Dr Sentance passes judgement on the Bank of England

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After last week’s shocking inflation figures, savers could be forgiven for being sceptical about Sir Mervyn King’s claims that inflation will soon drop sharply and that deflation is a greater risk than inflation. The direction of inflation was the topic of a talk given last Thursday by Dr. Andrew Sentance, a former member of the Bank of England’s Monetary Policy Committee who often disagreed with the majority opinion. This is a summary of his speech.

The MPC’s remit is rightly to maintain price stability but the MPC has been reluctant to take action to keep inflation to its 2% target. Despite the views of the Bank of England and the MPC, current inflation is not temporary. An increasingly prevalent view is that it is a good thing that the MPC are turning a blind eye to inflation. This is dangerous. Since the early 2000s, CPI inflation has been drifting upwards, albeit with fluctuations while, from 2008-11, it has averaged 3-4%.

The MPC originally did a good job of keeping inflation to target, beginning with the RPIX target of 2.4% (1997-2003) and then the CPI target of 2% (until the end of 2007). Since 2008, however, things have gone awry. The myth that has grown up is that if something happens in the global economy there’s nothing we can do about it. This was not the attitude when the global financial crisis hit. Unfortunately the MPC has a worryingly asymmetric reaction to global phenomena. When global growth rebounded strongly in the second half of 2010 and early 2011, the MPC did not react – as it should have – by tightening policy. As a result, while the average rise in consumer prices in the Euro area and the US since January 2008 has been 7%, in the UK it has been 14%.

UK-specific factors affecting inflation

There are three domestic factors influencing inflation: the drop in sterling; the stubbornness of services inflation; and the limited spare capacity in our economy.

1. Sterling has depreciated 25% since 2007 as measured by its Effective Exchange Rate. This is very dramatic, the biggest downward shift in sterling since 1931 when we came off the gold standard. While some depreciation is warranted, manufacturing is not ultimately helped by manipulating the exchange rate to this degree. This is the old economics which led to the problems of the 1970s. The effects of a weaker pound have still not fully worked through.
2. With goods inflation high, we need low services inflation. But this has been remarkably subborn at about 4% ever since the MPC was founded and has been about 3-5% since 2008, except when VAT was cut. Services inflation will still be about 4% even when the VAT rise drops out.
3. Most seriously of all, the MPC continues to argue that spare capacity will drive down prices. But spare capacity is not exerting the downward pressure it was expected to. Current spare capacity in the economy is not very different to normal while manufacturing capacity is actually above average. Furthermore, the performance of the labour market and unemployment has been better than in the previous two recessions, again indicating less spare capacity.

What’s wrong with the MPC

The MPC has a target for inflation. But it has chosen to interpret the target as its forecast for inflation and these forecasts have been very badly wrong. The MPC places a very heavy emphasis on the output gap above all other factors. As has been said, it has an asymmetric response to the economy. As soon as it weakens, they move quickly to inject more QE yet they are unwilling to counter upward pressure on inflation. The Bank should have raised rates in the second half of last year and early this year but it did not.

There is a lack of scrutiny and accountability of the MPC. The letters between the Governor of the Bank and the Chancellor have become ridiculous. The Governor says that monetary policy targets are to head off deflation and the Chancellor simpy says, “ok”.

MPC forecasts give too much weight to spare capacity. As a result, the target becomes a growth target, not an inflation target. The bank has a poor record of forecasting inflation and does not take enough account of sterling.

On 18th October 2011, Mervyn King said:

“Our objective must be to steer the UK economy slowly back to a position of more normal interest rates and lower budget deficits. With a lower level of sterling and a credible plan to reduce the fiscal deficit over the medium term, we were on track. But the problems in the Euro area and the marked slowing in the world economy have lengthened the period over which a return to normality is likely.”

King talks at length about the objective of monetary policy but not once does he mention the importance of price stability or inflation.

Dr. Sentance concluded with some suggestions for reforming the MPC:

• Strengthen outside members. The Governor has a massive amount of power but there is nobody on the MPC with business experience since Dr. Sentance left.
• The MPC should be held more firmly to account by the Government and the Treasury Select Committee, which is underpowered and insufficiently expert.
• The letter exchange should be made more substantial with statements to Parliament and the Treasury Select Committee hearings.
• There should be a TSC enquiry into the conduct of monetary policy and the Bank’s forecasting record since the financial crisis.
• Forecasting should be separated from decision-taking with an Office for Monetary Responsibility to match the Office for Budgetary Responsibility.
• The Bank of England should stop talking down the pound, as they have over the past couple of years.

