Transcript Tom Allen, Head of Economics, Eton College

Has the Bank of England now got
too many tasks to perform?
Tom Allen, Head of Economics, Eton College
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Modern monetary
policy 1
• C Monetary policy involves the manipulation of interest rates, the money
supply and the exchange rate.
• C Students today associate UK monetary policy with the Bank of England’s
Monetary Policy Committee, MPC, which sets the Bank Rate.
• C It also directly influences the size of the money supply through its
programme of quantitative easing and thus indirectly influences the value of
sterling, even though the UK has a floating exchange rate.
• C But interest rate setting has not always been the preserve of the Bank.
Until 1997 it was the Chancellor of the Exchequer who set Bank Rate as
well as conducting fiscal policy.
Modern monetary
policy 2
• C The 1997 Labour Government established the MPC, giving it ‘operational
independence’ in setting Bank Rate.
• C The remit of the MPC was to hit the inflation target, which from 1997 to
December 2003 was 2.5% on the RPIX measure of inflation.
• C If inflation was below target or, was forecast to drop below target, then the
MPC would cut Bank Rate, taking into account the acknowledged time lag of
up to 24 months between implementation of policy and full effect.
• C This loosening of monetary policy was expected to boost aggregate
demand via the Monetary Transmission Mechanism, causing inflation to
rise back towards target.
Modern monetary
policy 3
• C Conversely, the MPC would raise Bank Rate if inflation were forecast to
rise above target, thus dampening aggregate demand and reducing
inflationary pressures.
• C The inflation target was changed in January 2004 from 2.5% on RPIX to
2% on the Consumer Price Index (CPI).
• C Between 1997 and 2007 the MPC changed Bank Rate on 37 occasions.
• C Bank Rate ranged from 3.5% to 7.5% over that period
and inflation remained within 1% of its target,
representing a period of unparalleled stability in modern
times.
Modern monetary
policy 4
• C Low inflation and relatively stable interest rates contributed to sixteen years
of continuous, positive economic growth between 1993 and 2008.
• C There was talk of a ‘New Paradigm’ of macroeconomics, with permanently
subdued inflation, strong economic growth, high employment and rising
living standards.
• C The period was dubbed the NICE (Non-Inflationary Consistent
Expansion) decade or the ‘Great Moderation’, which referred to the
volatility of the economic cycle and assisted in returning Labour to office in
2001 and again in 2005.
The financial crisis 1
• C The extended period of low interest rates plus the willingness of lightly
regulated banks to grant mortgages to households who lacked an
appropriate credit record, helped to stimulate the housing markets both in
the US and the UK.
• C Many of these mortgages were ‘sub-prime’ in that they were offered to
families with insufficient income and assets.
• C When the US housing market took a dip in 2007 many households
defaulted on their mortgage repayments.
• C Unfortunately it was not just US banks which took the hit.
• C US banks had repackaged and sold on much of the debt to banks, pension
funds, and even local councils in other countries, especially in Europe.
• C Many financial institutions were unaware of the full extent of their exposure
to such losses, resulting in a rapid unwillingness to lend out further money
and resulting in a credit crunch.
The financial crisis 2
• C Households and firms in both the US and the EU found the credit tap firmly
turned off.
• C Firms had become accustomed to financing their investment projects from
debt and households were all too dependent on credit to fuel the splurge in
consumer spending that had run pretty much uninterrupted from the mid
1990s.
• C In consequence UK investment plummeted by 25% between 2007 and
2009, with consumer expenditure falling by 6%.
• C Trade volumes also declined and it was only a modest increase in UK
government expenditure and aggressive monetary policy which prevented
UK GDP from falling by more than the disastrous 6% seen in 2008-09.
• C The NICE decade was well and truly over.
Monetary and
fiscal policies
to the rescue 1
• C Emergency measures were required to prevent total collapse of the UK
economy.
• C From late 2008 to March 2009 the MPC slashed Bank Rate from 5% to a
record low of 0.5%.
• C Two of the country’s four major banks, RBS and Lloyds Banking Group,
were part nationalised to prevent their collapse and have accumulated
combined losses of ￡50bn since 2008.
• C In 2009 the Bank of England commenced quantitative easing, QE, which
involves the purchasing of assets – mainly government bonds – from
commercial banks, insurance companies and pension funds.
• C In selling bonds to the Bank, these institutions now had more money
available to lend to households and businesses, thus boosting aggregate
demand.
