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Dr Sentance passes judgement on the Bank of England
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.
- 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.
- 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.
- 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.