Interview: Charles Goodhart

Nearly all countries have now adopted a broadly similar model of monetary policy-making: the central bank is enjoined to set interest rates with the objective of achieving a given, low, inflation rate. The reasons for the popularity of this approach are well known and, by now, relatively uncontroversial. But already some flaws or cracks seem to be appearing. How well has it worked in practice so far?

It is working very well; or rather the countries that have adopted it are doing very well. How much is a result of a fortunate conjuncture and how much is due to the monetary regime is very difficult to tell at this stage. It's been going for too short a time.

The exceptions where it has not been working quite as well as one would have hoped are in Japan and New Zealand. However, the Bank of Japan does not have an inflation target, though many people feel that it should have either an inflation target or medium term price level target. In New Zealand they took the wrong approach to their monetary conditions index and interpreted a decline in the exchange rate in the wrong way.

In both cases I think that there is a question of how you deal with asset prices in the context of the assessment of inflation. In Japan over the last two decades the current goods and services CPI has been low and stable. If you looked at that alone, then Japan has the best monetary policy in the whole world. Whereas if you looked at the movement of assets prices, you can see more clearly why people regard the outcome of Japanese policy with a certain hesitation.

And the same question potentially arises in the United States. There has been this huge surge in equity prices and if that should be followed by a collapse, the whole question of the relationship between assets prices, inflation and monetary policy will come to the fore again.

What are the main advantages and disadvantages of this approach?

The main advantage is that it eliminates the political bias in interest rates decisions. Personally, I do not see that political bias coming from an attempt to surprise the electorate into a temporary boom, but much more from the fact that interest rate increases are unpopular. It is very difficult for a politician to take an unpopular step without having clear and present evidence of the need for that. That usually means that politicians will wait until inflation has risen before they actually raise interest rates, whereas you ought to raise interest rates in anticipation of inflation rising in the future. This is why forecasts are so important.

The other main advantage is that, because the responsibility is delegated but a quantitative objective is given or adopted, the whole process is much more accountable and much more transparent than it was when the minister of finance did it. Ministers never specified what they were trying to do and so it was impossible to hold them accountable. It was never clear exactly why they did what they did. The whole process has become much more democratically accountable, even though an unelected body takes the decision.

I really do not see many disadvantages. It does rely on forecasts and forecasts are very uncertain. But this is better than waiting for problems to come and hit you.

The unreliability of forecasting is basically a technical problem. Will advances in economics and econometrics solve this?

Perhaps. The problem is that the economy is always evolving and people are always learning and changing their own behaviour. Nothing remains fixed in the system. You are always chasing a moving target.

Forecasts are also subject to various biases. To take an example, the relationship between interest rates and the exchange rate might be in the process of change over the last few years. International capital flows used to be driven mainly by money market differentials. Increasingly, it now looks as if they are now driven by equity market differentials (either portfolio or FDI). In the past, an interest rate increase would raise the return on the money markets, so you could expect it to bring in capital flows and raise the exchange rate. If the relationship of capital flows is more equity based, an increase in interest rates could actually lower the equity market, deter capital flows and thereby lower the exchange rate. The relationship between interest rates and the exchange rate is now more uncertain than it has been in the last 25 years.

Nothing lasts forever. How long do you give this approach - five years or ten?

The idea that the monetary authority aims primarily at a nominal objective (price level or inflation target) will remain for the foreseeable future - i.e. 10 years or more. Where I see more difficulty is in our analysis of the transmission mechanism. In particular the forecast and the analytical approach tends to concentrate quite largely on the output gap - the relationship between current output and the sustainable level of output. Our ability to estimate the output gap has become increasingly bad. We don't know where it is exactly, and that whole approach has been subject to considerable pressure. What is the underlying growth in productivity in the US or the UK at the moment? What are the output gaps? If you don't know the output gap you are in some trouble. Central banks are trying to base their inflation forecasts on a variable that is very much a "will o' the wisp".

However, even if you cannot measure the output gap that accurately, under this new approach is it still possible that the monetary authority can make a huge policy mistake?

It is not clear. For example, it is now argued by a very good economist at the Federal Reserve Board called Orphanides that actually the Fed was following a Taylor reaction function in the period 1973-74, and the problem was that it did not appreciate that the rate of growth of productivity had declined really dramatically throughout the western world in the early 1970s. Consequently it thought that the US economy was operating way below its sustainable rate of output in 1973-74, and it expanded the money supply on a completely mistaken view of what the output gap was. Now when we look back knowing what the productivity trends were, we can see that it made a mistake. But at the time it was not clear that it was making a mistake at all. And if we do get major shifts in productivity - major shifts on the supply side - it is perfectly possible for any central bank to make quite a large error.

