How does monetary policy work? What does the Bank of England consider when setting interest rates and how effective has the Bank been in handling monetary policy since it was made independent of government in May 1997. These are some of the issues that we consider in this chapter.

A recap on the basics of monetary policy

Monetary policy involves changes in the base rate of interest to influence the growth of aggregate demand, the money supply and price inflation. Monetary policy works by changing the rate of growth of demand for money. Changes in short term interest rates affect the spending and savings behaviour of households and businesses and therefore feed through the circular flow of income and spending.

The transmission mechanism of monetary policy works with variable time lags depending on the interest elasticity of demand for different goods and services. Because of the time lags involved in setting an appropriate level of short-term 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.

All countries experience an interest rate cycle as monetary policy responds to changing economic conditions

Independence for the Bank

The Bank of England has been independent of the Government since 1997. In that time there has been a cycle of small changes in interest rates. They have varied from 3.75% (in the late autumn of 2003) to 7.5% in the autumn of 1997. Interest rates in the UK were raised from 4.5% to 4.75% in August 2006 at a time when interest rates in other countries including the United States and Japan have been rising. Generally though, the UK economy has experienced a sustained period of low interest rates over recent years. And, this has had important effects on the wider economy.

The Bank of England through the decisions of the Monetary Policy Committee prefers a gradualist approach to monetary policy – believing that a series of small movements in interest rates is a more effective strategy in achieving their aims rather than sharp and unexpected jumps in the cost of borrowing money. Knee jerk changes in monetary policy can be very unsettling for both consumers and businesses throughout the economy.

The role of monetary policy

A summary of the role that monetary policy plays is provided in this quote from the Government of the Bank of England, Mervyn King.

Monetary Policy and the Exchange Rate

There is no official exchange rate target for the British economy. The UK operates within a floating exchange rate system and has done ever since we suspended our membership of the European exchange rate mechanism (the ERM) in September 1992. The Monetary Policy Committee has occasionally discussed the relative merits and de-merits of intervening in the current markets to influence the external value of the pound but no official intervention has occurred for over a decade. There are in any case doubts about the effectiveness of direct intervention in the foreign exchange markets as a means of achieving a desired exchange rate.

Monetary policy and the money supply

There are currently no targets for the growth of the money supply measured by MO and M4. Data on the growth of the stock of money provides useful information for the MPC on the strength of aggregate demand but interest rates are not determined with reference to specific targets for the money supply. In addition the UK no longer imposes supply-side controls on the growth of bank lending and consumer credit. Instead monetary policy in the UK is designed to control the growth in the demand for money through changing the cost of loans and influencing the incentive to save via changes in interest rates.

The determination of interest rates – how the Bank gets to work in the markets

It is important to understand how the BOE influences interest rates via daily intervention in the London money markets. 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 income tax) so, each day there is a shortage in the 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 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 whole economy - for example the rate of interest on mortgages and the rates on offer to savers.

Monetary policy in Britain is designed to be pro-active and forward-looking because changes in interest rates always take time to work through the economy. The reaction of businesses and consumers to interest rate movements is uncertain, as are the time lags involved. The belief is that by making interest rate changes in a pre-emptive fashion, for example raising rates before the rate of growth of AD becomes too fast, or cutting rates to reduce the risks of recession, then the scale of interest rate changes needed to meet the inflation target will be reduced. The thinking is that a monetary policy regime that offers the prospects of relatively stable interest rates over time can help to promote consumer and business confidence.

Factors considered by the Monetary Policy Committee

Before each meeting of the Monetary Policy Committee, a huge raft of economic information is put before members of the MPC rate-setting board. Much of the data that is considered will be information that you may have become familiar with during your AS and A2 economics courses. The economic data considered each month by the MPC includes the following:

• GDP growth and spare capacity: The rate of growth of real national output and the estimated size of the output gap are central to discussions within the MPC about setting the appropriate level of interest rates. Their main task is to set monetary policy so that demand grows more or less in line with the increase in the country’s productive potential.
• Bank lending and consumer credit figures including the levels of mortgage equity withdrawal from the housing market and also monthly 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 state of play in the UK housing market has been influential in shaping interest rate decisions over the last two to three years although we must remember that the monetary policy committee has no official target for the annual rate of house price inflation.
• Consumer confidence and business confidence indicators – confidence surveys are thought to provide useful “advance warning” of possible turning points in the economic cycle. So for example, a sharp dip in consumer optimism might herald a retrenchment of spending which could lead to slower GDP growth and a weakening of inflationary pressure.
• The growth of wages, average earnings and unit labour costs in the labour market – these are considered important as indicators of demand pull and cost push inflationary pressure. The Monetary Policy Committee might become concerned if the annual rate of wage inflation surged above the 5% mark as this might eventually feed through into a rise in consumer prices.
• Unemployment figures and survey evidence on the scale of shortages of skilled labour – these are also labour market indicators as was mentioned in the last bullet point.
• Trends in global foreign exchange markets – for example the trend in the value of sterling against the Euro or the US dollar. A weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services.
• Forward looking indices such as the Purchasing Managers’ Index and quarterly surveys of business confidence including data from the Confederation of British Industry and the British Chambers of Commerce
• International economic data including recent macroeconomic developments in the twelve member nations of the Euro Zone and the world’s largest economy, the United States.

