The Difficulty of the MPC's Monthly Decision

The Difficulty of the MPC's Monthly Decision

  1. Is it the right objective? The MPC's one and only objective is the control of inflation. In the USA, the equivalent body (the Federal Reserve) has to control inflation and consider other important objectives, in particular the rate of growth of the economy. This is significant. Any old fool can keep inflation low by keeping interest rates high, but this causes unemployment and recession. So, although the MPC have their eye on inflation, unofficially they have to consider how their decisions will affect the whole economy.
  2. Lots of conflicting information. The rate of interest affects many things. The information that the MPC receives every month is varied and often contradictory. The decision is difficult. How do the committee members vote if average earnings are rising (causing cost-push inflation) but the value of the £ is high (bearing down on inflation via lower import prices)? In fact, for most of the life of the MPC, the value of the £ has been higher than most exporting manufacturers would like. They have only raised rates when other inflationary evidence out-weighs the deflationary effect of the strong £.
  3. Incorrect information. The MPC are only as good as the information they receive. The MPC inherited a base rate of 6% in May 1997. They felt that rates had stayed too low for too long (perhaps the previous government kept them low to increase their chances of being elected?) so they raised by a quarter of one percent in May, June, July, August and November until they stood at 7.25%. They stayed at this rate for half a year. Then some information came out stating that average earnings were rising at an annual rate of over 5%. The previous month's figure had been well below 5%. The MPC increased the base rate to 7.5%. A few months later it was found that this information was wrong, and that the annual rate of increase of average earning had not risen above 5%. The MPC cut rates back to 7.25%. This statistical error was very damaging to industry who rely on lower interest rates for a lower value of the £ and for investment purposes.
  4. Time lags. Most economists agree that a change in the base rate will take anything up to two years to fully feed through the economy. Whilst some effects are relatively short term (banks and building societies tend to change the mortgage rate within a couple of months), others are much more long term in nature. For example, cuts in the interest rate make house buying more attractive. But buying a property is time consuming. The spending on house improvements that tends to follow will obviously happen even later. And then there is the multiplier effect to think about. The MPC publishes an inflation report every quarter in which they summarise the state of the economy as they see it and make forecasts for inflation for the next two years. In they think that inflation is likely to be higher than 2.5% at some point during the two years that follow a report, it is likely that interest rates will rise shortly.

Generally, the MPC has to assess where the economy is going over the next two years, which, in turn, will help them to gauge where inflation is going.

If they think the data points to an inflation rate of over 2.5% some time over the next two years, they will vote to raise the base rate. If the data points to an inflation rate of under 2.5% some time over the next two years, they will vote to lower the base rate. Otherwise, they will vote to leave the base rate as it is.

Remember, the nine members may disagree as to what the data is saying, so different members may vote in different ways. It is the majority decision that counts.

Here are the different pieces of information that the MPC have to mull over each month.

  1. Average earnings growth. This one is very important. Wages make up something like 70% of GDP, so if earnings are growing quickly, costs will be growing quickly and it is quite likely that firms will begin to raise their prices. It was the inaccurate earnings growth figures that convinced the MPC to raise rates in June 1998.
  2. Business optimism. There are often surveys (especially from the Confederation of British Industry, or CBI) gauging the confidence of businesses. This is a popular piece of information because it tells the MPC how businesses are feeling at that moment. Official statistics are often a bit out-of-date.
  3. Consumer confidence. Like the business optimism one above, this is found using surveys. Again, this is popular because of the 'up-to-date' factor.
  4. The housing market. After the experience of the late 80s, an economist would be unwise to ever take their eyes off the housing market. When the housing market is booming, not only will there be increased spending on DIY things, furniture and other home improvement products, but those who already own a home can borrow against the increased value of their home and spend well in excess of their annual income. They could extend their house, go on an expensive holiday or buy a car. For those who dont have a home, they can find agents from sites such as Propertywide.co.uk to get them started. Of course, a declining housing market can work the other way. Some economists believe that the booming housing market of the late 80s was the main reason for the boom and subsequent inflation. When the bottom fell out of the market as interest rates rose to 15%, the economy went with it. When the housing market went bad, the economy went bad!
  5. The value of the £. When the £ is strong, exports become relatively more expensive and imports become relatively cheap, and vice versa. In terms of keeping inflation under control, the MPC would rather the £ was strong, but this can cause exporting firms to go bust creating many unemployed workers. The story of much of 2000 was that many economic signals pointed to higher interest rates, but the strong £ tended to cancel them out. Also, remember that higher rates would make the £ rise even higher. If the £ had been at a lower level during that year, interest rates would definitely have risen.
  6. Input prices and factory gate prices. Input prices include fuel and raw materials. The factory gate prices are, quite literally, the prices of goods, on average, as they leave the factory gate. These pieces of information are useful to the MPC because they give you an idea of future inflation. If input prices were rising, then, after a time lag, one would expect factory gate prices to rise. This should eventually lead to a rise in retail prices in the shops.
  7. The main economic statistics. There are numerous other statistics that the members of the MPC will have their eye on. The actual inflation rates, real growth rates, unemployment rates, employment growth rates, export volumes and many others. Many of these, though, give information about where the economy was a month or two ago. The MPC needs to know where the economy is going. The other five pieces of information above tend to be more up-to-date and, in many cases, better at helping them predict future changes in the economy.

Why the MPC is a good idea

  1. The lack of political influence. The lack of political influence has given the MPC more credibility, and without having to think about getting re-elected, they are more likely to make the right decisions. The MPC can think of the long term rather than worry about short-term political goals.
  2. Evidence from abroad. Independent central banks around the world tend to be more successful and more credible, keeping inflation low with sustainable growth rates (the Federal Reserve in the USA has been particularly successful). The fact that independent banks keep inflation lower means that people begin to believe that inflation will stay relatively low over the long term, and so their inflation expectations fall.

Why the MPC is not so good

  1. Lack of accountability. Detractors argue that the setting of interest rates is second only to fiscal policy in terms of importance, and so should be in the hands of democratically elected, accountable politicians.
  2. Short-term reactions. As we saw earlier, the MPC can act incorrectly in response to inaccurate short-term data, but then the government could do that as well.
  3. Is the Bank of England an 'inflation nutter'? Some argue that, even though the target has been set so that very low inflation is as bad as very high inflation, the Bank of England unofficially prefer to under-shoot the 2.5% inflation target, and so they might keep interest rates higher than they otherwise need to be. This might lead to higher unemployment than is necessary and perhaps lead the economy into an unnecessary recession.
  4. Who should set the target? Should the MPC be able to set the inflation target as well as the rate of interest, as the European Central Bank (ECB) does? Opinions are divided about this one. Are the members of the MPC more qualified to set the target? Probably, but the government are accountable to the people; the MPC is not.
  5. Membership of the MPC. Finally, some argue that the idea of the MPC is good, but the cross-section of the members should be different. Perhaps there should be less Bank of England placemen and more independent economists who have experience of the real world.

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