When the Bank of England became operationally independent 25 years ago, the Monetary Policy Committee was given the mandate of aiming for a specified inflation target. The first members faced several key questions, not least on the precise way in which they would make decisions on interest rates.
I was appointed to the first Monetary Policy Committee (MPC), assembled after Gordon Brown had given the Bank of England independence in May 1997. We had a mandate from Parliament to try to hit a specified inflation target. But monetary policy instruments work with a considerable lag, so it would be impossible and impractical to achieve the desired inflation target each quarter. The effect of changing interest rates on inflation immediately is so slight that it would require a huge change in interest rates to try to offset a given shock and would destabilise the economy as a result. So, what did the mandate actually imply?
According to econometric estimates now and at the time, the full effect of monetary policy – in the guise of changes in interest rates – on inflation is achieved after about two years. So, our interpretation of the mandate was that we should vary the path of interest rates now, to achieve the forecast inflation targets two years down the line. That same interpretation has, I believe, been generally accepted among most other major central banks.
There were other considerations that the initial MPC had to discuss. The first was the degree of individualism that the separate members of the committee should be allowed, even encouraged, to maintain. One reason for having external members was to avoid ‘group think’. And the then governor, Eddie George, encouraged us to stand up for our own individual views, and be prepared to present and defend them in public.
There are a variety of arguments for and against a more individualistic committee, and there was an exchange of views on the subject in published articles between Willem Buiter and Otmar Issing at the time. In my view, the decision then to maintain an individualistic MPC was, and remains, correct.
In conjunction with that decision, there was an associated need to decide on the precise procedure for reaching a decision on interest rates. If the governor was to speak first, a dissent from his views would be more challenging than if he had not yet revealed his hand. So, the governor then chose to speak last. Similarly, to support fairness and individuality, the procedure for choosing the order of members to give their views was adjusted randomly from meeting to meeting.
Another early decision related to the units of change. There was nothing to stop the committee adjusting interest rates in any number of basis points, as is sometimes done in China. But fairly early on, it was agreed that the unit of change should be 25 basis points. Since then, an asymmetry has seemingly crept into the maximum amount of change depending on whether the perceived crisis is deflationary or inflationary.
In deflationary crises, such as at the onset of the global financial crisis of 2007-09 or the Covid-19 pandemic, there is now seemingly no particular limit to the extent that interest rates may be cut. But in inflationary crises, such as now, there seems to be a limit of 50 basis points to any increase.
Finally, there was a discussion on the role and position of the external committee members. Although initially it seemed that these members might have continued with their ordinary day jobs, it soon became clear that with a very few exceptions, like me, the requirements both of the job and of confidentiality required them to become continuously based in the Bank of England during their period of office.
But if they were to be there permanently, what should they do? They were there initially completely on their own, with no support staff. Although it was felt that they could call on the regular staff at the bank, working for an external committee member would naturally be given less priority by the staff than working for their internal bosses.
So, the external members felt that they did not have enough support to do their allocated jobs as they thought appropriate. The decision was then made to allocate to each external two full-time members of staff: one a more senior economist and the other a more junior official.
I had one main surprise during my period in office. This was that each time we made a current step change in interest rates, this appeared, according to the forecast, to be sufficient to achieve the inflation target two years later. But the very next quarter, it often appeared that an exactly similar change would again be required.
I concluded that for some reason the forecasting process underestimated the effects of various underlying, but changing, trends. The long sequence of similarly sized interest rate changes may have been put in place to avoid large, surprise changes in interest rates. But they demonstrate the inherent limitations, and perhaps constraints, on the forecasting process itself.
