A Note on Monetary Policy

John Whittaker

In the UK and other countries with developed financial markets, central banks set the short-term nominal interest rate for the currency that they issue: the short-term interest rate is the monetary instrument. In recent years, monetary policy has been supplemented in the major economies by : the purchase by the central bank of government debt and other assets.

The first part of this note describes how the central bank interacts with financial markets and how its policy choices are transmitted to the wider economy. The second part describes how the central bank makes its policy choices.

1. What is monetary policy? 1.1 The functions of commercial banks 1 1.2 The ’s operations 2 1.3 Interest rates in the money-market, and banks’ retail rates 3 1.4 Effects of the financial crisis and the recession 5 1.5 Bank regulation 6

2. How does the central bank choose the interest rate? 2.1 The effects of changes in interest rate: the transmission mechanism of monetary policy 9 2.2 The role of expectations 10 2.3 The central bank’s choice of interest rate 11 2.4 Quantitative easing 13

Appendix: Monetary base control 15

Economics Department Lancaster University January 2017

http://www.lancaster.ac.uk/staff/whittaj1/

1. What is monetary policy?

1.1 The functions of commercial banks account holder makes a payment (see the The traditional business of commercial banks is simplified balance sheet below). But loans are to take deposits and to lend, and they make the largest component of banks’ assets and they profits from the interest margin between the rate are illiquid: they may, for instance, be loans to they charge for loans and the rate they pay to firms which are used to purchase fixed assets or depositors. Many large banks also perform mortgage finance to householders, and cannot other functions such as managing investment easily be sold if the bank needs to repay its funds and dealing in securities, although depositors. regulation is now attempting to enforce separation of these functions from retail To cope with net withdrawals of deposits, banks banking, in response to the financial crisis. need liquid assets, the most liquid being holdings of currency (banknotes) and reserves. The other important function of commercial Reserves are the banks’ own deposits at the banks is to operate the payments system. For central bank (hence they appear as liabilities on this purpose, about half of private sector the Bank of England’s balance sheet) and they deposits in UK banks are sight deposits that are liquid because they may be immediately may be withdrawn without notice when the withdrawn in the form of currency.

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UK banks and building societies: consolidated account. Sterling balances, £ billions assets Feb.06 Aug.16 liabilities Feb.06 Aug.16 £ currency (vault cash) 5.7 10.9 private sector deposits 1668.7 2628.7 reserve deposits at BoE 0.8 333.2 public sector deposits 38.2 41.6 govt and private securities 126.5 434.2 repo loans from BoE 26.7 24.2 loans to UK private sector 1776.7 2335.0 capital and net other 176.1 418.8 1909.7 3113.3 1909.7 3113.3

Bank of England (BoE), £ billions assets Feb.06 Aug.16 liabilities Feb.06 Aug.16 government securities 15.6 469.2 £ currency issued 36.9 72.7 repo lending to banks 26.7 24.2 bank reserve deposits 0.8 333.2 government deposits 0.8 4.1 net other 3.8 83.4 42.3 493.4 42.3 493.4 Simplified balance sheets for UK banks (£ sterling balances) and the Bank of England. The earlier date (Feb. 2006) is included to show the difference before interest was paid on reserve balances and before quantitative easing: see section 2.4. Source: Monetary and Financial Statistics, Bank of England (‘Bankstats’), tables B1.1.2, B2.1, B2.2, B2.2.1

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As currency earns no interest, the banks keep changes on the consolidated balance sheet of stocks of ‘vault cash’ that are only a small the banks presented above and are not relevant fraction of their deposit liabilities (see balance for monetary policy. The transactions that are of sheet). They prefer to hold their liquidity in the interest are those that involve the central bank. form of reserves1 which (since May 2006) earn interest at the Bank of England’s official (0.5% since 2009, reduced to 0.25% in 1.2 The Bank of England’s operations August 2016) or interest-earning securities such as treasury bills and government bonds. These While monetary systems in all the major assets are liquid as they may easily be sold in economies operate in similar ways, the financial markets or used as collateral security following is a simplified description of for loans from other institutions. The banks’ transactions that involve the Bank of England. holdings of reserves have increased markedly since 2009 as a result of quantitative easing Suppose that individuals decide to hold more (see Section 2.4 below). currency, as they regularly do during holiday seasons, and they draw on their bank deposits When a retail payment is made, for instance by for this purpose. Since commercial banks only a cheque drawn on the payer’s bank account hold small stocks of currency (‘vault cash’), which the payee deposits in a different bank, or they must obtain the extra from the Bank of using a debit card, the paying bank owes the England. In the above balance sheets, deposits amount of the payment to the receiving bank. at banks fall while the currency liability of the The wholesale debts between banks thus Bank of England rises. created by retail payments may be settled in a variety of ways: for example by transfers of The banks pay the Bank of England for this bank reserve deposits at the Bank of England, currency by drawing on their reserve deposits: by sales of assets, by loans that are secured on the relevant bookkeeping entry is a reduction in assets (usually in the form of ‘repos’: sale and bank reserves equal to the amount of the extra repurchase agreements2) or by unsecured currency. interbank loans. Settlement by transfers of As another example, suppose the government reserves is now more common, given the banks’ receives a payment of tax which the payer large holdings of reserves. draws from his deposit at a commercial bank. If Note that these transactions are between the the government pays the tax into its deposit at banks – one bank’s loss of a deposit is another the Bank of England, this again causes a debt of bank’s gain – hence they will not cause any the commercial bank to the Bank of England which is settled by an increase in the bank’s

