Monetary Policy

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					Monetary Policy
    What is Monetary Policy?

 A change in the base rate
 A change in the money supply
 A change in availability of credit
How does Monetary Policy work?

   It works by changing the rate of growth of
    demand for money
   According to Monetarists, monetary policy is a
    more powerful weapon than fiscal policy in
    controlling inflation
   The transmission mechanism of monetary
    policy works with variable time lags
   The BOE works on the basis of hitting the
    inflation target over a two year forecasting
    Monetary Policy in the UK

 The Bank of England has been
  independent of the Government since
 The UK has experienced low interest
  rates in recent years
     Interest Rates of Major World

To find out current global base rates click here
Data from the BOE’s November 05
         Inflation Report

  Current GDP projection based upon
  a nominal interest rate of 4.5 per cent
Data from the BOE’s November 05
         Inflation Report

  Current CPI inflation projection based upon
  a nominal interest rate of 4.5 per cent
Data from the BOE’s November 05
         Inflation Report
    Market beliefs about future
    interest rates
Monetary Policy and the Exchange

 There is no official exchange rate target
  for the British economy
 The UK operates with a free floating
  exchange rate and has done since it
  pulled out of the ERM in 1992
      Monetary Policy and Money

   There are currently no specific targets
    for the growth of money supply
    measured by M0 to M4
    What are M0, M1, M2, M3 & M4?
   M0 - A narrow measure of money which consists of
    notes, coins and retail banks` balances at the Bank of

   M1 - one measure of the money supply that includes
    all coins, currency held by the public, traveller's
    checks, checking account balances, NOW
    accounts, automatic transfer service accounts, and
    balances in credit unions. see also M2, M3.

   M2 - one measure of the money supply that includes
    M1, plus savings and small time deposits, overnight
    repos at commercial banks, and
    non-institutional money market accounts. A key
    economic indicator used to forecast inflation. see also
What are M0, M1, M2, M3 & M4?

   M3 - One measure of the money supply that
    includes M2, plus large time deposits, repos of
    maturity greater than one day at commercial
    banks, and institutional money market
    accounts. see also M1.

   M4 - A broad measure of money which
    consists of notes, coins and all deposits with
    banks and building societies denominated in
      Other Information on Money
   Data on the growth of the stock of money
    provides useful information for the MPC on the
    strength of AD
   However interest rates are not determined
    with reference to specific targets for money
   The UK no longer imposes supply-side controls
    on the growth of bank lending and consumer
   Instead, interest rates are used to control the
    growth in demand for money and influencing
    the incentive to save
         How are Interest Rates

   The BOE influences interest rates through
    daily intervention in the London money
   Each day huge sums of money pass between
    the Government to banks and vice versa
   Usually much more money flows from banks to
    the Government (e.g. tax payments from
    individuals and firms) leaving a shortage in
    the market
       How are Interest Rates

 The BOE is the main provider of
  liquidity to the wider financial system
 It can choose the rate of interest it
  wishes to charge the financial
  institutions requiring money
 This rate is quickly passed on through
  the system and affects the rate of a
  whole range of financial products
  (including loans and mortgages)
          Also consider…

 UK monetary policy is forward-looking
  and pro-active
 Changes in interest rates take time to
  feed through to the economy (up to a 2
  year time lag)
 Interest rate changes are therefore
  made in a pre-emptive fashion
    What Factors does the Monetary
     Policy Committee Consider?

   GDP growth and spare capacity (measured by
    the size of the output gap) – monetary policy
    needs to be set so that demand grows in line
    with the country’s productive potential

   Bank lending and consumer credit figures –
    this includes data on mortgage equity
    withdrawal from the housing market and
    monthly data on car lending
    What Factors does the Monetary
     Policy Committee Consider?

   Equity markets (share prices) and house prices
    – both help determine consumer wealth which
    feeds through to borrowing and retail

   Consumer confidence and business confidence
    data – these provide and advance warning of
    possible turning points in the economic cycle
What Factors does the Monetary
 Policy Committee Consider?

   Wage growth, average earnings growth,
    unit labour cost growth – these are
    indicators of demand-pull and cost-push
    inflationary pressure

   Unemployment figures & survey
    evidence – these provide evidence of the
    scale of any shortages in skilled labour
    What Factors does the Monetary
     Policy Committee Consider?
   Trends in global foreign exchange markets – an
    example might be the trend 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 The PMI report is an extremely
    important indicator for the financial markets as it is
    the best indicator of factory production. The index is
    popular for detecting inflationary pressure as well as
    manufacturing economic activity, both of which
    investors pay close attention to
 What Factors does the Monetary
  Policy Committee Consider?

 Finally…
 The MPC also looks at international
  economic data including recent
  macroeconomic developments in the
  Eurozone (data from the European
  Central Bank) and the United States
  (data from the Federal Reserve)
    The Neutral Rate of Interest

 This is the principle that there may be a
  rate of interest that neither deliberately
  seeks to stimulate AD and growth, nor
  deliberately seeks to weaken growth
  from its current level
 Therefore a neutral rate of interest
  would only encourage growth close to
  the trend rate of growth of real GDP
    What is the case in the UK?

