Monetary Policy and Forward Guidance in the UK - Example

Central Banks Influence into the Exchange/Interest Rate and the Impact on Global Market: Monetary Policy and Forward Guidance in the UK Table of Contents Influence of Central Bank into the Exchange/Interest Rate and Its Impact on Global Market 3 Influence of Central Bank on Exchange Rate 3 Influence of Central Bank on Interest Rate 4 Exchange/Interest Rate and Its Impact on Global Market 5 A Brief Overview of Monetary Policy and Forward Guidance in the UK 6 Trends of the Unemployment Rate in the UK 9 Results of the Falling of Interest Rates in the UK 13 Reaction of Stock Prices to UK Monetary Policy 17 Effects of Stock Market on the UK Economy 19 References 22 Influence of Central Bank into the Exchange/Interest Rate and Its Impact on Global Market Management of exchange rate and interest rate is two key fields that influence the economic welfare of the general citizens. Central bank is a vital participant in controlling these two aspects of the economy (Samarasiri, 2011). Influence of Central Bank on Exchange Rate The exchange rate of a nation’s currency is regarded as the value of the money for global trade of products, services and finances, owing to which it is often regarded as an important component of monetary conditions of a nation. It is in this context that because central banks act as monetary authorities, they have provided flexible authority under applicable statues in order to decide proper foreign exchange policies. The central bank commences dealings in the foreign exchange markets that can be treated as a consequence of the services it provides to the clients, administrators of portfolio and policy execution procedures. In foreign exchange market, client transactions represent majority of the exchange activities by the number of dealings. In usual path of events, central banks control its currency rate by purchasing foreign currencies from the international market (Reserve Bank of Australia, 2014). Evidently, central banks possess a unique position in foreign exchange market. Unlike other parties who are involved in foreign exchange market, central banks’ participation does not have any profit intention. Central banks’ decision about monetary policy is dominant on exchange rate determination. Fundamentally, central bank addresses the national economic issues by changing the quantity of money and the interest rates, which results in changes in the exchange rate. Central bank can directly affect exchange rate through its interference into foreign currency market. It can utilise the national currency and foreign currency reserve in order to purchase and sell currencies straight to the foreign exchange market (Lee& Chang, 2004). In accordance with the study of Dominguez (1998), the intervention of central bank can influence the behaviour of exchange rate. In practice, central banks define intervention as any official sale or purchase of foreign assets against national assets in the foreign exchange market. There are two channels of central bank intervention, namely non-sterilised intervention and sterilised intervention. Non-sterilised intervention comprises change in national monetary base, which are comparable to open market operations. On the other hand, sterilised operations comprise counterweighing national asset deal that re-establishes the original size of monetary base. Non-sterilised intervention further influences the degree of exchange rate in percentage to the change in the relative supplies of national and foreign currencies. While, sterilised intervention imposes considerable impacts on the exchange rate by signalling channel to the market (Beine & et. al., 2003). Influence of Central Bank on Interest Rate According to Friedman & Kuttner (2010), central bank is responsible for managing the money supply of a nation. Apart from printing or circulating money, a central bank is typically entitled to ensure price stability, economic ability and reduced unemployment rate within the nation. It has various tools to apply which comprise the capability to set the interest rate and monetary intervention. Central bank is also responsible to decide upon any alterations of the interest rate on the basis of nation’s economic requirements. According to the basic principle, central bank is believed to increase the interest rate in order to raise the cost of lending, which interprets higher financing expenses for borrowers and vice-versa. Due to increased interest rates, corporate loans, mortgages and equity loans become more expensive. With these increases, central banks are able to confine the borrowing and money supply within the market. On the other hand, the central bank of a nation confronting downturn or high level of unemployment, most probably reduce the interest rate. Lower funding expenses herewith inspire growth and thus, help in expanding the economy (Moessner & Nelson, 2008). Generally, interest rate activities performed by central banks are highly predictable because central banks sense that an increase in consumer spending is required for encouraging the economy, it can minimise the short-run interest rate while granting loans to the commercial banks (Blattner & et. al., 2008). This step usually minimises the interest rates, making borrowing less expensive for the customers, which the central banks expects would lead to increase in overall growth. On the other hand, if central banks feel that tightening of economy is required in order