1 reserves. The opposite transactions take place Some central banks oblige their banks to hold required reserves as a minimum ratio (e.g. 2%) of their own short- when the government spends out of its Bank of term deposit liabilities. However, the ability to vary this England deposits. ratio is not an additional tool of monetary policy, given that the central bank must always supply sufficient Changes in banks’ reserves at the Bank of reserves to cover any such requirement (see section 1.2 England are the balancing entry whenever any and Appendix). The Bank of England does not apply reserve requirements. of the central bank’s other liabilities or assets 2 change. The above transactions are Under a ‘repo’ or ‘sale and ’, the ‘autonomous factors’ that change banks’ borrowing bank sells the lending bank a security (such as a government bond or ‘gilt’) with an agreement to reserve balances, (i.e. they are not under the repurchase it later. A repo thus amounts to a loan backed control of the Bank of England). If they cause by the collateral security. Interest is effected as the banks, in aggregate, to run short of reserves, the difference between the sale and repurchase price of the Bank of England itself makes further reserves bond. available. Normally, it does this by routinely

2 granting them short-term ‘repo’ loans3. The Since 2009, however, the banks have had large interest rate charged for repo lending is close to excess reserve balances because of quantitative Bank Rate that it pays on reserve deposits. easing (QE, Section 2.4). There has been no need for the Bank of England to supply them The important point is that, by its own dealing with more reserves and it has suspended its with the banks, the Bank of England supplies routine short-term repos. In this situation, Bank the banks with reserves (provides liquidity) as Rate, as the rate paid on reserve balances, is the needed to ensure that, collectively, they always opportunity cost of short-term funding for the have positive reserve balances. It cannot do banks. This rate is transmitted to the wider otherwise. This is fundamentally because all economy via the sterling interbank market, as is financial liabilities denominated in sterling are explained in the following section. ultimately claims on sterling currency, the most obvious example being ‘sight’ deposits in 1.3 Interest rates in the interbank market commercial banks which the depositor can and banks’ retail rates withdraw as currency on demand, and because the Bank of England is, by law, the only issuer With the Bank of England lending to banks as of sterling currency. This is the defining required at its chosen Bank Rate and paying difference between the central bank and other interest to banks on their reserve balances, also financial institutions. at Bank Rate, short-term wholesale lending between banks also normally takes place at If the Bank of England failed to provide rates that are close to Bank Rate. At present, reserves as needed, or even if there were a with abundant reserve balances and little doubt suspicion that some bank would be unable to about bank solvency, competition between satisfy demands for currency withdrawal, the banks ensures that no bank has to pay more than likely consequence would be a bank run, as Bank Rate for a short-term loan from another happened to Northern Rock Bank in 2007. bank, and no bank would lend at less than Bank Rate when it is paid at Bank Rate on its reserve Since the Bank of England cannot refuse such deposits. The routine practice of the central lending, it has to choose the interest rate at bank, of lending to banks on demand and which it lends. This Bank Rate is the marginal paying interest on the banks’ reserve balances, cost of funds to the banks: it is the rate at which means that the wholesale rates for interbank banks know they can always obtain short-term lending remain close to Bank Rate (Figure 1).5 funds (provided they have sufficient collateral that is acceptable by the Bank of England for its argued that central bank lending against illiquid assets repos4). amounts to solvency support; see section 1.4. 5 Interbank rates became detached from Bank Rate during the financial crisis, reflecting lack of trust between the 3 See footnote 2. On balance sheets, Bank of England banks. For instance, three month libor reached as far as repo lending is shown as an asset on the Bank of 1½% above Bank Rate in late 2008 (Figure 1). During England’s balance sheet and a liability of the borrowing 2011, libor rates rose again; this may have reflected the bank. Under standard accounting conventions, the UK banks’ exposure to some eurozone banks. borrowing bank’s collateral security stays on its balance In the eurozone, there is the added complication that the sheet even though it is held by the Bank of England rate paid by the ECB for excess reserves, currently minus during the tenure of the repo. 0.4% (since March 2016; the rate on its ‘deposit 4 This raises the question of what happens when banks facility’), is less than its lending rate, currently 0% (its run low on liquid assets that the central bank deems to be ‘main refinancing rate’). Given that eurozone banks have eligible collateral for its repo loans. At the onset of the large excess reserves, it is the rate paid on those reserves financial crisis when many banks became illiquid, major that is relevant and the interbank rate (EONIA) is central banks reduced the quality of assets against which currently minus 0.35%, close to this rate. they will lend. The quality of assets that the European A further complication has been added by new Central Bank is prepared to accept for its repo lending regulations (the Liquidity Coverage Ratio, LCR) which remains much lower than before the crisis. It can be oblige banks to hold liquid assets, mainly reserves and

