Bank of England Monetary Policy from 2001 to 2013 - Case Study Example

Bank of England monetary policy from 2001 to Introduction A critical analysis of the economic history implies that the conventional perception in relation to monetary policies has gone through sizable modifications subsequent to major events such as financial crunches and conflicts. An extended period of stability leads to the establishment and solidification of monetary policy consensus, which is later, crumbled when a major event arises. A good example of such a scenario is global financial crisis, which has rendered a number of the conventional perception the components of a superior monetary policy obsolete. As a corollary, more modification of the consensus that was established and accepted after the great inflation, which happened in the 1970s. This paper investigates the modifications that have been established in the conduct and strategies of monetary policy by the Bank of England when the global financial crisis occurred. To come up with a comprehensive report this paper will be divided into two parts i.e. the pre-crisis period which looks into the monetary policies that prevailed before the crisis and the post-crises period, which looks into the new tradeoffs and controversies that have arose after the crisis (Bank of England, 2014). Monetary Policy before the Crisis So as to come up with a detailed account of the state of monetary policy analysis in the Bank of England before the crisis, this paper will make a great deal of reference to the 9 basic scientific fiscal principles, which are based on theory and empirical evidence. The basic scientific fiscal principles guided most monetary activities in most central banks including Bank of England (Bank of England, 2014). The first 8 of the basic principles are components of the building blocks of what has come to be known as the “new neoclassical synthesis”. Earlier before the crisis, most of the scholastic personalities, economists, and central bankers were in agreement with the new neoclassical synthesis. Below is a brief coverage of the monetary policies in the Bank of England that thrived before the global financial crisis (Bank of England, 2014). Inflation is always and everywhere a monetary phenomenon Before financial crisis, monetary policy in the Bank of England had some influences on the principle that supported on by most of macroeconomists pertaining to macroeconomic ebbs and flows that devalued the role of monetary factors. Before financial crisis, there was a consensus that expansionary monetary policies would be followed by increased inflation and at the same time an increase in the interest rates. The consensus led to the formation of the famous maxim “inflation is always and everywhere a monetary phenomenon” (Bank of England, 2014). What this maxim tried to put across is that expansionary monetary policy would lay a good foundation for inflation. A critical scrutiny of the activities by the Bank of England before the crisis, which were aimed at controlling inflation, was drawn from this maxim (Bank of England, 2014). Price stability has important benefits Before financial crisis, monetary policy in the Bank of England operated on the principle that high inflation reduces the value of money as a medium of exchange and that inflation brings about over-investment in the financial sector in a bid to companies as well as individual avert some of the effects of inflation. The Bank of England’s monetary policies worked under the pricipole that relations involving the tax system and inflation augments alterations that later impinge on economic activities very adversely. The Bank of England’s monetary policies earlier before the crisis were therefore founded on the notion that unforeseen inflation would lead to redistribution of wealth, and this would in turn increase the credit costs (Bank of England, 2014). There is no long-run tradeoff between unemployment and inflation Before financial crisis, there was a debate on whether there exist a long-run tradeoff between unemployment and the rate of inflation. However, it was later agreed that was no longrun tradeoff. It was argued that the economy would drift down to a natural rate of redundancy in the longrun, regardless of the rate of inflation. This assertion came to be refrerred to as the Friedman-Phelps natural rate hypothesis. The sentiments of the Friedman-Phelps natural rate hypothesis were that any endevours implemented in a bid to reduce unemployment beneath the natural rate would only lead to higher rates of inflation. The Bank of England as a result included aspects of the Friedman-Phelps natural rate hypothesis in its econometric models and monetary policies before the crisis to govern its monetary activities (Bank of England, 2014). Expectations play a crucial role in the macroeconomy One of the major contentions of the Friedman-Phelps natural rate hypothesis was that though sustained inflation might perplex companies and households in its initial establishment, it does not perk up the chances of increased and better employment for the reason that the expectations of inflation adapts to any sustained price increase rate (Bank of England, 2014). Before financial crisis, the theory of reasonable expectations was based on the assumption that economic mediators are motivated by optimising behaviour. One of the most essential insights of the rational expectations theory is that people’s outlook about prospective monetary policy have an imperative effect on the progression of economic activities. This insight had great influence on the Bank of Englands monetary policies, for instance, pertaining to the kinds of methodical behaviour on the part of policy-makers were postulated to be favorable to macroeconomic constancy and development (Bank of England, 2014). The Taylor Principle in relation to price stability Since economic outcomes relies on expectations of monetary policy, policy evaluation calls for an investigation of how the economy is affected by various monetary policy regulations. One of monetary policy regulations that received massive attention and had significant influences in the Bank of Englands monetary policies proir to the crisis is the Taylor rule. Taylor rule stipulates that in order to stabilise monetary policy a central bank oughts to increase the nominal interest rate in a way that it is higher than the rise in inflation (Bank of England, 2014). Time-inconsistency in relation to monetary policy The time-inconsistency setback can occur if monetary policy performed on a