Mervyn King: The MPC ten years on
Lecture by Mr Mervyn King, Governor of the Bank of England, to the Society of Business Economists,
London, 2 May 2007.
I am indebted to Alex Brazier, Iain de Weymarn, Richard Harrison, James Proudman, Chris Salmon, Tim Taylor and Ryland
Thomas who have worked closely with me on this lecture.
* * *
Not long before his untimely death, David Walton invited me to deliver this lecture. Anyone who knew
David will be desperately sad not only that he is no longer with us to ask important questions and
make us smile at his dry humour, but even more so that he is unable to take his place at the
deliberations of the Monetary Policy Committee to which he contributed so much in such a short space
of time. David had a wonderfully clear mind, an independence of thought, and was a warm and
generous colleague. He is, and will continue to be, deeply missed. David asked me to look back on the
experience of the first ten years of life with the MPC and to try to learn from that experience. So, in his
memory, that is my aim this evening.
Although the announcement in 1997 of independence for the Bank of England was a bolt from the
blue, it was a long time in the making. During the 1970s inflation in the United Kingdom averaged 13%
a year and peaked at 27%. Only towards the end of that decade, with first a Labour and then a
Conservative Government recognising that the control of inflation was the first step towards any
semblance of a coherent macroeconomic policy, did the transition from the Great Inflation to the Great
Stability begin. But the first steps were faltering. It took two painful recessions and sterling's exit from
the Exchange Rate Mechanism in September 1992 to reach the goal of low inflation. Even then, the
long-term commitment of the United Kingdom to low inflation was not fully believed by financial
markets. Granting independence to the Bank of England was the dramatic constitutional change that
convinced financial markets of the United Kingdom's conversion to stability as the basis of
macroeconomic policy.
Next Sunday is the tenth anniversary of the historic announcement on the morning of Tuesday 6 May
1997 that the Bank of England would be granted independence. Although that decision was both
unexpected and far-reaching, we had been preparing to implement the manifesto commitment to
introduce a monetary policy committee to help the Bank formulate its advice to the Chancellor in the
context of the previous regime, in which the Chancellor decided on the level of interest rates following
a meeting with the Governor.
On the very day that Gordon Brown and Ed Balls entered the Treasury carrying a draft letter to the
Governor setting out proposals for Bank of England independence, the Bank completed a paper for
the incoming team setting out proposals for how an advisory committee might operate. It
recommended a fixed timetable for meetings between Chancellor and Governor and for the
announcement of decisions on interest rates. Many of the recommendations were carried over to the
independent MPC that followed. The optimal time for meetings was thought to be the end of the first
week of the month, and with minor changes the timetable of a two-day meeting culminating with an
immediate announcement of the decision at noon on Thursday was adopted within a couple of weeks.
The key difference was that a purely advisory committee would not have published minutes of its own
deliberations - only the minutes of the meetings between the Chancellor and Governor would have
been made public - and voting was not an agreed feature of such a committee.
My predecessor - Eddie George - was informed of the new and enhanced role for the Bank early on
the morning prior to the announcement - a Bank Holiday Monday. Returning from the tennis court, I
received a call from Eddie asking me to meet him in the Bank as soon as possible. That was the last I
saw of the sun for quite a time. We sat in his office with a sense of excitement that now we really did
have a chance to show what the Bank of England and price stability could do for this country. Eddie
charged me with the task of preparing ideas on how the new committee - the Monetary Policy
Committee - would decide and set the level of interest rates, and to draft the speaking note for the
very last Chancellor-Governor meeting which was brought forward from Wednesday to 8am on the
Tuesday.
By the next morning when the public announcement was made, a paper was ready setting out the
questions that the Bank would have to answer on how the new Committee would operate. We had a
script but, at this stage, the cast was incomplete. Only four of the five internal and none of the external
members were in place. With the support and hard work of some extraordinarily talented young Bank
economists, the new arrangements were designed and put in place in not much more than three
weeks. They included the arrangements for briefing the Committee, the pre-MPC meetings, the format
of the decision-making meetings of the MPC, practical matters such as the ordering of a sound system
so that, in a break with tradition, it was actually possible to hear what was said in the Bank's older
meeting rooms, and rehearsals of the meetings and voting procedures with staff members playing the
roles of the MPC members. So short was the time available that some of the dress rehearsals came
after the first night of other parts of the policy process. Such was the adrenalin flow that at one
rehearsal a row broke out about how a decision would be reached if the Committee split three-ways in
equal numbers. Needless to say, such an eventuality has not occurred.1 But all was resolved and the
show opened on Wednesday 4 June. At that first meeting the MPC raised interest rates by 25 basis
points, as it did at its two subsequent meetings.
