Rachel Lomax: The MPC comes of age
Lecture by Ms Rachel Lomax, Deputy Governor of the Bank of England, at De Montfort University,
Leicester, 28 February 2007.
I am very grateful to Gareth Ramsay for his help in preparing this speech, and also James Proudman, Tony Yates and other
Bank colleagues for their help in preparing this speech, and to a number of colleagues at the Bank of England for useful
comments.
* * *
1 Introduction
It's a great pleasure to be in Leicester tonight, particularly given my long association with De Montfort
University, as a Governor.
Tonight I want to focus my remarks on the Monetary Policy Committee, which is ten years old this
year. This is a blink of an eye in the life of the Old Lady of Threadneedle Street as she approaches
313. But UK monetary policy frameworks have lived dangerously and died young. For them, ten years
is good going. To mark the occasion the Treasury Committee has launched a special enquiry. An
impressive weight of written evidence has already been published, including a detailed review by the
Bank of England.
Everyone agrees that the UK has experienced an unprecedented degree of economic stability over
the past decade. The average rate of inflation has come down from nearly 10% in the seventies and
eighties, to 2.5% since 1993, and the volatility of inflation has fallen very sharply. At the same time,
output growth has been higher on average and less volatile.1 The change has been stunning. To be
fair though, it predates the formation of the MPC by several years; and other countries have
experienced a similar, if not so pronounced, improvement in performance.
There is considerable agreement that better monetary policy is partly responsible for this better
outcome, though there is an ongoing debate about exactly how much was also due to unusually
benign global economic conditions, including the impact of globalisation.
Whatever the outcome of that debate, we clearly cannot bank on a trouble-free future. But we can and
should look hard at the way our current monetary policy framework is operating, to give it the best
chance of coping, if necessary, with a harsher climate. So tonight I want to consider what was so
special about the MPC; and ten years on, ask how age and success has changed it; and what we can
do to preserve its youthful vigour.
2 Historical background
The MPC has come to personify the monetary policy framework that was put in place when Gordon
Brown made the Bank of England independent in 1997. But by monetary policy frameworks, I mean
the broader set of rules and procedures for taking decisions about interest rates.
Prior to 1992, such frameworks often took the form of a commitment to maintain a fixed exchange
rate, most recently as a member of the ERM. But these proved hard to sustain - sterling was
repeatedly devalued, at great political cost to the Government of the day. Perhaps the most
controversial frameworks took the form of commitments to meet targets for the growth in the money
supply. These were meant to act as rules, which would tie the hands of politicians, but they proved
ineffective, not least because the underlying economic relationships broke down. There were also
periods - notably the 1970s - when there was no discernible monetary policy framework at all; when
monetary policy was in eclipse and Governments relied on incomes polices to control inflation. These,
too, were a dismal failure.
All these frameworks suffered from one of two basic problems. They either lacked credibility, or they
lacked sufficient flexibility for policy-makers to respond intelligently to events. So it is little surprise that
they were associated with two decades of poor macroeconomic performance.
Sterling's exit from ERM in the autumn of 1992 led to an overhaul in the way monetary policy was
conducted, with the adoption of an explicit target for inflation, and a number of moves to make the
process of policy-making more transparent through the publication of minutes of what was popularly
known as the Ken and Eddie show, and a new Inflation Report, produced by the Bank.
3 What was special about the 1997 arrangements?
In the event, 1992 marked a break with the past. But while the policy innovations of the 1993-97 years
were showing promise, the framework remained relatively informal. And decisions about interest rates
stayed in the hands of the Chancellor.
The change in Government in 1997 led to a far-reaching effort to institutionalise and depoliticise
monetary policy arrangements. A new Bank of England Act stipulated that the objective of monetary
policy should be domestic price stability, and only 'subject to that' to support the Government's
objectives for output and employment. The Act left responsibility for setting an annual remit for inflation
in the hands of the Chancellor; but it gave the Bank 'operational independence' to set interest rates to
meet this target. Interest rate decisions were to be taken by Committee of nine, which was to include
four appropriately qualified external members.
With these changes, the UK had a fully articulated, credible domestic monetary policy framework,
underpinned by statute, which gave the Bank, through the Monetary Policy Committee, an
independent role in meeting an explicit inflation target.
