These are the slides from the May 2017 revision webinar on UK Monetary Policy

1. UK Monetary Policy Revision Webinar – May 2017

2. Current objectives of UK monetary policy
Monetary stability means stable prices and confidence in the
currency. Stable prices are defined by the Government's inflation
target, which the Bank seeks to meet through the decisions taken by
the Monetary Policy Committee (MPC).
The Bank of England has been independent of the UK government
since May 1997. The current governor is Mark Carney.

3. Current Set Up of UK Monetary Policy
Free floating currency 2% inflation target
Quantitative Easing
(planned QE = £445bn)
Capital/liquidity
requirements for banks

4. Main functions of a central bank
• Monetary policy function
• Setting of the main monetary policy interest rate (the base rate)
• Quantitative easing (QE)
• Exchange rate intervention (with managed/fixed currency systems)
• Financial stability & regulatory function
• Supervision of the wider financial system
• Prudential policies designed to maintain financial stability
• Policy operation functions
• Lender of last resort to the commercial banking system
• Managing levels of liquidity in the commercial banking system
• Financial infrastructure function
• Overseeing the payments systems used by banks / retailers / credit
card companies including financial innovation
• Debt management
• Handling the issue and redemption of issues of government debt

5. UK Monetary Policy Interest Rates since 1975
-2
0
2
4
6
8
10
12
14
16
18
1-Jan-75
1-Jul-76
1-Jan-78
1-Jul-79
1-Jan-81
1-Jul-82
1-Jan-84
1-Jul-85
1-Jan-87
1-Jul-88
1-Jan-90
1-Jul-91
1-Jan-93
1-Jul-94
1-Jan-96
1-Jul-97
1-Jan-99
1-Jul-00
1-Jan-02
1-Jul-03
1-Jan-05
1-Jul-06
1-Jan-08
1-Jul-09
1-Jan-11
1-Jul-12
1-Jan-14
1-Jul-15
End month official Bank Rate

6. UK Monetary Policy Interest Rates 1946-2016

7. The Exchange Rate is a key part of Monetary Policy!
70
75
80
85
90
95
100
105
110
1-Jan-00
1-Sep-00
1-May-01
1-Jan-02
1-Sep-02
1-May-03
1-Jan-04
1-Sep-04
1-May-05
1-Jan-06
1-Sep-06
1-May-07
1-Jan-08
1-Sep-08
1-May-09
1-Jan-10
1-Sep-10
1-May-11
1-Jan-12
1-Sep-12
1-May-13
1-Jan-14
1-Sep-14
1-May-15
1-Jan-16
1-Sep-16
UK Effective Exchange Rate Index (Jan 2005=100)

8. Weightings Used in the Trade-Weighted Sterling Index
Broad Exchange Rate Index Weights (%)
Weight in
2015
Currency
USA 18.5 Dollar
Germany 12.2 Euro
China 8.7 Yuan
France 7.1 Euro
Netherlands 6.0 Euro
Belgium and Luxembourg 4.2 Euro
Ireland 4.0 Euro
Italy 4.0 Euro
Spain 4.0 Euro
Switzerland 3.5 Franc
Japan 2.8 Yen
Poland 1.8 Zloty
Sweden 1.8 Krone
India 1.7 Rupee

9. Monetary Policy Overview
• The Bank of England’s MPC does a thorough assessment
of the key data on UK economy each month
• They look at a range of demand/supply-side indicators
• Main issue is the likely strength of inflationary pressures
and the inflation forecast for UK over the next two years
• Inevitably there is a lot of uncertainty – there are
numerous internal and external shocks around
• Monetary policy is not an exact science
• Monetary policy affects both the demand and the supply-
side of the economy
• Monetary policy does not operate in isolation – especially
when policy interest rates are at the zero-bound.

