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The remit - Central Bank of Iceland

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					Monetary Policy in Practice:
    What the journals do not say

            Mike Wickens

Specialist Adviser to the House of Lords
      Economic Affairs Committee
                  and
           University of York
          Some assumptions
Monetary policy is conducted
• using inflation targetting
• by an independent central bank
                 The remit
Who should determine the remit?

 Government
 Central Bank
     Bank of England Act 1998
“In relation to monetary policy, the objectives
    of the Bank of England shall be:
(a) to maintain price stability, and
(b) subject to that, to support the economic
    policy of Her Majesty’s Government,
    including its objectives for growth and
    employment
           Additional features
• Central target of 2.5% defined in terms of RPIX
  (consumer prices less mortgage interest payments)
• To maintain inflation within 1% either side of
  2.5%
• Failing this, the Governor must write an open
  letter to the Chancellor to explain why inflation is
  outside the band and how this will be rectified
The Monetary Policy Committee
• The Bank had to constitute the MPC to make the
  interest rate decision
• Five members of the MPC are ex-officio as
  employees of the Bank
  -   Governor
  -   Deputy Governor
  -   2 Executive Directors
  -   Chief Economist
• Four external members appointed by the
  Chancellor
          Issues about the MPC
•   Who is really responsible: MPC or Chancellor?
•   How should external members be chosen?
•   Does conflict of interest affect the choice?
•   Accountability- credibility – transparency
•   Effectiveness of
    - Quarterly Inflation Report
    - Monthly Minutes
• Voting arrangements
• Communications between
    - the Governor and Chancellor
    - MPC and Government
• What is the role of the Court of the Bank of
  England?
              The objective
 Strict or flexible inflation targetting?
 What does “subject to that” mean?
 Should the following be taken into account
  -   Output
  -   Unemployment
  -   Exchange rate
  -   Asset prices
  -   House prices?
            Inflation target
• Should RPI, RPIX or HICP be the measure?
• What value should the central inflation
  target take?
• What sort of band is appropriate?
  - Should the band be symmetric?
• Should the Bank aim to be above as often as
  below target?
                   Timing Issues
• Over what horizon should the Bank target
  inflation?
• Should inflation always be kept within the band no
  matter the consequences for interest rates?
• What shocks should be offset and what
  accommodated?
  - demand v. supply shocks
  - domestic v. foreign shocks
  - real v. nominal shocks
  - temporary v. permanent shocks
           Forecasting Issues
• Response lags imply forward-looking objectives
• Forecasts or projections?
  - constant interest rates over forecast period
  - should MPC give a Fed-type “bias”
• Need for an inflation forecasting model
  - one model for all (eg Bank’s)
  - each MPC member makes own forecasts
  - independent forecasts
• How to forecast the exchange rate?
      Transmission mechanism
MPC ranking
1. Market rates
2. Asset prices
3. Expectations
4. Exchange rate

BOE model: in the first year the exchange rate
   accounts for 80%
     The interest rate decision
Why do MPC members differ in their views?
 - different forecasts?
 - different view of transmission
 mechanism?
 - how much should be revealed in the
 Minutes?
          Rules v. Discretion
• Which should the Bank use?
• Theory says a backward-looking rule is best
  as it reduces the variances of both inflation
  and output
• But who said…….
Some quotations
 “I do not think there is any rule which anyone has
  proposed which would be a feasible rule, in the sense
  that anyone would credibly believe that the MPC
  would literally work month in, month out, without
  deviating from it”
 “…whatever rule one could think of today as being the
  best rule, would be superseded by a better rule six
  months down the road”
 “If your rules keep changing all the time it is not a rule
  and it looks like discretion.”
   Some more quotations
 “What a Taylor rule does is essentially to say that if
  inflation is, or looks like it is going to be, above the
  target, and if growth is accelerating above the trend,
  that is the time you should be raising interest rates.
 If inflation is below target, or looks as if it is going to
  move further below target, and output is below trend,
  that is a time when you might be reducing interest
  rates.
 Now that is more like commonsense than a rule.
 From that point of view…the most successful central
  banks appear to have been following a Taylor rule,
  even if they had never heard of such a rule in the first
  place.”
Source of quotations

Mervyn King

Evidence to the House of Lords Select
Committee on the Monetary Policy Committee
of the Bank of England

23 February 1999
                The Record
• For nearly three years
  - Inflation was below forecast and central target
       (see graph)
  - Output above forecast
• Question:
  - would a correct inflation forecast have led to a
  lower interest rate?
  - would a higher output forecast have led to a
  higher interest rate and hence a larger inflation
  forecast error?
• What can explain the error?
  - positive supply shocks (eg productivity shocks)?
                          UK Inflation 1990-2003

12

10
                Inflation targetting begins
8
         RPIX
6

4
        RPI
2

0
 1990   1992         1994            1996     1998   2000   2002
            The Record cont.
• Goods and services inflation diverged
  - goods inflation rose
  - services inflation fell
• House price inflation was very high
• Large structural imbalances
  - regional inflation differences
  - industry output differences

• Can anything be done about this?
  - first, consider EMU
    Should the UK join EMU?
• Giving up a successful policy?
• Convergence is not the only issue
• The EMU system is non-sustainable in its
  current form
  - one-size fits all interest rate policy
  - Stability and Growth Pact

				
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