The Bank of England Monetary Policy - Essay Example

THE BANK OF ENGLAND MONETARY POLICY By The Bank of England Monetary Policy Introduction A monetary policy refers to the procedures and action taken by a given monetary authority of a country, most of which are central banks and in the case of the United Kingdom, the Bank of England, to control the circulation of money within the economy in order to stabilize and promote economic growth. These monetary authorities use the monetary policies to control the amount of money in circulation within an economy through instruments such as interest rates. The main goal of manipulating the economy through monetary policies is to keep in check vital indexes within the economy such as the rate of unemployment, the rates of inflation, the interest rates for loans and mortgages, as well as, the performance of the economy. The bank of England has the monetary authority to formulate and develop monetary policies within the United Kingdom that promote and enhance economic growth and development within the country (Alexander, Balino & Enoch 2011, p.9). Monetary Policies in the United Kingdom The bank of England has a monetary policy committee that has the sole power and authority to formulate and implement monetary policies affecting the United Kingdom’s economy. The committee meets once every month with its main task as set by the government through legislation, to keep the rate of inflation within the country at 2% or lower. The reason why the rate of inflation within the country forms the sole and important goal of this monetary policy committee is that inflation may lead to an economic failure, or a drop in economic development and progress. A high rate of inflation results to high prices of goods and services, which may become unaffordable to most consumers. This reflects to productivity and development within the nation whereby the high rate of inflation affects investment activities as an investor will have to invest more in order to secure some tangible returns on investments, which is impossible due to the high rate of interests raised by bloated inflation rates. Consequently, the monetary policy committee of the Bank of England meets on a monthly basis to deliberate means of securing the interest rates below 2%. The committee forecasts expected rates of inflation for a two-year period with the assumption that this may take much longer to take place, and use this platform to set a Bank Rate. The bank rate is the rate at which the bank of England charges other commercial banks and financial institutions for all the loans it releases, which in turn influences the commercial bank rates and mortgages that these banks charge the ordinary citizen or investor. The bank cuts its interest rates in order to stimulate job creation, borrowing and spending if it feels the inflation rates may undershoot the 2% target. On the other hand, if it feels that this rate may go higher than 2%, it will raise the interest rates, which brings about a dual effect through suppression of business investment and consumer demand (Andersson & Hofman 2009, p.13). A recent move adopted by the bank to control inflation is the Quantitative Easing (QE), renown as Asset Purchase Facility. The bank uses QE to create new money, which it later injects into the economy in order to promote spending, through purchase of assets from financial firms such as pension firms, insurance companies, and High Street banks. The banks believes that it will stimulate demand within the economy through QE if the companies it purchases assets from utilizes that money on expenditures, such as buying shares. For instance, the purchase of share by one company stimulates the other company, whose shares were on sale, to invest the money they receive through purchase of new equipment, taking new staff, and even assisting them to grow (Bofinger, Reischle & Schachter 2001, p.7). The bank of England normally buys gilts under QE, which are financial bonds that come in the form of IOU that governments issue when they want to borrow money from the public. An extra demand created by this provision leads to a ripple effect by lowering borrowing costs on a wider scale, hence assisting businesses and households. The only way the banks changes the bank rate, as well as, the amount of QE is through a majority vote of the nine members of the Monetary Policy Committee. As such, the bank of England used these monetary policy provisions in regulating and controlling the great economic depression that paralyzed the UK’s economy in 2007/2008. It still applies these methodologies in controlling the economy to spur recovery and growth after the failure previously experienced (Heather 2012, p.54). Part 1 Pre-Crisis The bank of England used various monetary policies before the economic crush experienced in the country in the late 2007 and early 2008. Before this period of financial difficulties came about, it was very simple for central banks, and as such, the bank of England, to control the economy since they had a clear and precise mission. This mission was to temper busts and booms in order to maintain a low level and stable rate of inflation, such as that of UK set at 2%. The bank used very ordinary means but seemingly effective in achieving their goal by nudging a key but short term rate of interest either upwards or downwards to suppress borrowing or enhance borrowing respectively in order to put inflation under check. The main goal of this policy was to tame inflation within the economy, thereby allowing the economy to grow and develop smoothly without interference from other practices. However, the situation took a shift turn of event with the occurrence of the “Great Moderation in economic cycle” as economists’ term it, forcing the bank to adopt and implement new measures (Kool & Thorton, 2012, p.34). Post-Crisis The 2007/2008 great economic recession crushed major economies of the world, including that of the United