   Between 2000 and 2003 the BOE set interest
    rates almost certainly below the neutral rate.
   Why? The BOE encouraged growth through
    expansionary (reflationary) monetary policy
   Perhaps in light of recent data the BOE may
    decide that further cuts need to be made to
    interest rates
The Policy Dilemma on Interest Rates

   Maintaining a low interest rate runs the risk of
    encouraging uncontrollable consumer
    spending and borrowing
   However, recent consumer confidence figures
    suggest that this is not such a worry
   However, higher interest rates could
    potentially damage the fragile manufacturing
    sector and the export market
   Furthermore, the recent weakness in the US
    dollar exacerbates the aforementioned
    The Case for Raising Interest Rates

   To curb the excessive growth of consumer demand
   To slow down the housing market (still trading at six
    times average earnings)
   To compensate for expansionary fiscal policy (Labour
    spending on health, education etc)
   The global economy is picking up (see latest data from
    US and Europe) therefore the economy can cope with
    a rate rise
   Commodity prices are rising quickly (China effect)
   To pre-empt improved growth in 2006 (as predicted
    by Gordon Brown in his pre-budget report)
    The Case for Cutting or Maintaining
              Interest Rates

   Consumer and business confidence is fragile
    (consumer spending has slowed)
   The high level of consumer debt is a weight around
    the neck of the economy now that is slowed – cutting
    rates will reduce this effect in the short term
   The housing market has already shown signs of
    slowing without the need for further rate rises
   Manufacturing in the UK is fragile and a rate rise
    would cause a rise in Sterling and damage exports
   The economy is operating below full capacity and
    inflation is not a major threat
           Transmission Mechanism – A
             Change in the Base Rate

            Market Interest                                 Domestic
                Rates                                      Inflationary
                                Domestic                    Pressure
                              i.e. C + I + G
Official     Asset Prices
Interest                                       Aggregate
Rate                                            Demand
            Expectations &
                                i.e. X- M

            Exchange Rate                                     Price
What are the Time Lags & Asymmetries in
     the Transmission Mechanism?

   Inevitably there will be time lags involved
   These may be difficult to predict
   Industries which export a large percentage of
    output amore affected by base rate changes
   Markets which have demand that is sensitive
    to interest rate changes will be affected more
    than those where the interest elasticity of
    demand is lower
   For example the demand for basic foods &
    clothing will be affected little by a small
    interest rate rise in comparison to the demand
    for new cars and luxury consumer durables
        Historic Inflation Performance
(data from 2005 “Red Book” – Budget Report)
              A Useful Point…
   Between 2000 and 2003 the UK and the USA
    used both fiscal and monetary policy in order
    to achieve short term economic growth
   Within these years short term interest rates in
    the UK fell by over 3% (and over 4% in the
   Within these years the UK budget deficit
    increased by over 3% of national income
    (despite allowances for the economic cycle).
    In the USA the fiscal expansion was over 5%!
This can be shown graphically…

                    Source: Red Book 2004
        Accommodatory Policies

   Macro-economic policies that seek to raise the level of
    demand and output in the domestic economy are
    known as “accommodatory policies”
   These boost demand beyond what would normally
    happen through the working of automatic stabilisers
   (NB: An automatic stabiliser is any mechanism that
    helps absorb a shock (e.g. through monetary policy -
    real interest rates, through fiscal policy - tax rates)
   Automatic stabilisers work as a tool to dampen
    fluctuations in real GDP without any explicit policy
    action by the government
    Are the UK and USA creating
       longer term problems?
 The rising budget deficit may become a
  problem for these governments in the
  years ahead
 The UK and USA both have huge trade
  deficits caused by strong consumer
  demand (mainly fuelled by high house
 At the same time export and investment
  good industries have remained weak
          Inflation Targets

 These were introduced when the UK
  pulled out of the ERM in 1992
 Why? Any anti-inflationary policy needs
  a benchmark by which it can be
  effectively judged
 The UK has a symmetrical inflation
  target (see EU presentation)
 It is currently set at 2%
    Why have a Credible Inflation

 Businesses can plan ahead as they will
  be more certain about the return on
  their investment
 Improved transparency and
  accountability of monetary policy (how
  well are the MPC doing their job?)
 A credible target lowers expectations of
Problems Forecasting Inflation

 Inflation figures are always subject to
  error and omission
 External economic shocks can affect
 This is why in the BOE’s inflation report
  it includes a fan chart for inflation rather
  than a precise prediction (see earlier
         Achieving Price Stability
    The UK’s low rate of inflation has been due to a number of

   Low wage inflation from the labour market
   Low global inflation and deflation in some countries
   The effectiveness of UK monetary policy
   Increased contestability (greater competition) in many
   Strength of Sterling (lowering cost of imports and
    squeezing demand for UK exports)
   Effects of increased IT – reducing costs and improving price
   Price cuts within the privatised utilities (under the regulator
    regime of bodies including OFTEL and OFGEM)
   Sharp decline in inflation expectations – therefore
    inflationary wage demands have fallen and the “inflationary
    wage spiral” has disappeared
   Now go to the Bank of England’s website and
    read the latest “Inflation Report” for the UK
   The report should be available as a webcast,
    PowerPoints or as Acrobat files
   Also, go to the MH Treasury website and
    download the latest Budget Report

   Using both of the above sources find out more
    about the way in which monetary policy
    decisions have been influenced by changes in
    the macroeconomy

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