A decade is a long time for any show to run. How has it fared? On the face of it UK macroeconomic
performance has improved with the creation of the new monetary framework. The MPC arrived on the
scene midway through what I have described as the nice (non-inflationary consistently expansionary)
not-so-bad
decade, and continued into the decade.2 Since the MPC was set up economic growth has
averaged 2.8% a year - a little above the post-war average rate - and there has not been a single
quarter of negative growth. The average deviation of inflation from target has been just minus 0.08
percentage points.
Let me stress that the Committee does not dwell on the past. But an important question for all of us is
whether our new found stability will persist. That is not a new question. On the tenth anniversary of the
MPC we should remember that this is also the fiftieth anniversary of Harold Macmillan's famous claim
that we had "never had it so good". But let me remind you too of the full text of his remarks. In a
speech on economic prospects in July 1957, the former Chancellor of the Exchequer, who had
recently become Prime Minister after the resignation of his predecessor following an unsuccessful
military excursion in the Middle East, said:
"Indeed, let us be frank about it: most of our people have never had it so good. Go around the country, go to the
industrial towns, go to the farms, and you will see a state of prosperity such as we have never had in my lifetime -
nor indeed ever in the history of this country. What is beginning to worry some of us is, is it too good to be true? -
or perhaps I should say, is it too good to last? ... Our constant concern today is, can prices be steadied while at
the same time we maintain full employment in an expanding economy? Can we control inflation? This is the
problem of our time".3
Some of you may think that it is the problem of our time too. CPI inflation has now risen above 3%, the
highest rate since the MPC was set up. Although I believe we are better equipped to maintain stability
now than fifty years ago, largely because we have a monetary framework based on an inflation target
and clearly defined responsibilities for the Bank of England, we should perhaps look in more detail at
how the MPC has worked before coming to a final judgement on the likelihood of continued success.
First, I want to look at the changes in the behaviour of the UK economy in recent years. How far is the
improvement attributable to the MPC? Second, I want to review how the MPC has operated as a
decision-making body. Has the process lived up to its billing as the most effective way of reaching
technical judgements on the level of Bank Rate? Third, and most important of all, I want to consider
the challenges to the MPC for the next ten years. What can we learn from the experience of the first
decade that may help us to improve over the next?
1. Changes in the UK economy
In examining the first ten years of the MPC a natural starting point is to ask what has been its impact
on the UK economy since 1997. The objective of the MPC is, of course, to meet its inflation target.
Chart 1 shows that since the mid-1990s, inflation in the UK has been lower than for a generation. And
there have been significant changes in the dynamics of inflation since the MPC was set up.4 Table 1
shows the mean, standard deviation and persistence of inflation over various periods. Inflation has
been significantly lower on average, less variable, and fluctuations in inflation have tended to be less
persistent.
More generally, the impact of the MPC is revealed by what I have called the "Performance" and
"Stability" charts - charts 2 and 3. In terms of average rates of output growth per head and of inflation,
charts 2a and 2b show the relative position of the UK economy among the G7 as a whole both before
(taken here to be the period 1950 to 1996) and after (1997-2006) the creation of the MPC. Ideally, a
good performance means that a country would be towards the top right hand corner of the charts -
inflation is plotted on an inverted scale. The average record on growth and inflation over the period
1950-96 (chart 2a) was not good relative to the rest of the G7. Indeed it was arguably the worst. In
contrast, after the MPC was set up the United Kingdom performed better than most if not all of the G7
countries. So although changes in the world economy may have proved helpful to achieving lower
inflation, the fact that the UK improved not only its absolute but also its relative performance - moving
from last to first in the G7 league table - is encouraging.
