LONDON – New Bank of England Monetary Policy Committee member
Martin Weale gave the following statement on monetary and economic
policy to the Treasury Select Committee Tuesday.

MONETARY AND ECONOMIC POLICY

Q: How might the system of control over monetary policy in the UK
be improved? Is the framework of an explicit symmetrical inflation
target the best within which to conduct policy? Has the MPC been given
an appropriate inflation target?

A: Since the banking crisis it has been recognised that the overall
policy framework needs to cover more than simply the use of the interest
rate to control inflation. The crisis demonstrated that the framework
also needed to pay attention to credit expansion and its implications.
It showed the risks that could arise if credit became over-extended even
if inflation showed no obvious sign of getting out of control. The
policy framework in place until the 1980s had other instruments such as
credit controls and special deposits which made this possible and, with
the establishment of the Financial Policy Committee it is likely that
related instruments, perhaps variable capital ratios for banks, will be
adopted.

This raises the key issue of the relationship between interest rate
setting by the Monetary Policy Committee and the use of other policy
instruments by the Financial Policy Committee. With the FPC likely to
meet less frequently than the MPC and with a substantial overlap of
membership, it makes sense for the MPC to set policy taking the FPCs
decisions as a given, but also being aware of how the FPC is likely to
respond to any policy changes made by the MPC. This should minimise the
risk of a lax attitude being adopted to the risk of a future financial
crisis because of a perception that economic activity was weak. Such a
problem would be more likely to arise if the decisions of the FPC and
the MPC were taken by a single body.

I am firmly of the view that an explicit symmetric target offers
the best framework within which to conduct interest rate policy. If
there were simply an upper limit then the MPC might be tempted to hold
inflation so low that it would become difficult for relative wages and
prices to adjust without fairly frequent downward movements.

The fact that people’s expectations of inflation are broadly
consistent with the inflation target is itself a strong reason for not
changing the target. In particular, any increase in the target would
deliver only transient benefits for the public sector, in terms of an
inflation-induced abatement of the national debt. But the costs in terms
of loss of policy credibility would be substantial and long-lasting and
overall, there is no good case for any change to the inflation target.

Q: What consideration should be given to the exchange rate and to
asset prices, including house prices, within the framework for inflation
targeting? In particular, how should monetary policy react to asset
price bubbles

A: The logic of the inflation targeting framework is that
consideration should be given to the exchange rate and house and other
asset prices only to the extent that they provide information about the
future path of inflation. The route by which the exchange rate
influences inflation is well understood even if not, as recent
experience has shown, precisely understood; it operates both as a direct
driver of prices and as an influence on demand. Other asset prices
including house prices work through the second route. Since housing
costs do not as yet have an explicit role in the Consumer Price Index1
they have at present no direct influence on measured inflation.

This analysis suggests that the MPC should look at asset prices
insofar as they are relevant to the task of controlling inflation.
Should the MPC look at them for any other reason? One valid reason would
be that misalignments could make the eventual task of controlling
inflation harder over and above the influence of asset prices at the
two-year horizon. But this is the sort of point that the FPC might be
expected to address since its remit includes responding to imbalances,
risks and vulnerabilities in the financial system. Certainly, since the
MPC has only one instrument, the interest rate, it would have to
sacrifice control of inflation at the two-year horizon if it were to
allow such considerations to influence its interest rate setting. My
view is that policy broadly defined should react to asset price bubbles
by policy tightening, but that it is unlikely that the interest rate is
the appropriate financial instrument to use for this purpose and
therefore this is not likely to be an issue for the MPC.

Q: What is your current estimate of the extent of the output gap?

Output may be as much as 10% below the level that it would have
been on had the crisis not occurred, but capacity utilisation rates
implied by surveys appear to have fallen by less than implied by this
fall in demand. This suggests that there has been some decline in the
economys supply capacity. Effective supply capacity is likely to have
been impaired by the impact of tight credit conditions. Restricted
access to credit may have made it more difficult or expensive for
companies to access the working capital required for day-to-day
operations. The lower level of investment has reduced growth in the
capital stock and in turn supply growth. The increase in company
liquidations may have also led to some capital being scrapped as
businesses became insolvent, although liquidations rose by much less
than in the early 1990s recession.

The output gap is not directly observable, so the extent of the gap
is uncertain. The high level of unemployment suggests there is
considerable spare capacity in the labour market. Survey evidence also
suggests that a significant degree of spare capacity has opened up
within companies in the recession as the chart below, taken from the
August Inflation Report, shows. There are tentative signs that the
margin of spare capacity within companies is starting to close as demand
recovers, although capacity utilisation remains below historical average
rates. The Office for Budget Responsibility suggests the output gap is
currently around 4% of GDP this seems a plausible number although at
the same time it is important to remember that all experience shows that
contemporary estimates of the output gap are highly uncertain and often
subject to substantial revision after the event.

Q: What do you regard as a sustainable household saving ratio?

A: The sustainable household savings rate cannot be identified in
isolation but depends on what is going on the rest of the economy.
Sustainable saving can be defined as the rate of saving thought
necessary to deliver future consumption levels in line with people’s
reasonable expectations. But a high level of business or government
saving reduces the need for household saving as is discussed further
below.

Saving is probably strongly motivated by a desire for people to
provide for old age; the extent of the saving that households need to do
to meet their reasonable expectations of consumption in old age depends
on other arrangements such as state pensions which exist for old people.
But the provision of state pensions to old people has to be financed by
young people unless it is properly funded. If the reasonable consumption
expectations of both old and young people are to be met, then they
should be funded by means of state saving as a complement to household
saving. The need for household saving also depends on the way in which
those businesses in which savings are invested behave. If they
distribute all of their profits to households then households will need
to save more than if businesses retain a significant proportion of their
profits leading to likely future growth of dividends.

If, which is reasonable, both government and business saving are
seen as being conducted on behalf of households, it follows that the key
to sustainability is not household saving but national saving, the sum
of these components. My own past work suggested that a savings rate net
of depreciation of just over ten per cent was needed to ensure that the
economy could afford a consumption pattern growing in line with the
underlying growth rate of the economy.

This contrasted with an actual pre-crisis savings rate in 2005 of
under six per cent and the savings rate has fallen since then. These
conclusions are inevitably sensitive to assumptions about future rates
of return and growth rates as are, indeed, all findings on
sustainability. It is also important to remember that extending working
lives reduces the need for saving. Nevertheless, the figures do indicate
that, pre-crisis, people were living beyond their means or, equally,
were at considerable risk at being disappointed by their future living
standard.”

-London newsroom: 4420 7862 7491; email: drobinson@marketnews.com

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