to deal with inflation led issues, central bank can again increase the interest rate, making the loans much expensive to obtain. As a result, it shall lead to overall decrease of consumer expenditure (Middeldorp, 2011). Exchange/Interest Rate and Its Impact on Global Market Interest rate plays a vital role in determining the prices of currencies in the foreign exchange market. As the central banks set interest rate, they are regarded as the most powerful actors of the global market. Through changes in the interest rate, they decree the flow of investment in a nation (Sanchez, 2005). Since currencies are regarded as the representatives of a nation’s economy, differences in interest rate impact on the comparative value of the currencies in relation to other nations. According to Pope & et. al., (2012) when central banks change the interest rates, they cause the foreign exchange market to experience money movement and volatility. In the realm of foreign exchange trading, accurate speculation of central banks’ activities is therefore believed to enhance the merchants’ likelihoods for engaging in successful global trade. A Brief Overview of Monetary Policy and Forward Guidance in the UK In every nation, one primary responsibility of central bank is to apply monetary policy, which provides steady progress to money supply and wealth distribution within the economy through the generation of better employment scope and stimulating other economic indicators towards growth. Monetary policy is the set of activities, central banks take in order to encourage economic growth and accomplish the fiscal objectives. Monetary policy has become progressively apparent in developed nations. Several economists argue that transparency increases the effectiveness of monetary policy. To begin with, transparency was observed as a critical component of accountability and was accordingly deemed as vital for central bank independence (Svensson, 2006). The most recent innovation of monetary policy transparency is the thought that the effectiveness of such policy can be improved if politicians inform the market of the predictable route for central bank’s policy rate, i.e. politicians can enhance the efficiency of interest strategy by delivering forward guidance regarding future route of the policy rate. Rudebusch & Williams (2006) agreed with the fact that forward guidance can enhance the effectiveness of monetary policy, on the grounds that central banks can influence the aggregate spending in preferred way. As observed in-depth, the worth of forward guidance is twin in nature. At the foremost, it can reveal information regarding economic shocks and functioning of economy and secondly, it can allow the central banks to influence public expectations in favourable way. However, Goodhart (2001) argued that forward guidance is entirely imaginary and counterproductive, because if entire path of interest rate were forecasted, the gain from such promise would be earned without expenses. Forward guidance curtails from the thought of Woodford (1999) regarding ideal policy. He argues that monetary policy have larger impact on long-run interest rate, which is equivalent to the forecasted short-run interest rate on the holding period of long-run security plus a consistent risk premium. Correspondingly, Rosenberg (2007) stated that the more persistent a central bank’s interest rate policy, the more it is stimulated or encouraged to provide forward guidance (Kool & Thornton, 2012). In the UK, ‘Bank of England’ also provides forward guidance by making assurance regarding the future, when mainly concerning the future interest rates. According to Miles & et. al., (2013), the single most useful aspect of providing forward guidance is that if inflation burden is managed within a controlled environment rather than on the basis of return to a standard monetary policy, it can lead to constant recovery in demand, which would further reduce the unemployment rate to a substantial extent (Miles & et. al., 2013). The reason, owing to which Bank of England has been providing forward guidance, has been principally steered by the motive to minimise the risks arising from economic recovery, which is still, to some extent, developing and not overwhelmed by the expectations that constriction in monetary policy is imminent (Miles & et. al., 2013). In the UK, Monetary Policy Committee (MPC’s) primary objective is to ensure price stability. Furthermore, MPC is also required to support economic growth and increased employment. Since the beginning of economic downturn, there has been significant ambiguity about the development of supply capability in the economy. That period was related with remarkably poor productivity growth and evidences suggested that spare capability of organisations in the UK has reduced since 2009 (see fig 1). Fig 1: Capacity Utilisation in the UK from 2000 to 2012 Source: (Bank of England, 2013) The above figure suggested that the capability of the UK economy to generate output and the supply of the economy might have been wrinkled in recent years. Bank of England has also been asserting that inflation rate is falling below 2% of the target that it has and the economic growth is sluggish in the UK. As argued by the authorities of Bank of England, MPC would intend to recover the inflation in about two years. However, the current unparalleled conditions permit bringing back inflation to the target at a slower rate than normal, in order to deliver greater support