the bank of england’s monetary policy independence: the first ten years alec chrystal professor of...

The Bank of England’s Monetary Policy Independence: The First ten Years

Alec Chrystal Professor of Money and BankingHead of the Faculty of Finance, Cass Business School

Outline of Talk• UK monetary policy has been delegated to the MPC of the

Bank of England for a decade.• The policy outcome have been excellent, but is this due to

good decisions by the MPC?• In part, probably, but it cannot all be down to MPC as

outcomes have been similar in many other countries.• AND it is likely that most of the gains have come from regime

credibility rather than from the policy decisions themselves.• Actual policy decisions are unlikely to have had much impact

on the economy.• The anchoring of inflation expectations has done most of the

work.• Finally we discuss what could go wrong and what steps are

needed to guarantee that credibility is maintained in future.

The end of macroeconomics?

• The outcomes discussed are relevant to several long running debates in macroeconomics:• Optimal stabilisation policy• Rules versus discretion• Credibility and time inconsistency• Political business cycles• Monetary targets etc• Central bank independence

• The recent institutional design has benefited from all these debates and the policy successes have almost certainly killed them stone dead.

UK GDP Gap, 1970-2006

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-4

-2

0

2

4

6

8

Year

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f Y*

GDP Gap

The Monetary Policy Committee (MPC)

• The MPC has 9 members

• Five are internal to the bank: The Governor, two deputy governors, the director of market operations, and the chief economist.

• Four are externals appointed for three year terms: currently two academics, and two ex-private sector economists.

• Each has one vote and the Governor has the casting vote in the event of a tie.

• Each is personally accountable for his or her own decisions to Parliament.

How interest rates are set

• Until the end of 2003, MPC set interest rates to meet the 2.5% RPIX inflation target set by the Chancellor.

• RPIX = RPI minus impact of interest rates (via mortgages etc)

• Now the target is 2.0% inflation of the CPI index (which used to be called HICP)

• MPC takes rate decision each month and has one day of data briefing and two days of analysis. They meet more often during the quarterly forecast round.

• Announcement at noon on 1st Thursday of each month.• Inflation Report and new forecast every 3 months.• Minutes published two weeks after meeting.• Votes are published with minutes.• The target is symmetrical and the Governor has to write

an open letter to the Chancellor if inflation is >1% above or below target explaining why and what will be done about it.

What interest rate is set and how is it done?

• Until May 2006, the rate set was the rate on two week “repo”.

• REPO = sale and repurchase agreement.• Bank of England would only lend to money markets on

a secured basis and only deal with acceptable counter-parties.

• Since May 2006 the Bank pays interest on commercial banks’ deposits at the Central Bank.

• The “official bank rate” is this interest rate.• There is a rate above this at which banks can borrow

from the Bank of England.

What factors influence decisions?

• Key influence is balance of AD relative to AS

• AD is made up of private consumption, investment, government consumption and the balance of trade (C+I+G+X-IM)

• AS depends in long-run on trend growth in capacity (potential GDP).

• In short run, trends in wages, and other input costs are relevant, as are forward looking surveys.

• They are briefed on: the world economy, monetary developments, labour market, macro data (C, I, G, X, IM), prices, market information.

• The Bank publishes every three months a “fan chart” “projection” of inflation and GDP growth.

• The Bank’s forecasting model is published.

• You can watch Press conference on web cast.

Inflation and GDP growth projections

• The MPC make a policy decision in light of alternative projections and only publish the ones consistent with policy decision.

• Up to August 2004 projections assumed constant policy rate (so they were not true forecasts).

• Since August 2004 projections assume market-based forward interest rates after the current period.

• MPC targets inflation two years ahead and projections used to go up to 2 years ahead but since August 2004 they project to a 3 year horizon.

• Virtually all inflation projections are on target at the two year horizon.

• NOTE: Inflation date are never revised but GDP data are subject to substantial revisions.