10. Source: ONS
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
340
360
380
400
420
440
460
480
2004Q1
2004Q3
2005Q1
2005Q3
2006Q1
2006Q3
2007Q1
2007Q3
2008Q1
2008Q3
2009Q1
2009Q3
2010Q1
2010Q3
2011Q1
2011Q3
2012Q1
2012Q3
2013Q1
2013Q3
2014Q1
2014Q3
2015Q1
2015Q3
2016Q1
2016Q3
UK Real GDP
Growth (%) RHS Levels (£ billion) LHS
Quarterly
growth(%)
Level of real GDP
(£bn per quarter)
Economic Cycle for the UK

11. Post-war recoveries in level of UK GDP
Source: NIESR

12. 0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
CPI Inflation and Sterling LIBOR since 1999, annual average
CPI Inflation (%) Sterling LIBOR (%)
Interest Rates and Inflation in UK Economy 1999-2016

13. Policy in a world of External Economic Shocks
1. Demand shocks. These are associated with a rise or a
decline in spending and confidence abroad.
2. Supply/price shocks. These affect the global supply and
prices of goods and services.
3. Financial shocks. These occur in the global financial
system, such as increased stress in the international
banking system or financial markets
• Key evaluation point:
• Not all shocks are necessarily negative – there can be
some positive supply shocks resulting from advances in
production technologies, newly internationally ratified
trade and investment deals and political reforms

14. Examples of External Shocks
Global Financial
Crisis (GFC)
Euro Zone
Economic Crisis
Volatile
Commodity Prices
China Slowdown
International Trade
& Investment
Deals
Currency volatility
and policy changes
e.g. devaluation
Extreme weather
events
Geo-political
uncertainty &
terrorism

15. Latest Bank of England CPI Inflation Forecast (Feb 2017)
The Bank of England retains
operational independence for
monetary policy in pursuit of a simple
inflation target set by the government
which remains at 2 per cent

16. Inflation in the UK – Deviation from Target 1997-2017

17. CPI Inflation Rising – But Policy Interest Rates on Hold?
0
1
2
3
4
5
6
2006JAN
2006JUN
2006NOV
2007APR
2007SEP
2008FEB
2008JUL
2008DEC
2009MAY
2009OCT
2010MAR
2010AUG
2011JAN
2011JUN
2011NOV
2012APR
2012SEP
2013FEB
2013JUL
2013DEC
2014MAY
2014OCT
2015MAR
2015AUG
2016JAN
2016JUN
2016NOV
CPI Inflation, annual % change in consumer prices

18. An Era of Extraordinary Monetary Policy
• Central Banks of many advanced countries including the
UK have made extraordinary sustained use of
expansionary monetary policy in recent years:
• Policy interest rates approached the zero bound and have
remained there (e.g. 0.25% in the UK)
• Negative policy rates in some countries (e.g. Japan,
Sweden, Denmark and Switzerland and the Euro Zone)
• Huge rise in the scale of quantitative easing designed to
increase the base supply of money / increase liquidity
• Growing use of exchange rate (currency) intervention as
an active instrument of monetary policy (i.e. a move
towards managed floating exchange rates) e.g. in Japan

19. Expansionary and Deflationary Monetary Policy
Expansionary
Monetary Policy
Fall in nominal and real level
of interest rates
Measures to expand the
supply of credit from the
banking system
Depreciation of the external
value of the exchange rate
Deflationary
Monetary Policy
Higher interest rates on
both loans and savings
Tightening of credit supply
(i.e. loans become harder to
get)
Appreciation of the
exchange rate

20. Why Low Interest Rates can be Ineffective
When consumer & business confidence (animal spirits) is low
When savers suffer a fall in their real incomes / purchasing power
When there is a very high level of unpaid debt
When there is deflation causing real interest rates to rise
When export markets are weak after a currency depreciates
When fiscal policy working in the opposite direction e.g. austerity
When low interest rates distort pension funds and create asset bubbles

21. The Keynesian Liquidity Trap
A liquidity trap occurs when low nominal interest rates and a high
amount of cash balances fails to stimulate aggregate demand
Two Sides of a
Liquidity Trap
Risk averse
commercial
banks
Required to
hold more
capital
Risk premium
on new loans
Private sector
businesses and
consumers
Low on
confidence
Focused on
cutting debt

22. Arguments for using Negative Policy Interest Rates
• Negative interest rates are designed to:
1. Get banks lending – i.e. they will pay the central bank
interest for holding money on deposit with them
2. Bring about a reduction in real interest rates – which
might then stimulate increased business investment
3. Negative rates are partly designed to cause an outflow
of hot money thereby depreciating an exchange rate
• Main aim of negative interest rates is to lower the risks
from a country experiencing price deflation
• Key evaluation point:
• Negative interest rates are a sign that the conventional
policy of low nominal interest rates has stopped being
effective in reflating debt-ridden economies.

