Monetary policy works by changing the rate of growth of demand for money; changes in interest rates affect the spending and savings behaviour of households and businesses
The transmission mechanism of monetary policy works with time lags depending on the interest elasticity of demand for goods and services
Because of the time lags involved in setting an appropriate level of interest rates, in the UK the Bank of England sets rates on the basis of hitting the inflation target over a two year forecasting horizon.
The Bank of Englandhas been independent since 1997. In that time there has been several cycles of changes in interest rates. They have varied from 0.5% (since the winter of 2008-09) to 7.5% in the autumn of 1997.
Monetary Policy and the Exchange Rate
There is no exchange rate target for the UK because the UK operates within a floating exchange rate system and has done since we left the exchange rate mechanism (ERM) in 1992. That said changes in policy interest rates still have an effect on the demand and supply of currencies in the foreign exchange rate markets.
Monetary policy and the money supply
There are currently no targets for the growth of the money supply. In addition the UK no longer imposes supply-side control on the growth of bank lending and consumer credit. Since the spring of 2009 the Bank of England has operated a policy of quantitative easing as an extra tool of monetary policy.
Each day there are huge flows of money from the government to banks and vice versa.
Usually more money flows from the banks to the government - for example people and companies paying their taxes - so, each day there is a shortage in the money market.
The BOE is the main provider of liquidity to the wider financial system, in the markets it is known as the “lender of last resort”. It can therefore choose the interest rate it wishes to charge to financial institutions requiring money. The interest rate at which the BOE is prepared to lend to the financial system is quickly passed on, influencing interest rates in the economy - for example the rate of interest on mortgages and the rates on offer to savers. These interventions are sometimes called ‘open market operations’.
Open market operations are where the Bank of England sells short-term government securities and bills. This will reduce the liquid assets of the banks and raise interest rates. If the government sells large amounts of gilts, this will mean a transfer of funds from the banking sector to the Bank of England. This will limit the ability of the banks to create credit and therefore limit the growth in the money supply.
What is quantitative easing and has it worked?
On 11th March 2009 the Bank of England started a policy of quantitative easing. QE is also called as ‘asset purchase scheme’. It was extended to a total of £275 billion in October 2011.
The aim of QE is to support demand in the economy and prevent a period when inflation is persistently below target or becomes negative (deflation).
Rather than acting on the short-term price of money through changes in the policy rate, the Bank of England can use quantitative easing to act on the quantity of money. The media call this ‘printing money’ but this is only true in an electronic sense – the Bank will not actually print new £10, £20 and £50 notes in a direct attempt to inject cash into the economic system.
Under this ‘unconventional strategy’, the MPC discusses each month how many assets, including government bonds, to buy with central bank money. This money is created by the central bank and is the equivalent of turning on the printing press.
QE is a deliberate expansion of the central bank's balance sheet and the monetary base. A rising demand for bonds and other assets ought to drive up their price and lead to a fall in long-term interest rates (yields) on such assets. (There is an inverse relationship between bond prices and bond yields). If long-term interest rates fall and the banks have stronger balance sheets because of BoE purchases under QE, the hope is that this will stimulate lending and stronger growth of business and consumer demand in the economy.
In practice the Bank of England has been purchasing UK government bonds – and with the government having a huge budget deficit, there have been plenty of bonds to buy!
The evidence on QE so far has been mixed. Asset purchases have improved the liquidity of banks and pension funds but some commentators argue that the banks have been happy to ‘sit on the cash’ and hoard it rather than use it as the basis for new lending to businesses and consumers. Credit availability remains low in the aftermath of the credit crunch and there are signs that banks and building societies have tightened the conditions on which they are prepared to give out new loans, overdrafts and mortgages.
Households have realised the full extent of their borrowing and have decided to save extra income or repay debt, they are unlikely to respond to an increased availability of credit made possible by QE
The banks are still engaged in a process of de-leveraging that means they are desperate to reduce the amount of debt they still have before starting to lend out again. Banks are cautious about future lending in the wake of significant losses arising from the financial crisis.
QE has been tried in other countries including the United States. And it became an important part of the policy of the Bank of Japan to drag their economy out of a deflationary slump in the 1990s. The European Central Bank (ECB) has been more reluctant to use QE during the present slump. Following the introduction of quantitative easing in March 2009, UK monetary policy now works through price and quantity – this is an important change.
