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Thursday, 6 June, 2002, 07:15 GMT 08:15 UK
Five years on: Rating the MPC
For the past five years, interest rates in the UK have been set independently by the Bank of England's Monetary Policy Committee - ending a long tradition where the Chancellor and the Governor of the Bank of England jointly determined the UK's basic interest rate.
The creation of the MPC has been hailed as the most important decision Gordon Brown ever made, and has now been endorsed by all Oppositon parties as well.
But two broader questions remain: how will the new system help or hinder the UK economy, if it faces a serious recession; and whether such pressures could undermine the independence of the new body.
Much has been claimed of the effectiveness of the MPC - especially compared with its counterparts, the European Central Bank, which sets interest rates across the 12 European countries that have adopted the euro, and the Federal Reserve, the US Central Bank.
Unlike the Federal Reserve, the Bank of England has a fixed target for inflation, which, it is argues, makes it clearer when it will take action, taking away uncertainty.
But unlike the European Central Bank, its inflation target is "symmetrical", and the Bank must pay as much attention to inflation being below as well as above target.
That, it is claimed, means that the Bank of England will ensure that growth as well as inflation is given priority.
Finally, it is said, the MPC explains its policy decisions better than other central banks, publishing the minutes of its meetings just two weeks after they take place, and setting out its thinking in detail four times a year.
In the end, however, the structures only matter if they enhance the credibility of the MPC.
If markets and individuals believe that the Bank will intervene decisively to restrain inflation, they will modify their behaviour - and make the Bank's task much easier.
This has clearly happened in the past five years.
In particular, wage demands have been more moderate than in the past, and companies have not sought to increase prices in response to higher wages.
As a result, the Bank has been able to keep interest rates lower than previously thought despite the low unemployment rate.
Taking the credit
But in some ways, the new system of setting interest rates has not yet been tested.
Inflation has been relatively benign across the whole of the developed world.
And in the UK, the high value of the pound on foreign currency markets has acted as a further check on inflation, as companies tempted to raise prices have been facing cheaper foreign imports.
And the Bank's forecasting model has not worked too well, consistently predicting higher inflation than actually happened, according to retiring MPC member Sushil Wadwhani.
A sudden change in exchange rates, or a continued surge in house prices, could make the Bank's rate-setting dilemma sharper.
No economist is yet clear on how long it takes for interest rates to affect the real economy - and whether the MPC's two year forward look at inflation is realistic.
In the past, other sorts of targets - including money supply and the exchange rate - have been tried and failed as a means of controlling inflation.
Despite the new system, as the Bank of England has admitted, the UK economy is suffering from serious imbalances.
The service sector and private consumption are booming, as evidenced by the house price boom, while exports and the manufacturing sector are stagnating.
"The challenge for monetary and fiscal authorities is to restore domestic demand growth to sustainable levels," said Deputy Governor Mervyn King in a recent speech.
He argues that the "rebalancing" of the UK economy could lead to "considerable movement in the exchange rate, oil prices, and even wages" as resources shift from private consumption into exports and public spending.
This could be quite disruptive, although it is "possible - even likely" that the path to lower growth rates of consumption could be smooth.
The MPC's difficult taks could lead to questions in the future about whether it is sufficiently independent from the government.
Former member Sushil Wadwhani argues that if unemployment starts to rise, questions will be raised about the performance of the committee.
Doubts have already been expressed about the political make-up of the committee, with the Chancellor appointing four of the nine members - for relatively short terms of 3 years each.
In the United States, in contrast, the members of the Federal Reserve board serve for 14 years.
And it is the Chancellor, not the committee, that sets the target - though why he has adopted 2.5%, rather than, say the ECB's 2% target, has never been spelled out.
If the MPC's performance were to falter, there would be more pressure to review these elements, and perhaps to revise the inflation target itself.
And the question of more formal coordination with fiscal policy - depriving the Chancellor of his freedom to plan for the long-term - might also come to the fore.
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