What is the future of monetary policy?
This morning I went to a Resolution Foundation event about the future of monetary policy. Although I cannot claim to be an expert, having listened to the views of the panel I thought I’d make some reflections.
The story of recent monetary policy
During the Global Financial Crisis, the Bank of England cut its base interest rate substantially and rapidly. This was to provide stimulus: it should have led to cheaper borrowing. This manifests itself in various ways, but the focus of the discussion today was on mortgage repayments. With lower interest rates, those with mortgages pay back less each month, increasing their disposable income and boosting consumer spending. The Resolution Foundation have estimated that this policy provided a boost of £24 billion to this group of mortgage holders.
However back then the Bank of England hit a problem: the zero lower bound. The zero lower bound ‘tragedy’ is that conventional monetary policy loses traction when it is needed most. The real interest rate is defined as the nominal interest rate minus inflation expectations. The problem is that the central bank’s base interest rate cannot fall below zero. (This is because central bank policy rates are the rates at which the central bank will lend in the short term to commercial banks. Negative lending rates would expose the central bank to losses which are, at least in the long run, unsustainable.) Given this, the real interest rate can fall only to “minus expected inflation”.
And what if there is an adverse demand shock so severe that this “minus expected inflation” real interest rate isn’t enough to restore equilibrium? Monetary policy fails to stabilise output, and this has knock-on effects. If output is less than it should be there are deflationary pressures which lower expected inflation, which actually raises the real interest rate and lowers output further. This result is known as the ‘deflationary spiral’.
The zero lower bound hence represents a constraint on conventional monetary policy: there are circumstances where it cannot stabilise the economy on its own.
As a result of this constraint the Bank of England introduced Quantitative Easing. This is where the central bank creates new electronic money balances for purchase of assets such as government (mainly) and corporate bonds. By purchasing assets from the private sector, bank and investor balance sheets become more liquid. Hence QE should boost bank lending, triggering increased expenditure.
Was QE effective? It didn’t boost bank lending as predicted, the academic verdict is that it “has boosted the narrow money supply but has not induced the bank lending needed to convert this into broad money supply, demand and inflation”. The panel at today’s event felt that it probably had a small positive effect.
As Matt Whitaker’s presentation highlighted: we should expect a crisis. The economy is cyclical, and with the last crisis occurring 8 years ago it won’t be long until we’re due another one. There are already warning signs evident; it appears we could have another crisis without having ever recovered from the last one.
But the base rate, unchanged since the last crisis, is still at 0.5% and no one expects it to be shooting up any time soon. Hence if another crisis occurs, there appears to be little room for the Bank of England to cut its base interest rate as a method of providing stimulus.
Cutting the base interest rate below zero
The world today is different from the one we knew before the GFC. Nordic central banks have set nominal interest rates below zero, for example Sweden’s Riksbank. And, as far as I’ve heard on the news, the world hasn’t ended.
Expanding Quantitative Easing
Quantitative Easing appeared to help a little bit and not cause chaos, so if another crisis occurred it doesn’t seem a bad option.
However monetarist economists would argue that QE as practised was not aggressive enough, because ultimately the Bank of England could retrieve the money it created by selling back the assets it purchased. To raise inflation expectations it needs to “credibly commit to irresponsibility”. There are different options, but the most discussed (probably because of how crazy it sounds) is that of a “helicopter drop” of money, for example everyone in the population waking up to a cheque from the Bank of England on their doorstep. Perhaps less chaotic is the prospect of monetary financing, where the central bank buys government bonds with no commitment to reverse the purchases.
Raising the inflation target
A higher inflation target would mean that, for the same level of stimulus, the nominal interest rate set could be higher. Should an adverse shock occur the Bank of England would have more room to cut nominal interest rates, and higher inflation expectations would also allow the real interest rates to fall further, preventing the deflationary spiral.
Although there are concerns that changing the inflation target would de-anchor inflation expectations, a more legitimate concern in my opinion is that it simply wouldn’t be credible. The Consumer Prices Index rose by 0.2% in the year to December 2015, when the Bank of England is supposed to be targeting inflation at 2%. Having inflation rise to 3 or 4% just doesn’t appear possible in the near future.
Being willing to use fiscal policy
I cannot highlight enough that the first two suggestions about cutting base interest rates to below zero and using unconventional monetary policy would have sounded crazy less than a decade ago. They are untested and we have no idea about adverse impacts that they could have.
When it comes to stabilising output and employment, the alternative to monetary policy is fiscal policy, where the government takes it upon itself to keep output and employment high during a crisis. In essence it does this by cutting taxes and/or increasing spending.
Yet this government and the last has severely constrained fiscal policy, citing concerns about government debt. The TUC has long argued that these policies have restrained activity more than expected, and placed undue reliance on monetary policy. Faced with a slump in the economy in 2012 there was a welcome pull back from cuts. It may be time to do so again.
Does all of this matter?
I am sorry that this discussion seems dry, but it is important. Monetary policy has a role in stabilising the economy, and should be an important tool for preventing job loss and wage stagnation. As the panel highlighted, we need to ensure that it is not constrained when and if the next adverse crisis occurs. We also need to make structural reforms to reduce the likelihood of such crises occuring (in particular we need to consider the debt overhang which darkens our doors) and be prepared to use fiscal measures when monetary policy fails.