That raises the question of why actually most central banks and most economies except Japan over the course of the last four or five years have done so well. Is it purely an accident and good fortune, or good management? I would not be surprised if to a large extent it was down to good fortune. I don't think the present system has really been tried under adverse conditions. Where there have been adverse conditions, as in Japan, it is difficult to assess whether the response has been appropriate.

One near-universal feature of the current model is that interest rate decisions are taken through a committee process, normally on the basis of inflation forecasts which may or may not be published. What are the advantages and disadvantages of decision-making by committee?

In a sense a committee process of some kind is virtually inevitable. If you were appointed governor, before coming to a policy decision you would want to discuss and analyse it with a group of people who were technically qualified. You would feel hesitant about taking such an important decision on your own. Any governor will tend to surround himself with a committee.

The question is: do you make the soundings and the assessments of the committee official or leave them unofficial? There are a couple of reasons for making it official. First, it is great protection for a governor. For example, when former Bundesbank president Helmut Schlesinger was under attack at the Bath meeting for not helping the UK stay in the ERM in 1992, and Norman Lamont, the UK finance minister at the time, said, "Why don't you lower interest rates for the benefit of all?", Schlesinger was able to turn round and say: "I hear what you say but it is not my decision. I will take what you say to my Directorate and make them aware of your views."

Governors need some protection. It is a very exposed position for a governor to have this very crucial decision just to be his or her own responsibility. But at the same time a committee is also protection from a governor should a governor take a line that was very idiosyncratic. I would argue that Japanese monetary policy is more than somewhat idiosyncratic, so the fact that there is a committee does not mean there is necessarily someone to stand up to the governor.

Would you also say that having a committee packed with top external economists also helps to dampen down criticism of policy decisions from the outside?

I would agree with that. By having the experts with him, it protects the governor from external technical criticism. I also think that, because there is individual responsibility, and differing views and differing votes, and that these are explained, actually does provide an important educational process. Those central banks that go in for a more collegiate approach in which all members have to sing from the same hymn sheet do not have the same educational effect. By having, say, a Sushil Wadhwani on the one hand and, say, a Mervyn King on the other does give you the range of arguments that are important.

And are there any disadvantages from having a committee?

The main problem comes with forecasting, because so much weight is put on the forecast. And if you have got committee members that disagree, then there is the problem of how you organise a forecast where there is disagreement.

In the Bank of England's case, there is a very considerable degree of confusion in the world out there between what you might call the uncertainty within a given forecast and in the variance between the different members of the committee. This is where the Don Kohn paper really comes in. It is an issue which I have taken up in an article published in the National Institute January Review about how you should do this forecast. [Editor's note: Don Kohn, head of monetary affairs at the US Federal Reserve, conducted a review of way the Bank of England conducts monetary policy at the request of the court of non-executive directors. It was published last year and is available on http://www.bankofengland.co.uk/kohn.pdf/.]

Certainly the forecast is the area with which the MPC itself is least happy. Apart from the forecast, Don Kohn's report only suggested minor changes. Despite general agreement among MPC members about the model, the inflation forecast which presents their "best collective judgement" may actually reflect the views of no-one on the committee. For example, the assumption used to forecast the exchange rate. Half the committee wanted a random walk assumption, half the committee wanted to use uncovered interest rate parity. We decided on halfway in between the two, which nobody believed.

Which side were you on?

I was on the random walk side. Uncovered interest rate parity is the best intellectual baseline, but the problem is that it forecasts incorrectly more than 50% of the time.

A few countries still put the final decision on the governor. Does this have anything to be said for it? For example, it does solve the forecasting problem.

The governor should be responsible for the forecast, although I don't think he should make the final decision over interest rates. The Bank of England's forecast should provide one clear message and at the moment this isn't happening. This one clear message should come from the governor. But this would not mean the governor could wrestle control over the interest rate decision from the committee. The forecast is just one part of the decision making process. As you will recall, in August 2000, the forecast showed the inflation rate slightly above the target and some people were surprised when interest rates were not raised. My interpretation of that was that what had happened was that the forecast was based on the "no change in interest rate assumption". What a lot of people on the committee were thinking and arguing was that we could still hit the target if that forecast comes out by varying interest rates rather more at a later date, ie, we could raise interest rates later if needs be.

