The Bank of England has allowed inflationary drift to set in. It is time for a change...
ON WEDNESDAY and Thursday of this week, the Bank of England's Monetary Policy Committee will again meet to decide UK interest rate policy and to reassess its recent decision to inject more stimulus into the UK economy through Quantitative Easing, writes former MPC member Andrew Sentance.
There is little doubt about the outcome of the meeting. Interest rates will be held at 0.5%, and the Committee will confirm its October decision to inject £75bn of new money into the economy over the next few months.
But while the outcome of the meeting is predictable, MPC members should feel uncomfortable about their current policy stance. They have injected more stimulus into the UK economy when inflation has been running persistently above target. Since January 2008, CPI inflation has averaged 3.4% and our consumer prices have risen at double the rate seen in the US and the Euro area. The primary remit of the MPC is price stability and the Bank of England website proudly boasts that "The Bank sets interest rates to keep inflation low to preserve the value of your money". Yet UK monetary policy no longer "does what it says on the tin". Price stability no longer underpins the decisions of the MPC.
This is fairly clear from the behaviour of the Committee since the summer of 2007. While UK inflation has been persistently running above target, all the policy moves have been to provide more stimulus to head off deflation – cutting the Bank rate from 5.75% to 0.5% and injecting £275bn of new money into the economy. No acknowledgement is given to the possibility that the policy response of the MPC might have aggravated the over-run in UK inflation. The arguments that I made from the middle of 2010 onwards that policy stimulus should be reduced were rejected by the majority of the Committee, which prefers to believe its own model of how the economy should work rather than observing how it is actually behaving.
Over the past few weeks, I have given a number of public talks highlighting the current problems with UK monetary policy which have contributed to this situation. The MPC, led by the Governor of the Bank of England, has effectively redefined its target – and the Government appears to have acquiesced to this approach. No longer does the Committee feel bound by its mandate which states clearly that: "The inflation target is 2 percent at all times: that is the rate which the MPC is required to achieve and for which it is accountable." Instead, the Committee is targeting its own forecast of inflation, and is disregarding actual inflation performance.
There are two problems with this approach, which I have discussed in earlier blogs. First, the Committee's recent forecasts of inflation have been badly awry. A couple of years ago, the MPC forecast that inflation around now would be 1-1.5%, not the 5% plus we have experienced. Even in the second half of last year the MPC forecasts were for inflation of 2.5-3% by the end of this year. These forecast failures are not just the result of a chapter of unhappy accidents. They reflect the fact that the Committee puts far too much weight on the impact of spare capacity in pushing down inflation, and not enough on the factors which have been driving UK inflation recently - global inflationary pressures, the decline in the value of the pound and persistently high services sector inflation. I highlighted these problems in a series of speeches early this year when I was a member of the Committee, but these criticisms have been effectively ignored. And the bodies which scrutinise the MPC – notably the Treasury Select Committee – did not take up the challenge.
The other problem is more deep-seated and structural. The MPC is being allowed to make its own forecast, which then drives its decisions. It is a bit like students taking a degree course who are allowed to forecast their own results, instead of being assessed by the objective measure of their performance in their final exams. It is very easy to predict which way the bias will operate in these circumstances. Very few students will forecast a fail and most will over-estimate their success. That is exactly what is happening with the MPC. It is being allowed to forecast its own success in bringing down inflation when the reality, reported by the Office of National Statistics, tells us otherwise.
Inflation is 5.2%. It will probably rise higher before falling back. And the fact that it has averaged 3-4% over the past four years suggests it will fall back to that level, not to below the 2% target as the MPC is currently forecasting. An independent Central Bank is meant to safeguard price stability, not pursue policies which drive high inflation.
What should be done to address these problems? In my recent talks, I have advanced a number of proposals for reforming the MPC and the UK monetary framework. The framework which was put in place in 1997 is not perfect, and we should learn from the problems we have encountered in recent years. Here is my agenda for reform.
First, we need to strengthen and diversify the external membership of the Committee so it is no longer dominated by an internal bloc of Bank insiders – as is currently the case. Paul Tucker and Charlie Bean, the two Deputy Governors, have recently revealed they were very close to voting for interest rate rises earlier this year.
Can we really believe that their decisions were not influenced by their working relationship with the Governor who made very clear in a speech at the end of January that he was strongly opposed to higher interest rates? With the Bank taking on new responsibilities and strengthening its financial stability role, a 9 member MPC which had a majority of external members (eg 6 external and 3 (internal) could be much more effective and independent of a prevailing "Bank view".
This would also free up time for some internal members to focus on their core financial stability and regulatory responsibilities. And such a structure would allow a greater range of experience to be included on the MPC. For example, there is currently no-one on the MPC with the business background that Kate Barker, DeAnne Julius and I were able to bring to the committee.
Second, the MPC mandate should be tightened to counter the reinterpretation and redefinition of inflation target which has occurred over the past couple of years. In particular, the paragraph in the mandate which allows the MPC to accommodate deviations in inflation due to "shocks and disturbances" should be more tightly worded. Such shocks and disturbances should not be allowed to justify inflation deviations lasting many years, as has been the case throughout the financial crisis.
Third, the MPC should be held more firmly to account for inflation performance by the Government and the Treasury Select Committee (TSC). There are a number of ways in which this could be achieved. The exchange of letters between the Governor and the Chancellor which occurs when there is a significant deviation of inflation from target should be a more substantial event. At present, it is something of a farce, with the Governor repeating a familiar list of excuses for high inflation and the Chancellor writing back saying "that's OK".
There is little in the letter exchange which reflects the notion of accountability for inflation performance. The Chancellor is far too happy to accept the Bank's forecasts, despite the appalling recent forecasting record. There should be a parliamentary debate and a series of TSC hearings every time these letter exchanges occur. The TSC could also hold an inquiry into the conduct of monetary policy and Bank forecasting record since the financial crisis. This would put the spotlight on some of the weaknesses of the "output gap" model of inflation being used by the Bank, which I have highlighted above.
Fourth, serious consideration should be given to separating forecasting from decision-taking in the UK monetary policy framework, as we have done in the fiscal framework. The Treasury (the decision-making body) no longer forecasts public finances – that is carried out by a specialist body, the Office for Budget Responsibility (OBR). The forecasting failures of the Bank of England and the MPC have been so significant that we should consider a similar approach in the monetary sphere – establishing an OMR (Office for Monetary Responsibility) to match the OBR. Or there may be merit in a combined OBR/OMR to achieve efficiencies of scale.
At the tenth anniversary of the MPC, the Treasury Select Committee held a major inquiry – "The MPC, ten years on" – and by and large gave the UK monetary framework a clean bill of health. Nearly fifteen years on, after facing the stern test of a financial crisis, things don't look so good. There is a strong case for reforming the MPC framework to counter the inflationary drift we have seen in recent years.
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