Monetary and Fiscal Policy in the UK

monetary-vs-fiscal-policy

Readers Question: What do you understand by the terms ‘monetary policy’ and ‘fiscal policy’? Explain with reference to a country of your choice:- a) How these policies have been used by the government to try to achieve its objectives Definition – monetary and fiscal policy Monetary policy is managed by the Bank of England. They have …

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Quantitative easing: risks vs benefits

definition-quantitative easing

Readers Question: Could you comment on This BBC programme on Q.E.

The programme highlights several criticisms of Quantitative Easing, especially the Q.E. adopted by the Bank of England.

Since 2009, the Bank of England’s balance sheet has quadrupled, and now a third of all government bonds are now held by Bank of England. The programme fears this is storing up future inflation and a possible loss of confidence in the bond market.

Firstly, just to recap:

Quantitative easing involves

  1. Central Bank creating money electronically
  2. Using this electronic money to purchase bonds (mostly government bonds)

The effect of quantitative easing has been

  • To reduce bond yields on government debt.
  • Increase money supply and bank reserves of commercial banks.

Drawbacks of quantitative easing

  • The new inflow of money into commercial banks from quantitative easing has encouraged banks to use this extra money through greater risk-taking. Some argue that Q.E. has increased the risk-taking nature of banks (a problem behind 2008 crisis)
  • Bond traders have benefited from making large profits out of the Bank of England by manipulating the bond market.
  • Because government debt is being financed by quantitative easing, the government has less market discipline to think about reducing fiscal deficits and tackle the underlying problem of UK public sector debt rising to 100% of GDP by 2016.
  • Quantitative easing has been a stealth method of reducing the value of the Pound and Dollar – and therefore making UK exports cheaper. Some commentators call this currency manipulation (or currency wars). They argue this is unfair on emerging markets who are seeing their exports become less competitive.
  • The increase in money supply has led to an unexpected rise in commodity prices, such as oil. This is unusual when the Western economies are in recession; rising oil prices have led to cost-push inflation.
  • By depressing interest rates, quantitative easing has wiped out people’s return on savings (though share price rises have compensated to a certain extent.)
  • Quantitative easing is causing inflation in the UK. (Inflation has frequently been above the government’s target of 2%, and when the velocity of circulation rises, these extra bank balances will be lent – causing a possible inflationary surge.
  • The scale of quantitative easing could make it impossible to sell bonds back to the market and this will damage the UK’s ability to borrow in the future. If the UK’s ability to borrow is constrained, this will lead to higher interest rates and reduce economic growth.
  • Evidence in the US suggests even raising the possibility of tapering could cause damage to the bond market, and higher interest rates. These higher interest rates could reduce economic growth.

Potential benefits of Q.E.

  • Low bank lending. There is no real evidence that there has been a surge in risky bank lending. In fact, the opposite has been the main concern over the past few years. – A more potent criticism of Q.E. is perhaps that it did so little to increase commercial bank lending. Bank lending is still very low compared to pre-crisis trends.
  • We need fiscal expansion, not austerity. It is a very good thing if Quantitative easing has reduced the need for austerity and immediate measures to cut budget deficits. If the UK has pursued Greek or Spanish style austerity, the UK recovery would have been much weaker or non-existent. A recession is not the time to tackle the public sector debt. The important thing is to promote economic growth; this will enable debt to be tackled in the long term when the economy can better absorb spending cuts and tax rises.

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Expansionary Monetary Policy

  • Expansionary monetary policy aims to increase aggregate demand and economic growth in the economy.
  • Expansionary monetary policy involves cutting interest rates or increasing the money supply to boost economic activity.
  • It could also be termed a ‘loosening of monetary policy’. It is the opposite of ‘tight’ monetary policy.

When to pursue expansionary monetary policy

interest-rates

The recession in 2008/09, caused the Bank of England to cut interest rates dramatically to try and boost economic recovery. Interest rates fell from 5% to 0.5% in a few months

The MPC of the Bank of England has an inflation target of 2% +/-1. They also consider other economic objectives such as economic growth and unemployment. If inflation is forecast to fall below the target, they can consider loosening monetary policy to target higher inflation and enable a higher rate of economic growth.

Also, if the economy is forecast to enter into a recession, they are likely to cut interest rates and try to boost economic growth.

