What factors should we consider when setting monetary policy?
Basics of monetary policy
If inflation is above the target and economic growth too fast, the Bank will likely increase interest rates.
- Higher interest rates increase the cost of borrowing and reduce investment/consumer spending – leading to a lower rate of economic growth. See more at the effect of higher interest rates
- If inflation is falling below target, the Bank can cut interest rates to try and boost economic growth.
- In extreme circumstances, the Bank could try:
Base rates and CPI inflation in the UK since 1998.
Factors to consider when setting monetary policy
1. What is the target of monetary policy?
The current inflation target is 2% +/-1.
But, also the Bank needs to consider wider economic variables, such as economic growth and unemployment.
In some circumstances, the Bank may consider unemployment and recession a more serious problem than inflation overshooting the target.
2. Which is worse – undershooting target or overshooting target?
If inflation increased to 5%, it would be 3% over the Governments target. However, this kind of inflation rate may help reduce unemployment and if economy does start to grow too quickly, it is relatively easy to deal with inflation overshooting the target. Higher interest rates are quite effective for bringing inflation under control.
However, if the inflation rate undershot the target, we would have deflation. (Inflation rate -1.0%). This deflation may be much more damaging than overshooting the target. Why is it worse to undershoot the target?
- It is hard to solve deflation – very difficult to cut interest rates below zero, so real interest rates may be too high. By contrast, it is easier to increase nominal interest rates to reduce inflation.
- Deflation can cause a debt-deflation spiral, where firms and consumers pay a greater percentage in servicing debt and therefore reduce spending. This can lead to lower economic growth.
- With wages sticky downwards, we may see a rise in real wage unemployment.
- Falling prices may cause consumers to delay purchases, leading to lower economic growth.
- See more on problems of deflation.
3. Different types of inflation
Cost-push inflation in 2011/12
When inflation increased to 5% in 2011, why did the Bank of England keep interest rates at 0.5%? Real interest rates were negative.
- The inflation was cost-push inflation – (due to rising oil prices). Therefore, the cost-push inflation also caused lower economic growth. The Bank had a worse trade-off. Higher interest rates would have made the 2011 recession even worse.
- Cost-push inflation is often temporary. Once oil prices stop rising, cost-push inflation stops. When the Pound stops depreciating, the rise in prices from higher import prices will also slow down.
If inflation of 5% was caused by demand-pull inflation – and a pick up in economic growth, the Bank would have responded in a different way.
Setting interest rates in 2017
- The UK economy is likely to experience cost-push inflation from the recent depreciation in the value of the Pound.
- However, this depreciation may have limited impact in boosting exports because of uncertainty over Brexit deals / low growth in Europe.
- If the government were to pursue a form of expansionary fiscal policy to support economic growth, this would influence monetary policy, but if government pursue more austerity, then monetary policy may need to play a bigger role in supporting demand.