HOUSE OF LORDS Select Committee on Economic Affairs 1st Report of Session 2006–07 The Current State of Monetary Policy Report with Evidence Ordered to be printed 12 December and published 18 December 2006 Published by the Authority of the House of Lords London : The Stationery Office Limited £price HL Paper 14 The Economic Affairs Committee The Economic Affairs Committee is appointed by the House of Lords in each session with the orders of reference “to consider economic affairs”. Current Membership The members of the Economic Affairs Committee are: Lord Kingsdown Lord Lamont of Lerwick Lord Lawson of Blaby Lord Layard Lord Macdonald of Tradeston Lord MacLaurin of Knebworth Lord Oakeshott of Seagrove Bay Lord Paul Lord Sheldon Lord Skidelsky Lord Turner of Ecchinswell Lord Vallance of Tummel Lord Wakeham (Chairman) Information about the Committee The reports and evidence of the Committee are published by The Stationary Office by Order of the House. 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Committee Office, House of Lords, London SW1A 0PW The telephone number for general inquiries is 020 7219 4568 The Committee’s email address is [email protected] CONTENTS Paragraph Page Introduction 1 5 The current state of inflation 4 5 Inflation and the labour market 6 6 Inflation and money growth 11 7 Figure 1: UK Inflation and Money Growth 1985–2006 7 Inflation and asset prices 14 8 Monetary and fiscal policy 20 9 External appointments to the MPC 27 10 Conclusions 31 11 Appendix 1: Economic Affairs Committee 12 Appendix 2: List of Witnesses 13 Appendix 3: Call for Evidence 14 Oral Evidence Mr Mervyn King, Governor of the Bank of England Ms Rachel Lomax, Deputy Governor of the Bank of England Sir John Gieve, Deputy Governor of the Bank of England Ms Kate Barker, External Member of the Monetary Policy Committee Professor David Blanchflower, External Member of the Monetary Policy Committee Oral evidence, 31 October 2006 1 Written Evidence Professor Ray Barrell and Ms Rebecca Riley 12 Professor Jagjit Chadha 15 Professor Tim Congdon 16 Professor Charles Goodhart 28 Mr E J A Haygarth 29 NOTE: References in the text of the report are as follows: (Q) refers to a question in oral evidence (p) refers to a page of written evidence The Current State of Monetary Policy Introduction 1. This is the fourth report of the Select Committee for Economic Affairs on the work of the Monetary Policy Committee (MPC) of the Bank of England. The previous reports were published in 2003, 2004 and 20051, and before this the Select Committee on the Monetary Policy Committee of the Bank of England, the predecessor to this Committee, published reports on monetary policy in 1999 and 2001.2 2. This report covers the main features of monetary policy for the twelve month period since November 2005. It is based mainly on evidence given to the Committee by Mervyn King, Governor of The Bank of England, and four other members of the MPC in October 20063, on the Inflation Reports for 2006, and on the Minutes of the MPC. The Committee invited written evidence on the current state of monetary policy. The report also takes account of this. 3. Over the last twelve months the Bank’s repo rate was raised by 25 basis points on two occasions, in August and November 2006. At the end of the year it stands at 5%. The August increase was the first change in the official interest rate since August 2005, when it was cut by 25 basis points to 4.5%. On neither occasion was the MPC unanimous in its decisions. In November two members of the MPC (David Blanchflower and Rachel Lomax) voted against the increase, preferring to keep rates constant. In August only Professor Blanchflower voted against the rate increase. In November the majority took the view the prospects for demand were strong due to rising money growth, equity and house prices, and to falling long-term interest rates. Those who voted against an increase thought that falling energy prices and slack in the labour market would allow the economy to continue to grow without threatening inflation. The current state of inflation 4. The estimated rate of Consumer Price Index (CPI) inflation for October 2006 is 2.4%. This compares with 2.3% twelve months ago, in October 2005. In between, inflation fell to 1.8% in March 2006 and has climbed slowly since then. Although this level of inflation is high compared with recent inflationary experience, it is well within its permitted range of 1–3%. The central projection for inflation in the November Inflation Report is that it will continue to rise until the end of the year before reverting rapidly to 2%. 