Differences Between monetary policy in the UK and the ECB - Coursework Example

How does the operation of monetary policy in the UK differ from that under the ECB? The UK monetary policy framework may be compared with that of the euro-zone and of the US. The ECB was allowed to define its own remit. It consists of two objectives: an inflation target consisting of an upper limit of 2 per cent inflation based on the harmonised index of consumer prices across euro-zone countries, and a monetary pillar, a compatible rate of growth of broad money. The US Federal Reserve Board has no explicit remit. In practice, it seems to take much more account of output than either the Bank of England or the ECB (Balls, & ODonnell, 2002). The main reason for the differences coming short may so be given by the treasury was the previous failings of monetary policy. In their description of the new monetary framework of October 1999, the principal argument was that previously there had been that numerous shortcomings in the design and conduct of monetary policy. Objectives were often inappropriate or unclear, while decisions were often poorly coordinated with fiscal policy or were made too late to prevent inflationary pressures from building. Roles and responsibilities were also ill-defined, creating the impression that policy decisions could be based on short-term political considerations. A lack of transparency hindered accountability and meant that policy-makers were unable to build credibility (Balls, & ODonnell, 2002). Given that the Treasury was conducting both monetary and fiscal policy prior to giving independence to the Bank, this is a remarkable statement. It seems to be either a vote of no confidence in the Treasury, or in the incoming government. It was argued that previous governments had often accompanied an apparently tough budget with an interest rate cut, only to raise interest rates again shortly afterwards, when the budget proved more inflationary than expected. As a result, they proposed that a test of fiscal policy was whether an independent Bank would change interest rates following a budget. Their finding under the new monetary policy arrangements was that interest rate changes did not seem related to the previous budget (Goodhart, 2006). A possible test of what type of policy the Bank is pursuing may be possible when the Bank is faced by a supply shock. Interest rates control inflation through their effect on aggregate demand. Since a positive aggregate demand shock raises demand and inflation, the correct monetary policy response would be to offset the increase in aggregate demand by higher interest rates. In contrast, a negative supply shock- say an oil price increase, would also raise inflation but it would reduce output. If the Bank were a strict inflation targeter it would again increase interest rates, causing a further fall in output (Goodhart, 2006). But if it were a flexible inflation targeter, it would give weight to the fact that output had already fallen and not raise interest rates, or would raise them a lot less. The MPC has usually refused to say much about how it would respond to a supply shock. If anything, the Bank has claimed that if inflation were to increase from whatever cause then it would seek to reduce it. At the time of writing this, in September 2005, the MPC is in exactly this dilemma; the internal members of the MPC have favoured raising rates while the external members have obtained a majority vote to lower them (Goodhart, 2006). Unlike the Bank of England, the ECB claims to be a strict inflation targeter. The US Fed is clearly a flexible inflation targeter. Recently, for example, although inflation changed relatively little, for some time it maintained very low interest rates in order to counteract recession, and then slowly and steadily returned rates to more normal levels. In the case of the ECB matters are less clear. This is due to money growth being a second pillar to inflation in the conduct of ECB monetary policy. In practice, however, the ECB has acted as much like a strict inflation targeter as the MPC since it habitually resists pressure from member countries to cut interest rates to stimulate the economies of low growth countries (Goodhart, 2006). As a result, the ECB has had great difficulty justifying the presence of the money pillar, which was introduced in deference to the monetary policies of the old Bundesbank. Having a money growth target and using interest rates as the instrument shows a logical inconsistency at the heart of ECB monetary policy. Under inflation targeting, with the interest rate the instrument, the money supply becomes an endogenous variable and so is no longer of much concern. While long-run narrow money growth may be expected to be close to the long-run rate of inflation, this is due to the endogeneity of narrow money. At best, narrow money growth may prove a useful early indicator of longer-term inflation, but not an instrument of monetary policy (Goodhart, 2006). On the issue of conservatism, it may be noted that UK short-term interest rates have usually been at least 1 percentage point higher than those in the euro-zone even though they have had similar rates of inflation. Whether this can be attributed to greater conservatism by the MPC, or to a sterling risk premium. As already noted, at the same time UK long rates have been similar to those in the Euro Area (Goodhart, 