Credibility is seeping away from the Bank of England’s Monetary Policy Committee. The minutes of its latest meeting released last week revealed fundamental differences of view at best and muddle at worst within the committee. They showed that three of the nine votes cast were in favour of a change in policy.
Despite modestly positive news on the economy and inflation projected to remain above target for more than two years, two MPC members including the governor shifted their voting positions towards more quantitative easing. This was unexpected.
Sir Mervyn King’s vote seemed inconsistent with a recent speech that warned about the limitations of monetary policy. Paul Fisher, executive director of the bank, voted for £25bn additional gilt purchases, contradicting his previous view that such a small amount was “neither here nor there”.
While there is considerable debate among economists about the effect of QE on growth, there is virtual unanimity about its effect on the exchange rate. The split vote indicated a higher probability of future QE and sterling duly fell when the vote was announced. It fell even further later in the week when the credit rating agency Moody’s downgraded the UK’s rating from triple A to Aa1.
The Group of Eight countries solemnly maintain that they are not using their monetary policies to target their exchange rates. Yet coded references to the need to rebalance the British economy towards manufacturing and exports repeatedly crop up in MPC members’ speeches. Perhaps the support for more QE was a tactical ploy to weaken sterling without buying more gilts. If so, it succeeded.
However, it is more likely that the split reflects a strategic realignment within the MPC. The minority voters are stronger believers in the positive effects of QE – at least through the exchange rate channel – and less concerned about the persistence of inflation than are the majority.
Unfortunately the MPC’s inflation forecasting model provides little help with such questions. It portrays inflation in the conventional way as the result of imbalances between demand and supply. The latest minutes show that the committee has side-stepped this problem by judging “that demand and effective supply were likely to continue to move reasonably closely together. That implied that some of the uncertainties around the outlook for GDP growth should have only limited implications for spare capacity and hence inflation.”
No wonder the markets are confused when the main communication vehicle of the MPC – its published inflation report – no longer provides guidance on the key issues it is debating.
When Mark Carney takes over as BoE governor in the summer, the strategic debate within the MPC is likely to intensify. At his confirmation hearings, Mr Carney repeatedly stressed the importance of good communication with the markets and his belief that a flexible inflation-targeting regime could be consistent with long periods of above-target inflation.
If sterling continues to fall on the expectation of further QE, the inflation provoked by the devaluation will present a tough communication challenge for the new governor, especially if the Treasury has launched a review of the monetary policy remit. Even undeclared currency wars carry big risks.
The writer is a former member of the Monetary Policy Committee of the Bank of England