News Analysis: Clues to the MPC's thinking on rates

News Analysis: The Bank of England is opening up about how the Monetary Policy Committee makes its decisions are made
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The Independent Online
THE BANK of England will today publish for the first time comprehensive details of economic models used by the Monetary Policy Committee when setting UK interest rates.

The move - designed to improve "the understanding and transparency of monetary policy", according to Eddie George, Governor of the Bank of England - follows pressure from both inside and outside the Bank to promote openness and improve accessibility.

At the request of Select Committees in both the Commons and the Lords, the Bank is also to release a short paper explaining the way it believes changes in interest rates - the main tool of economic management used in Britain - impact on inflation and economic growth.

The paper, called "The Transmission Mechanism of Monetary Policy", provides one of the most clear insights to date of the thinking of the MPC. It explains how interest rate changes can have an immediate effect on variables such asbond and equity prices, market confidence and exchange rates, and how movements in these variables eventually affect both output and inflation.

One of the paper's key contentions is that changes in interest rates affect economic growth long before they feed through into inflation. A movement in interest rates can affect growth almost immediately, according to the Bank. But it may take at least a year before there is any appreciable effect on inflation.

Moreover, a temporary change in interest rates may only have a short- lived effect on output, the paper says, but can affect the inflation rate for many years.

Applying this logic to recent aggressive cuts in UK interest rates, we should soon expect to see definite signs of an upturn in economic growth. However, the flipside of recent interest rate cuts - a resurgence of inflation - may not become apparent until the beginning of next year.

Both the paper and the Bank's economic models owe far more to contemporary economic thinking than to the traditional monetarist doctrine pursued after Margaret Thatcher swept to power in 1979. Although the details of the models - spelt out in a 150-page volume peppered with complex mathematical equations - will be primarily of interest toacademics, they provide some useful clues to the MPC's current priorities.

To the horror of many traditionalists, the growth in money supply - for many years the key determinant of interest rate policy in the UK - is assigned a fairly low-key role in the Bank's models. Although the Bank is still a firm believer that, in the long term, there cannot be a sustained increase in the inflation rate without a sustained increase in the money supply, it is sceptical of the usefulness of the money supply as a short- term indicator of activity.

Instead, far more emphasis is placed on analysis of the labour market, as well as the role played by market expectations of key variables such as interest rates, exchange rates, and inflation. The current treatment of expectations in the Bank's economic model is seen as inadequate, and is one of the areas earmarked for improvement. Indeed, the priorities of Sushil Wadhwani, the former hedge fund director who will join the MPC in June, are likely to include refining the Bank's analysis of financial markets.

Despite the theoretical tone of the publications, the Bank denies that its interest rate decisions are purely model-driven. Included with the model descriptions is a discussion of the importance of judgement in policy decisions. Also emphasised is the value the MPC attaches to surveys of forward-looking indicators such as business confidence and manufacturing orders.

"The Transmission Mechanism of Monetary Policy" is available on the Bank of England's website:

Copies of "Economic Models at the Bank of England" are available, priced pounds 10, from the Bank's Publications Group.