Question: Who are the Monetary Policy Committee? What problems could they face when predicting inflation?
An economy’s central bank controls the interest rate and money supply. In the UK the central bank is the Bank of England (BoE). However, it is not the BoE who decide on interest rate changes, instead this is decided by the Monetary Policy Committee (MPC). The MPC is a group of 9 economists, 5 are from the BoE and 4 are independent experts and they are responsible for controlling inflation in the UK. The MPC use the CPI measure of inflation and target inflation of 2% plus or minus 1%. The MPC use the interest rate and money supply to influence AD and control inflation. The MPC are independent from the government and apolitical so they have credibility in inflation targeting.
The MPC meet once a month and consider all the factors affecting inflation over the next 2 years:
- Economic growth. Higher growth causes income and consumption to rise and demand-pull inflation.
- Consumption. An increase in consumption causes demand-pull inflation.
- Asset prices. A rise in house prices induces a wealth effect that increases consumption and causes demand-pull inflation.
- Unemployment. Lower unemployment means income and consumption rise so there is demand-pull inflation.
- Exchange Rate. A fall in the exchange rate causes exports to rise, imports to fall anddemand-pull inflation. Also, imports are more expensive so there is cost-push inflation.
- Commodity prices. A rise in commodity prices means imported commodities are moreexpensive and firms’ costs rise so there is cost-push inflation.
- Less Developed Country (LDC) wages. UK workers must compete with low wages in LDCs to attract MNCs and find employment, this leads to lower wages for UK firms and cost-push deflation.
After considering all the factors affecting inflation, the MPC predict inflation over the next two years and decide on what should happen to interest rates to keep inflation within its target. If inflation is too low, the MPC will use loose monetary policy to decrease interest rates and increase inflation. If inflation is too high, the MPC will use tight monetary policy to increase interest rates and decrease inflation.
The MPC face many problems when setting interest rates to target inflation.
For example, there may be trade-offs. Higher interest rates reduce inflation but they may also reduce AD, income, employment and real GDP. This causes a conflict with the government’s macroeconomic objectives.
Also, there may be lags. It takes time to change interest rates. Also, it takes roughly two years for interest rates to exert their full effect on investment and consumption. This makes it more difficult to plan what should happen to interest rates.
Additionally, the MPC may face uncertainty. Some events cannot be predicted (maybe oil price shocks or financial crises). Resultantly, the MPC will fail to implement an effective policy response, interest rates may be too high or too low so inflation will be off target.
Furthermore, there may be data reliability issues. Data may be imperfect, and if the MPC plan and act with inaccurate information they will set the wrong type of interest rate response.
Moreover, the issue of conflicting data could cause a problem. Conflicting data makes it more difficult for the MPC to decide on the interest rate response. Some data could indicate that inflation is rising so interest rates must rise whilst other data indicates that inflation is falling so interest rates must fall.
Lastly, the MPC may face a problem with their models. Economists do not agree on the ‘correct’ model of the economy (for example Keynesian models vs. Classical models). MPC members may not agree on models, some may argue that interest rates must rise whilst others may argue that interest rates must fall.