2006). One of the key elements of the Banks conduct of monetary policy is the strength and timing of the response of inflation to interest rates. The Bank has transformed its internal activities to meet its new remit. This has resulted in large resources being devoted to research on monetary policy and, in particular, to analysing the transmission mechanism of interest rates to inflation. The centrepiece of this is BEQM, which has only recently been completed and largely replaces the various disparate models first used. BEQM is a bold and innovative attempt to incorporate the latest thinking in macroeconomic theory with the needs of the Bank to determine interest rates each month. It is both a forecasting model and a tool for simulating alternative policies. However surprising it may seem to some, it is not easy to combine successfully both activities within one model (Goodhart, 2006). A related question is the frequency and size of interest rate changes. As noted above, the record of the interest rates set by the MPC and the ECB are very different. The ECB has kept interest rates constant for long periods. The US Fed has made sharp reductions in interest rates and then returned them to a more neutral position in a series of small increases. The MPC is somewhere in between. It has tended to steer the economy with occasional small changes in interest rates. As inflation has been similar in the three monetary zones, these differences are indicators of the positions of the three central banks on strict versus flexible inflation targeting. They show that the ECB is more of a strict inflation targeter than the MPC (Nickell, 2005). A criticism sometimes heard is that the MPC does not provide interest rate forecasts like some other central banks, such as the Riksbank. Until recently, its inflation and growth forecasts even assumed that interest rates would stay constant. Consequently, the MPC preferred to call them projections. The MPC now bases its forecasts on market forward rates. These are not really forward-looking, however, as they are based on the current term structure. It would be expected that market forecasts to be affected by forecasts of interest rate by the MPC. The MPC seems to be inhibited from providing interest rate forecasts by the possibility that it might want to choose different rates at a later date (Nickell, 2005). Inflation targeting is one of the great success stories of modern monetary economics. So successful has it proved that it has been adopted by central banks across the world. It is difficult to find a better example of the effectiveness of inflation targeting than in the UK since the Bank of England was given its independence. The thirty-year search for a nominal anchor to replace the Bretton Woods system seems to be over. UK monetary policy has improved hugely since inflation targeting has been used. The new regime of giving independence to the Bank of England in setting interest rates has cemented the gains from inflation targeting. The MPC may take considerable credit for this (Nickell, 2005). Nonetheless, a puzzle remains at the heart of the policy over whether the way inflation targeting has worked in practice is consistent with the theory of inflation targeting. Excess demand does not seem to have a strong effect on inflation; interest rates do not seem to have a strong effect on aggregate demand; the exchange rate channel appears to be important, yet how exchange rates are determined is still shrouded in uncertainty; meanwhile the Governor often stresses the crucial role of inflation expectations, a channel particularly difficult to tie down (Nickell, 2005). The MPC has shown a tendency to overpredict inflation and underpredict output. The former suggests that interest rates may have been set too high, but had the output forecasts been more accurate, interest rates might have been set even higher. Errors in forecasting the exchange rate and inaccurate GDP data seem to have been factors causing the forecast errors. The Bank of Englands remit focuses exclusively on inflation. As a result, the Bank is concerned with GDP only in so far as it affects inflation. This is in contrast to the US Fed which has shown a willingness to target GDP directly (Goodhart, 2006). This case seems strongest when there are negative supply shocks. Inflation targeting requires an increase in interest rates when inflation rises above target. Excessive increases in demand (positive demand shocks) raise GDP and inflation. The correct response of monetary policy is to raise interest rates to control demand and hence inflation. However, a negative supply shock such as an oil price increase raises inflation but depresses GDP. Increasing interest rates would reduce inflation but would depress GDP even further. According to the remit of the Bank of England, and the theory of inflation targeting, this would be the correct response. But it seems to be an occasion when giving more weight to GDP would be preferable (Goodhart, 2006). Works Cited Balls, E. and ODonnell, G. (2002), Reforming Britains Economic and Financial Policy, Palgrave. Goodhart, C.A.E. (2006), An essay on the interactions between the Bank of Englands forecasts, the MPCs policy adjustments, and the eventual outcome, Journal of Central Banking Studies (forthcoming). Nickell, S. (2005), Practical issues in UK monetary policy, 2000-2005, British Academy Lecture. Read More