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Revision Webinar on UK Monetary Policy

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

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Revision Webinar on UK Monetary Policy

  1. 1. UK Monetary Policy Revision Webinar – May 2017
  2. 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. 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. 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. 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. 6. UK Monetary Policy Interest Rates 1946-2016
  7. 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. 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. 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. 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. 11. Post-war recoveries in level of UK GDP Source: NIESR
  12. 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. 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. 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. 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. 16. Inflation in the UK – Deviation from Target 1997-2017
  17. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 34. Household debt in UK compared to advanced economies Source: NIESR
  35. 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. 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. 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. 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. 39. UK Monetary Policy Revision Webinar – May 2017

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