Interest rates and the financial crisis: Why did the Bank of England get it wrong?
There is already a growing debate about why the Bank of England are acting so late on interest rates given the rapidly deteriorating economic situation.
One could argue that the Bank has been the victim of unforeseen circumstances. Yes, growth was slowing throughout 2008 but there were also strong inflationary pressures: two countervailing forces which generally pointed to the need to hold rates. The need for cuts was only apparent when the recent stockmarket crashes and unprecedented banking crisis revealed the real weakness of the economy. One member of the MPC, Tim Besley, made this very argument a couple of days ago.
However, the credibility of this claim is not helped by the fact that another member of the Monetary Policy Committee, David Blanchflower, saw all this coming some months ago and voted alone for cuts when all the other members (which let’s not forget includes five senior officials at the Bank) were voting for holds or even, incredibly, rises. And as Prof. Blanchflower pointed out yesterday, the recent dip in UK economic growth may have only been clear in the headline statistic last week but there were plenty of indicators revealing the reality of what was happening well before the recent financial crisis.
The MPC now seems to be in rate cutting mode and so will probably escape any immediate threat to its operation. But if the recession lasts for more than two quarters and, in particular, if the UK slowdown lasts longer than other economies, there will doubtless be a lengthy post-mortem investigating what went wrong at the Bank. My guess is that if these economic facts do come to pass, we can at least expect a major inquiry by the Treasury Select Committee into the Bank’s monetary responsibilities.
Personally, I have no easy answers to the problem but I think I do know three questions that should be asked.
1. Is the remit of the Bank right? Is it too focused on inflation at the expense of growth and jobs? Is the freedom that exists in the remit for the Bank to limit the focus on the inflation target at certain times clear enough and strong enough? I have written a bit about this elsewhere on this blog.
2. Are the economic models that formally and informally inform the MPC decisions appropriate? In particular, are the majority of the personnel on the MPC trapped in a mindset that emerged during the 1970s and 1980s to address the crises of the 1970s? In essence, are they the prisoners of models that emphasise the primary importance of inflation and inflationary expectations as the key threats to stability above all else to the point where they ignore other key factors and fail to understand that the UK economy is very different today to the 1970s? As a result, are they too focused on the risk of a 1970s style wage-price spiral to notice that wage setting processes today are unrecognisable to those that existed thirty plus years ago? Interestingly, wage setting processes are a specialism of David Blanchflower.
3. Finally, is there something wrong with the internal decision-making processes at the Bank and in the MPC? I sometimes wonder, for example, whether drowning the MPC in statistics every month is beneficial? The minutes of the MPC meetings reveal an impressively detailed, comprehensive and responsible discussion of the latest economic indicators. This reflects the little known fact that while the Committee spends two days formally deciding on the rate, they have days of briefing and discussion beforehand. The risk of being bombarded with a flood of usually contradictory stats every month is that it inevitably inclines some to decision paralysis. Speeches by MPC members which, while always incredibly thoughtful, do sometimes seem to suffer from the “on the one hand there’s this stat, but on the other hand there’s this stat” syndrome. My feeling is, is that Blanchflower is driven by a consideration of indicators but also places a lot of weight on other pieces of empirical evidence, his own knowledge of historical and contemporary economic processes as well as having some confidence in the intangible benefit of accumulated experience.
I’m sure there are other key questions but that’s my two-penneth (or two base points) for now.