In some cases, they may pursue expansionary monetary policy, even if inflation is above target – if they think inflation is temporary and there is a greater risk of recession. (see: cost-push inflation)

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Question: What are the similarities and differences between the Bank of England and the ECB?

Readers Question: What are the similarities and differences between the Bank of England and the ECB? Thank you

  • They are both responsible for controlling inflation. However, this year, the Bank of England have shown much greater flexibility and willingness to consider other objectives such as full employment and preventing recession. The ECB has been much more rigid in targeting low inflation.
  • The Bank of England is also willing to pursue quantitative easing and increase the money supply where necessary. The ECB has promised to avoid creating money and not to get involved in buying government bonds (in any significant quantity).

UK unemployment threshold of 7%

Readers Question Why is the forward guidance threshold set at 7% unemployment and how does this affect the threshold for inflation? The MPC have a remit to target inflation of CPI = 2% +/-1. But, the MPC also consider wider issues of economic growth and unemployment. UK Real GDP is still lower than the level …

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Forward guidance in monetary policy

Forward guidance is when the Central Bank announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.

The aim of forward guidance is to influence long term interest rates and market expectations. For example, the Central Bank might want to boost economic activity by convincing markets that interest rates will stay low for the foreseeable future.

It means that Central Banks are pledging to keep interest rates low, even if inflation starts to creep above its target. It can be seen as an indirect way of placing less emphasis on low inflation and more emphasis on economic recovery.

The Central Bank could say it intends to keep interest rates at 0.5% for a certain time period (until 2015) or
it could say it intends to keep interest rates at 0.5% until certain economic criteria are met (e.g. interest rates will stay at a certain level until unemployment falls below 6%).

What are the benefits of forward guidance?

It helps the Central Bank to influence long term interest rates. The Central bank can only directly control short term rates – Base rates. In normal economic circumstances, a change in base rates usually leads to an equivalent change in commercial bank rates (the long term lending rates which are important in an economy) However, in the credit crunch / great recession there was a divergence between base rates and commercial bank rates. Lower base rates were not passed onto consumers.

base-rates-bank-rates-mortgage-rates

mortgage rates and bank lending rates didn’t fall as much as base rates

If commercial banks feel the cut in base rates is temporary, they may not want to cut their long term rates. But, if the Central Bank confirms that it will keep base rates at 0.5% for a considerable time, then commercial banks may be more willing to reduce their long term rates (e.g. mortgage and lending rates) because they know they will be able to borrow from the Central Bank at 0.5%. The hope is that this will encourage banks to cut rates, and increase overall lending in the economy. This increase in lending should boost investment and economic growth.

Inflation / deflation expectations. Another feature of forward guidance is that it might influence inflation expectations. If the Central Bank states that interest rates will stay at zero until unemployment falls below 6%, markets, firms and consumers may be more liable to expect higher inflation than previously. Some economists argue that, if there is currently a risk of deflation, higher inflation expectations can help boost spending and economic growth. This is particularly beneficial in a liquidity trap.

How credible is forward guidance?

There is nothing to stop the Central Bank ignoring its own pledge. The Bank of England could  pledge to keep interest rates at 0% until 2015, but if circumstances change – they could raise interest rates. Markets and banks know this and this could reduce the usefulness of the commitment, but it can still give an indication of how monetary policy will operate. Markets do tend to place a lot of weight on Central Bank pronouncements. 

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The MPC and setting of Interest rates in UK

Readers Question: To what extent does the government influence the monetary policy committee when they set the interest rates?

The Bank of England Monetary Policy Committee (MPC) is responsible for setting interest rates and trying to achieve a target rate of inflation.

  • In the UK, The Monetary Policy Committee has independence in setting interest rates.
  • The government appoint members to the MPC. In theory they could appoint members who are more sympathetic to the ‘government’s point of view’. In practice they don’t. Nor do the government threaten to remove members for choosing a certain monetary policy.
  • The government set the inflation target currently CPI = 2% +/- 1. In theory the government could change the inflation target or remit of the MPC. In practise they haven’t. However, if there was a serious economic shock. e.g. rising oil prices causing cost push inflation (stagflation – rising inflation and rising unemployment) some governments may be tempted to raise the inflation target from say 2% to 4%. In effect this is telling the MPC not to increase interest rates. In practise I think governments would have difficulty getting away with this. – Markets would soon lose confidence in monetary policy. Also, the Bank of England has often decided to accept a higher inflation rate rather than risk lower growth.

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