The stability charts - 3a and 3b - show the stability of growth and inflation in the G7 countries in the
two time periods. In these charts a good performance is to be near the origin of the axes, close to the
bottom left hand corner of the chart. The rather poor performance of the United Kingdom prior to 1997
is evident, as is the remarkable degree of stability in the United Kingdom relative to the rest of the G7
after that date.
Of course, correlation does not imply causation. And there is little reason to suppose that the MPC is
responsible for the higher average growth rate over the past decade. That more likely reflects
structural changes in the UK economy, associated with other policy reforms. It is the stability of the UK
economy which appears to be the most marked contribution of the MPC. That is a surprise. The
conventional wisdom is that, although there is no long-run trade-off between the levels of inflation and
output growth, there is a trade-off between the stability of inflation and of output growth. Inflation can
be kept closer to the target only by larger changes in interest rates and bigger fluctuations in output
growth. Policy-makers thus face a choice between different combinations of inflation and output
growth volatility, which, when plotted on a chart, describe a "stability possibility frontier".5 They can
choose a point on that frontier depending on the relative importance they place on stabilising inflation
and output growth, but they cannot move inside it. That is, they cannot reduce the volatility of both
inflation and output growth.
An example of that "stability possibility frontier" is shown in chart 4. Points B and C represent
alternative choices by central banks with different reaction functions, corresponding to the different
weights they attach to the costs of volatility in inflation and output. Central bank B tends to bring
inflation back to target more slowly than central bank C. So the real surprise is that, over the past
decade, we have moved not along the frontier, say from point B to point C, but instead to A. The
frontier itself has moved significantly inwards.6 The conventional wisdom has been overturned. Was
that the result of luck: an absence of shocks and favourable structural changes in the economy? Or
has the new monetary framework itself played a role?
How might the MPC have been lucky over its first decade? First, there might have been unusually few
significant economic shocks to which the Committee had to respond. Output and inflation would have
been more stable even without a change in the monetary framework. Second, when shocks did occur
the economy might itself have responded in a self-regulating manner.
On the first, it is difficult to argue that there have been no major economic shocks since 1997. At the
outset, the Committee had to confront the consequences of a 25% rise in the effective exchange rate
and the resulting fall in import prices. Between 1996 and 1998 import prices fell by 20% relative to
overall consumer prices - the biggest fall over any two year period since the early 1950s. That was
shortly followed by the Asian financial crisis and the Russian default and devaluation in 1998 which led
to concerns about the stability of US and other financial markets. Later there was the world IT-led
slowdown in late 2000 and 2001, and sharp falls in equity prices. The share of government final
consumption in nominal GDP rose by 4 percentage points between 1998 and 2005 - the biggest
continuous expansion since 1945 - and the share of taxes in total income rose. More recently, oil
prices more than doubled and the labour force expanded by 1 1⁄2% in 2006, a rate exceeded only once
in the past 35 years. And the terrorist attacks on September 11 2001, and the wars in Afghanistan and
Iraq, added to uncertainty.
So the environment in which the MPC has had to operate has not been without excitement. But did the
economy respond to that excitement in a self-regulating way? It is clear from the performance chart
that the supply side of the UK economy has undergone substantial change - the average rate of
growth of output per head has increased from 2.1% between 1950 and 1996 to 2.4% in the past
decade. It could be argued that the structural reforms of recent decades have made the UK economy
and, in particular, the labour market, more flexible. Greater flexibility has enabled unemployment (and
its natural rate) to fall steadily.
Structural reforms also led to more stable growth of employment and output. If businesses are to
stabilise employment in the face of changes in costs, employees must accept fluctuations in the real
value of their take-home pay. When import prices fell sharply, employees benefited from rapid growth
in real take-home pay. More recently, however, businesses have faced higher energy costs and
employees have accepted somewhat weaker growth of real take-home pay.
The acceptance of necessary adjustment in real take-home pay has helped to stabilise employment
growth which, over the past decade, has been four times less variable than over the previous five
decades. That has shifted the "stability possibility frontier" faced by the MPC inwards, enabling the
MPC to keep inflation more stable than in the past.