Forward-looking monetary policy
It is the Bank of England’s responsibility to ensure that inflation remains on target. They use interest rates to keep inflation within a 1% band of the inflation target set by the government of 2%
Monetary policy in Britain is designed to be pro-active and forward-looking because changes in interest rates take time to work through. By making interest rate changes in a pre-emptive fashion, the scale of interest rate changes needed to meet the chosen inflation target will be reduced.
At each of their rate-setting meetings the members of the MPC consider a huge amount of information on the state of the economy. Here are some of the factors they consider when making rate decisions.
GDP growth and spare capacity: The rate of growth of GDP and the size of the output gap. Their main task is to set monetary policy so that AD grows in line with productive potential.
Bank lending and consumer credit figures including equity withdrawal from the housing market and also data on credit card lending
Equity markets (share prices) and house prices - both are considered important in determining household wealth, which then feeds through to borrowing and retail spending. The monetary policy committee has no official target for the annual rate of house price inflation but it has been criticised for not doing enough to prevent the housing bubble during the first eight years of present decade.
Consumer confidence and business confidence – confidence surveys can provide “advance warning” of turning points in the economic cycle. These are called ‘leading indicators’.
Labour market data: The growth of wages, average earnings and unit labour costs. Wage inflation might be a cause of cost-push inflation. The MPC also looks at unemployment figures and survey evidence on the scale of shortages of skilled labour.
Trends in global foreign exchange markets – a weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services.
International data including recent developments in the Euro Zone, emerging market countries and the United States. Along with data on international commodity prices.
The neutral rate of interest
One important feature of interest rate setting is the concept of a neutral rate of interest
The idea behind this is that there might be a rate of interest that neither deliberately seeks to stimulate AD and growth, nor deliberately seeks to weaken growth from its current level
Nominal interest rates in the UK have been held at 0.5% since the spring of 2009 – this is an extended period of below-normal interest rates because of the exceptionally difficult economic conditions facing the British economy in recent times.
At some point the BoE will start to raise policy interest rates but given the fragility of the economy, it may take many months, perhaps years for nominal interest rates to reach a neutral level again.
The policy of ultra-low interest rates
Ultra-low interest rates are an example of accommodatory monetary policy i.e. a policy designed to deliberately boost AD and output. In theory cutting nominal interest rates close to zero provides a big monetary stimulus to the economy:
Mortgage payers have less interest to pay – increasing their effective disposable income
Cheaper loans should provide a possible floor for house prices in the property market
Businesses will be under less pressure to meet interest payments on their loans
The cost of credit should fall encouraging the purchase of items such as a new car or kitchen
Lower interest rates might cause a depreciation of sterling boosting the competitiveness of exports
Lower rates are designed to boost consumer and business confidence
Some economists argue that in current circumstances, the usual transmission mechanism for monetary policy may have broken down and that cutting interest rates has little effect on demand, production and prices. Several reasons have been put forward for this:
The unwillingness of banks to lend – most banks are de-leveraging (cutting the size of loan books)
The incentive to lend when interest rates are at such low levels is reduced
Low consumer confidence – people are not prepared to commit to major purchases – recession has made people risk averse as unemployment rises. Weak expectations lower the effect of rate changes on consumer demand – i.e. there is a low interest elasticity of demand.
Huge levels of debt still need to be paid off including over £200bn on credit cards
Falling asset prices – and expectations that property prices will continue to fall
The chart above shows how bank lending to various sectors of the economy has remained weak since 2009. A negative growth rate means that the annual level of lending is falling.
The Liquidity Trap
In the 1930s, Keynes referred to a liquidity trap effect – a situation where the central bank cannot lower nominal interest rates any lower and where ‘conventional’ monetary policy loses its ability to impact on spending. Paul Krugman has defined the liquidity trap as “a situation in which conventional monetary policy loses all traction.”
When interest rates are close to zero, people may expect little or no real rate of return on their financial investments they may choose instead simply to hoard cash rather than investing it. This causes a fall in the velocity of circulation of money and means that an expansionary monetary policy appears to become impotent. This means that different approaches are called for in order to stabilize demand in an economy on the verge of a depression:
Intervention in the currency markets to drive the value of the currency lower to boost export industries