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Musings on the Monetary Policy Committee
In the middle of each month a document of around 14 pages lands on my desk, adding to my reading pile. The document in question is the minutes of the monthly Monetary Policy Committee meeting which are published two weeks after the meeting takes place.
The publication of these minutes arises from Gordon Brown's decision when Chancellor to make the Bank of England independent and also make them responsible for meeting a set inflation target.
The inflation target, as measured by the Consumer Prices Index (CPI), was set at 2% per annum +/-1%. The tool that the Bank of England was given to control inflation was interest rates. Thus, we saw the end of cynical Chancellors manipulating bank base rates in budget speeches shortly before a general election in order to 'entice' the electorate to continue to support them.
Equally interestingly though is that the government (quite rightly) retained responsibility for fiscal and hence taxation policy. This then gives the Bank of England an ongoing dilemma. The use of interest rates to control inflation is not a tool which can act quickly on an economy and so a reasonable amount of foresight and forecasting is required which is inherently an inaccurate science in the world of economics.
On the other hand, changes to taxation policy can have relatively quick impact on the annual rate of inflation as we have seen recently with the increase in VAT, as well as the fall and rise in VAT undertaken by the precious government.
Consequently we have seen a government policy have a significant impact on the rate of inflation within two months or so of it being announced whilst the Bank of England only have an interest rate tool to try and counter that inflationary impact over the medium term.
It is not really possible to gauge and understand the strategy being adopted by the Bank of England through the reading of just one months set of minutes. Rather, this picture can be built up through the reading of consecutive documents over a number of months.
It has been particularly interesting to read the deliberations of the Monetary Policy Committee during the credit crunch and beyond. We have seen the implementation of the Quantative Easing (QE) experiment alongside the slashing of interest rates to the historic low level of 0.5% which has been in place for quite some time now.
Reading the Monetary Policy Committee meetings over the last two or three years some interesting observations to be made with regard to their approach strategy. The QE experiment which led to some £200 billion being pumped into the banking system by the Bank of England was, as we know, an economic experiment. It is quite clear from the commentary during the period that the money was being put into the market and in the subsequent months that the committee were expecting to see the amount of money in the economy increasing by a reasonably similar amount. However, this materially failed to happen.
The Committee were unable, or unwilling, to explain in their minutes why this had happened or indeed exactly where the money had gone.
This leads us on to an interesting area of speculation with regards to the future unwinding the QE programme. In essence what has happened is that the Bank of England bought short dated gilts from the banks in order to provide them with liquidity. Thus it is entirely possible that the Bank of England will merely wait until the short dated gilts expire naturally to get their money back rather than embark upon a process of selling the gilts back into the market. This would seem to be the most likely approach although the committee has been notably silent on this point.
What is not clear is what might happen if they do decide to sell gilts back into the market with regards to the money supply. Just because we didn't see the money supply increase when they bought the gilts does not necessarily mean that the money supply will not decrease if the Bank sells them back into the market. That is the problem with experiment - you are never entirely sure what the outcome of a particular action will be.
The committee also have a very close eye on the money markets. On numerous occasions they have considered what the market was expecting them to do with regards to interest rates - both as an immediate decision as a result of their monthly meeting and indeed a longer-term expectation. It is clear from the commentary within the minutes that the Bank of England has on occasion done what the market expected it to do and one wonders whether or not this position has been justified by the positioning of the way the minutes were written rather than necessarily what the members of the committee actually felt. Certainly during the height of the credit crisis there was no doubt that the Bank of England wanted to avoid giving the markets anything other than what they expected in order to reduce the impact of any short-term shocks with the markets.
We also have the rather vexed issue of inflation. As I said earlier the committee have a responsibility to achieve a 2% inflation target and we are well above that target at the moment. Again the minutes and commentary are enlightening. The committee feel it is their duty to get back to the 2% inflation target in the medium rather than the short-term and to some extent will let one-off inflationary factors such as VAT rise play themselves out over the course of a 12 month cycle.
What they are not trying to do is to achieve an average rate of inflation over an economic cycle. Thus, where we have a period of inflation in excess of the target the committee are not looking to try and achieve a period where inflation is below that target level in order to give us a economic cycle average of the target 2% rate.
Thus, unless we have a sustained period of low or zero inflation we will see that average inflation over the current economic cycle will be above the government's 2% target.
This presents interesting challenges for all those involved in financial planning with regards to anticipating future client specific inflation. It seems to me that one would do well to assume a higher rate of inflation rather than optimistically rely on the Bank of England achieving its inflation target on a regular and consistent basis.
So, there we have it. The Bank of England England committee has a relatively blunt tool to influence and control an inherently difficult economic factor with regards to predictions in a manner that will not upset the markets and at the same time knowing that their lords and masters in the government can inadvertently act in an opposite direction with regard to their tax policy over which the Bank of England clearly has no control.
And one final point to consider. The inflationary target the Bank of England is working to was a Labour government target set by Gordon Brown. Perhaps this will be the only aspect of Gordon Brown's economic policy that the current incumbent at Number 11 Downing Street will seek to continue with!
February 2011
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