What was the defining characteristic of this approach to policy, and other broadly contemporary
frameworks developed by countries like Canada, New Zealand and Sweden? The best short answer is
encapsulated in a term originally coined in 1997 by two US academics, Ben Bernanke and Frederick
Mishkin (now Chair and member of the FOMC respectively). It is 'constrained discretion'2.
Bernanke described this as "an approach that allows monetary policy-makers considerable leeway in
responding to economic shocks, financial disturbances, and other unforeseen developments.
Importantly, however, this discretion of policy-makers is constrained by a strong commitment to
keeping inflation low and stable."3
In the UK, the Government is constrained by the institutional framework, which is set in statute. And
the MPC is constrained by the need to meet the inflation target. But while the MPC are told what to do,
they are not told how to do it. At the operational level, there is a lot of discretion.
The commitment to meet the inflation target is fundamental, as a matter of law and economics. As
long as it is credible, such a commitment will help to anchor people's expectations about future
inflation, and stabilise their response to unexpected shocks. But the scope to exercise discretion about
how long temporary inflation disturbances will be tolerated is critically important too, for the
performance and long term credibility of the framework. Of course it must be used with integrity -
saying one thing and doing another, for short term advantage, is toxic.
This approach was reflected in the Open Letter procedure, which was an explicit part of the 1997
arrangements. This recognised that the MPC would not attempt to bring inflation back to the target
immediately following a large shock, but required the Governor to write a letter to the Chancellor if, as
a result, inflation deviated from the (then) 2.5% target by more than one percentage point.
As Ed Balls commented in a lecture in 20014:
"Some have assumed it [the requirement to write an open letter] exists for the Chancellor to discipline
the MPC if inflation goes outside the target range. In fact the opposite is true...... In the face of a
supply-shock, such as a big jump in the oil price, which pushed inflation way off target, the MPC could
only get inflation back to 2.5 per cent quickly through a draconian interest rate response - at the
expense of stability, growth and jobs. Any sensible monetary policymaker would want a more
measured and stability-oriented strategy to get inflation back to target. And it is the Open Letter
system which both allows that more sensible approach to be explained by the MPC and allows the
Chancellor publicly to endorse it."
Constrained discretion also provides much needed room for learning. Monetary policy remains more
art than science, and its practice is riven with uncertainties and risks. As the present Governor put it in
a lecture delivered in 19975: 'Inflation targets are a practical response to the fact that knowledge
increases over time.'
So a framework of constrained discretion combines much needed scope to implement policy flexibly,
in the light of both circumstances and experience, with the credibility benefits of committing
policymakers to secure a pre-determined outcome for inflation. That, in essence, was the key difference
from the failed experiments of the past.
4 The development of the MPC
The MPC got off to a good start. It inherited an inflation rate that had been low for the past 5 years.
And the financial markets welcomed it by reducing the risk premia on UK assets.
No one had very clear expectations about how it would behave or how it might think. While it inherited
some technical features of the previous regime, the new Committee had quite a lot of scope to define
its own operating procedures and intellectual framework. If not a blank sheet of paper, it was a book
with many pages still to fill. As time has gone by, whole volumes have been filled. The Committee's
procedures and thinking have matured. It has acquired patterns of behaviour and earned a name for
itself.
There have been a number of stages in the Committee's development. Early on the MPC took steps to
set out the intellectual framework within which it would be operating, to promote public understanding
and enhance credibility. Over time, the Committee's thinking has evolved, as members have rotated
on and off the group, and as the Bank has struggled to understand developments in the wider world.
And, as a result of taking more than 100 policy decisions, the MPC has acquired a track record, which
has allowed others to draw their own conclusions about its likely behaviour in different circumstances.
Practice in other central banks has developed too, as inflation targeting has spread, and all central
banks have become more transparent in their communications. This has raised the bar for a central
bank that wants to stay at the leading edge of monetary policy practice.
Finally, the MPC has acquired an enviably high reputation as a result of its overall performance and
the unprecedented stability of the economy over the past decade.
In short, the world has moved on, and the MPC has acquired a past and an identity.