States, the United Kingdom, and many other members of the G20 economy. This was due to the constant recession followed by a crunch in the credit sector. In response to this, the bank of England slashed its benchmark lending rates close to zero – an approach economist refer to as the “zero lower bound” in order to spur borrowing and economic growth. However, this was not enough to spur economic growth, which remained elusive in the UK meaning that even if the rates fell lower than zero there would be no monumental response. Such negative rates would on the contrary encourage depositors to withdraw and hold in liquid cash all their savings from the banks which had a rate of return of zero, higher than the below zero rate adopted by the bank of England (Levin 2012, p.66). Due to the failure of conventional monetary policies in controlling the rate of inflation, the bank of England decided to make use of unconventional monetary policies to control the economy and stimulate growth. These unconventional policies fall into two broad categories, which are forward guidance and asset purchases (QE). The bank of England printed new money and used it to buy assets from other financial firms. The QE works in such a manner that the bank of England puts emphasis on the portfolio-balance effect, which occurs by the bank using new money to buy bonds from investors and the investors using the proceeds they get to rebalance their portfolio through purchase of assets with different natures of risk and maturity. This process boosts the prices for assets while at the same depresses the rates of interest because the increased demand for bonds creates an allowance for their sale to be at lower rates. This low rate of borrowing entices businesses and households to invest in projects and mortgages respectively thereby bringing about a turnaround in economic performance from failure to recovery. On the other hand, the bank of England also utilizes the QE to stimulate the economy to recover through creation of a fiscal effect. The lower rates of interests reduce the borrowing costs by government, and as such, lower the expected future rates of taxation. The low rate of taxation entices investors to borrow money and set up projects since they have an assured increase in the return on investment, owing to the low rates of taxes. QE is also another pathway to economic recovery that the bank of England uses to pull out the UK economy from the mud it sank into during the 2008 economic depression. Furthermore, QE also enables the bank of England to shape its expectations on the rate of inflation within the economy. For instance, the bank of England may use QE by announcing to the markets a new and higher target of inflation, and convincing the market that it will meet this new target through maintenance of constant rates of other factors (Mishkin, 2007, p. 25). As such, an increase in the money levels already circulating in the economy leads to higher prices of goods and services. When the economy operates with the thought that the money they have now will have little value in the future due to a higher rate of inflation, then there will be a gold rush to spend it immediately, as “a pound today is worth two in the future”. Such aggressive spending from the economy, such as households, investors, and organizations leads to an improvement of the economy (Moosa 2013, p.5). The inflation rate of the UK economy at the onset of the global financial crisis in 2008 was 5%. The bank of England employed QE techniques to curtail the economy and spur growth, owing to the deplorable conditions in employment rates and public spending. The initial figures that the bank used in QE was £75bn of new money, but increased it over the years expansively to the current level of £375bn. Nonetheless, the economy continues to falter with little signs for a quick recovery. For instance, the inflation rates in the country are already below 2% at 1.7%. Part 2 The bank of England’s governor, Mr. Mark Carney recently made a speech in which he mentioned overhauling his policy of “forward guidance” in a period of six months after its implementation. The bank decided on this option owing to the continued faltering of employment rates and the slow rates of economic recovery within the country. From the excerpt provided by the governor, a forward guidance policy is a promise made about the future, and in particular, about the future of interest rates in the economy. As such, with the use of forward guidance, the bank expected to control directly the short-term rates of interest. Consequently, the bank utilizes the policy of forward guidance in converting low-short-term rates of interest into lower long-term rates of interest. The misconception created by this policy is that it will entice High Street banks to borrow from the bank of England overnight at 0.5%, which is the current bank rate, for many nights in a row, or many months, which may turn into many years to come. On the other hand, the banks will hopefully be willing to lend money to the economy for much longer terms, as well as, at commensurately low rates of interests. This is similar to Quantitative Easing whereby the bank opted to create a certain deficit of long-term bonds within the economy, thereby spurring or stimulating investors to put their money into use. As such, the increased spending now would lead to much faster economic growth and development rather than delayed spending held for future dates. This policy of forward guidance is not the best option for the bank of England to use in stimulating the economy, as well as, enhancing growth and development in various deplorable sectors such as the growing rate of unemployment currently standing at 7% and growing. In addition, it has no guarantee as it relies on the assumption that investors and households will hopefully buy the bait over an increment in inflation at future dates. Although some may buy this move, it is not possible