The inflation "doves" in the Bank of England may be winningby Liam Halligan / May 20, 2002 / Leave a comment
The defining act of New Labour’s economic policy- absent from its manifesto-was granting “operational independence” to the Bank of England in 1997.
Responsibility for the setting of short-term interest rates was handed to a nine-member Monetary Policy Committee (MPC) comprising four in-house officials and four outside experts, with Governor Eddie George in the chair. These arrangements would, the chancellor proclaimed, ensure monetary policy was guided by “the long-term needs of the economy, and not short-term political considerations.” The left groaned at this act of neo-liberal orthodoxy while the financial markets cheered. Long-term interest rates fell in anticipation of low inflation.
So, five years on, how has the reformed Bank of England performed? Politically, the new arrangements have worked well. The Tories now accept the MPC. Concerns about democratic accountability, most audible among Labour backbenchers, have also died away, as rates have dropped to 4 per cent-their lowest for 38 years.
Any judgement on the new Bank depends, of course, on the interest rates it has set. Here the evidence is mixed. There are concerns that over the last five years rates have been systematically too high-with adverse effects on thousands of redundant employees and millions of mortgage-holders. Inflation has been below the 2.5 per cent target for most of the last three years-which suggests rates could have gone lower, faster. Research by Ken Wallis, a Warwick University economist, says the MPC has consistently overestimated the threat of higher inflation.
Wallis calculates that since 1997, the MPC’s one-year forecasts of underlying inflation have been, on average, 0.2 percentage points too high. “The numbers are small and the MPC is still learning,” he says. “But these mistakes have costs, and more accurate probabilities would have made earlier reductions in interest rates more likely.”
Many businesses and trade unions, and even some MPC members, agree with Wallis that rates should be below 4 per cent. British rates, while historically low, are still the highest in the western world. Rates are 1.75 per cent in the US and 3.25 per cent in Euroland.
Underlying this inflation debate is an unresolved dispute about the “new economy” effect. This describes the idea that heightened competition-in markets for everything from food to microchips-has coincided with technology-induced productivity gains and a more flexible labour market to create a new lower-inflation world.
Several proponents of this theory sit, or have sat, on the MPC. The so-called “doves” think the new economy changes mean that the 2.5 per cent inflation target can be delivered at lower interest rates.
DeAnne Julius, the former British Airways chief economist, was the MPC’s first “ultra-dove”-consistently favouring rate cuts until her term expired last year. The doveish cause has since been taken up by other “outsiders,” including Chris Allsopp, an Oxford academic, and particularly Sushil Wadhwani, a City economist.
MPC outsiders past and present privately complain that hawkish insiders have too much influence on the Bank’s inflation forecast, in part because they hog the best research staff. An academic squabble, you might say. But one which many experts say is keeping British rates too high-with adverse effects for debt-holders, growth and jobs. One of these experts is Alan Budd-a founder MPC member, now Provost of Queen’s College, Oxford. Budd generally voted as a hawk, but has since changed his mind. “The performance of the economy has improved,” he says. “This type of change is difficult to detect, and the MPC is divided on it. With hindsight, I think the doves have been right more often than the hawks.”
He goes further, urging the chancellor to break with convention, and re-appoint the dovish Wadhwani when his term expires in May. This possible re-appointment is a hot topic in the City. A Kenyan-Asian by birth, Wadhwani is the only MPC member to have worked for a hedge fund-the highly leveraged, high-stake investment vehicles, which have terrorised the Bank in the past- and he has a “feel” for financial markets. Softly spoken, yet persuasive, he has successfully challenged the Bank’s conventional wisdom. Hence the pressure to reappoint him.
This pressure is growing not least because the interest rate cycle is about to turn. Retail sales growth is at a two-year high and unemployment is falling: the next move will probably be up. MPC hawks point out the dangers of personal indebtedness-with homeowners racking up “equity withdrawals” at record levels.
On the other side of the debate, former chancellor Kenneth Clarke is shifting from a dove to a hawk. He warns that huge amounts of money have been pumped into the world economy, as central banks have lowered rates to avert recession. “I don’t think the rules of economics have changed,” he says, dismissing the “new economy” fad.
When people like Budd and Clarke publicly change their mind, a genuine debate is happening. That is how interest rates should be set-in a transparent manner, after deliberations between policy experts. Five years on, the Bank of England is working well. In a bid to generate credibility, it has perhaps been a bit too hawkish. But the MPC is helping to deliver low inflation and sustained growth-a combination that has eluded Britain for decades.
And what about the euro? If we join the euro, the ECB would decide interest rates not the Bank of England. The MPC would be disbanded and rates would be set with reference to 13 countries. Preserving the new Bank of England, one of New Labour’s great policy achievements, is one reason Gordon Brown is likely to prevent a euro referendum during this parliament.