Ten years is too soon for a mid-life crisis, but middle-aged members of the audience will readily
recognise the pressures that advancing years can bring. Sometimes we are tempted to bask in past
success, whether or not it is fully earned. In our better moments, we reflect on all that we have learnt,
through bad times as well as good. But there are days when we peer in the mirror and ask anxiously
whether we have lost our freshness and drive. Have we become too set in our ideas and in our ways?
Have others stolen a march on us? Have we become, to a degree, prisoners of our own past Maybe
even victims of our own perceived success?
The only way to deal with such fears is to confront them. That is a far larger task than I can do justice
to tonight, and it needs to be part of a continuing effort to improve our performance. But let me try and
give you an overview of some of the main issues in the remainder of my remarks.
Intellectual development
I want to start with the MPC's intellectual development.
As the world around us changes, it throws up new policy challenges which force us to examine old
ideas and develop new ones. So the MPC has been on an intellectual voyage of discovery since it
was established.
The formation of the MPC unleashed a ferment of intellectual debate and activity inside the Bank. It
was a thrilling time for those who were closely involved. The Committee had to set out how it thought
about the world, first of all for itself, and then for the outside world. You can still see evidence of all this
activity on the Bank's website - in speeches describing how the MPC saw the world, and in books
which set out the MPC's models of the economy.
But the world does not stand still. Over the last decade, the Committee, and the Bank staff who
support it, have had to confront some enormous changes in the economic environment. The
Committee's thinking has had to evolve to meet this challenge.
Without going into detail - that would require another speech - let me give you a flavour of some of
the questions with which we have been grappling during my own time on the Committee alone.
First, we have had to understand the implications of some very big movements in asset prices, both
domestically and globally. House prices have risen steadily, tripling since 1997, to reach record levels
relative to household incomes and rents. Share prices soared in the run up to the millennium, then
slumped, but have subsequently recovered. There has been a long running debate among central
bankers about how they should respond to asset price booms - and possible busts - with some
arguing that there is a case for taking pre-emptive action, over and above what might be warranted to
meet the inflation target over the normal two to three year horizon. There have been members of the
MPC on both sides of this argument.
Second, there has been an acceleration in the pace of globalisation. The entry into the global market
economy of China, India and Eastern Europe is effectively doubling the world economy's supply of
workers - from 1.5bn to 3bn. This is having pervasive effects on wages, prices and, potentially,
economic relationships in developed countries in ways we need to understand in order to set interest
rates.
Third, the last few years have seen the largest recorded entry of foreign workers to the UK. This has
increased the supply capacity of the economy, as well as boosting demand, but the precise scale and
likely duration of these effects are very hard to judge. How is migration changing the ground rules by
which we set policy? If labour shortages were to cause more migration, rather than higher wages, we
would be in a rather different world from the one we are used to.
Finally, there has been a major surge in energy prices in the past three years - first a doubling in
global oil prices, and then an even larger rise in natural gas prices which was specific to the UK. Up
until now at least, the UK and the global economy appear to have weathered the impact of these
major cost shocks remarkably well. But precisely because the world has moved on so much since the
1970s, it has not been straightforward to predict or understand the impact of higher energy prices on
the inflationary process. (I will return to this subject later in my remarks).
The MPC tackles challenges like these all the time: you will see these questions discussed in the
minutes of our policy meetings, in our speeches, and in the quarterly Inflation Report. We also
commission research into these questions, which we publish in academic papers. This is not research
for its own sake; it is carried out to help Committee members, present and future, do a better job. We
need to keep refreshing our intellectual capital. Half a century ago, Governor Cobbold famously said
that the Bank of England is a bank, not a study group. Nowadays, the best central banks have
something of the study group about them.
Anniversaries are a good moment to take stock. So the TC enquiry and other events will prompt us to
review what we have learnt, and to identify where there are gaps in our knowledge.
Procedures and communications
The 1997 institutional reforms did more than take political considerations out of interest rate decisions.
They were intended to convince people that the inflation target regime was here to stay. The idea was
to align expectations of future inflation more closely to the target, by putting monetary policy in the
hands of technocrats whose behaviour would epitomise professionalism. The pre-announced monthly
Inflation Report
cycle of meetings, regular quarterly forecasts, and set briefing routines, were very
much part of the package. The goal of these new arrangements was to make the system
understandable and predictable to outsiders.