The neutral rate of interest

One interesting and important feature of interest rate setting both in the UK and overseas 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 aggregate demand and growth, nor deliberately seeks to weaken growth from its current level. In other words, a neutral rate of interest would be that which is set at a level which encourages a rate of growth of demand close to the estimated trend rate of growth of real GDP. There can be no such thing as an exact measure of the neutral rate, and it will certainly differ from country to country.
Students who want to explore this further might want to read up on something called the Taylor Rule

In Britain over the last two to three years, interest rates set by the Bank of England have almost certainly been below the estimated neutral rate. Why? Well the Bank has been careful to maintain economic growth given the absence of any serious threat from higher inflation. In the summer of 2003, the MPC cut interest rates to 3.5% and it was quite clear at the time that monetary policy was being expansionary. This means that monetary policy was actively seeking to stimulate confidence and spending in the domestic British economy at a time of great global economic uncertainty.

A recent survey of city economists (admittedly a small but pretty high-powered sample!) puts the neutral rate of interest in the UK at between 4.5 – 5.5%. At the time of writing UK official short-term interest rates are at 4.75%. This suggests that monetary policy in the UK is now broadly neutral in terms of its effect on the rate of growth of demand.

The monetary policy transmission mechanism

The usual view of the transmission mechanism of monetary policy is illustrated in the flow chart below:

Time lags and asymmetries in the transmission mechanism

Although a change in interest rates affects the macro-economy in several ways, there are inevitable time lags in involved. It is also worth stressing that some sectors of the economy are more affected by base interest rate changes than others and some regions of the economy are also more exposed to a change in the direction of interest rates. For example industries that export a high percentage of their output will be more exposed to movements in the exchange rate that might follow from a change in monetary policy. Similarly markets whose demand is sensitive to interest rate changes will be affected to a greater extent than markets where the interest elasticity of demand is lower.

Consider for example the effect of a 2% rise in interest rates over a period of 6 months. The demand for basic foods and clothing is unlikely to be influenced much by this whereas the demand for new cars, expensive household durable goods and other “interest sensitive” products will probably experience a much greater change in demand from consumers.

The impact of interest rate movements is not uniform throughout the economy. But the Bank of England sets interest rates to meet a national inflation target, and cannot be expected to determine interest rates to meet the particular needs of an individual industry, sector or region of the country.

Macro-policies that seek to raise the level of demand and output in the domestic economy are called “accommodatory policies”. In other words, they boost demand beyond what would normally happen through the working of the automatic stabilisers.

The Role of Inflation Targets

Inflation targets have been in place in the UK since the autumn of 1992 and they have also become a frequent feature of macroeconomic policy-making in many other countries. They were first introduced following the UK’s departure from the ERM because it was believed that a credible anti-inflation economic policy needed a clear anchor by which the policy could be judged.

The inflation target that has been introduced in Britain is symmetrical – this means that temporary deviations of inflation below the target are treated with the same degree of importance as deviations above the target. The main reason for this design of the inflation target is that monetary policy should not only deliver price stability, but also seeks to support the broader aims of sustained economic growth and high employment.

If the inflation target was set at 2% or below, there might be a tendency for the Bank of England to drive inflation as low as possible to ensure they meet the inflation target.  But this would risk creating deflationary pressures in many sectors of the economy to such an extent that unemployment might be higher and national output lower than desired. The Bank of England is as concerned to avoid some of the economic and social costs of deflation as it is the well documented implications of a surge in inflation.

Inflation has been remarkably stable since the early 1990s. The next table provides long-term data for UK inflation since 1950. The average annual rate of inflation fell from 13.1% during the 1970s to just 2.5% since the introduction of the inflation targets. Notice too that the standard deviation of inflation (a measure of variance) has also come down sharply over the last ten years. The 1970s and 1980s were by and large, decades of high and volatile inflation. By contrast, the last fifteen years has been a period of much greater stability, leading to a sustained fall in inflationary expectations

Long Term Inflation Data for the UK Annual average percentage change in retail prices
	Mean Inflation	Standard Deviation
1950-59	4.1	1.06
1960-69	3.7	0.72
1970-79	13.1	1.81
1980-92	6.4	1.14
1993-02	2.5	0.21
Source: Bank of England www.bankofengland.co.uk

There is now a consensus that low and stable inflation can contribute to growth and employment creation in the long run. To that end, many countries have put in place inflation targets.