Monetary and
fiscal policies
to the rescue 2
• C The increased purchasing of bonds also raised their price, thus reducing
the percentage yield payable on the bond, making it cheaper for both
government and firms to borrow money.
• C The resultant increase in the UK broad money supply put downward
pressure on sterling, assisting the UK’s trade position.
• C A total of ￡375bn of asset purchases had taken place in the UK from
2009 to summer 2013, representing around 25% of UK GDP – a
considerable sum.
• C The Bank of England has estimated that QE contributed up to 2% per
annum to UK GDP growth.
• C The period of ultra-loose monetary policy was accompanied by the loosest
fiscal policy seen for over 60 years. In 2008-09 the UK government ran a
budget deficit of 11% of GDP, which has declined to 8% for 2012-13.
• C The resultant rise in the UK’s national debt led to the loss of the AAA credit
rating in early 2013.
Policy conflicts 1
• C During the financial crisis it was easy to lose sight of the MPC’s remit,
which is to ‘deliver price stability – low inflation – and, subject to that, to
support the government’s economic objectives including those for growth
and employment.
• C Normally low interest rates and increased money supply would prove
inflationary as firms and households increase their expenditure.
• C But, the lack of confidence and available credit, along with
a sizeable negative output gap and elastic aggregate
supply curve, meant that demand-pull inflation was unlikely.
Policy conflicts 2
• C However, the effect on sterling was dramatic.
• C Low UK interest rates reduced the demand for sterling and QE later
increased its supply.
• C The pound fell by 25% against major currencies, pushing up the price of
imported goods and commodities.
• C CPI inflation spiked above 5% in late 2008 before temporarily falling to 1%
in 2009 and then rising to average over 3% from 2010 onwards.
Policy conflicts 3
• C The Bank’s main dilemma lies in attempting to achieve two major
objectives – low inflation and economic recovery.
• C Conventional theory tells us these require opposing policies: contractionary
monetary policy for the first and expansionary monetary policy for the
second.
• C Lord King, former Bank Governor, defended the MPC’s actions by claiming
that the forces that had driven inflation above target were temporary.
• C Critics of the Bank responded that five years is getting beyond ‘temporary’.
Policy conflicts 4
• C Chancellor Osborne in his March 2013 budget altered the MPC’s remit to
give it more latitude to target economic growth, provided that the
accompanying inflation remained under control.
• C On 7th August 2013 Mark Carney, the new Bank Governor, unveiled a new
policy of ‘forward guidance’.
• C This is where the Bank committed to keep interest rates on hold until
unemployment fell from the then rate of 7.8% to 7%.
• C Mr Carney said it meant more than 750,000 extra jobs would have to be
created before the end of 2016 for interest rates to begin to rise again.
• C This signal that interest rates would remain for three more years at 0.5%
predictably prompted considerable debate about the benefit of the Bank’s
new policy.
A way forward ? 1
• C Has the Bank of England now got too many tasks to perform?
• C I have argued that it has, but the NICE period from 1993-2007 showed that
it was possible to achieve consistent economic growth amidst a low
inflationary climate.
• C Low and stable inflation, along with relatively low interest rates did foster
strong aggregate demand, but the accompanying stability in the economy
also provided suitable conditions for an increase in long run aggregate
supply, which offset the inflationary demand-side pressures.
• C The increase in globalisation and the emergence of the internet also
helped to reduce price and cost pressures, further increasing aggregate
supply.
• C The disinflationary effects of globalisation and the internet have surely not
yet run their course and it might be possible to return to this model in due
course, with interest rates of 4-6% and inflation back near its 2% target.
A way forward ? 2
• C The authorities will have to be careful not to repeat the errors that led to the
financial crisis.
• C I would advocate an inflation target such as RPIX which incorporates asset
prices such as houses.
• C If such a measure had been targeted from 2004 onwards, then arguably the
MPC would have raised rates earlier in the cycle and perhaps prevented the
housing bubble.
• C Banking regulation has been tightened and banks themselves will be
reluctant to undertake risky lending for many years to come.
• C The Bank’s immediate focus, will be on stimulating demand without
stoking unacceptable inflationary pressures, eventually unwinding the QE
process before gradually raising rates without spooking the financial
markets and excessively strengthening sterling.
• C This will provide an immense challenge for the new Bank Governor and
will require exquisite timing and, no doubt, some good fortune.