Why the Monetary Policy Committee must learn the importance of being boring
Tuesday 02 November 1999
Of course, economists generally do well on the dullness front but rather badly when it comes to consensus. They are a famously argumentative lot. So it should perhaps not have come as a surprise that, now the interest rate-setting process has had time to settle, there has been a row over the allocation of the Bank's too-scarce resources for monetary analysis.
It is a row that is in one sense easy to resolve. The independent members should certainly be able to commission research without the say-so of the internal members, and if that means hiring some additional dedicated economists then the Court of the Bank of England should allocate them a budget for it. It would probably be impossible ever to completely offset the advantage of the home team, but then the four external members have actually played a big role in setting the terms of the MPC's debate so far, even with their less-than-adequate access to research resources.
The eruption of the dispute should also, at last, convince everybody how ludicrous it is to argue that the MPC should include representatives of industry, unions or the regions. If the four pointy-heads who are currently external members feel at such a disadvantage in the debate, how on earth would the pillar of the local Chamber of Commerce or chairman of a regional development agency fare if they disagreed with the collective wisdom of the Bank of England's 130 economists?
Unfortunately, fierce rows that spill over into the newspapers do not do a lot to bolster the impression of the MPC's quiet technical competence, and this is the harder part of the problem it now has to solve. The more so as that competence was also questioned in last week's quarterly report from the National Institute of Economic and Social Research. Andrew Blake and Garry Young used the Institute's model of the economy to look at how different growth and inflation would have been if interest rates had been constant at 6 per cent since May 1997 rather than climbing to 7.5 per cent in mid-1998 and falling to 5 per cent this past summer.
The answer is that there would have been almost no difference at all. But it is wrong to draw the apparently obvious conclusion that the MPC should therefore have been seriously inactive because the outcome would have been roughly the same - if anything fractionally higher growth with little extra inflation. For one thing, the Niesr simulation is just a thought-experiment - it is daft to imagine that a constant rate policy would have been acceptable in practice during a period which saw windfall gains to consumers give way to the Asian financial crisis.
More important, the fact that interest rates could have been up to one and a half percentage points lower or higher than they were in practice without having any significant impact at all on the economy tells us two crucial things. One is that monetary policy must have been about right. If there had been big policy errors, it would certainly have made a noticeable difference to the outcome.
The second point is that the response of output and prices to interest rates is neither swift nor easily predictable. Perhaps a difference of 1 per cent in the level of borrowing costs will have a big impact five years on, but it certainly does not within the two-year forecast horizon. And even if the difference did turn out to matter more in the longer term, we have no idea what the effects might be. The economy is so complex - and changing constantly with it - that no model can predict reliably that far in advance.
The moral is that we should all keep the power of monetary policy in perspective. Getting it broadly right matters, but being wrong by a quarter or half a point does not. It will be especially important to take this broad brush view this week, when the MPC has to decide whether or not to raise rates again. It probably ought to do so - the economy has accelerated through its trend growth rate, the tight jobs market is starting to push up pay deals and spending power is now showing up in frothy areas like the housing market. This is as convincing as early warning signals ever get.
On the other hand (as an economist would say), actual inflation is low and there is also the knotty "new paradigm" question. It is entirely plausible that technical and competitive developments have made it much harder for many prices to rise - but the scale of the phenomenon is unclear.
A decision to raise rates this week, while expected by the City, will be all the more controversial because the members of the MPC have fallen out. The usual critics will have additional ammunition to lob at the committee's hawks, and will do so gleefully. Still, there is some comfort in the fact that the microscope of policy debate has focussed on a row over what research gets done in Threadneedle Street - if there had been real mistakes, it could have been something a lot more serious.
As Voltaire once said, “Ice cream is exquisite. What a pity it isn’t illegal”
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