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their lending by borrowing in the interbank market at rates close to the central bank’s dealing rate, so they do not wait for deposits before lending, as would be implied by the textbook ‘money multiplier’ theory (see appendix). When a bank has an opportunity to lend, its decisions over whether to lend, how much to lend and at what interest margin, can

be taken mainly on the basis of the perceived default risk. The banks are said to practice ‘liability management’: lend and then find the Figure 1. Bank Rate and an interbank rate. necessary funds (liabilities). libor = London Interbank Offer rate, for unsecured lending source: Bank of England

What interest rate will banks offer for deposits? Deposits and interbank borrowing are alternative sources of funds so, as competitive profit maximisers, they set the rate offered on deposits at some margin below Bank Rate to cover administration and transactions costs (Figure 2 displays this pattern up to 2008). For short-term deposits used for transactions, the margin must also cover liquidity risk: the risk Figure 2. Retail deposit and lending rates that the deposit may be withdrawn without source: Bank of England notice.

Similarly, the rate charged by banks for their However, for some banks that had become lending to individual and corporate borrowers over-reliant on short-term interbank market exceeds Bank Rate by a margin to cover funding, this method of working broke down transactions costs, also default risk and the cost dramatically after the onset of the financial of holding capital to support the loan. In other crisis in 2007, when the quality of their assets words, the banks set their retail lending and fell under suspicion and other banks were deposit rates at appropriate margins above and unwilling to roll over their interbank loans. below the of the central bank. When Bank Rate changes, the banks’ retail rates normally change approximately in At the end of 2008, the relationship between parallel. Bank Rate and the commercial banks’ retail rates also changed as Bank Rate was rapidly Another consequence of the central bank’s reduced from 5% to 0.5% while retail rates did routine provision of liquidity (and the payment not fall so far (Figure 2). Lending margins have of interest on excess reserves) is that the remained higher than before the crisis and commercial banks’ retail lending decisions are banks are still competing to attract deposits by not dependent on their having sufficient offering rates for some short-term deposits that deposits. They know they can normally fund are greater than Bank Rate. This is indicative of a change in the banks’ attitude to risk together

with tighter Basel III regulations (section 1.5). government bonds, equal to 100% of their short-term interbank borrowings. This has markedly reduced the After aggressive expansion of lending up to volume of lending in the interbank market. 2007, the banks are still rebuilding their balance sheets to increase the proportion of lending that

