Download the money supply and the framework of monetary

THE MONEY SUPPLY AND THE FRAMEWORK OF
MONETARY POLICY
Recent UK policy:
1.
2.
3.
Targets for growth of various measures of the money supply (Medium Term Financial
Strategy) between 1980 and 1990, based broadly on belief in the Quantity Theory.
Membership of ERM between 1990 and 1992 (following a period of ‘shadowing’ the DM
after 1987) – commitment to maintaining value of £ within fixed range (plus or minus 6%
of the central parity) against all other ERM currencies.
Inflation targets since exit from ERM in 1992 (target and inflation measure changed in
December 2003). Monitoring of growth of two measures of the money supply, though
neither is an explicit target.
M0 (narrow measure) – notes and coins in circulation (these account for over 99% of M0) and
banks’ operational deposits held at the Bank of England. A COINCIDENT INDICATOR of
consumer spending – i.e. it reflects, but doesn’t cause, changes in consumer spending/retail
sales.
M4 (broad measure) – M0 plus sight and time sterling deposits held by UK residents in banks and
building societies; such deposits include those made by savers AND those created by banks
making loans to customers (every loan creates an equivalent deposit). Changes in M4 indicate
changes in the demand for credit at present interest rates.
THE MONETARY POLICY FRAMEWORK SINCE 1997








The central objective of macro-economic policy is a high, stable and sustainable level of real
GDP growth and employment (no return to ‘boom and bust’)
A low rate of price inflation is seen as a key condition of meeting this objective
The primary aim of monetary policy is therefore to deliver ‘price stability’
The goal of monetary policy is specified precisely by the Chancellor in the form of an inflation
target; since December 2003, the target is 2.0% p.a. for the Consumer Price Index measure
of inflation, with allowance of 1.0% either side of the central target. Hence the target is
symmetrical – undershoots are as unacceptable as overshoots.
The primary focus of monetary policy is on changes in the base rate of interest set at its
monthly meetings by the Monetary Policy Committee of the Bank of England; the Bank has
been operationally independent of the Government since May 1997.
Policy is proactive and preemptive, thus taking account of forecasts of future (18 to 24
months) inflation and of the time taken for interest rate changes to take effect
There are several transmission mechanisms whereby interest rate changes affect inflation
Fiscal policy is seen as subordinate, and must be consistent with monetary policy; this has
implications for the government’s borrowing requirement. Between 1996-97 and 2000-01,
when the economy was growing above trend, the fiscal stance was tightened by 4% of GDP.
Since then, with the general below trend growth, it has been eased by 3% of GDP.
WHY MIGHT INTEREST RATES CHANGE?






The government’s inflation target appears to be under threat
Borrowing is rising too rapidly or slowing down too rapidly
Asset prices (housing and shares) are rising or falling too rapidly (strong link with C)
To influence movements in the value of the £ (though there is no explicit target for the £)
To persuade lenders to finance a large PSNCR/PSBR (hence an increase in rates)
Economic growth is above (inflationary gap) or below (deflationary gap) the trend rate
THE MAIN TRANSMISSION MECHANISMS OF MONETARY POLICY
Monetary policy is designed to influence one or more components of Aggregate Demand (AD),
which in turn reduces or increases inflationary pressure in the economy. The various ways in
which interest rates affect the rate of inflation are called transmission mechanisms. The most
significant transmission mechanisms (in the case of an interest rate increase) are:






An increase in the proportion of disposable income saved (higher interest returns); this
reduces consumer spending and thus AD.
A reduction in the amount of new borrowing by consumers and firms; this reduces both
consumer spending (C) and investment (I), and thus AD.
An increase in the amount of income needed for debt servicing (monthly repayments on
variable interest loans and mortgages); this reduces the disposable income of consumers
and firms, and thus both C and I, and thus AD.
Higher interest rates mean that mortgage finance is less attractive. This should lead to a
reduction in the demand for private housing, and thus to fewer housing market
transactions and to a moderation of house price increases. The reduced asset price
increase means that the wealth of homeowners rises at a lower rate than was expected,
which in turn may reduce consumer confidence and spending – especially if further
increases in interest rates are expected.
Higher interest rates will tend to make the £ more attractive to investors and speculators
on the foreign exchange market; the resulting speculative inflows drive up the value of
the £, thus reducing the price of imports, which then exerts direct downward pressure on
the rate of inflation.
A monetary policy regime that succeeds over time in keeping inflation within its target
range has a downward influence on the future inflation expectations of firms, consumers
and pay bargainers; this then moderates pay and price increases, which contributes to
continuing low inflation. The effect is to keep down long run interest rates, which reduces
government debt interest and frees resources for increased spending on public services.
WHAT DOES THE BANK LOOK AT IN MAKING ITS MONTHLY INTEREST RATE
DECISIONS?
The MPC has a wealth of statistical information and projections at its disposal. In forming its
interest rate judgement, the most important economic trends reviewed are:








Changes in AD (size and composition, especially consumer spending, as reflected in
retail sales and the M0 measure of the money supply), and thus changes in income and
GDP growth.
Current inflation rates (various measures such as CPI, RPI, RPIX, producer input prices)
and indices of expectations of future inflation.
Bank lending; outstanding consumer debt; growth of different measures of the money
supply.
House prices and the volume of housing market transactions; other asset values, such as
share prices.
Consumer and business confidence surveys; the proportion of firms working below
capacity.
Labour market trends – employment and unemployment; wages and earnings growth;
overtime hours worked; job vacancies and reported labour shortages; unit labour costs
(link with productivity changes); regional variations.
The estimated size of the output gap – the difference between potential and actual output
growth (in other words, whether output is currently increasing at a greater or lower rate
than its long-term trend rate).
Import prices and changes in the value of the £; external ‘shocks’, particularly changes in
oil and imported commodity prices.
WHY MIGHT THE EFFECT OF INTEREST RATE CHANGES BE FAIRLY LIMITED?
In practice, interest rate changes represent an exercise in fine-tuning, and are not normally
intended to have a dramatic effect on the economy – this is why all but four of the MPC’s changes
since 1997 have been in the order of 0.25%. Moreover, interest rate changes may have limited or
delayed effects for a number of reasons:






Mortgage lenders do not always adjust their own rates fully or immediately in line with
base rate changes.
A growing proportion of mortgage holders are borrowing at fixed rather than variable
rates, and are therefore not affected by base rate changes.
Credit card and store card companies are remarkably reluctant to follow base rate cuts.
Businesses with plenty of spare capacity are unlikely to invest more in response to a
small interest rate cut.
Cuts in rates reduce the incomes of savers, which partly offsets the benefit to borrowers.
Time lags are critical – in practice consumer and business confidence have a far greater
effect on spending decisions – and, in particular, average house price increases and
firms’ profits.
INTEREST RATE CHANGES SINCE BANK INDEPENDENCE






May 1997 – June 1998:
5 rises from 6.25% to 7.5%
October 1998 – June 1999:
7 cuts from 7.5% to 5.0%
September 1999 – Feb 2000: 4 rises from 5.0% to 6.0%
(Interest rates unchanged for 12 months)
Feb 2001 – November 2001:
7 cuts from 6.0% to 4.0%
(Interest rates unchanged for 15 months)
February 2003 – July 2003:
2 cuts from 4.0% to 3.5% (lowest base rate since 1955)
Nov 2003 – August 2004:
5 rises from 3.5% to 4.75%
The pattern shown above is crystal clear. The MPC introduces a succession of interest rate
increases when it fears that future inflation is likely to exceed the target, and introduces a
succession of interest rate cuts when it fears that future real GDP growth will be below trend.
The Bank has an excellent record. It has met the Government’s inflation target in every month
since independence, and inflation is now at its lowest and most stable level (below 2% on the CPI
measure) for over 40 years. The MPC has met on 94 occasions up to April 2005, and has
adjusted rates on 30 occasions – 14 increases and 16 cuts. 26 of these adjustments involved a
rise or fall of 0.25%. The four 0.5% changes were all downwards, in the context of the 1998/99
Russian debt and Asian crisis, and after 11th September 2001. Policy has therefore been
particularly successful in dealing with external shocks and in avoiding any subsequent recession.
The UK economy has been the most stable G7 economy since 1997, with volatility in real GDP
growth and inflation around half that of the average for the other six. Growth of real GDP per
head has been more than a third higher than the average for the other six. Each full interest rate
cycle has also seen rates bottom at successively lower levels.
RECENT POLICY
In the spring and summer of 2003, the MPC lowered rates to 3.5% on account of the sluggish
global recovery, and with a view to stimulating consumer spending. The predicted growth
slowdown was avoided; indeed the housing market continued to boom and household borrowing
exceeded £1,000 billion for the first time ever in June 2003.
The global recovery was well under way by the autumn of 2003, and the MPC responded to the
perceived danger of over-heating by raising rates on five occasions between November 2003 and
August 2004. This brought the Bank back to a more neutral stance – in other words, a level of
interest rates that neither boosts nor restrains AD, and which is consistent with the economy
growing at its trend rate (estimated to be 2.75% p.a.) over the medium term. Hence the emphasis
was on withdrawing an earlier monetary stimulus rather than shifting to a more restrictive stance
– a case of ‘taking the foot off the accelerator rather than of applying the brake’.
The effect of these interest rate increases has been to slow down consumer spending growth,
while there has been a dramatic moderation of house price inflation. The Bank is anxious to avoid
any housing market ‘crash’, which accounts for its caution. The Bank’s Quarterly Inflation Report
(February 2005) concluded that ‘the overall risks to growth and inflation are finely balanced’,
though added that if rates remained at 4.75%, stronger demand would push inflation above its 2%
target by the end of 2006. There is thus now an expectation that inflation will continue to rise
slowly towards its central target value, and that there will be further interest rate rises, though not
this side of the general election. The Bank has identified various ‘upside risks’ to inflation, and in
particular, upward revisions of recent quarterly growth statistics, the increasing rate of average
earnings growth, higher oil and commodity prices, the deteriorating fiscal position, and the
continuing growth of household debt. On the other hand, faster than expected productivity growth
has increased potential output; house price inflation has fallen dramatically, and external demand
growth might slacken if oil prices continue to increase. After eight months in which rates have
remained unchanged, further small rises are expected in May and beyond.
THE CASE FOR INFLATION TARGETS