to the productivity of the nation. Under such a condition, clear forward guidance rendered by the central bank is expected to improve the efficiency of monetary incentive in three ways within the UK. At the foremost, it shall provide better transparency regarding MPC’s interpretation about proper trade-off between nations on which, inflation is returned to the target and the rapidity with which, productivity and employment scenario within the UK can recover. Correspondingly, it minimises doubt regarding the future path of monetary policy as the economy improves through encourage investor confidence. Accordingly, it shall provide a strong agenda within which, MPC can search scope of economic growth without increasing risks for price and financial constancy within the UK (Bank of England, 2013). Trends of the Unemployment Rate in the UK As argued by Dale (2013), monetary policy that cannot control the unemployment rate in the long term is unable to create sustainability, higher productivity or employment. Merely by printing and injecting more money in the economy cannot ensure high employment rate (Dale, 2013). It is worth mentioning in this context that in the UK, monetary policy continued to have only one target, i.e. to control the inflation rate. However, the adverse economic conditions in 1970s and 1980s provided the lesson behind the irrationality of attempting to control the inflation only by reacting to the movements in a single intermediary target (Dale, 2013). According to Dale (2013), the UK economy is facing two significant challenges — one being the uncertainty of poor productivity and the other, being the level at which such uncertainty will reflect as demand rises. The unemployment rate is particularly well suited to deal with this uncertainty, given the underlying assumption that as demand increases, organisations can utilise their existing employees to more industrious activities before employing additional employees. This suggests that to the degree, productivity increases in reaction to increasing demand it should reduce the unemployment rate substantially. As such, MPC can stay largely uncertain regarding the level to which, productivity probably picks up and reacts to the indication delivered by activities in the unemployment rate. In accordance with the study of Spence (2011), for 1971 to 2011, there has been increasing trend in the proportion of females in employment and descending trend in employment rate for males as observed in the UK. The employment rate for females increased from 53% in 1971 to 66% in 2011. On the other hand, the employment rate for males took its peak at 92% in the year 1971 and decreased to 76% in 2011. As can be observed, the unemployment rate in the UK have varied significantly over the past decades wherein high rate was observed in 1980s, 1990s and throughout the period of recession. During and after the recent economic recession in 2008-2009, unemployment rate growth in the UK became sluggish in comparison to earlier recessions. According to the statistics of the Office for National Statistics (ONS) (2013), the percentage of employment within age group of 16 years to 64 years in the UK was 72.1. There were about 30.15 million people having proper employment in 2013. From June 2013 to August 2013 and from September 2013 to November 2013, there was considerable increase in the employment rate and large reduction in unemployment rate (see fig 2). Fig 2: Employment Rate from 1971 to 2013 in the UK Source: (ONS, 2013) The statistical report published by BBC (2014) revealed that in the UK, unemployment rate has reduced to 7.1%, which is close to the point where Bank of England will consider increasing the interest rate. A fall of unemployment level of 167,000 has been recorded over three months i.e. from November 2013 to January 2014, which was certainly a new observation in past seventeen years. This reduction in high number of individuals out of employment has increased the possibility that the central bank would enhance the interest rate given that the inflation would return to 2% of the target rate and that the pressure of expenses would restrain thereon (BBC, 2014). Results of the Falling of Interest Rates in the UK If the Bank of England notices that inflation is falling below 2% of the target, it is likely to be in tension of minimising the interest rate. According to ACCA (2008), interest rate in the UK is determined by MPC of Bank of England. The MPC is liable to maintain a low inflation rate, as high inflation shall reduce the value of money owing to the fact that individuals are required to expend more but obtain less during such situations. This makes electorate unhappy and consequently the government is required to maintain a low inflation rate. On the other hand, low level of inflation is good as it progressively enhances the value of asset (ACCA, 2008). From a theoretical understanding, Burnette (n.d.) asserted that reducing the interest rate can help to reduce the cost of borrowing. It can encourage the expenditure and investment, encouraging better money supply to the economy. This increased expenditure and investment can lead to higher Aggregate Demand (AD) and economic growth. However, such economic growth can also generate inflationary pressures. Thus, reducing the interest rate would minimise the motivation of people to save because saving will provide low level of return, motivating people to spend more. Low interest rate will also minimise the borrowing