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University of Surrey Discussion Papers in Economics by Christopher Spencer DP 06/06

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University of Surrey Discussion Papers in Economics by Christopher Spencer DP 06/06 råáp=== = = ======råáîÉêëáíó=çÑ=pìêêÉó Discussion Papers in Economics REACTION FUNCTIONS OF BANK OF ENGLAND MPC MEMBERS: INSIDERS VERSUS OUTSIDERS By Christopher Spencer (University of Surrey) DP 06/06 Department of Economics University of Surrey Guildford Surrey GU2 7XH, UK Telephone +44 (0)1483 689380 Facsimile +44 (0)1483 689548 Web www.econ.surrey.ac.uk ISSN: 1749-5075 Reaction Functions of Bank of England MPC Members: Insiders versus Outsiders∗ Christopher Spencer† Department of Economics, University of Surrey Abstract In 1997, the Bank of England was granted operational responsibility for setting interest rates to meet a Government inflation target of RPIX 2.5 percent. As part of the shift towards indepen- dence, operational decisions on monetary policy were delegated to a Monetary Policy Committee. Using voting data obtained from Minutes of Monetary Policy Committee Meetings, I show that as a group, internally appointed MPC members (insiders) on average prefer higher interest rates than external appointees (outsiders). Further, ordered logit analysis demonstrates that insiders and outsiders are motivated by different concerns when setting interest rates, with the interest rate setting behaviour of outsiders being less easy to predict than those of insiders. Keywords: Monetary Policy Committee, insiders, outsiders, voting Contents 1 Introduction 3 2 Relationship to the Literature 4 3 The Monetary Policy Framework at the Bank of England 5 3.1ObjectivesofMonetaryPolicy............................... 6 3.2TheMonetaryPolicyCommittee............................. 6 3.3OperationalIndependence................................. 7 3.4 Monetary Policy Formulation and Voting Arrangements at the Bank . 7 3.5TheDecisionontheinterest-rateinPractice...................... 8 4 MPC Performance Under Sir Edward George 8 5 What Data is the MPC using? 9 ∗Financial support from the ESRC gratefully acknowledged. This paper is based on Chaper 5 of my PhD thesis, “Committee Decisions and Monetary Policy”. Special thanks goes to my principal supervisor, Professor Paul Levine, for invaluable support and advice during my time as a doctoral research student in the Department of Economics at the University of Surrey. I have also benefitted from the comments of Dr. Alex Mandilaras, Professor Graham Bird, Paul Temple and members of the Surrey Centre for International Economic Studies. Finally, thanks goes to Keith Wade and Stuart Block at Schroders Economics (UK) for taking time to discuss their ‘MPC Machine’ with me. The usual disclaimer applies. All comments are welcome. Do not quote without the permission of the author. c Department of Economics, University of Surrey, Guildford, Surrey, UK. ° †Research Fellow, Department of Economics, University of Surrey, Guildford, GU2 7XH, U.K. Tel: +44-1483-68- 2771; fax: +44-1483-68-9548. Email address: [email protected] 1 6 Individual Policy Preferences 10 7 Group Policy Preferences 10 7.1 Are Insider-Outsider Differences Statistically Significant?............... 10 7.2MeasuresofAgreement.................................. 15 8 Estimating Members’ Reaction Functions 19 8.1The‘Blinder’Rule..................................... 20 8.2TaylorRule......................................... 21 8.3BroadInformationSet................................... 23 9 Econometric Results 27 10 Predicting the Votes of MPC Members 29 11 Concluding Remarks 31 12 Appendix 33 12.ATheOrderedLogitModel................................. 33 12.A.1 Marginal Effects for the Ordered Logit Model . 34 12.A.2MeasuringtheGoodnessofFit.......................... 35 12.BTheGMTindex...................................... 37 12.CListofVariables...................................... 39 12.DResultsforGrangerCausalityTests........................... 40 13 Bibliography 41 2 “ThereshallbeacommitteeoftheBank,tobeknownastheMonetaryPolicyCommitteeoftheBankof England, which shall have responsibility within the Bank for formulating monetary policy.”BankofEngland Act 1998, Section 13(1) 1Introduction June 1997 witnessed a landmark change in the conduct of UK monetary policy. In a move towards independence, the Bank of England was granted operational responsibility for setting interest rates to meet a Government inflation target of RPIX 2.5 percent. As part of the shift towards inde- pendence, operational decisions on monetary policy were delegated to a nine member Monetary Policy Committee. It is the interest-rate setting behaviour of this committee1 -morespecifically, the policy preferences of individual members as revealed by the voting record - which forms the basis of this paper.2 Since the inception of the MPC, the voting behaviour of its members is a