Alternative approaches to macro policy (such as monetary targets or exchange rate targets)
have generally been unsuccessful as a means of controlling inflation
The success of inflation targets elsewhere – pioneered in New Zealand, and highly
successful in USA, Japan, Germany, etc.
Inflation has devastating effects on the economy – low inflation is now seen everywhere as
the key to high and stable growth and employment through its effect on confidence and
competitiveness
Confirms commitment to low inflation – hence targets ‘anchor’ monetary policy and make it
more credible in financial markets
With Bank operational independence, an inflation target improves the transparency of
monetary policy and provides clear rules for its conduct
Target has a key influence on expectations of future inflation and thus on the behaviour of
wage bargainers and price setters
The target has enabled the Bank to build up a track record as it has consistently been met –
and so allows interest rates to fall over time without causing inflation increases since the risk
premium of holding sterling is reduced
The successful pursuit of low inflation encourages planning and investment by firms, with
beneficial effect upon trend growth rate
Bank’s record: inflation below the central target for 76 of the 94 months to April 2005
REASONS FOR CONTINUING LOW INFLATION IN THE UK ECONOMY



Success of the inflation target adopted since 1992; policy has been dictated by need to meet
a low but credible target, both before and after Bank independence (1997)
Continuing low inflation has affected expectations of future inflation of price and wage setters
in a downward direction – the change in inflationary psychology has become self-fulfilling
Despite high GDP growth rates in most years and falling unemployment since 1993, earnings
growth has seldom risen sharply (exceeding 4.5% in only 3 of the last 13 years), thus
reducing cost push inflation pressures







The high value of the £ for most of the period since 1995 has restrained imported inflation
through its impact on the price of imported manufactured goods, commodities, component
parts and raw materials (but see below)
Until 2004, there have been no dramatic 1970s-style external shocks – such as huge oil and
commodity price hikes – in any event oil price increases (as seen in 2004) have much less
impact on inflation than previously
Consumers have become more resistant to price increases – reflected in high street price
wars, near-permanent ‘sales’ by some retailers and growth of internet sales
Rapid growth of information and communication technology has reduced costs of many
products, and has also made prices more transparent, and easier to compare
Opening up of many markets to competition has forced firms to focus on cost cutting to
remain profitable, reflected in lower prices; tough regulation of privatised utilities, together
with liberalisation, has resulted in dramatic price cuts (e.g. in telecomms, electricity and gas)
Contribution made by more flexible labour markets in keeping down wages (and thus prices)
But a gentle trend increase in inflation since 2003 – currently at a seven-year high; MPC
responded with interest rate increases in 2004. Increased imported commodity and fuel
prices have contributed, as well as Council Tax increases, and pressure of consumer
demand, reflected in record indebtedness and recent housing market recovery. The declining
value of the £ against the euro (though not against the $) has also driven up import prices.