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ERC Research Papers

Cracks in the Foundations


Published April 30th 2007
By David B. Smith of Derby University and Beacon Economic Forecasting
ISBN 9780903499279

For the first time since 1992, Britain's CPI inflation rate has exceeded 3% and triggered a letter from the Bank of England to the Chancellor. The real figure for most people though is closer to the RPI - 4.8%. And just earlier this week, in a letter to the Financial Times, several leading economists criticised the Bank of England's monetary policy for underestimating the likelihood of continued above target inflation. Clearly all is not well at the Old Lady of Threadneedle Street.

Summary

On the 10th anniversary of the granting of operational independence to the Bank, the Economic Research Council, Britain's oldest economic think-tank, has commissioned Visiting Professor David B. Smith of Derby University, Chairman of the Institute of Economic Affair's Shadow Monetary Policy Committee and formerly a well-known City Economist, to conduct an audit of the past decade and propose reforms to the existing structure.

Smith lucidly illustrates how over the last 10 years the following cracks have emerged in the intellectual and institutional foundations of British monetary policy:

The removal of the Bank's debt management and regulatory responsibilities was a probably an error, in part because of the resultant loss of market 'feel' when the Bank had to act as a lender of last resort.

The sole reliance on base rates has left the MPC with an inadequate tool kit to deal with all monetary challenges.

The Bank's main forecasting model is flawed, relying too much on assumed theory and too little on empirical observation.

Smith recommends that some of these cracks can be closed with the following reforms:

The introduction of additional monetary instruments.

Re-integrating the Debt Management Office into the Bank.

Restoring the Bank's supervisory powers over the deposit-taking institutions whose liabilities correspond to M4 broad money.

Making the Bank- not the Office for National Statistics - the main source for compiling and disseminating the UK's macroeconomic statistics.


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