Monetary Policy in Practice: What the journals do not say Mike Wickens Specialist Adviser to the House of Lords Economic Affairs Committee and University of York

Some assumptions Monetary policy is conducted using inflation targetting by an independent central bank

The remit Who should determine the remit?  Government  Central Bank

Bank of England Act 1998 “In relation to monetary policy, the objectives of the Bank of England shall be: (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

Additional features Central target of 2.5% defined in terms of RPIX (consumer prices less mortgage interest payments) To maintain inflation within 1% either side of 2.5% Failing this, the Governor must write an open letter to the Chancellor to explain why inflation is outside the band and how this will be rectified

The Monetary Policy Committee The Bank had to constitute the MPC to make the interest rate decision Five members of the MPC are ex-officio as employees of the Bank - Governor -Deputy Governor -2 Executive Directors -Chief Economist Four external members appointed by the Chancellor

Issues about the MPC Who is really responsible: MPC or Chancellor? How should external members be chosen? Does conflict of interest affect the choice? Accountability- credibility – transparency Effectiveness of - Quarterly Inflation Report - Monthly Minutes Voting arrangements Communications between -the Governor and Chancellor -MPC and Government What is the role of the Court of the Bank of England?

The objective  Strict or flexible inflation targetting?  What does “subject to that” mean?  Should the following be taken into account -Output -Unemployment -Exchange rate -Asset prices -House prices?

Inflation target Should RPI, RPIX or HICP be the measure? What value should the central inflation target take? What sort of band is appropriate? - Should the band be symmetric ? Should the Bank aim to be above as often as below target?

Timing Issues Over what horizon should the Bank target inflation? Should inflation always be kept within the band no matter the consequences for interest rates? What shocks should be offset and what accommodated? - demand v. supply shocks - domestic v. foreign shocks - real v. nominal shocks - temporary v. permanent shocks

Forecasting Issues Response lags imply forward-looking objectives Forecasts or projections? - constant interest rates over forecast period - should MPC give a Fed-type “bias” Need for an inflation forecasting model - one model for all (eg Bank’s) - each MPC member makes own forecasts - independent forecasts How to forecast the exchange rate?

Transmission mechanism MPC ranking 1.Market rates 2.Asset prices 3.Expectations 4.Exchange rate BOE model: in the first year the exchange rate accounts for 80%

The interest rate decision Why do MPC members differ in their views? - different forecasts? - different view of transmission mechanism? - how much should be revealed in the Minutes?

Rules v. Discretion Which should the Bank use? Theory says a backward-looking rule is best as it reduces the variances of both inflation and output But who said…….

Some quotations  “I do not think there is any rule which anyone has proposed which would be a feasible rule, in the sense that anyone would credibly believe that the MPC would literally work month in, month out, without deviating from it”  “…whatever rule one could think of today as being the best rule, would be superseded by a better rule six months down the road”  “If your rules keep changing all the time it is not a rule and it looks like discretion.”

Some more quotations  “What a Taylor rule does is essentially to say that if inflation is, or looks like it is going to be, above the target, and if growth is accelerating above the trend, that is the time you should be raising interest rates.  If inflation is below target, or looks as if it is going to move further below target, and output is below trend, that is a time when you might be reducing interest rates.  Now that is more like commonsense than a rule.  From that point of view…the most successful central banks appear to have been following a Taylor rule, even if they had never heard of such a rule in the first place.”

Source of quotations Mervyn King Evidence to the House of Lords Select Committee on the Monetary Policy Committee of the Bank of England 23 February 1999

The Record For nearly three years - Inflation was below forecast and central target (see graph) - Output above forecast Question: - would a correct inflation forecast have led to a lower interest rate? - would a higher output forecast have led to a higher interest rate and hence a larger inflation forecast error? What can explain the error? - positive supply shocks (eg productivity shocks)?

The Record cont. Goods and services inflation diverged - goods inflation rose - services inflation fell House price inflation was very high Large structural imbalances - regional inflation differences - industry output differences Can anything be done about this? - first, consider EMU

Should the UK join EMU? Giving up a successful policy? Convergence is not the only issue The EMU system is non-sustainable in its current form - one-size fits all interest rate policy - Stability and Growth Pact