A New Era of Monetary Policy

Over the last few years, monetary policy has changed dramatically. Newspapers are littered with terms such as interest rates, money supply and quantitative easing. If you are new to Economics, and interested by what all this means, this may be a good article for you.

This blog explains the basics behind monetary policy before exploring how it has evolved over recent years. I finish with evaluating “forward guidance”, a new monetary policy introduced by Mark Carney, the governor of the Bank of England (BoE).

What is an interest rate?

An interest rate is simply the cost of money (or the price of borrowing money), where ‘money’ is literally the banknotes in your wallet or the balance in your checking account. There are obviously many interest rates, however, when a central bank sets the interest rate, it is referring to the (risk-free) short-term rate on cash deposits, such as the overnight rate between banks.

The most basic economic concept is that in all markets, the price of a good is the equilibrium between supply and demand. An excess demand over supply will lead to a price rise until demand equals supply again and the opposite is true for an excess supply. The money market is no different. People and firms demand money for transactions and the central bank supplies it. Since the interest rate is the price of money, it sits where money demand is equal to money supply. If money supply outstrips money demand, the interest rate will fall until a new equilibrium is reached. Therefore when a central bank says they are reducing an interest rate, what they are really doing, behind the scenes, is increasing the supply of money. By injecting more money into the system, the price of money (i.e. the interest rate) falls.

Conventional Monetary Policy

Prior to the recession, conventional monetary policy involved the BoE simply setting the interest rate (the base rate) each month. If the bank wanted to reduce the rate (for example down to its current level of 0.5%), it would do so by increasing money supply. The BoE does this by buying safe, short-term assets, usually government bonds, from the market. It pays for these assets with money hence increasing the amount of money in the system (increasing liquidity) and reducing the interest rate, as explained above.

The reason the BoE reduced the interest rate so dramatically was to boost the UK economy. The idea is that a reduction in interest rates would encourage spending over saving. A consumer’s return to saving (and the opportunity cost of holding money) falls. Consumer spending is the largest part of GDP and hence the most important factor in boosting an economy. Lower interest rates also encourage a to firm invest more since the cost of financing that investment has fallen. Furthermore, the demand for the pound falls as interest rates fall, depreciating the currency. This in turn increases demand for imports and decreases demand for exports, improving the trade balance. All these factors contribute towards growth.

With any policy come the unintended consequences, which in this case, is inflation. As aggregate demand increases so does the general price level. In fact, the BoE have an inflation target of 2% and must do the very opposite (increase the interest rate) if inflation is too high.  High inflation can be dangerous for an economy for several reasons.

More importantly, excessive monetary policy can lead to a ‘liquidity trap’. This occurs when increasing the money supply can no longer reduce the interest rate. When an economy’s interest rate is close to zero, a central bank can no longer reduce it. Most economies found themselves in this position during the financial crisis, which made them turn to other unconventional methods of boosting the economy, such as quantitative easing.

Quantitative Easing

Many economies turned to QE when rates could be lowered no more. On a very basic level, this involves the central bank buying longer-term and therefore riskier assets, such as longer-term government bonds (gilts). They do this simply by printing money. Technically, this is not true. Central banks use banks as intermediaries. In effect, banks buy longer-term assets from financial institutions, which they in turn sell to the central bank in return for a higher reserve balance (a bank account that a bank holds with the BoE!)

The whole point of this is to reduce longer-term interest rates (‘further out on the yield curve’) and increase the supply of money further.  Conventional monetary policy focused only on short-term interest rates. Although lower short-term rates can feed through to longer-term rates, this is a more direct way of doing so. 

Since yields on government bonds have fallen, is it cheaper for companies to raise capital - lower longer-term interest rates encourage even more investment. As long-term returns to fixed income products fall, investors turn to the stock market instead for better returns, boosting share prices. Most importantly, the hope is that those firms that have sold their assets, spend the money they receive. As banks increase their reserve balances, the hope is that they also will lend more, leading to cheaper long term borrowing costs for the consumer. In the UK, the asset purchase facility (QE) stands at £375bn.

The problem with QE is that if there is no spare capacity to absorb the increase in spending, the policy can be dangerously inflationary. Printing money can lead to hyperinflation such as in Germany in the 1920s post WW1.

Furthermore banks may not lend out their additional reserves (cash hoarding) and institutions may sit on the extra cash without re-investing. There is no policy to force these institutions to spend the increase in money supply.

Forward Guidance

Mark Carney, the new governor of the BoE, was made famous for forward guidance when he implemented it in Canada. He has now done so in the UK. The idea is simple promise. Carney has promised the UK that he will not increase interest rates until unemployment falls below 7% (currently at 7.8%). This has very similar effects to QE. It flattens the yield curve, or in other words, reduces longer-term interest rates and expectations of future interest rates. Carney said he does not expect the interest rate to rise until at least 2016.

Forward guidance is supposed to provide the markets with reassurance and confidence. It allows firms to invest knowing they will not be hit with higher costs of financing their debt in the medium-term and encourages consumers to buy mortgages with the knowledge rates will stay low for a while yet. In summary, it increases spending and borrowing.

Yet the FTSE tumbled and the opposite happened when forward guidance was announced. The first reason for this was that Carney anchored an interest rate change to another variable – unemployment. Tying a future rate rise to the level of unemployment leads to a lot of uncertainty. Firms and consumers cannot accurately predict when unemployment will fall to 7%. In fact, the markets believe that the BoE is far too pessimistic and are predicting a rate rise much sooner in 2015. It also makes a mockery of the monthly unemployment statistics as firms and net borrowers sit and hope that the jobless remain jobless so that rates do not rise. The more optimistic view of the markets hence meant that the yield curve was not flattened as much as Carney would have liked.

Furthermore, there are too many get-out clauses that make the date of a rate rise far too unpredictable. If medium-term inflation expectations become too high then rates will rise. As we have seen, low interest rates cause inflation. With inflation currently at 2.9%, markets fear that this get-out clause is a possibility. Furthermore, the Financial Policy Committee (FPC) can force a rate rise if they believe the policy causes “potential systematic risks”. In other words, the rate can be raised at any time.

My conclusion on forward guidance therefore is that it is a great idea if it is bold. If you can make a credible commitment to keep rates low for a certain amount of time, like he did in Canada, then forward guidance can have the intended consequences. Albeit very risky, a promise such as “I will not raise the interest rate until 2016,” would certainly have the desired effects if credible. However, by tying it to the unemployment statistics and providing too many get-out clauses, the policy does not do much at all. In fact, all has done is bring forward the markets’ expectation of when rates will rise.