discretionary, daily basis sets in motion poor long-run results than those that could be accomplished by committing to the mandated policy rules. The Bank of England was tempted to adopt some discretionary policies and devoid of a commitment mechanism, financial policy-makers found themselves incapable of consistently following the best possible plans over time (Bank of England, 2014). Roles played by financial frictions in the business cycle Preceding to the crisis, central bankers were fully aware that fiscal interference could be very detrimental to the economy. As a result, the Bank of England took extraordinary actions during the crisis to shore up financial markets. Nonetheless, the macroeconomic methods used for prediction and policy analysis, did not take into consideration the effect of fiscal interferences and frictions on economic activity (Bank of England, 2014). Monetary Policy after the Crisis The global financial crunch of 2007-09 was a hurricane that trampled the economy all over the world. It also rendered some of the principles of monetary policy obsolete, necessitating an entire rethink. Below are some of the policies that were adopted by the Bank of England after the crisis (Bank of England, 2014). Flexible Inflation Targeting While the support for the flexible inflation-targeting framework was not undermined by the crisis, the lessons suggested that the elements of a flexible inflation and at the same time the meaning of flexibility, should to be looked into. The fundamental amendments to the flexible inflation-targeting structure that have been considered by the Bank of England include the most preferable level of inflation, and whether price level targeting would lead to improved financial results (Bank of England, 2014). Risk Management and Gradualism To achieve normal market functioning most effectively, the Bank of England’s monetary policy was streamlined to be timely, decisive, and flexible. The risk management policy that was adopted is one that disregards the recommendation of the linear-quadratic framework (i.e. the best possible monetary policy should involve gradual modifications). Instead, huge, pre-emptive, and aggressive modifications in monetary policy were adopted to minimize macroeconomic risk (Bank of England, 2014). The Lean versus Clean Debate The lean versus clean debate originally payed attention to whether monetary policy is supposed to respond to prospective asset price bubbles. Two types of asset price bubbles were to be considered i.e. credit-driven and irrational exuberance bubbles (Bank of England, 2014). Dichotomy between Monetary Policy and Financial Stability Policy One of the lessons learnt from the crisis is that monetary policy and financial steadiness policy are inherently related, hence making the dichotomy between them false. Financial crisis supported a systemic regulator and hence the Bank of England is best-suited for this role (Bank of England, 2014). Comments to speech by the Governor of the Bank of England One of the lessons learnt from the crisis is that monetary policy and financial steadiness policy are inherently related, hence making the dichotomy between them false. Financial crisis supported a systemic regulator and hence the Bank of England is best-suited foe this role. Below are some charts and graphs illustrating the information above; Source of data: www.bankofengland.co.uk Source of data: www.bankofengland.co.uk Source of data: www.bankofengland.co.uk Comments to speech by the Governor of the Bank of England Governor Mark Carney cautioned the UK citizens during the Davos CBI British Business Leaders Lunch that Escape velocity from financial crisis would come at a cost. Carney’s speech covered a comprehensive overview of the worldwide economic position, fiscal improvement, and monetary policy in the UK. The remarks that gined most of the attention is those that pertained to monetary policy especially from financial markets. After stating that the realization of the 7% unemployment threshold would not prompt the increament of interest and inflation rate, Carney stipulated that The MPC would mull over an array of alternatives to the Bank of England’s guidance (Bank of England, 2014). In my opinion, I do not think there is need to change guidance especially beacuse the Bank of England’s current guidance does not guarantee accomplishment. In fact, what the guidance guarantees is the Bank of England’s inaction regardless of what transpires with unemployment. I imagine this statement is more about an attempt to delay the day of reckoning when the citizens of the United Kingdom will demand for a detailed schedule for rate increaments. Carney elucidated that a decrease in inflationary strains made the Bank of England to reconsider its decision to increase rates. I suppose this means that the Bank of England will make an effort to improve guidance with inflation targets (Bank of England, 2014). The point I would have wanted Carney to expound on is the ‘surprisingly poor performance’ expiriences by the suppliers in the UK’s economy. Carney points out that before the recent conundrum, the only thing central bankers had to do was to react to fluctuation in demand because the supply was growing in a steady style. Currently, it looks like the slump in demand may also have crippled productive ability, thus making monetary policy less precise (Bank of England, 2014). Carney also stipulated that the British currency was among the factors swiftly keeping inflation in check. He said that: “…inflation has fallen from 5% in 2011 back to the target for the first time since 2009. Global inflation is subdued, with both euro area and US consumer price inflation now less than 1%; oil prices have fallen by 4% relative to a year ago; other commodity prices have fallen by more than 10%, and sterling has appreciated by almost 9% since last summer. All of these developments will hold back imported inflation pressures that have largely explained the above-target inflation over the past five years.” I am sure this kind of commentary heightened the sense that the Bank of England is finally getting uncomfortable with the steady strengthening in the British pound The reaction to this commentary was notable as the British pound sank against every major currency on Friday 24th January 2014, even the U.S. dollar (Bank of England, 2014). Reference Bank of England. (2014). Forward Guidance: Base Interest Rates and UK Employment retrieved from: http://www.bankofengland.co.uk/publications/Pages/speeches/2014/705.aspx on 27th February 2014. Read More