After a sharp burst of activity in the late 1990s, the processes and procedures surrounding monetary
policy have now settled down. We still use much the same internal processes and means of
communicating with the outside world as we did a decade ago.
But the outside world has not stood still, in at least two respects.
First, over time the MPC has established a track record of actions and communications which people
have, as intended, learnt to parse with great precision. There is a cottage industry in interpreting its
every utterance, in the light of its past behaviour, in order to predict its next actions. Any deviation from
past behaviour is assumed to be deliberate and considered.
A topical example is the market reaction to the latest interest rate rise. The formal position has always
been that the MPC may change rates at any one of its policy meetings. And in the early days of the
Committee that's pretty close to what happened. But since 2001, as a matter of fact, rates have been
Inflation
much more likely to change in the months when we publish a new quarterly Report. That was
why the January rate rise caused such surprise even though commentators were fully expecting a rate
Inflation
rise to accompany the February Report. Indeed, such was the surprise that the market
immediately revised up its expectations for future interest rates. And there was a measurable increase
in uncertainty, as different interpretations of the Committee's unusual action were debated across the
wires.
This episode highlights the difficult balance which the mature Committee needs to strike between
innovation and predictability. Today's Committee members - only one of whom has been there since
the beginning - quite reasonably do not want to be unduly constrained by the habits of their
predecessors. But the passage of time has given 'the Committee' a collective personality. So changing
established patterns of behaviour requires at least as much care and explanation as in the early days
of the framework.
Second, even if we have not changed our procedures very much over the past decade, other central
banks have. They have become much more transparent. And the debate about how much central
banks should communicate - and how - has moved on, among academics, central bankers and
central bank watchers.
For example, a long-standing issue is how much central banks should say about their expectations of
future interest rates. The traditional concern has been that commentators would mistake a projection
for a commitment, the risk being that when interest rates did not change as projected this would be
damaging to credibility.
However, in recent years other central banks have moved increasingly towards giving indications
about the likely path of interest rates, given their forecast for the economy. Some inflation targeting
central banks - Norway, New Zealand and Sweden - are now publishing charts which show how they
expect to change policy rates to achieve their targets6.
Inflation Report
Should the MPC follow this trend? If you follow press reports of our regular forecasts,
you might be forgiven for thinking we already have. But actually no: our forecasts take market
expectations for interest rates as their starting point, and we leave commentators to draw their own
inferences. We have maintained the position that we do not give hints about future interest rate
changes. Naturally we are looking closely at what happens elsewhere and we will want to learn from
their experience - though of course, since the MPC is not a consensual body, it would be a significant
complication to get it to agree an explicit path for interest rates.
Have we become prisoners of our past success?
Let me come, finally, to the biggest, and most difficult of the issues I want to raise tonight - namely the
extent to which the stability of the past decade has conditioned expectations of what the MPC can and
should do, in ways which may be both helpful and unhelpful to its ability to do its job.
The so-called Great Stability of the past decade has bestowed on the MPC the great gift of credibility -
a golden halo which eluded monetary policy-makers in the UK for most of the twentieth century.
What part has the MPC played in its own success? It's difficult to say. But it is hard to believe that luck
played no role. My own view is that the MPC has benefited from a virtuous circle. As we have kept
inflation close to target, people have increasingly come to expect us to do so in the future, and to act
on the assumption that inflation will stay low. These expectations have underpinned the wages they
have bargained for, and the prices they have set. And that behaviour has helped us to keep inflation
under control in the face of destabilising events.
However, the unusual degree of stability, and the prestige it has conferred on central bankers, may
also have bred some less helpful attitudes: such as complacency about the ease with which the
economy can absorb shocks, and unrealistic expectations about what monetary policy can achieve.
Just to be clear: monetary policy can pin down average inflation over the medium term. It can not
deliver inflation at target at all times and in all circumstances, and certainly not in combination with
rock-steady growth in output.
Let me illustrate these points by looking more closely at one of the key challenges I mentioned earlier,
the impact of higher energy prices over the past two years.