subject which has received considerable attention in the financial press and news media - attention largely attributable to the publication of voting records shortly after a decision on the interest-rate is taken. Near split decisions often constitute stories in themselves. The Financial Times on 25th January 2001 ran the headline ‘Bank committee voted 5-4 to hold interest rates’, reporting that only the use of the casting vote by the Governor of the Bank, Sir Edward George “prevented the MPC cutting [the] cost of borrowing by 0.25%”. The story also featured an index ranking MPC members according to their degree of ‘hawkishness’, with higher numbers corresponding to a more hawkish voting record.3,4 It is even a subject which has come to the attention of the House of Commons 1 Herafter referred to as the BoEMPC. 2 The decision to shift to operational independence can be interpreted as a means of ameliorating the well known problem of time-inconsistency: taking the decision on the short-term interest rate out of the control of “politi- cians...who might bend it for their electoral ends” (The Economist, September 1997, pp.36-37) should in theory be instrumental in increasing the credibility of, and by implication the success of UK monetary policy. However, us- ing the criteria for measuring the degree of independence of a central bank developed by Grilli, Masciandaro and Tabellini (1991) - hereafter referred to as GMT - it is possible to see that the shift to operational independence has not drastically increased what they define as the level of ‘political’ independence afforded to the Bank - a measure associated “with how the members of the central bank board are appointed, its relationship with government and its responsibilities” (see Table A.2 in the Appendix for clarification of this point). This is echoed in the words of Buiter (2002), for whom “Even operational independence is qualified in the case of the Bank of England...Any form of pressure by the government on the MPC to change its behaviour, other than a public, and properly enacted, change in its mandate, would violate both the spirit and the letter of operational independence. There has not been a single instance of such pressure in the first three years of the MPC’s existence.” In other words, it is not implausible to suggest that the operational nature of the independence granted to the Bank is not in itself a guard against undue political influence. Indeed, commentators of more cynical leanings may, after close scruting of the Bank of England Act 1998, conclude that the monetary policy framework enjoyed by the Bank is potentially susceptible to political manipulation. This may be in spite of the relatively high degree of economic independence enjoyed by the bank, which to employ GMT’s terminology concerns the ability of a central bank to use the instruments of monetary policy without interference from governmental bodies or institutions. In the case of Bank of England, this corresponds to the ability to pursue the inflation target unimpeded. 3 It is also possible that changes in voting patterns may yield information about how interest rates will move in the future. This avenue of research is not pursued here. See Andersson et al (2001) and Gerlach-Kristen (2001) for applications to the Executive Board of the Swedish Riksbank and BoEMPC respectively. 4 It is noteworthy to add that such interest in the voting record is not confined to the case of the Bank of England MPC. The composition and voting record of the United States Federal Open Markets Committee (FOMC) generates similar interest, where to quote Haubrich and Humpage (2001) “Newspapers and financial magazines can be counted on to count up the “hawks” and “doves” whenever a new member is appointed or the next batch of reserve bank presidents rotate on the committee.”p.3 3 Treasury Select Committee, to which the MPC is partially accountable. The following exchange between George Palmer MP, Member of the House of Commons Treasury Select Committee, and RichardLambert,externalmemberoftheMPC,reflects this assertion: George Palmer: “It is known that there has been widespread speculation over the years that the Bank staff are more hawkish on interest rates than the independent members of the MPC. In May [2003], the five Bank staff all voted to maintain rates and the four independent members all voted to reduce rates. The probability of this happening by chance 0.019%. Do you think that there was in fact a coincidence?” Richard Lambert: “I am not sure I really properly understand the question. It seems to me, looking at the minutes, that here were nine people: four came to one conclusion and five came to another. I did not get a sense from the minutes that their internalness or externalness had a bearing on the outcome.”5 (emphasis added) In this paper, evidence is presented demonstrating that ‘internalness’ and ‘externalness’
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