23. Risks from Negative Interest Rates
1. Negative interest rates can cut commercial bank profitability
by reducing the interest-rate margins between savings and
loans rates
2. Negative rate may also cause banks to take excessive risks in
search of higher returns - leading to asset bubbles including
the housing market (another housing boom?)
3. Lower interest rates on deposits may cause households and
businesses to hoard cash rather than spend/invest
4. Pension and insurance companies may struggle to meet
their long term liabilities if long term interest rates (yields)
are close to zero or below
5. Economy may be over-dependent on ultra-low interest
rates – low-rate junkies and survival of zombie firms
6. Micro effects - sales of safes are soaring!

24. Incomes of savers
• If the interest on savings is less than inflation, savers
will see a reduction in their real incomes – this then
affects their spending power on goods and services
Incomes of home-owners with mortgages
• If interest rates fall, the income of home-owners
who have variable-rate mortgages will increase –
their effective disposable income grows
Interest rates on unsecured debt
• Lower interest rates on loans such as credit cards
and bank loans will fall – but cuts in base rates do
not necessarily lead to lower credit card rates
Distributional Effects of Very Low Interest Rates

25. How QE works as an instrument of monetary policy
Central bank creates new money electronically by
adding money to their balance sheet. This money
is then used to buy financial assets
More demand leads to higher prices for assets.
Rise in price of bonds leads to lower yield (%) on
bonds
The effect of QE can then cause a fall in long term
interest rates e.g. mortgages and corporate bonds
Lower interest rates and increased cash in the
banking system should stimulate AD through a
rise in consumption and investment
Extensive QE also works through the exchange
rate - lower yields on assets usually causes a
currency depreciation

26. How QE has affected ownership of UK government debt
The Bank of England, through its
Asset Purchase Facility now holds
30 per cent of the stock of
outstanding UK government debt

27. Evaluating QE – A Case For
Argument For more / continued Quantitative Easing
Point
QE was needed as an unconventional monetary policy because very low
interest rates were proving to be ineffective in stimulating demand
Explanation
Keynes wrote about a liquidity trap – a situation when even low nominal
interest rates have little effect on aggregate demand because of low
business and consumer confidence and a fragile banking system
Evidence
QE is estimated to have cut long term interest rates by around 1% - making
it easier for companies to issue bonds and for people to get a cheaper
mortgage. It has helped avoid the threat of deflation.
Evaluation
Cheaper mortgages have reignited the housing market but rising house
prices make the economy even more unbalanced that it was before

28. Evaluating QE – A Critique of QE
Argument Against Quantitative Easing
Point QE has led to widening income inequality in the UK
Explanation
QE has only helped to support stock markets, which only
benefits owners of assets who are mainly in the higher
income groups
Evidence
A Standard and Poor's report in Feb 2016 suggested that
value of financial assets has risen by £600bn whilst mean real
wages have fallen by 8%
Evaluation
However, without the introduction of QE growth, GDP
growth could have been worse and we might have seen
deflation with a negative impact on all groups

29. The Interest Rate Dilemma Facing the Bank
Brexit uncertainty EU and USA
developments
Impact of Chinese
slowdown
How much spare
capacity?
Savers need
higher rates!
A gradual return
to normal rates?

