UK - recent inflation performance
Nick Fawcett of Cambridge University considers how much of the credit for Britain's continued low rate of inflation can be given to the Monetary Policy Committee of the Bank of England.
The UK has recently been enjoying some of the lowest inflation rates in decades; the government and others put this down to the calculated decisions of the independent Monetary Policy Committee (MPC) of the Bank of England, which was set up by the current Labour government in May 1997. Looking at the wider picture, however, we can ask whether or not an independent central bank is necessary to achieve low and stable inflation.
The very recent low inflation performance is certainly down in part to the decisions of the MPC when setting interest rates; the effects of the monetary tightening it started when it started raising interest rates in September 1999 are now beginning to come through. In addition to this, a Parliamentary Committee reviewing the performance of the MPC concluded that its quick action in the second half of 1998 helped the economy avoid a hard landing; this would suggest that the MPC has avoided high inflation and at the same time allowed the economy to run relatively quickly.
However, it is not strictly true that the establishment of the MPC heralded the dawn of low inflation as the current government might have us believe! As the chart below shows the UK has actually enjoyed low inflation since 1993:
Since the Conservative chancellor Norman Lamont introduced an inflation target of 1% to 4% on the RPIX measure, inflation appears to have become far less volatile; interestingly, it is impossible to tell simply from the path of RPIX inflation, when the MPC took control of monetary policy. This raises the question of whether or not it is more beneficial to have an independent central bank to deliver low inflation.
The answer, based on the evidence we have, is yes, for a number of reasons.
Lower inflationary expectations - since the MPC was established, we saw a marked fall in the financial markets' expectations of future UK inflation. This was partly thanks to the credibility of an independent Bank of England - the markets are sure that the MPC will not lower rates close to an election to engineer a temporary period of economic growth, whatever the cost to the economy in the long run.
Lower volatility of interest rates - As the chart below shows, during the recent cycle in interest rates the MPC only raised interest rates by one percentage point (or 100 basis points), whereas in the previous cycle base rates had to rise by 175 basis points. In addition, rates seem to have peaked now at 6% - 150 basis points lower than the last peak. This was made possible by the bold pre-emptive rate rises it announced late last year, which helped to restrain inflationary pressures to the extent that interest rates are not likely to rise again in this cycle - though the changing nature of the economy does not make this certain!
MAJOR POLICY CONFLICT?
One of the main arguments against an independent central bank is that there is no formal co-ordination of fiscal and monetary policy. In the worst scenario, we could have, say, an expansionary fiscal policy trying to stimulate demand whilst monetary policy could be tightening to restrain demand. This possible conflict was brought to light earlier this year after Gordon Brown announced a relatively expansionary budget, much to the dismay of some who feared that the MPC would have to raise interest rates as a direct response.
One of the UK's leading economists, the Director of the National Institute of Economic and Social Research, Martin Weale, commented last year that ". one should not infer, because things have worked well for two years, that there will never be problems arising from the separate setting of the two policy instruments." Even though policy conflict may be a danger, it is important to remember that it is the Chancellor who sets the MPC's inflation target, so in effect the Bank of England is not totally independent - in contrast, for example, to the Bundesbank in Germany before it adopted the Euro.
CONCLUSION
The establishment of the MPC has been a success in several ways; not only has inflation remained low and stable, but also peoples' expectations of inflation have fallen and interest rates seem to have peaked at a much lower rate than they did at the last peak of the rate cycle. However as Martin Weale points out, "we have been in a stable environment, there have not been shocks to the world economy of the sort that we were getting in the 1970s and 1980s so the Monetary Policy Committee has taken on its job in a very benign period".
Time will tell therefore whether or not the MPC will continue to deliver low inflation for the UK economy.
Nick Fawcett
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