Structural improvements in the labour market are, however, unlikely to explain the full improvement in
the stability of inflation and output. They cannot explain the low and stable level of inflation
expectations. Changes in the yields on government bonds indicate that investors' expectations of
inflation over the medium-term - and the premium they require to compensate them for the risk of
future inflation - have also fallen significantly. Chart 5 shows the sharp fall in expected inflation that
resulted from the actual announcement of independence for the Bank of England in 1997.
It seems to me likely that the new framework for monetary policy has been a key, though not the only,
driver in moving the frontier inwards. By eliminating uncertainty about the inflation target and ensuring
that the objective of low and stable inflation is well understood and credible, the change in the
framework in 1997 helped to anchor expectations of inflation in the medium term. By doing so, it has
made it possible for the MPC to keep inflation closer to target with smaller changes in monetary policy,
and hence fluctuations in output, than would otherwise have been the case.
The anchoring of inflation expectations has changed the way businesses respond to unexpected
shocks. Faced with changes in their costs stemming from, for example, changes in import or energy
prices, businesses can respond in two ways, each consistent with the necessary change in
employees' real take-home pay. They can pass those cost changes forwards to prices or backwards to
money wages. With inflation expectations well-anchored to the target, companies have restricted the
pass-through of changes in costs to prices. The necessary adjustment of real take-home pay has
taken place more through fluctuations in money wages than prices.
In short, the behaviour of the UK economy has improved over the past decade, both in terms of its
performance and its stability, and that improvement has been more marked in the United Kingdom
than in the rest of the G-7. Although structural reforms to the economy over several decades have
made the economy better able to respond to economic shocks, the new monetary framework has also
played a key role. Inflation expectations have been successfully anchored to the target. And that has
meant that cost changes have affected wages and profits rather than prices. As a result, inflation and
output growth have been remarkably stable.
2. The change in monetary policy decision making
It appears then that the success of the framework in anchoring inflation expectations has played a key
role in the economic stability of the past decade. What was it about the framework that accounted for
that?
Since its inception, the MPC has met 120 times.7 At those meetings it raised Bank Rate 17 times,
lowered it on 17 occasions, and left it unchanged 86 times.8 Bank Rate has varied between 3.5% and
7.5%. The MPC has changed interest rates at just over a quarter (28% in fact) of its monthly meetings.
Companies, households, trade unions and financial market participants can see that we change
interest rates in response to news about the inflation outlook. That anchors inflation expectations. In
the jargon of economists, people understand that we have a "reaction function" - we react to the
economic data in order to keep inflation on track to meet the target.
If the economics profession could agree on a model which described exactly how the economy
behaved, then it would be possible to set up a Royal Commission of the country's leading economists
to determine the optimal "reaction function" for the Bank of England to follow. It would specify how
interest rates should respond to the unfolding of economic data. It could even be implemented by a
computer without any need for a Monetary Policy Committee at all. That sounds quite attractive
(especially when you've attended 120 meetings!).
So why don't we set up a Royal Commission? As members of the SBE know only too well, none of us
knows the true structure of the economy or all the shocks that might occur. How long do you think it
would be before some other economists would argue, undoubtedly persuasively, that their own
research had made the findings of the Royal Commission redundant? Who would have thought in
1997 that monetary policy would have to respond to the challenges posed by the largest inflow of
migrant labour and the fastest fall in import prices since Harold Macmillan was Prime Minister?
Uncertainty is at the heart of practical monetary policy making. The best that we - as economists -
can do is continually to learn about the changing nature of the economy. It is impossible to write down
any stable "reaction function". Even if we could identify the shocks hitting the economy, judgement as
to how we should react to each of them cannot be set in stone. The structure of the economy changes
through time as does our knowledge of the way it works. The MPC is there to exercise discretion
about how to react to shocks. Central to the design of a framework for monetary policy is our
ignorance and uncertainty about how monetary policy works. The MPC is an institutional response to
that ignorance.9
The best way to make technical judgements under uncertainty is by making use of the accumulated
wisdom of a committee whose members can pool their knowledge and expertise. This is the
motivation behind the MPC and explains its two key features.10
First, it is a committee of experts who, before making their decision, discuss their interpretation of the
economic data and learn from each other.11 Our Wednesday afternoon discussions take the form of a
debate, not a series of presentations. And on Thursday mornings when the time comes to go round
the table and make a decision, it is common, as, for example, happened at our most recent meeting in
April, for members to want to listen to the views of other members before making up their mind which
way to vote. That is why no-one is forced to cast their vote for a particular level of Bank Rate until they
have heard the views of the whole Committee. As a result, there is often some suspense as to the final
outcome. In January, for example, when the Committee raised Bank Rate by five votes to four, that
outcome looked unlikely when at one stage opinion was four to two for no change with only three
people to speak.
