The Bank of England's Monetary Policy Committee: A View from a Parliamentary Specialist Adviser
Wickens, Mike, National Institute Economic Review
This article assesses the new monetary policy regime introduced in the UK in 1997. It discusses the original remit given to the Bank of England, how it has been interpreted by the Bank and the conduct of monetary policy by the Monetary Policy Committee (MPC) subsequently. The article draws heavily on my experience as Specialist Adviser to the House of Lords Select Committee on Economic Affairs over this whole period. I conclude that the MPC has been very successful in fulfilling its remit, but that a puzzle remains at the heart of the policy over whether the way inflation targeting has worked in practice is consistent with how it is said to work in theory.
Keywords: Inflation targeting; monetary policy; Bank of England Monetary Policy Committee; House of Lords Economic Affairs Committee
JEL classifications: E42; E52; E58
In December 1998 the House of Lords appointed a Select Committee under the Chairmanship of Lord Peston to consider the operation of the Monetary Policy Committee of the Bank of England. The Committee reported in July 1999 and February 2001. Renamed the Select Committee on Economic Affairs in order to reflect its wider remit, the Committee published further reports on the MPC in July 2001, February 2003 and November 2004. For each of these reports I have been privileged to be the Committee's Specialist Adviser. This has given me a unique perspective on the conduct of monetary policy in the UK under the new regime, on which I propose to draw in this article.
Judged by its record, the MPC has been very successful in controlling inflation. In every month inflation has satisfied the remit given to the Bank of England. As a result, for the first time since the breakdown of the Bretton Woods system around 1970, the UK seems to have discovered a monetary policy that is able to control inflation under a floating exchange rate. Nonetheless, this success has many puzzling aspects. Not least is that, in practice, inflation control does not seem to have worked as theory predicts.
The basis of inflation targeting is the use of interest rates to control aggregate demand and, through this, inflation. This transmission mechanism suggests a theoretical limitation to inflation targeting as it appears much better suited to offsetting the effects of demand than supply shocks. The main channel through which the Bank seems to expect this to work is through controlling the cost of capital. There is, however, evidence that in practice monetary policy does not seem to work like this. This shows that the exchange rate and inflation expectations could well be more important channels than the cost of capital, especially in the short to medium term. Evidence from the Bank's own research has revealed that the effect of interest rates on inflation is so small that the size of the interest rate changes needed to eliminate levels of inflation outside the permitted range would be large, possibly too large to be politically acceptable. The time lag in the response of inflation to interest rate changes causes the Bank to forecast inflation and economic growth two years ahead. The evidence shows that the Bank has tended to overpredict inflation and underpredict growth. This suggests that the wrong interest rates may have been set.
If inflation targeting works in practice, then all of this may seem unimportant. Ronald Reagan, no doubt intending a slight to economists, said, "One definition of an economist is somebody who sees something happen in practice and wonders if it will work in theory". Unwittingly, Reagan put his finger on an important principle: it is only if we have theories that work in practice that we can have any confidence in that theory, and hence in our understanding of why things happen. This is why it is important to look more deeply into the MPC's record.
Apart from these technical economic considerations, a surprising number of additional issues arise in the practical operation of monetary policy. …