expenses. Consequently, it will motivate people to take loans for spending or investment. Furthermore, it will also leave the householders for more disposable income. Rising asset price is the other consequence of increased interest rate, as it can make it more attractive to purchase assets such as house or land (Burnette, n.d.). On the contrary, low interest rate can also reduce the exchange rate. Thus, if the UK minimises the interest rate, it will make it relatively less attractive for people to save money because they will obtain better return in saving to other nation. Thus, there will be less demand for domestic currency, i.e. Pound, causing fall of its value in the international market. A fall in the foreign exchange rate of Pound will also make the exports more competitive and imports more expensive, facilitating economic freedom (Burnette, n.d.). Thus, reduced interest rate will increase the AD as it will increase consumption (C), investment (I), government spending (G) and net export (X – M) [where AD = C + I + G + (X – M)] (Burnette, n.d.). It is owing to the same reason that after the economic recession in 2008, Bank of England has maintained a low interest rate in order to facilitate economic growth in the UK (see fig 3). Fig 3: Interest Rate Maintained by Bank of England Source: BBC (2014) This lower level of interest rate has increased the GDP rate in terms of high economic growth, which is apparent from lower unemployment rate currently observed within the economy. However, it is worth mentioning that lowering the interest rate is only partially successful in generating high economic growth, as there are other factors, which might also influence economic progress (BBC, 2014). According to Smithers (2014), even if Bank of England reduces the base rate, it will not pass this base rate onto consumers. For instance, during the credit crunch of 2008 to 2009, the UK banks were short of liquidity and keen to inspire more savings. Furthermore, increase in economic growth also depends on other factors. For example, according to Allen & Paligorova (2011), after credit crunch of 2008, banks minimised the accessibility of loan. Thus, even if people desired to borrow money at low interest rate, it would require high deposit. Consumer confidence is the other aspect, which can also hinder the spending. If the confidence of consumer is low, they are likely to restrain from engaging in spending activities. For example, after economic recession, it has been observed that irrespective of interest rate changes in a more stable manner, there was an increase in saving due to low level of confidence, which caused adverse influences on consumer spending trends (Curtin, 2002). In the UK, inflation rate was recorded at 1.85% as on January 2014, which is regarded as highly volatile in nature (Smithers, 2014). Moreover, concerning the reduction in unemployment rate, it is expected that inflation will increase, as depicted in the figure below (see fig 4). Fig 4: Inflation rate of the UK from 2008 to 2014 Source: (Smithers, 2014) The unemployment rate in the UK is presently below the average level. At this point of unemployment, inflation is well above the target. The UK organisations that experience increase in demand for their products and services prefer to employ more workers. Therefore, this economic condition has augmented the requirement of increasing the interest rate. However, according to BBC (2014), even if economic recovery has strengthened in current months, Bank of England is also worried regarding sustainability of such economic growth and the consequence of lowering the interest rate on inflation rate in the long run. It is hence unenthusiastic to increase the interest rate until it has become more certain that the UK is heading securely towards economic progress. Reaction of Stock Prices to UK Monetary Policy The stock markets also play a multidimensional role in reaction to the monetary policy. According to Mishkin (2001), the stock market performance is highly influenced by improvements in monetary policy through numerous channels. As, stock prices represent the economic growth to a significant extent, these are considered by MPCs while making decisions. Furthermore, stock prices also provide response to the central banks about prospects of private segments (Mishkin, 2001). According to Chatziantoniou & et. al., (2012), one of the key channels by which monetary policy promulgate the stock prices is interest rate. A change in the interest rate influences the cost of capital, which ultimately imposes considerable impacts on the present value of cash flow. Accordingly, high interest rate results in lower present value future cash flow, which in turn results in lower stock prices. This channel signifies the Keynesian way of transmission instrument of interest rate. The other important channel through which, monetary policy influences the stock price is credit channel. This channel suggests that central banks can affect the stock prices by altering the credit rates, which can influence the investment pattern largely. In this context, it is assumed that level of investment largely influences the market value of assets and that high corporate investment leads to higher future cash flow. Accordingly, an additional channel, through which monetary policy influences the stock price, is through wealth affect, which propose that increased interest rate can reduce the price of long-run assets. In particular, high interest