The greatest debate among the Committee usually occurs during the quarterly forecast round which
often stimulates fresh thinking. So it is perhaps not surprising that this is when many, but by no means
all, changes in interest rates are decided - see chart 6. Changes have been twice as frequent in
Inflation Report
months as in other months. But it is changes in economic conditions which are more
important in determining the timing of our decisions.
Second, members of the Committee are individually and publicly accountable for their votes.
Disagreement among the Committee is inevitable; it is also desirable because it represents the
individual judgements of members, rather than an attempt to create a false consensus. It is a source of
strength. Over the past ten years, there have been 153 dissenting votes, on average more than one
per meeting.
This institutional encouragement of open debate is in contrast to many other central banks. We don't
"do consensus", as one former member put it. Dissent is more frequent than on other central bank
committees which publish individual votes, and is not just token. Table 2 reports the proportion of
dissenting votes in four central banks during the period since the MPC was set up. Not only is the
number of dissenting votes greater on the MPC, the frequency of more substantive disagreement -
where one quarter or more of the voters dissented - is markedly greater.
Voting patterns on the MPC reflect the distribution of views about how to interpret the economic data,
not a hint about where rates will go. Voting is certainly not used as a signal by the Committee. That is
why you can discount claims that disagreements can be used reliably to predict future movements in
rates. Sometimes they do, sometimes they don't.
Much of the commentary on the MPC has been subject to what I call the "small sample" problem.
Descriptions of diversity of view within the MPC have ranged from the Committee allegedly acting as
"the North Korean politburo" during periods when most of the votes were unanimous, to the view that it
was "a bunch of squabbling senior common room academics" during an earlier period when split votes
predominated. In fact, as chart 7 shows, there is no obvious pattern over the lifetime of the MPC.
There are times when the state of the economy is difficult to read and there are naturally differences of
interpretation leading to split votes. Equally, there are times when the nature of the economic shocks
is not in dispute and the response of the MPC is agreed by all members. For example, a sequence of
nine unanimous decisions starting in the summer of 2004 reflected a shared view within the MPC that
Bank Rate at 4% was too low and that some of the monetary stimulus it provided should be withdrawn.
Differences of view tell you more about the nature of the uncertainty confronting the MPC than the
nature of the MPC itself.
Similar arguments apply to the question of whether the MPC has become more or less "activist". Large
committees can be subject to inertia. At its very first meeting the Committee debated the merits of
"gradualism" in adjusting interest rates. Although the debate attracted some interest, looking back over
ten years it is hard to see that it had any practical impact. As chart 8 shows, there is no obvious
persistent trend in the frequency of rate changes over the lifetime of the MPC. Economic conditions
have determined the number and direction of rate changes. There is some indication that the number
of changes was lower in the second than in the first five year period. But that reflected the size and
nature of the shocks over the respective periods, and also the building of credibility which meant that
market anticipations of future actions allowed the Committee to offset shocks by smaller changes in
interest rates. It is striking that the MPC is in the middle of the ranking of the major central banks by
the number of interest rate changes a year - see table 3.
My view, therefore, is that it is the economic data which lie behind the debate and decisions of the
MPC. Do you agree? To answer that question the Bank of England asked the Society of Business
Economists (SBE) to carry out a survey of its members. The aim was to discover what kind of
information was of most use to private sector economists in trying to understand the future path of
interest rates at different horizons, and how the communications of the MPC were perceived as part of
that process. The survey consisted of an electronic questionnaire sent to 354 members of the SBE.
141 replies were received, a response rate of 40%.12 Over 85% of respondents said that forming a
view of interest rate prospects was important to them.
For those of us who have continually argued that the news on interest rates stems from developments
in the economy rather than meetings of the MPC, it is heartening that, collectively, you place more
weight on economic data than on MPC communications in forming a view of interest rate prospects.