30. Evaluating an era of low interest rates – UK House Prices
100000
120000
140000
160000
180000
200000
220000
240000
2005Jan
2005Jun
2005Nov
2006Apr
2006Sep
2007Feb
2007Jul
2007Dec
2008May
2008Oct
2009Mar
2009Aug
2010Jan
2010Jun
2010Nov
2011Apr
2011Sep
2012Feb
2012Jul
2012Dec
2013May
2013Oct
2014Mar
2014Aug
2015Jan
2015Jun
2015Nov
2016Apr
2016Sep
2017Feb
UK average house price, seasonally adjust, £s

31. Consumer Confidence and Growth of Consumer Credit
-35
-30
-25
-20
-15
-10
-5
0
5
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Annual Growth of Consumer Credit (LHS) and Consumer Confidence (RHS)
Consumer Confidence Consumer Credit
% change,
year-on-year
Net balance of
optimists - pessimists

32. UK Labour Market edges closer to Full-Employment
4
5
6
7
8
9
10
Oct-Dec2011
Dec-Feb2012
Feb-Apr2012
Apr-Jun2012
Jun-Aug2012
Aug-Oct2012
Oct-Dec2012
Dec-Feb2013
Feb-Apr2013
Apr-Jun2013
Jun-Aug2013
Aug-Oct2013
Oct-Dec2013
Dec-Feb2014
Feb-Apr2014
Apr-Jun2014
Jun-Aug2014
Aug-Oct2014
Oct-Dec2014
Dec-Feb2015
Feb-Apr2015
Apr-Jun2015
Jun-Aug2015
Aug-Oct2015
Oct-Dec2015
Dec-Feb2016
Feb-Apr2016
Apr-Jun2016
Jun-Aug2016
Aug-Oct2016
Oct-Dec2016
Labour Force Unemployment Rates for Men and Women, %, SA
People Men Women

33. Judging the amount of spare capacity in the economy
The chart shows the estimated output gap for the UK. It suggests that –
seven years after the end of recession – UK GDP is close to potential level.
Negative output
gap – i.e. where the
economy has large
margin of spare
capacity of factor
resources.
Positive output gap
– i.e. where actual
GDP is above
potential GDP – a
sign of possible
excess aggregate
demand
-4
-3
-2
-1
0
1
2012Q1
2012Q2
2012Q3
2012Q4
2013Q1
2013Q2
2013Q3
2013Q4
2014Q1
2014Q2
2014Q3
2014Q4
2015Q1
2015Q2
2015Q3
2015Q4
2016Q1
2016Q2
2016Q3
Range of output gap model estimates
Central estimate
% of potential GDP

34. Household debt in UK compared to advanced economies
Source: NIESR

35. Evaluating the impact of UK Monetary Policy
Successes Policy has helped avoid the
worst effects of a period of
price deflation
Bank acted swiftly to avoid
1930s style depression
Expansionary policy has
supported GDP growth
during years of fiscal
austerity
Lower exchange rate has
maintained price
competitiveness of exports
Bank has interpreted
inflation target flexibly –
using discretion not rules

36. Evaluating the impact of UK Monetary Policy
Criticisms Ultra-low policy interest rates
have had some negative side-
effects
Build up of consumer debt
Surge in house prices and rents
– hitting affordability
Little evidence that weaker £
has improved the net trade
balance
Record current account deficit
of over 5% of GDP in 2016
Few signs lower interest rates
have increased investment as a
% of GDP
UK still lags behind on
investment, research &
development + productivity
Low interest rates may have
widened inequalities of income
and wealth
Steep fall in real incomes for
savers – many on low incomes
Young unable to afford to buy
or rent

37. Should UK Monetary Policy be Reformed?
• 1997 – Bank of England made operationally independent
• 2017 – Criticisms from the PM about the Bank’s handling
of Monetary Policy in speech to Conservative Party
conference
• “People with assets have got richer. People without them
have suffered. People with mortgages have found their
debts cheaper. People with savings have found themselves
poorer. A change has got to come. And we are going to
deliver it.”
• After 20 years of independent – is it time to change
aspects of monetary policy in the UK?
• Is the era of ultra-low interest rates having diminishing
returns on the real economy with bad side effects?

38. Should UK Monetary Policy be Reformed?
• Would the UK benefit from a higher inflation target?
Change to the inflation target
• Negative interest rates on savings deposits
• Gesell Money - direct cash transfers to households e.g. via a smart card
Ultra-non conventional policies
• New Gilt Purchase Fund to target infrastructure projects?
• e.g. Helicopter money - monetary financing of extra government spending
More co-ordination with Fiscal Policy
• Should the BoE continue with a free-floating £ or move to managed rates?
Intervention in currency markets

39. UK Monetary Policy Revision Webinar – May 2017