for the bank to estimate in tangible figures the expected rise in inflation. Consequently, it will be much difficult in convincing High Street banks to borrow at low rates from it, and then lend out at similarly low rates to their customers for a prolonged period of days, running into months, running into years. This uncertainty faults the policy and makes it non-functional in the event the high street banks fail to buy it, therefore making the move by the governor of the bank of England in changing it a positive one. The Appendix The graphs below in the appendix explore more about the shifts in inflation rates as controlled by various aspects of the economy both during the pre-crisis period, as well as, during the post crisis period. the first and second graph explore how money and asset prices in pre crisis and post crisis period, with the first graph showing the changes in bank rates while the second graph shows the effect of these bank rates changes on household borrowing and quoted rates. The third graph shows the quantities of UK exports demanded before and after the financial crisis. The fourth graph shows output and supply, particularly the level of unemployment within the economy. The fifth graph similarly shows unemployment trends in the pre-crisis season, particularly focusing on the costs and prices. The sixth graph shows the prospect of inflation as deduced during the post-crisis period. Appendix Graphs Showing Inflation Rates and Monetary Policies in the UK Money and Asset Prices (post crisis) Bank Rate and forward market interest rates The August 2013, November 2013 and February 2014 curves are estimated using overnight index swap rates in the fifteen working days to 31 July 2013, 6 November 2013 and 5 February 2014 respectively. Money and Asset Prices (pre crisis) Bank Rate and quoted rates on household borrowing (a) End-month sterling quoted rates on different mortgage products and on unsecured personal loans. Weighted averages of rates from a sample of banks and building societies with products meeting specific criteria (b) Quoted interest rate on a £10,000 personal loan (c) The two-year 90% loan to value series is only available on a consistent basis from May 2008 and is not published for March to May 2009 as fewer than three products were offered. (d) End-month rates. Demand (pre crisis) UK-Weighted World Trade and UK Exports (a) Chained-volume measure excluding the estimated impact of MTIC fraud. Official MTIC-adjusted data are not available, so Bank staff for MTIC fraud has adjusted the headline exports data by an amount equal to the ONS’s imports adjustment. (b) Constructed using data for import volumes of 143 countries weighted according to their shares in UK exports. For the vast majority of countries, the latest observation is 2013 Q3. For those countries where national accounts data for 2013 Q3 are not yet available, data are assumed consistent with projections in the IMF WEO October 2013. Output and Supply (post crisis) Bank staff projection for the near-term headline LFS unemployment rate The magenta diamonds show Bank staff’s central projections for the headline unemployment rate for September, October, November and December 2013 at the time of the November Report. The green diamonds show the current staff projections for the headline unemployment rate for December 2013, and January, February and March 2014. The bands on either side of the diamonds show uncertainty around those projections based on staff estimates of root mean squared errors of past forecasts for the three-month LFS unemployment rate. Costs and Prices (pre-crisis). Real product wages, the unemployment rate and productivity (a) The latest observation is 2013 Q3. (b) Market sector output per worker (c) Private sector AWE total pay deflated by the market sector gross value added deflator. Prospects for Inflation (post crisis). GDP projection based on market interest rate expectations and £375 billion purchased assets The fan chart depicts the probability of various outcomes for GDP growth. It has been conditioned on the assumption that the stock of purchased assets financed by the issuance of central bank reserves remains at £375 billion throughout the forecast period. To the left of the vertical dashed line, the distribution reflects the likelihood of revisions to the data over the past; to the right, it reflects uncertainty over the evolution of GDP growth in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of GDP growth would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter green areas on 30 occasions. In any particular quarter of the forecast period, GDP growth is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth can fall anywhere outside the green area of the fan chart. Over the forecast period, this has been depicted by the light grey background. See the box on page 39 of the November 2007 Inflation Report for a fuller description of the fan chart and what it represents. Reference List Alexander, W., Balino, T. & Enoch, C., 2011, the Adoption of Indirect Instruments of Monetary Policy, Part 2, Cengage Learning, Stamford, Connecticut Andersson, M. & Hofman, B., 2009, Gauging the Effectiveness of Quantitative Forward Guidance: Evidence from Three Inflation Targeters, European Central Bank, Frankfurt, Germany. Bofinger, P., Reischle, J. & Schachter, A., 2001, Monetary Policy: Goals, Institutions, Strategies, and Instruments, Oxford University Press, Oxford. Heather, M., 2012, Quantitative Easing - Unabridged Guide, Emereo Pty Limited, Brisbane, Australia Kool, C. & Thorton, D., 2012, How Effective is Central Bank Forward Guidance? Federal Reserve Bank of St. Louis, Research Division, St. Louis Levin, A., 2012, Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound, Bibliobazaar, New York. Mishkin, F., 2007, Monetary Policy Strategy, MIT Press, MA. Moosa, I., 2013, Quantitative Easing as a Highway to Hyperinflation, World Scientific Publishing UK, London Read More