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Outsiders at the Bank of England's MPC.

Article Excerpt
MONETARY POLICY TODAY is set by committee in many countries, but the Bank of England's monetary policy committee (MPC) is unusual in that it has both internal and external members. The inclusion of outsiders raises the question whether they vote in different ways from insiders and, if so, how they have impacted on interest rate decisions. There are two competing views of the outsiders' role in the decision process of the MPC. The first is that outsiders do not vote systematically differently from insiders and that any differences between insiders' and outsiders' views thus are random and negligible. (1) The second view is that outsiders differ systematically from insiders in their assessment of the appropriate interest rate level. The presence of outsiders thus may change the course of monetary policy.

Several papers study the MPC's voting record. (2) Gerlach-Kristen (2004) finds that between 1997 and 2003, dissents in the MPC predicted future interest rate changes even if the slope of the short end of the term structure, as a measure of near-term interest rate expectations, is controlled for. Thus, if a minority of committee members today favors an interest rate cut, it is likely that policy will be loosened at the next MPC meeting. Furthermore, the term "structure" itself responds to the publication of the voting record, indicating that financial market participants believe that the votes are informative about the likelihood of future policy changes. Gerlach-Kristen (2003) shows that up to mid-2003 outsiders dissented more frequently from the majority than insiders and tended to do so in favor of lower rates. Spencer (2006a) establishes that the differences in voting between insiders and outsiders in the same period are statistically significant and relates the votes to the professional background of the MPC members.

Bhattacharjee and Holly (2006) estimate reaction functions for individual MPC members and find that Willem Buiter and DeAnne Julius, who were both outside members, attached more weight to the output gap than the internal members. Spencer (2006b) shows that up to mid-2003 insiders were more likely to raise interest rates in response to an increase in inflation than outsiders, that outsiders were faster to cut rates when inflation declined, and that they responded more strongly to changes in GDP growth. Harris and Spencer (Forthcoming) demonstrate, using data up to mid-2006, that insiders tend to favor tighter monetary policy than outsiders and often vote as a block. Finally, Besley, Meads, and Surico (2007) consider individual voting data before mid-2007 and suggest that insiders' and outsiders' long-run responses to inflation and the output gap are the same. (3)

This paper adds to the literature by presenting a formal model that replicates the differences in voting behavior of internal and external MPC members. Section 1 provides facts on the MPC's organization and policy decisions. Section 2 discusses why insiders and outsiders might differ in their voting behavior. Section 3 presents a model of interest rate setting in a committee that allows for different preferences across groups. As a benchmark case, identical loss functions for insiders and outsiders are assumed. Then, outsiders are assumed to be "recession averse." The simulations in Section 4 show that this last model replicates the actual voting pattern well if it is assumed that outsiders are more uncertain about what level of interest rates to set than insiders. Section 5 concludes.

1. MPC FACTS

The MPC of the Bank of England has nine members. (4) The five internal MPC members are the governor and the two deputy governors, who are appointed by the queen, as well as two executive directors, whom the governor appoints after consultation with the chancellor of the exchequer. There are four outside members on the committee, distinguished economists drawn from academia and the private sector, who are appointed by the chancellor on renewable 3-year terms. Over the sample considered in this paper, which spans June 1997 to February 2008, the MPC had 25 members.

The MPC took its first interest rate decision on June 6, 1997, and there were 130 decisions up to February 2008. Given the length of the sample and the number of policymakers, it is unlikely that the results presented here depend on the votes of a few individuals or on a few particular episodes. The policy rate was changed on 37 occasions in the sample: on 4 occasions interest rates were cut by 50 basis points, on 15 occasions they were reduced by 25 basis points, and on 18 occasions they were increased by 25 basis points. Interestingly, on no occasion they were raised by 50 basis points, so that the MPC appears to cut interest rates faster than it raises them. Decisions are made by majority vote. Before November 1998, dissenting members simply indicated whether they favored tighter or looser monetary policy than the majority. Since then, they have explicitly voted for an alternative level of the policy rate. All dissents but one have been by 25 basis points (Willem Buiter voted in March 1999 for a rate cut of 40 basis points). The voting outcome is published with a lag. At the time of writing, the release date was 2 weeks after the MPC meeting. Before October 1998, the voting record was published only after the next policy meeting.

Figure 1 shows how often insiders and outsiders voted with the majority, how often they voted for lower, and how often for higher rates. (5) There are 1,139 votes in the sample, of which 637 are by insiders and 502 by outsiders. Panel A shows that insiders voted more frequently with the majority than outsiders (91.1% of all votes versus 78.3%). Indeed, the hypothesis that the two groups dissent equally frequently is rejected in a Wald test (p-value of 0.00). Outsiders tend to dissent more often in favor of interest rate reductions than insiders (15.5 % versus 2.0%, p-value of 0.02). (6) By contrast, members of the two groups dissent with roughly equal frequency in favor of higher rates (6.2%...

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