The question of the appropriate interest rate assumption is another difficult point. Because the forecast is based on a series of assumptions and the horizon itself which is being aimed for is also uncertain, the forecast does not absolutely dominate the decision. Even if the governor does set the forecast, it would still leave the decision making process open. There will be cases when other people on the committee will not agree with the forecast and there will be opportunity for other members to dissent. The governor if he is sensible will produce a forecast that is neither a "best collective judgement" of all members nor completely out of line with the views of the majority of the other members. The governor will listen to the views of all the other members, but it will be the governor alone who takes the final decision about what the inflation forecast will be.

The median number of members on central bank policy committees in the central banks we have examined is eight. Why eight? Is a committee of three, like in Switzerland, too small, and a committee of 17, like the ECB, too large?

The reason we have got eight is that it is half way between seven and nine. Seven and nine are in fact roughly the appropriate size. That goes back to the operation of committees. If it is three you don't get enough variety of views and very likely somebody with a dominating personality runs the show. If it is as large as 17 you can't really give everybody a chance to participate within a process that lasts a short time.

The maximum number for reasonable interchange is possibly around 11. The minimum number to give a reasonable discussion and exchange of views is possibly around five. And, low and behold, add five and 11 and divide by two and you get your magic number again.

Depending on the size of the country, on average a committee of eight also manages to incorporate most of the leading outside macro-monetary economists. It is certainly possible in Australia and New Zealand and even Japan, but impossible in such large areas as the Eurozone or United States.

Moving to another aspect of policymaking, much attention is now devoted to how a central bank communicates its decisions and positions to its various audiences. Many central banks seem to have problems in this area. Do you agree and if so why is this?

I am all in favour of communications experts advising the committee on the appropriate way to conduct communication with different audiences. I don't think that leads on at all to them participating in the decision making process itself. The objective that the monetary policy committee is trying to achieve is given to it by the UK finance minister. So given the objective, setting interest rates to achieve that objective is really a technical issue. And if it is a technical issue, you need technical experts to do it.

In any case, it is much better if those involved in taking the decision are required to justify it in their own terms and under questioning by, for example, the UK's treasury select committee. It is a part of the responsibility of taking a decision which does affect the lives of everybody to some extent, that they themselves in their own words are able to express their arguments for doing so.

Did you enjoy the question sessions in front of the Treasury Select Committee?

They are occasions which certainly make one quite nervous. They are sometimes very tense. You never exactly know what's coming. The ability to think very fast on one's feet and under pressure is a different ability from the ability to provide a reasoned judgement when you have got time and no external pressure.

Chris Allsopp, the Bank of England MPC member who replaced you on the committee when your term expired last October, was given a fairly rough ride at his "approval" meeting with the parliamentary select committee. The select committee of politicians deemed his performance so bad that they actually recommended that the finance minister should find another candidate.

Preparation for these public meetings with politicians is one area where specialised communications advice would be helpful. I rather doubt that Chris Allsopp got sufficient advice beforehand what to expect and on the kind of approach that would be most useful under the circumstances.

The select committee has a group of very good economic advisers and the line of questioning is carefully thought out beforehand and allocated between various members of the select committee. The initial questions asked by each MP are very well considered. It is only when the questioning has gone on for a time that the MP may enter into an area of subsidiary questions where he hasn't got the technical abilities or hasn't thought about it sufficiently to really push that line of questioning.

Don Kohn, head of monetary affairs at the US Fed, recently published his report on the Bank of England's monetary policy process. He criticised the way the forecasting process works saying it does not present a clear picture to policymakers, the markets or the public at large. He said that their needs to be a tighter link between the forecast and the monetary policy decision. What is your view on Don Kohn's report?

The report is basically ok. His main argument is that the present forecasting process is rather confusing, but he also says if there was any clear-cut solution it would have already been put in place. The answer is not simple.

I think there is already a very tight link between the forecast and the monetary policy decision. Where there is room for improvement is the relationship between the single forecast and the divergent views of the monetary policy committee.

One of Mr Kohn's proposals is that Table 6B from the Inflation Report be removed and that instead the individual members would give themselves a paragraph or two actually stating how they individually divorce themselves from the forecast. So you could actually have ten forecasts. You could have a published forecast and nine individual comments. But where does this take you in terms of clarity of presentation.

Even under the present system it has always been considered possible that if any member of the committee really felt disaffected, he could have his own completely separate forecast prepared with help from the bank staff. It has not happened but there were a couple of occasions where it was not that far off.

That would still be possible while having a single governor's forecast. But in some ways if the forecast was the sole responsibility of the governor, it would be easier for somebody who felt some distance away from it to approve it than at the moment where everyone has to sign it, and you have individual responsibility from it.

The report also said on the side that there were too many monthly meetings?