1 Select Committee on Economic Affairs, 2nd Report (2002–03): The MPC and Recent Developments in Monetary Policy (HL 66); Select Committee on Economic Affairs, 3rd Report (2003–04): Monetary and Fiscal Policy: Present Successes and Future Problems (HL 176-I); 4th Report: The Current State of Monetary Policy. 2 Select Committee on the Monetary Policy Committee of the Bank of England (1998–99, HL 96-I); Select Committee on the Monetary Policy Committee of the Bank of England (2000–01, HL 34-I). 3 Kate Barker, David Blanchflower, Sir John Gieve and Rachel Lomax. 6 THE CURRENT STATE OF MONETARY POLICY 5. Given the uncertainties twelve months ago associated with the potential effects on inflation of higher oil prices, which increased by nearly 25% in the year ending July 2005, the inflation outcome may be regarded with some satisfaction. Two major contributory factors in this success have been the fall in the prices of oil and gas in recent months. The price of oil fell by 23% between August and November 2006 while, since the beginning of the year, the price of gas fell by roughly 60%. Inflation and the labour market 6. The main concerns for inflation noted in the Inflation Reports published in 2006 were the possible effects on wage claims of the higher rate of inflation— especially Retail Price Index (RPI) inflation, on which most wage claims are based—and the degree of slack in labour markets, the effect of university tuition fees and the double digit rate of growth in the money supply. 7. In his evidence to the Committee, the Governor said that his greatest concern was the balance between demand and supply, particularly the uncertainties on the supply side. His single biggest uncertainty was the size of the labour force. He said: “We just do not know how big the population of the United Kingdom is and, because the composition of the population and its split between different groups of workers, young versus old, migrant workers versus normally resident workers, have changed in recent years, it may well be that some of the statistics we are using are not giving a very accurate reading”. One example he gave was the measure of unemployment on the claimant count which he said: “…may be an accurate measure of the unemployment statistics for those claiming unemployment benefits, but ignores the large chunk of migrant workers who have not yet qualified for unemployment benefit.” As a result he thought that this measure of unemployment may be an understatement. He contrasted this measure with the Labour Force Survey measure of unemployment which he thought: “…may be overstating unemployment because the statistics, although purporting to be drawn for the economy as a whole are drawn from sample surveys which are then aggregated up to a national total using estimates of the population which may well be out of date and inaccurate.” (Q 2) 8. Commenting on the implications for the MPC of inaccuracies in the unemployment statistics, Mr King explained that the MPC uses the rate of unemployment as a quantitative indicator of the pressure of demand on capacity in the labour market. If the measure of unemployment is biased due to not having a good estimate of the total population then this would affect their judgement about the pressure of demand on capacity. He said that this was the basis of the MPC’s uncertainty about “why a very tight labour market was not in fact pushing up wages.” (Q 9) 9. In a further comment, Mr King said that it was not entirely clear to the MPC whether wages had fully taken on board the adverse shocks to the terms of trade resulting from the increase in oil prices. He said “the question was whether firms will need to raise prices relative to costs in order to get back to a position in which it remains profitable to produce output.” (Q 2) 10. Clearly, unmeasured migration makes it difficult to estimate the amount of spare capacity in the economy. But this may be less true for the balance of the labour market, where statistics can give fairly consistent month-to-month measures of the changing balance of supply and demand in the (mainly non- THE CURRENT STATE OF MONETARY POLICY 7 migrant) labour force. Nonetheless, we accept that these are valid matters of concern for the MPC, not least because differences of opinion about the tightness of the labour market have been identified in the Minutes as one of the main reasons why members of the MPC have voted differently on interest rates.