Since 2004, global oil prices have more than doubled, a far sharper rise than at any time since the
1970s, when as some of you may recall, inflation took off, eventually peaking at 25%. Then, last
winter, UK wholesale gas prices surged, as a result of supply and storage problems that were, in large
part, specific to our market. The resulting increases in household gas and electricity bills have had a
large direct impact on inflation. By December, they alone were directly contributing 1pp to the
measured inflation rate.
These energy price shocks are now starting to unwind, at least for now. The oil price has fallen back,
although the outlook remains uncertain - the thin margin of spare capacity continues to make oil
prices unusually sensitive to all kinds of news, from politics to weather and supply. We can have more
confidence that the gas price shock is ebbing. The temporary supply and storage issues which caused
the price spike last winter have been addressed. Together with a milder winter, this has helped to
bring wholesale prices back to where they were two years ago, and retail prices have started to fall
back.
So, just as energy price increases have boosted inflation over the recent past, it now seems likely that
energy price falls are going to reduce it - possibly quite sharply - over the year ahead. Indeed we
expect inflation to fall below the target by the end of 2007.
Let me make two observations about this episode.
First, looking back over the past three years, the big picture is that inflation has stayed surprisingly
low, and output growth remarkably stable, given the scale of these cost increases. Inflation has never
deviated by more than 1 percentage point from the 2 per cent target.
But second, judging by the media and public reaction to the rise in inflation over the past few months,
it is clear that even a small deviation in inflation from target can now look very significant after the
stability of the past decade.
This illustrates both the helpful and unhelpful legacy of a decade of remarkable stability for the UK
economy.
On the helpful side, there is no doubt that a highly credible monetary policy framework has helped to
contain inflation, in the face of a very large cost shock. The UK has become a low inflation economy
since the 1970s and people expect the MPC to keep it that way. That affects the way they behave
when they take decisions about wages and prices.
The less helpful legacy is that even a small movement in inflation away from target - one percentage
point - has prompted some highly coloured media coverage, and may have unsettled people's
expectations about where inflation is headed in the short run.
How does this less helpful legacy affect the policy debate?
Remembering the earlier discussion of constrained discretion, a temporary spike in inflation, as a
result of a large cost shock like the recent rise in energy prices, is exactly the sort of shock to which
policy-makers should be able to react flexibly within an inflation targeting framework. That enables
them to avoid excessive volatility in output and employment, as long as public expectations of inflation
over the medium term remain pegged to the inflation target.
On the other hand, the MPC can never afford to ignore evidence that medium-term inflation
expectations are becoming dislodged: anchoring these expectations is fundamental to the success of
the framework. But direct evidence of inflation expectations is very hard to come by; the measures we
have are patchy and poor.
So there is a difficult dilemma here, which the MPC has been grappling with over the past few months.
And it has left me with a nagging worry. My concern is this. If the price of maintaining the public's
confidence is that we have to try to keep inflation within a whisker of the target at all times - even in
the face very large shocks - the flexibility that is such an important feature of our present
arrangements may get significantly eroded7.
That is why the Open Letter procedure remains important - and why it is a great pity that it has been
widely misrepresented as a punishment, rather than as an opportunity for the MPC to explain itself.
Our monetary policy framework can only offer flexibility as long as it remains credible. But our
credibility needs to reflect reality. It is important that the unprecedented stability of the past decade
does not lead people to believe that central banks can walk on water. They can't. When that becomes
clear - as at some stage it will - I see some risk that people will be excessively disillusioned.
So let me end by being very clear about what I regard as reality. The MPC cannot keep inflation
exactly on target, at all times and in all circumstances. Large price shocks will sometimes drive us
away from target, and we need to be able use our judgement in deciding how to react. But we can and
will keep inflation close to target on average. Short run deviations from the target should not leave
anyone in any doubt about that.
Conclusions
The stability of the period since 1992 has been almost as unexpected as the falling of the Berlin Wall,
and every bit as welcome. It remains something of a puzzle and we cannot assume it will continue
indefinitely.
We do not know quite how big a part the MPC has played in achieving this outcome. But it has
certainly been shaped by it. Success - however earned - has its price. It may have bred expectations
of the MPC and what monetary policy can deliver which are frankly unrealistic - and unsustainable in
the longer term.
In the original concept, the defining characteristic of inflation targeting and the MPC was the scope it
offered for exercising constrained discretion. We need to hang on to that big idea.