rate can result in indebtedness of national exchange rate, resulting in high level of import and low level of export. In this context, it can be stated that low level of export has adverse impact on the attractiveness of a nation, causing minimisation in productivity and lowering the stock prices (Chatziantoniou & et. al., 2012). According to Tobin (1969), high interest rate results in low stock valuation. Increased interest rate can therefore cause transfer of funds from stock market to bond market, thereby pushing the stock prices down. In accordance with the theory of ‘Discounted Cash Flow Model’, stock prices are equal to the present value of future cash flow. Concerning this theoretical viewpoint, monetary policy play a crucial role in influencing the returns either by changing the discount rate or by manipulating the prospects of market participants regarding future economic activities. These channels can be observed as interlinked, as more preventive monetary policies usually infer high discount rate and low future cash flow. Hence, monetary policy tightening is required to be related with lower stock prices (Ioannidis & Kontonikas, 2006). According to the analysis of Bredin & et. al., (2005), in the UK, monetary policy has statistically significant influence on both AD and industry stock returns. However, the sensitivity of such influence is subject to specific industry framework; for example, industries such as automobile and household products are deemed as extremely sensitive to monetary shocks. According to Bordo & et. al., (2007), the UK stock market conditions was robust during mid-1970s due to surprising increases in the inflationary monetary shocks. On the other hand, deflationary monetary shocks supported market boom in the UK during mid-1980s. The UK adopted ‘inflation-targeting monetary policy’ in the year 1992 and accordingly, the Bank of England successively tightened the monetary policy in the year 1994 in order to control inflation through interest rates. To be mentioned in this context, the long run interest rate of Bank of England resulted in boom of stock market during that period (see fig 5). Fig 5: The UK Stock Market Condition from 1964 to 2000 Source: (Bordo & et. al., 2007) Effects of Stock Market on the UK Economy According to Alghamedia (2012), stock market plays a vital role in the procedure of economic development through financial activities, divergence of risk, simplification of liquidity, promotion of corporate control and transmission of path for monetary policy among others. Besides, stock market also influences steady condition of growth by changing the rate of savings, technological development and economic effectiveness. However, it is worth mentioning that at times, economic growth slowed by stock market progress. Therefore, without careful regulatory authorities, stock market can misrepresent the capital creation and the distribution of resources (Alghamedia, 2012). In accordance with the study of PricewaterhouseCoopers (2013), in the UK, stock market prices are not regarded as reliable predictors of economic growth in terms of GDP growth and unemployment rate. In the similar context, the US represents a strong association of stock market prices with the economic growth. While in the UK, share price variations barely make changes on consumer spending, because it is much more uncommon for households to hold large number of shares. Thus, they experience weak impact and almost invisible wealth effects when there is change in the value of shares. Unlike other western nations, in the UK, shares are held by official investors such as asset management organisations, pension funds and life insurance organisations among others. Hence, the relationship between the stock market and consumer spending is much insignificant. In addition, the fluctuations in stock market in the UK take lengthier period to nourish through to the economy for instance about three quarter for GDP and about one year for unemployment. It is particularly owing to the reason that primary channel for stock market variations to effect the UK economy is by business assurance and succeeding investment decisions, prior to imposing changes in consumer spending (PricewaterhouseCoopers, 2013). The UK stock market comprises several global organisations with their earning subjected to the fluctuation in international economy than the domestic economy. Thus, the relationship between the UK stock market and the performance of domestic economy is likely to be poor (Taylor, 2001). The research of PricewaterhouseCoopers (2013), also stated that the momentum effects in the UK is quite weak, owing to the fact that the UK economy is sensitive to the international economic fluctuation, also due to the fact that the impact of stock market in the UK economy operate much slowly. Irrespective of low impacts of stock market on the UK economy, it is worth mentioning that to a certain extent, the fluctuations in stock market price can disrupt the economic growth in the short-run. For example, the stock market crash in 1929 was regarded as a key aspect of great depression in 1930s. However, such impact did not last for longer time. Although, it did impacted on the monetary policy where the Bank of England has maintained low interest rate due to the fear that such stock market crash can cause economic downturn (Taylor, 2001). References ACCA, 2008. The Impact of Interest Rates. Content. 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