Main Advantages of a Credible Inflation Target

Business planning and investment: Businesses are better able to plan ahead if they believe that the inflation target will be met. They will be more certain about their costs and expected rates of return on investment
Policy transparency: An inflation target provides improved transparency and accountability for the conduct of monetary policy – the general public can see for themselves whether the target is being achieved and whether economic policies are being effective. The target provides clear rules for monetary policy which in the long term enhances policy-making effectiveness.
Controlling inflationary expectations: A credible target lowers expectations of inflation – and this helps to control the growth of wages, in other words, a well designed inflation target can be seen as a key policy “anchor.”

The Problems involved in Forecasting Inflation

Inflation in any economy can never be forecast with perfect accuracy! For a start, the published inflation measure is the result of millions of pricing decisions made by businesses large and small operating in thousands of different markets and sub-markets.  The calculation of the consumer price index in the UK although extremely thorough, is always subject to error and omission.

Furthermore, the complex nature of the inflation process makes it difficult to forecast, even when inflationary conditions appear to be benign. External economic shocks can make forecasts inaccurate. For example, a jump in world oil prices or the deep falls in global share prices both have feedback effects through the economic system. The exchange rate might fluctuate leading to volatility in the prices of imports.

The Bank of England in its quarterly Inflation Report does not even attempt to forecast a precise rate of inflation over its two year forecasting horizon. Instead it produces a colourful ‘fan-chart’ which encompasses its central forecast for inflation based on the probabilities of inflation falling within certain ranges over the next twenty-four months. The central projection is always that the inflation target will be met. But it could not be otherwise, for if the Bank was to say that its current interest rates were not appropriate to meeting the inflation target going forward, and then a change in policy would be required!

Price stability

Inflation has been low and stable in recent years. The former Chairman of the US Federal Reserve, Alan Greenspan has defined price stability as follows:

There is no hard and fast numerical rule for price stability – but steady inflation of 1-3% must come close to meeting the requirements – in this sense, the British economy has enjoyed a return to price stability in recent years.

Reasons for low inflation in the UK in recent years

	Average Earnings	Unit Labour Costs	Producer Prices	Retail Price Index (CPI)	Consumer Price Index (CPI)
	% change	% change	% change	% change	% change
2000	5	3.4	-0.2	2.9	0.8
2001	5.2	3.8	-0.6	1.8	1.2
2002	3.7	2.6	-0.1	1.6	1.3
2003	3.3	1.9	1.3	2.9	1.4
2004	4.5	2.2	1.2	2.9	1.4
Average 1997-2004	4.5	3.1	0.0	2.5	1.4

Among the factors helping to keep inflation in Britain low, we can identify the following:

• Low wage inflation from the labour market: There has been a very subdued growth of wages and earnings which have grown at a fairly modest rate in recent years, staying close to the Bank of England’s desired upper limit of approximately 4.5% per year despite the sustained fall in unemployment. As the table above illustrates, during the years 1997-2004, the average rate of growth of earnings has indeed been 4.5%.
• Low global inflation and deflation in some countries: The absence (until recently) of major external global inflationary shocks such as a sharp jump in international commodity prices. There has been a clear fall in the average rate of inflation among leading economies, and this decline in global inflation has filtered through to the UK. Oil prices have soared during 2004 – but thus far, the effect on the rate of inflation in the UK has remained modest. This is explored in a separate section on the macroeconomic effects of an oil price shock in an earlier section of this study companion.

• The effectiveness of monetary policy in the UK: The success of the Bank of England in keeping aggregate demand under control through interest rate changes
• Increased contestability of many markets: Microeconomic supply-side reforms has led to much greater competitive pressure in many industries – many markets have become more contestable in the last decade and this extra competition has placed a discipline on businesses to control their costs, reduce profit margins and seek improvements in efficiency. In some industries there has been a huge reduction in the pricing power of businesses, globalisation has accelerated this process
• Strength of the exchange rate: The recent strength of the pound over the years 1996-2002 has undoubtedly helped to keep inflation under control because it lowers the sterling cost of imported products and also squeezes demand for UK exporters
• Information technology effects: The rapid expansion of information and communication technology has helped to reduce costs and has made prices more transparent for consumers
• Price cuts within the utilities: Cuts in the prices charged by many of the privatised utilities under the regulatory regime of bodies such as OFTEL and OFGEM
• Sharp decline in inflation expectations: Expectations of inflation have fallen – leading to a fall in inflationary wage demands. The wage price spiral has been largely absent from the British economy over the last decade or more. The Governor of the Bank of England, Mervyn King has coined the 1990s as the “nice decade” – a period of time when a combination of favourable factors has kept inflation in check allowing continued economic growth and a fall in unemployment!