingdom capital markets are linked so closely as
in themselves to account for what has happened to the £/$
and £/DM rates. More generally on exchange rates, presumably
what matters are relative rates of interest, notably those between
the US and the United Kingdom. A more careful examination of
that may in due course clear up some of the exchange rate puzzles.
6.28 A lack of explanation and a historical perspective
tell us not to jump to simple conclusions. We must add that this
is not the same as asserting that the problem is not there. Industry's
objections are a true reflection of their experience, and are
valid. There can be no doubt about the recent pressure felt by
the tradeable goods sector. There are problems with the goods
section of the balance of payments, although these are of long
standing. Either the MPC must pay attention to this as part of
its "subject to that" remit, or the Chancellor must
find another form of solution.
What have
been the costs of the policy to date?
6.29 If interest rate changes are supposed to
translate into inflation only after 18 months to two years it
will naturally be too early for most individuals and companies
to evaluate their personal inflation costs and benefits at this
stage. However, because interest rate changes have an immediate
effect, and because they may have an effect on exchange rates,
there will be many who will have felt a cost already. Sir Brian
Moffatt, for example, has felt such a cost, and his view that
"a tight monetary policy … has brought big pressures
on industry, particularly in manufacturing" (Q 1295) is not
an isolated one. Mr Stan Hardy, Chairman of the Yorkshire Ridings
Branch of the Institute of Directors, said that "the upward
pressure on sterling caused by high interest rates lost export
orders" (p 358); the National Farmers' Union claimed that
"The high level of interest rates in the United Kingdom in
1998 imposed a large cost on the agricultural industry with the
interest bill to agriculture rising by some £100 million
when compared to 1997" (p 363); and the UK Steel Associated
claimed that:
"The UK steel industry
was therefore particularly badly hit by the surge in the value
of sterling against other European currencies. In total, UK steel
companies lost £1.5 billion of revenues on export sales made
over the two years to June 1998. In response the industry introduced
accelerated cost reduction programmes with associated job losses
and the closure of several mills. Employment in the ECSC (primary
steel) sector of the industry alone fell by 7.4 per cent last
year (2,600 job losses)." (p 375)
Generally, many in industry might agree with the
MSF Union, who stated:
"High interest rates—in recent times
more than twice those of our major competitors—and an over-valued
pound have been important factors in falling output, job losses
and the manufacturing trade deficit." (p 362)
22 Lecture at Queen's University, Belfast, 17
May 1999. Back
23
Ibid. Back
24
Ibid. Back
25
What we mean by "benign period for inflation" is a period
when circumstances are conducive for maintaining low inflation. Back
26
Source: Treasury. Back
27
Bank of England Annual Report, p 3. Back
28
Ibid p 4. Back