We're absolutely stuck. The Bank of England Act says that the MPC should meet every month. It's a legal issue. And the problem is how do you get the Bank of England staff to get a decent holiday among other things. Apart from the fact that meeting every month is too many. The whole process is too time-consuming the Bank staff do not have enough time to reflect and do more fundamental background economic work. Eight times a year would be the right number. There is one countervailing argument, which is that the data come in a monthly cycle.

Kohn said that one option for central banks is to adopt a Fed-style likely path for policy. Do you think this would be preferable?

I am very much against that. The reason being that once you have outlined a prospective policy path, this is taken by the market as a degree of commitment and when you decide to change, as you inevitably will, the markets think you are reneging. The market never has any clear idea of what your commitment to this likely path is. The Fed has had some trouble and continues to have difficulty with its bias because of this. If the Fed adopts a bias towards easing and then wages begin creeping up, how difficult would it be for the Fed now if the next move in interest rates was now upwards? I think the actual signalling of where we are going is done in some senses much better by reading the votes and the arguments put out by the committee members.

Inflation targeting is becoming increasingly the most popular choice of monetary policy framework in the world today. However, some central banks are still firmly against it. Is inflation targeting appropriate for all countries, both developed and developing?

I do not believe that inflation targeting is appropriate for all countries. First, if you have a very small economy with huge trading links to a large partner, it is arguable that you would do much better to have a fixed link. This is one reason put forward why the UK should join European monetary union. Second, inflation targeting might not be appropriate if a country is subject to frequent supply shocks. In these countries neither headline nor core inflation give a good measure of inflationary tendencies. This group will mainly comprise primary, commodity producing, emerging markets.

Moving to the role of foreign reserves, developing countries have been significantly building up foreign exchange reserves to increase confidence in their exchange rates - and to use intermittently for intervention in the foreign exchange markets. But most academics argue that exchange rate intervention is useless. What is your view on the role of reserves?

I have always been an advocate of intervention. I was one of those who argued strongly in favour of the Bank of England intervening to bring sterling down against the euro earlier in 2000. I was also in favour of the ECB intervention to push the euro higher. When they look back, the ECB council members will feel the main thing they did wrong was not intervening earlier and in greater force using more money. You have to put your money where your mouth is. What is the purpose of having reserves unless you are prepared to use them at a time when you currency is far out of line with the fundamentals? The other point is that it would have been a good investment opportunity for both the Bank of England and the ECB. There is a difference between a good medium term investment opportunity and the belief that you can move the market dramatically in the very short run.

The other argument that I would make is that if you really do not believe intervention is desirable, then the absolutely logical implication of that is that you should get rid of all of your reserves because they are a low return investment. Anyone who takes the line that intervention should be avoided under virtually all circumstances, and you have a floating exchange rate, the only logical and consistent position would be that reserves should be sold.

Has the experience of September 1992 when Britain was forced out of the ERM frightened the Bank of England away from ever intervening again?

The one situation you never want to get into is having your back against a wall and to be cornered. The problem was that the UK was in a pegged exchange rate that was under pressure. There was nothing the Bank could do but intervene. When you are cornered you are going to lose - always. One of the problems is that many of the academic studies of intervention fail to distinguish between when the central bank is cornered - and therefore on a hiding to nothing - and when the central bank can choose the moment, the time and the grounds, and the extent of its intervention. Never allow yourself to be cornered which is why it is much better to go in for a managed float rather than a pegged but adjustable rate. I think that the reason the Bank did not want to intervene last year was that the majority of the MPC thought it wouldn't work and the Bank would lose reputation.

Do you think the ECB has been successful in its intervention policy or is it too early to tell?

I don't think that the actual intervention had an enormous effect. But the ECB was quite right that the euro was unsustainably low and therefore it was a good investment opportunity. It is very difficult to demonstrate that the ECB's intervention was the driving force that shifted the euro back up. In fact I would be prepared to say that it was probably unlikely. But it was still the right thing to do. When else are you going to use your reserves except when there is a good investment opportunity? At the same time you are putting your money where your mouth is.

Do you think e-money has a realistic chance of supplanting cash in the modern industrialised economy?

The IT revolution will affect the structure of financial markets enormously and it will affect the way financial products are sold and organised. It will probably have least effect on currency usage and central banking. However, even if IT should get rid of currency, the central bank will still be able to control the market anyway. Commercial banks, and the way commercial banking is done, are much more under threat than currency usage and the market power of the central bank.

If there are going to be fewer currencies in the world in the future it will be for reasons other than technology. Although there is a trend towards the establishment of regional currencies and more dollarisation and euroisation, it will be a gradual process.

Source: Central Banking Journal, Vol. XI, No. 3, Published Feb 16, 2001

Interview was approved by Professor Goodhart on Jan. 10, 2001.