 Should interest rates rise?

When questioned afterwards about raising interest rates, Dr. Sentance said he felt now was not quite the right time. “Rather, I would be looking for an opportunity next year when global economies will pick up. I do believe we should have raised interest rates but to make a big U-turn now might be wrong.” He thought, however, that the MPC should be preparing the ground for an interest rate rise. He also made the point that small and medium-sized companies are over-dependent on bank finance.

We often accuse members of the MPC of being out of touch with ordinary people, particularly savers, but that appears not to be the case with Dr. Sentance. When he was on the MPC, he rang his mother shortly after a sharp cut interest rates, only to be told: “I’m not sure I should be talking to you.”

Dr. Sentance will shortly be joining PwC as senior economic adviser. At present, however, he has a website which is well worth visiting.

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6 Comments

1. X

   October 26, 2011 at 10:28 pm

   Looks like the MPC were wrong again. Interest rates should have been given a little nudge upwards earlier in the year to inspire confidence that they were serious in their remit in controlling inflation, and to stop inflation soaring out of control. Too late now.

   Why didn’t they listen to Dr Sentance.

   If the government introduced a savings rate tax of say 10% (real inflation rate – savings rate) how would people react? How would they react if the value of their assets were also taxed at this rate? In effect a wealth tax.

   I bet you’d hear a lot more complaints then. The problem is that inflation has the same effect as a wealth tax. Wealth is being stolen from the prudent. People really need to fight more as their wealth is being stolen right now due to the policies of the MPC and the British government, and after QE round 2 it will only get worse. It does seem that it’s starting to sink in with people though and there are stirrings of anger starting to brew at Mervyn Kings repeated lies.

   Not even the Scandanavian countries under socialist rule had a wealth tax anywhere near what the UK effectively has now.

   Recommend (9)
2. Rob

   October 27, 2011 at 6:33 pm

   On the “What should savers say to the MPC?” topic on your site, I posted this message.

   “The UK will take the route of QE2 and make payments via the IMF to save the Eurozone. In doing so it will effectively be stealing from UK savers to save Eurozone members, Greece in particular.

   This is going to be allowed via the British government.”

   Osborne announced today that the UK will not be contributing to the EU fund, but what he didn’t state is that he IS going to contribute to it indirectly through the IMF.

   He is stealing savers wealth through inflation and handing it over to the EU via the IMF. Mervyn King comes out from time to time to try to scare people from any uprisings and retaliations with his constant lies. I feel ashamed to call myself British when recognised British people like these are stealing from so many fellow Brits and handing the proceeds to the EU whose accounts have not even been audited for the past 14 years. The way I feel right now about King and Osborne, I wish hanging was brought back as a punishment for people like them.

   Recommend (11)
3. frances

   October 27, 2011 at 8:33 pm

   i have totally had it with the whole lot of them
   They and HMRC are a bunch of lying thieves
   not only are they devaluing our savings they are taxing the paltry interest we recieve and to add insult to injury i have to wait till may 2012 to reclaim the tax they illegally withold from me
   i cant use R85s they wont allow the use of R40s or interim R40 and withold nearly 1/5th of my income and refuse to even pay interest on it

   yet if i was self employed i could hold onto the tax due for 14 months
   LITRG are battling to get HMRC to treat pensioners fairly but no we are bludgeoned at every turn

   Recommend (8)
4. John

   November 1, 2011 at 6:38 pm

   What does LITRG mean? I am puzzled!

   Thanks.

   Recommend (0)
5. frances

   November 8, 2011 at 12:05 am

   LITRG = LOW INCOME TAX REFORM GROUP support for all on less than 15 thousand pounds

   yet the government GOUGES tax out of every saver and pensioner at under 10K

   Recommend (3)
6. Lynne

   December 30, 2011 at 11:12 am

   I feel that there is an enormous amount of anger out there, but no real outlet. This site would sadly put many people off. Carols at the Bank??? I can just see the politicians quaking in their boots at the thought of it. “Oh no, not that”, they must be saying.

   We need to organise something more effective. How many people think that a new, more active website with ordinary people contributing, not establishment figures, is needed?

   Maybe some radio buffs could organise something on analogue radio, in preparation for the digital kill switch plan, which is coming soon and which will isolate us further.

   Recommend (0)