Download UK Monetary Policy

How Effective has UK
Monetary Policy been?
Brian Ellis and Colin Ellis
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For ten years the picture looked good.
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The Bank of England Monetary Policy Committee was established in 1997.
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Its success shifted expectations towards low and stable inflation.
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This in turn moderated pricing decisions and wage demands and made the MPC’s job easier.
• By 2010 the wheels of the monetary policy machine had not completely come off but had started
wobbling.
• Throughout 2010 inflation was above the CPI target of 2% and above its acceptable range of 1-3%.
• This was contributed to by a fall in sterling which pushed up import prices.
• There was also a rise in world commodity prices, especially oil.
• The government itself also raised VAT from 15% to 17.5% in January 2010.
• MPC has continued to forecast a fall in inflation.
• They have not taken anti-inflationary measures partly because of the time lag of about one year before
monetary policy takes effect.
• The Bank’s August 2010 prediction was that inflation would not return to target until the start of 2012.
• The Bank Rate has stuck at 0.5% although the MPC has been divided.
• Monetary policy works by influencing aggregate demand.
• The link between changes in the base rate and aggregate demand is summed up by the monetary policy
transmission mechanism.
• Here a rise in the base rate will lead to a rise in other interest rates in the economy.
• Households will then find saving more rewarding and borrowing more expensive.
• This should case a fall in consumption, which is the biggest component of aggregate
demand.
• The plunge in the base rate as a result of the recession reduced rates to savers.
• Typical savings accounts now offer about 1% interest, whilst CPI inflation is over 3%.
• The real return on saving has now been negative for 18 months.
• Classical theory suggests consumers should spend more and save less as a result.
• In reality UK savers have saved more of their income than when previously there was a
positive return on saving.
• Before the recession the UK experienced negative saving where household borrowing exceeded saving.
• But in 2009 the savings ratio went above 8%.
• This shows that other factors can have more influence than interest rates.
• Looking at borrowers we can see that there are even more problems with the transmission mechanism.
• Recession has made people more risk averse, so borrowing is less attractive.
• Also, commercial banks lending rates have not exactly followed base rate downwards as theory predicts.
• 0.5% is considered as being as low as base rate can go.
• Even this did not generate as much stimulus to aggregate demand as the MPC considered desirable.
• They therefore introduced quantitative easing (QE).
• QE involves the Bank of England buying bonds from sellers who then initially deposit the payment into
their bank accounts.
• These deposits are liquid assets which enable banks to lend more if they wish to.
• The MPC appreciates that ‘expansionary’ low interest rates and QE have had only limited impact in
reviving the economy.
• GDP is only expected to return to pre-recession levels by 2012.
• On a narrow view the MPC is not concerned with recession, just inflation.
• However, the Monetary Policy Framework says that: “The (MPC) remit recognises the role of price
stability in achieving economic stability more generally, and in providing the right conditions for
sustainable growth in output and employment.”
• The medium-term priority of the Chancellor of the Exchequer is to remove the Public Sector Borrowing
Requirement and stop growth in the national debt.
• This approach reflects the divide between two major approaches to macroeconomic policy.
• It could be that spending cuts and tax increases perpetuate weakness in aggregate demand, leading to
capacity being scrapped and increased unemployment and skill loss.
• Keynesians believe that weak aggregate demand can be boosted by government fiscal injection.
• This could lead to higher employment and tax receipts and lower benefit payments.
• The Public Sector Borrowing Requirement should then fall automatically.
• Some broadly ‘classical’ economists welcome a reduction in the size, role and spending of the public
sector.
• The UK spending cuts and tax increases of autumn 2010 are expected to lead to nearly one million job
losses, particularly in the public sector.
• The Chancellor believes the private sector will expand to take up the slack.
• But, public sector cuts will reduce both household disposable income, and hence consumption, and
government spending.
• Other governments in Europe are also planning to reduce fiscal deficits.
• But Japan has a gross national debt in excess of 250% of GDP yet continues with expansionary
measures.
• The USA has a public sector deficit of more than $1,000 billion per annum, and seems headed for policy
deadlock between ‘hawks’ and ‘doves’.
• The Bank of England and the MPC should not discuss fiscal policy, much less oppose it.
• Using monetary policy to counteract government fiscal tightening would raise serious questions about
the MPC’s role.
• But, those MPC members considering additional QE are concerned with the impact of weak demand on
medium-term inflationary pressures.
• Weak demand could push inflation below target, once the current short-term dynamics abate.
• However, some MPC members worry about second-round effects, where above-target inflation triggers
strong earnings growth, pushing inflation higher in turn.
• How far is the MPC fully independent of the government?
• To what extent can fiscal and monetary policies operate independently of each other?
• After recent difficulties, how might the MPC rebuild confidence that it has control of inflation?
• Does increasing international integration leave price levels in one country at the mercy of global
markets?
• Will economists ever resolve the tension between those who favour a ‘classical’ approach which gives
maximum freedom to market forces and others who favour more regulation and government
intervention?