A new research report calls for longer terms of office for members of the Bank of Englands Monetary Policy Committee (MPC). Writing in the Economic Journal, Brian Henry, Mathan Satchi and David Vines argue that this would guard against the potential danger of the MPC taking too short-term a view of the economy when setting interest rates.
Much attention has been given in the press as to whether new MPC appointments are doves or hawks. But past work by Charles Bean now the Bank’s chief economist but then an LSE professor implied that, providing the Bank remains properly independent, we should not really worry. Both hawks and doves will normally make roughly the same decision and both are likely to serve society well.
The new study by Professor Vines and colleagues shows that this conclusion is only valid if policy-makers take a long-term view of the economy. Policy-makers who take a short-term view are much more likely to disagree and may not serve society well.
We know that the MPC cares about keeping inflation stable, but how much should it also care about stabilising unemployment? The Bank’s remit does not pin this down with any precision nor is it clear how it could. So how much the MPC cares about unemployment must depend largely on the preferences of its individual members. These preferences in large part determine the differences between doves and hawks.
The issue is this. When inflation rises above target, there is a real trade-off between the objectives of controlling inflation and controlling unemployment. How much unemployment is needed to get inflation down again? How can we know how the MPC will respond in such a situation given that we do not know how much it cares about unemployment? And will it respond in a way that is in the best interests of society?
Bean’s work suggests that our lack of knowledge is not a problem. This is because policy-makers with quite different ideas on the trade-off will actually choose fairly similar policies. The reason is that to get inflation down means restraining demand, with the regrettable consequence of unemployment.
If policy-makers whether hawks or doves take a long-term view then, Bean shows, they will agree among themselves as to how this trade-off should be managed. So long as their preferences fall into a broad range that can be described as reasonable, the outcomes of policy are not likely to be much altered as policy-makers come and go. And these outcomes are likely to be similar to the policy of an ideal policy-maker, one who cares about inflation-unemployment trade-off in exactly the right way.
The new study shows that this happy conclusion will not hold if policy-makers focus on the short-term outcomes of policy, rather than taking a long-term view. The reasons are subtle. Doves who take a short-term view will be likely to want less unemployment after an inflation shock, and to prefer a policy that would take longer to get inflation down. They would like to put off the necessary unemployment until the future, when as viewed from the present it will seem less costly. They want to have a good time now rather than high unemployment now, which would deliver low inflation in the future.
But paradoxically, hawks with short-term view are likely to want to do exactly the opposite. It may be possible to get inflation down very fast by having high unemployment now. This will be especially true if tight monetary policy now can cause exchange rate appreciation and enable lower inflation to be imported through cheaper import prices. Impatient hawks might be prepared to do this now, and then to deal with any problems caused by unwinding the currency appreciation in the future, when as viewed from the present these problems will seem less costly. They too will want to have a good time now and that means getting inflation down now, without worrying about the future consequences.
We can thus see that there will be a problem if MPC members take a short-term view: the views of hawks and doves may come to differ significantly from each other, and from the ideal policy. In becoming more short-termist, the hawks and the doves will come to disagree much more strongly among themselves, and their desired policies may differ very significantly from ideal policy.
Professor David Vines comments:
It is important to stress that there is nothing in our work to suggest that members of the MPC have in fact taken a short-term view. Indeed, the widely perceived success of the MPC process would actually suggest otherwise.
But we believe that institutional arrangements that deter short-termism from arising in the future could be very worthwhile. For example, the term of service for a member of the MPC is currently only three years. This term is unlikely to safeguard against short-termism: it implies that the average MPC member has a remaining term of only 18 months. Our suggestion is that the terms of appointment to the MPC should be lengthened.
Notes for editors: The Effect of Discounting on Policy Choices in Inflation Targeting Regimes by Brian Henry, Mathan Satchi and David Vines is published in the January 2006 issue of the Economic Journal. The authors are at the University of Oxford.
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