THE FUTURE OF MONETARY POLICY by Sir John Vickers

This week we had the opportunity to hear Sir John Vickers, Professor of Economics at Oxford University, on the issues surrounding the UK Monetary Policy.

The areas examined in this talk included:

►   Overview of history of UK monetary policy

►   Inflation targeting – success or failure?

►   Should monetary policy have a new objective?

Sir Vickers began by giving an explanation of the Monetary Policy. Monetary policy, in essence, says that the monetary system is a very important part of the success of an economy (if it goes right) or failure (if it goes wrong), Every economy has to deal with decisions about its currency and the amount of the currency in circulation. In UK, the money supply is decided by the Bank of England. A related issue faced by economies is deciding the price of money, that is, the interest rate. In 1998, when Sir Vickers was part of the Monetary Policy Committee, the interest rates set were around 5-7.5%. It was noted that a talk on this topic would have been strange five years ago when the monetary policy was to be used to achieve the 2% ±1% inflation target and there was nothing more to be discussed. The questions arising now tend to revolve around the use of this demand side policy after the financial crisis, that is, 2008 onward.

History of the inflation in Britain

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SOURCE: Mankiw & Taylor, figure 1-2

 

The chart above shows the inflation in the 20th century. Most of the time, inflation has been between 0-10% but there has been two inflationary surges. One was associated with the First World War and the second with the oil crisis in the 70s where inflation reached over 25%. At such high levels, inflation erodes savings and the value of money because of which this situation is undesirable. Deflation (or negative inflation) is also not desirable when the prices fall. This was experienced during the period after the war as the government was trying to bring inflation down to the pre-crisis level. After the 1930’s UK has not had deflation. What is desirable is low stable inflation. This was the case during the 90’s when inflation was within the range of 1% – 5% and the inflation was well within the target of 2.5% ± 1%, which recently hasn’t been the case.

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SOURCE: Bank of England, Monetary and Financial Statistics and UK Statistics Authority

The chart above shows the relatively stable period of inflation after the 70’s indicated by the blue line. The economy grew steadily during this period. The red line is the official bank rate set by the Bank of England.

There are three phases that can be observed:

I.            During the 70s when inflation was high, the inflation adjusted bank rate (accounting for inflation by using Bank rate minus Inflation) was heavily negative. This meant that if the inflation was 25% and the bank rate 10%, the saver loses 15% in real purchasing power terms.

II.            In the 80s and 90s there was a positive difference between the bank rate and inflation, which is more usual. Times when the interest rates were very high were during times when inflation was high and economy needed to slow down.

III.            After the crash in 2009, Bank of England, like other central banks, put the interest rates very low at 0.5% whilst inflation has been bubbling round. This has been another period where the savers have been losing in real terms.

 

Monetary Regimes

Throughout history, there have been several forms of monetary arrangements. Between the Napoleonic war and WWI, the gold standard was used where the monetary arrangement was the gold commodity. The prices of all other goods were anchored to the price of gold. The prices fluctuated as the supply of gold fluctuated. Although gold standard achieved quite good long-run price stability pre-1914, it collapsed in the times of the crisis, particularly, during the WWI. For Keynes it was ‘already a barbarous relic’ by 1923 and he believed we could do much better than anchoring our prices on this shiny metal. In the 1920s the decision of returning to the gold standard was under consideration. Winston Churchill, the Chancellor of the Exchequer at the time, decided in 1925 to return to gold standard (at the old rate). It was later admitted to be the worst decision he ever made. It was finally dropped in 1931, following the period of Great Depression.

Another focus for the monetary policy could be low unemployment, an idea which though seductive given the evident benefit of low unemployment, would not be ideal as money supply would not be effective in achieving the aim. Targeting monetary policy towards maintaining a fixed exchange rate, for example the Sterling to the Deutschmark, was painful for the economy as it required the pushing up of interest rates. This was given up in 1992 as it did not work.

The method then adopted was targeting the inflation rate. This is done by using the interest rates to control inflation or by buying government bonds which are issued to fill the government deficit. This is done via printing money electronically.

Now questions are also raised about targeting in real (nominal less inflation) or nominal (in money terms) GDP growth. This idea is still being debated.

Inflation targeting in the UK

Inflation targeting has been the objective of the Monetary Policy Committee of the Bank of England, comprising 9 members who hold monthly meetings to decide on interest rates. This has been the target of monetary policy since 1992 after the ejection of the Exchange Rate Mechanism (ERM). Until the 1990s, the decisions on interest rates were made by the Chancellor with advice from the Bank of England. Later, the Bank of England Monetary Policy was given operational independence since 1997 under Gordon Brown. The target for inflation is now chosen by the Chancellor and left to the Monetary Policy Committee to meet. The target was 2.5% for RPIX inflation up to 2004 and then the target was set at 2.0% for CPI inflation.

Whether inflation targeting is the most suitable target for monetary policy is debatable. On the one hand, it seemed to be the best and the one that worked successfully for 15 years from 1993, after having tried several other forms of monetary arrangements. On the other hand, it has not been able to burst the asset bubbles or protect banks when the sub-prime mortgages came in. Some argue that the five years following the crisis has shown its failure.

Inflation projections

The following chart from the Bank of England’s inflation report maps the inflation forecast for the coming quarters. It shows that inflation has been overshooting the target at 2% represented by the black line. The Monetary Policy Committee is, however, content with the overshooting as it is not massive and using a tight monetary policy at this time may risk worsening the current economic situation. The expected inflation in the coming years is shown as a range, reflecting the considerable uncertainty surrounding the forecast.

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Quantitative easing (QE) has been used increasingly as part of the monetary policy. This is where electronically created money is used to buy bonds with the view to lowering interest rates not only in the short term but also in the long term. This has also lowered the government interest rate of borrowing to 2% which is lower than inflation. The quantity of assets purchased under QE has reached the figure of £375 billion, which is ¼ of GDP.

The question revolving around this is whether more QE should be carried out and whether QE will only lead to an inflationary problem down the track.

Where to now?

Some argue that monetary policy needs a huge rethink whilst some would even criticise inflation targeting. Sir Vickers argued that what is needed alongside inflation targeting is recognising that inflation targeting is not the means to achieve everything and that we need other, new tools to achieve other objectives like using regulation on banking and controlling booms and busts better.

Time for helicopter money?

Some argue that we have got to the point where money should be showered from a helicopter, that is, financing the deficit by printing money. This differs from QE because QE involves government issuing bonds and BoE printing money to buy bonds. When things get back to normal, BoE sells those bonds for cash – the hoover after the helicopter. Sir Vickers argued that he was against this proposal since without the hoover (bonds that could be sold for cash controlled by the BoE) there would be much greater inflation risk for the future.

A provisional view

The problems exposed in 2008 were with financial regulation and not inflation targeting. We need to build much better financial regulation, including ‘macro-prudential’ tools. It is best for the monetary policy to stick with inflation targeting and 2% is a reasonable target but there is a need to implement the monetary policy flexibly – both in terms of tolerating overshoots and the instruments deployed. Nonetheless, the inflationary lessons of history have taught that price stability really matters and should not be jeopardised.

 

The talk came to an end with several questions ranging from the issues of equity as inflation rises to whether the downgrading of the UK economy mattered. Thank you to all those who attended. Any further discussion on this topic is welcome.

 

 

 

 

 

 

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