Has the Bank of England now got too many tasks to perform?

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Tom Allen, Head of Economics, Eton College

Students today associate UK monetary policy with the Bank of England’s Monetary Policy Committee, MPC, which sets the Bank Rate.

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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.

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Modern monetarypolicy 1

Monetary policy involves the manipulation of interest rates, the money supply and the exchange rate.

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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.

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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.

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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.

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Modern monetarypolicy 2

The 1997 Labour Government established the MPC, giving it ‘operational independence’ in setting Bank Rate.

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This loosening of monetary policy was expected to boost aggregate demand via the Monetary Transmission Mechanism, causing inflation to rise back towards target.

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The inflation target was changed in January 2004 from 2.5% on RPIX to 2% on the Consumer Price Index (CPI).

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Between 1997 and 2007 the MPC changed Bank Rate on 37 occasions.

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Modern monetarypolicy 3

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.

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Conversely, the MPC would raise Bank Rate if inflation were forecast to rise above target, thus dampening aggregate demand and reducing inflationary pressures.

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There was talk of a ‘New Paradigm’ of macroeconomics, with permanently subdued inflation, strong economic growth, high employment and rising living standards.

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Modern monetarypolicy 4

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.

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Low inflation and relatively stable interest rates contributed to sixteen years of continuous, positive economic growth between 1993 and 2008.

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The financial crisis 1

Many of these mortgages were ‘sub-prime’ in that they were offered to families with insufficient income and assets.

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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.

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When the US housing market took a dip in 2007 many households defaulted on their mortgage repayments.

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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.

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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.

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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.

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The financial crisis 2

In consequence UK investment plummeted by 25% between 2007 and 2009, with consumer expenditure falling by 6%.

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Households and firms in both the US and the EU found the credit tap firmly turned off.

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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.

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The NICE decade was well and truly over.• C

From late 2008 to March 2009 the MPC slashed Bank Rate from 5% to a record low of 0.5%.

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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.

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Monetary andfiscal policiesto the rescue 1

Emergency measures were required to prevent total collapse of the UK economy.

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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.

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In selling bonds to the Bank, these institutions now had more money available to lend to households and businesses, thus boosting aggregate demand.

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The resultant increase in the UK broad money supply put downward pressure on sterling, assisting the UK’s trade position.

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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.

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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.

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The Bank of England has estimated that QE contributed up to 2% per annum to UK GDP growth.

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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.

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The resultant rise in the UK’s national debt led to the loss of the AAA credit rating in early 2013.

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Monetary andfiscal policiesto the rescue 2

Normally low interest rates and increased money supply would prove inflationary as firms and households increase their expenditure.

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Policy conflicts 1

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.

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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.

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Low UK interest rates reduced the demand for sterling and QE later increased its supply.

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Policy conflicts 2

The pound fell by 25% against major currencies, pushing up the price of imported goods and commodities.

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However, the effect on sterling was dramatic.• 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.

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Conventional theory tells us these require opposing policies: contractionary monetary policy for the first and expansionary monetary policy for the second.

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Policy conflicts 3

Lord King, former Bank Governor, defended the MPC’s actions by claiming that the forces that had driven inflation above target were temporary.

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The Bank’s main dilemma lies in attempting to achieve two major objectives – low inflation and economic recovery.

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Critics of the Bank responded that five years is getting beyond ‘temporary’.

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On 7th August 2013 Mark Carney, the new Bank Governor, unveiled a new policy of ‘forward guidance’.

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Policy conflicts 4

This is where the Bank committed to keep interest rates on hold until unemployment fell from the then rate of 7.8% to 7%.

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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.

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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.

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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.

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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.

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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.

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A way forward ? 1

Has the Bank of England now got too many tasks to perform?• C

The increase in globalisation and the emergence of the internet also helped to reduce price and cost pressures, further increasing aggregate supply.

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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.

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I would advocate an inflation target such as RPIX which incorporates asset prices such as houses.

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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.

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Banking regulation has been tightened and banks themselves will be reluctant to undertake risky lending for many years to come.

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The authorities will have to be careful not to repeat the errors that led to the financial crisis.

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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.

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This will provide an immense challenge for the new Bank Governor and will require exquisite timing and, no doubt, some good fortune.

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A way forward ? 2