Respondents were asked to allocate a total of 100 points across the categories of information in terms
of how useful they were in forming such a view. Twice as many points were given to economic data as
to MPC communications, especially at the longer horizons - see chart 9. And the weight on data was
divided roughly equally between financial data, official data on real activity, official figures for costs and
prices, and business and consumer surveys. So the argument that the MPC responds to
developments in the economy has been largely understood. This is welcome news for those of us who
wish to be boring.
So far I have talked only about the past - the performance of the UK economy and the behaviour of
the MPC since 1997. What of the future?
3. Challenges for the next decade
I want to devote the remainder of this lecture to the challenges facing the Monetary Policy Committee
over the next ten years. That is not because I see major fault lines in the present arrangements. On
the contrary, the careful institutional design that lay behind the construction of the MPC has proved its
worth. Nor is it because I share some commentators' boredom with a system that has remained
largely unchanged for a decade. After all, in the area of macroeconomic policy, boredom is a good
thing. Rather, it is a conviction that to remain successful the MPC must always be engaged in a
process of continuous improvement.
The anchoring of inflation expectations has been central to the stability enjoyed by the UK economy
over the past decade. The key lesson from economic theory is not to take those expectations for
granted - they depend on the actions of the MPC. Inflation expectations have been anchored because
the MPC has responded to events that have pushed the outlook for inflation away from target, and
households, businesses and financial markets have understood and anticipated our responses.
So the main challenge facing the MPC is to keep doing whatever is necessary to keep inflation on
track to meet the target. In modern models of inflation, monetary policy is represented by a "reaction
function" that is sufficient, in that model, to pin down inflation and, therefore, inflation expectations.
But that just assumes away the challenge facing us. How do we know, in an uncertain and
everchanging world, what precise path of interest rates is necessary to stabilise inflation in the medium
term? That raises questions about both what we do and what we say.
(a) What we do: The role of money and the nominal anchor
Let me start with what we do and how we provide an anchor to the price level in the long run. With a
paper currency, expectations that the future price level will remain stable are an article of faith. Such
expectations are the basis of the trust without which people will not willingly use paper money. They
reflect beliefs about how the central bank will react to events. Given our current arrangements, the
anchor for expectations of the future price level is the judgement and character of the men and women
who currently, and will in the future, serve on the Monetary Policy Committee. That is a crucial
difference between money as a standard of value, where its value is determined by the judgement of a
group of experts, and the standards of weights and measures, such as the metre, kilo or second,
which are based on objective scientific measurement. I hope that one day the Governor of the Bank of
England will be regarded as occupying a position similar to that of the Chief Executive of the National
Weights and Measures Laboratory.13 For the time being the value of money will depend upon the
discretionary judgements of the MPC.
For those judgements to command respect, it is vital that the Committee demonstrate their
determination to react to all signals about the outlook for inflation. It is common - both in the press and
within central banks around the world - for discussion of the inflation outlook to be dominated by an
analysis of so-called real changes in the economy such as movements in demand or supply and
changes in the relative prices of imports or energy. It is true that, in trying to stabilise inflation in the
short-term, the MPC will take those events into account. But we know that, beyond the short-term
forecasting horizon of up to around three years, inflation has nothing to do with these developments. It
is, in the old adage, the result of too much money chasing too few goods.
That is why money growth rates and inflation rates are well correlated across countries and over long
time horizons. Many of the great economists of the past from David Hume to Milton Friedman
emphasised the link between money and the price level in the long run.
Why, then, does money not play a more prominent role in discussions of the outlook for inflation and
monetary policy? Monetary developments can reflect two different causes: changes in the demand for
money and changes in the supply of money. They have very different implications for inflation.
Movements in the demand for broad money, relative to spending in the economy, reflecting changes in
the way different assets and liabilities are used in transactions or shifts in portfolio preferences, have
no implications for spending in the economy or the path of inflation. They make the relationship
between money growth and inflation unpredictable. That contributed to the poor outcomes when
explicit money supply targets were used to guide monetary policy in the late 1970s and early 1980s.
Changes in the supply of broad money, however, will lead to an imbalance in the relationship between
money and prices. Either spending and the price level