May 1997 Inflation Report

August 1997 Inflation Report

November 1997 Inflation Report

February 1998 Inflation Report

May 1998 Inflation Report

August 1998 Inflation Report

November 1998 Inflation Report

February 1999 Inflation Report

May 1999 Inflation Report

August 1999 Inflation Report

November 1999 Inflation Report

February 2000 Inflation Report

May 2000 Inflation Report

August 2000 Inflation Report

November 2000 Inflation Report

February 2001 Inflation Report

May 2001 Inflation Report

August 2001 Inflation Report

November 2001 Inflation Report

February 2002 Inflation Report

May 2002 Inflation Report

UK RPIX inflation. August 2002 Inflation Report

Source: August Inflation Report 2002

November 2002 Inflation report

February 2003 Inflation Report

May 2003 Inflation Report

August 2003 Inflation Report

November 2003 Inflation Report

February 2004 Inflation Report

CPI projection, February 2004 Inflation Report

CPI projection, May 2004 Inflation Report

CPI projection, August 2004 Inflation Report

CPI projection November 2004 Inflation Report

CPI Inflation, February 2005 Inflation report

CPI Inflation, May 2005 Inflation Report

CPI Inflation, August 2005 Inflation Report

CPI Inflation, November 2005 Inflation Report

CPI Inflation, February 2006 Inflation Report

CPI Inflation, May 2006 Inflation Report

CPI Inflation, August 2006 Inflation Report

CPI Inflation, Nov 2006 Inflation Report

CPI Inflation, Feb 2007 Inflation Report

CPI Inflation, May 2007 Inflation Report

GDP projection, November 1997 Inflation Report

GDP projection, February 1998 Inflation Report

GDP projection, May 1998 Inflation Report

GDP projection, August 1998 Inflation Report

GDP projection, November 1998 Inflation Report

GDP projection, February 1999 Inflation Report

GDP projection, May 1999 Inflation Report

GDP projection, August 1999 Inflation Report

GDP projection, November 1999 Inflation Report

GDP projection, February 2000 Inflation Report

GDP projection, May 2000 Inflation Report

GDP projection, August 2000 Inflation Report

GDP projection, November 2000 Inflation Report

GDP projection, February 2001 Inflation Report

GDP projection, May 2001 Inflation Report

GDP projection, August 2001 Inflation Report

GDP projection, November 2001 Inflation Report

GDP projection, February 2002 Inflation Report

GDP projection, May 2002 Inflation Report

UK GDP growth. Actual to 2002Q1 and projected to 2004Q2

Source: August Inflation Report 2002

UK GDP Growth: November 2002 Inflation Report

UK GDP Growth: February 2003 Inflation Report

GDP Growth: May 2003 Inflation Report

GDP Growth: August 2003 Inflation Report

UK GDP Growth: November 2003 Inflation Report

UK GDP Growth: February 2004 Inflation Report

UK GDP Growth: May 2004 Inflation Report

GDP Growth: August 2004 Inflation Report

UK GDP Growth: November 2004 Inflation Report

UK GDP Growth: February 2005 Inflation Report

UK GDP Growth: May 2005 Inflation Report

UK GDP Growth: August 2005 Inflation Report

UK GDP Growth: November 2005 Inflation Report

UK GDP Growth: February 2006 Inflation Report

UK GDP Growth: May 2006 Inflation Report

UK GDP Growth: August 2006 Inflation Report

UK GDP Growth: Nov 2006 Inflation Report

UK GDP Growth: Feb 2007 Inflation Report

UK GDP Growth: May 2007 Inflation Report

Some Issues• The inflation target has established itself as a strong

“attractor”.• Letter writing in only one month in the past decade is an

amazing outcome.• However, credibility would be hard to restore if it were ever

lost……and interest rates could become much more volatile.• One constant in the current regime has been Mervyn King.

When he retires, a “political” appointment to Governor could easily destroy hard won credibility.

• Fiscal policy restraint is also essential, as the MPC would be in a difficult position, if in the face of high public sector demand, it had to raise interest rates substantially to lower private sector demand.

• It is essential that MPC continues to have a strong core of technically competent economists. The public appointment process to be introduced may help here, but the drafting of the “essential skills” for the job will be very important.