4 is funded by deposits rather than interbank be divided into tranches with a prescribed borrowing, to increase their holdings of liquid priority order of pay-out when some of the assets to meet new statutory requirements, and underlying loans default on payments. In a to raise their capital ratios (both risk-weighted simple structure containing a senior, a capital and leverage ratios). mezzanine and an equity tranche, the first losses are borne by the equity tranche, and the The irony is that, whilst the government is mezzanine tranche only becomes impaired raising banks’ costs by regulation, it is also when the losses exceed the entire amount of the pressing the banks to increase their lending. The equity tranche. Similarly, the senior tranche government cannot have it both ways. only suffers if losses exceed the amounts of the mezzanine and the equity tranches, making it much more secure than the original pool. 1.4 Effects of the financial crisis and the recession The senior tranche is thus credit-enhanced and, before the problems of 2007, it invariably In late 2007, it became clear that some banks gained the highest rating from one of the credit had been lending too freely and too cheaply, rating agencies, thus becoming an attractive particularly for home loans, driving up the investment to other institutions such as pension prices of houses and other assets to funds. This process enabled banks to turn risky unsustainable heights (Figure 3). In both the illiquid loans into assets that could be sold or United States and Britain, mortgage loans were used as collateral for repo funding in the granted in amounts that were six times the financial markets, freeing up cash for further borrower’s annual income and up to 125% of lending. Under existing bank regulations, it also the value of the secured property. When house enabled institutions that owned senior tranches prices started falling and significant numbers of to hold smaller amounts of regulatory capital loans began to default (initially in the than if they held the original assets, thereby ‘subprime’ market in the US) there was a increasing leverage. widespread fall in confidence in the banks and several had to be bailed out or recapitalised by In the years prior to 2007, the issue of asset- governments. backed securities grew at an increasing rate, reaching a global value of around $10 trillion in mid-20076, with banks in most developed countries becoming involved as originators of these securities, or buyers, or both. And as the market expanded, more complex financial instruments were introduced such as collateralized debt obligations which are, for instance, securitised assets created by combining several mezzanine tranches of previous securitisations. These new assets were hard to value and they had the effect of concealing risk. When the market in these assets broke down, many were written down to Figure 3. UK house prices a fraction of their face values, earning the label ‘toxic assets’. One of the factors which drove this expansion in lending and also played a major part in the banking collapse was securitisation, whereby a bank pools together several hundred loans to 6 Estimate from Bank of England Stability Report, create an asset-backed security. This may then October 2007.

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During 2008, this deterioration in the value of measures, in particular quantitative easing (see banks’ assets quickly led to justifiable doubts section 2.4) about the solvency of many banks including several of the world’s largest. As a result, banks became reluctant to lend both to their retail 1.5 Bank regulation customers and to other banks. The sudden reduction in the availability of credit, The other response to the financial crisis has accompanied in Britain and the US by sharp been a large increase in regulation under the falls in property prices, was a major contributor international Basel Accords, with the intention to recession7 in all major economies. of preventing future financial crises and their consequences. The core of the Basel regulations Faced with a potential disruption of payments has always been to stipulate minimum levels of systems, central banks gave support to bank capital. vulnerable banks, by providing liquidity for longer periods and against lower quality As with any firm, profits add to the firm’s collateral. And governments provided banks capital stock (or ‘net worth’ or ‘equity’: the with new capital, in some cases amounting to shareholders’ claim on the firm) and losses partial or complete nationalisation. subtract from it, and the firm is solvent (in accounting terms) if the value of its capital is Governments also responded with expansionary positive. It follows that the larger the value of (Keynesian) fiscal policy, but the scope for the firm’s capital, the greater its ability to extra government spending or for tax reduction sustain losses and the more likely it is to remain as limited because of high government debt solvent. levels. Government debts had risen sharply because of the recession-induced reduction in The insolvency of any firm implies losses for tax revenue and increased welfare spending (the creditors, job losses for the firm’s employees, ‘automatic stabilisers’) and because of the and interruption of production. In the case of a support given to the banks. The high levels of bank, the creditors are the bank’s depositors government debt in many countries continue to who would lose their uninsured savings, and an impede economic recovery. important bank ‘product’ is the operation of the payments system (Section 1.1). If one bank is At the same time, monetary policy was used unable to process a payment, this can lead to a aggressively in the attempt to mitigate the chain of failed payments and to the weakening recession and central banks rapidly reduced of other banks. Widespread breakdown of the their interest rates towards zero. Recently, some payments system would be catastrophic for the central banks have even reduced their rates economy. Thus, while the failure of non- below zero: the European Central Bank financial firms and small banks might be currently pays negative 0.4% on excess reserve tolerated, there is a strong case for government deposits and the Bank of Japan negative 0.1%. and/or central bank intervention to prevent the However, central bank deposit rates cannot fall failure of large banks; large banks may be far below zero, otherwise banks would gain by considered as ‘too large to fail’ (TLTF). Indeed, holding (zero-earning) currency instead of governments of all major economies provided (negative-earning) reserve deposits. financial support (‘bail-out’) to a number of banks which suffered heavy losses after the In view of this lower limit on official rates, onset of the financial crisis in 2007-08. central banks have turned to other stimulatory If the bank’s shareholders were to absorb all losses, they would be inclined to ensure that the bank carries prudent levels of equity relative to 7 A common but arbitrary definition of recession is two successive quarters of negative real economic growth. their risky assets. However, the owners of large banks know that they can expect bailout in the

6 event of failure. They therefore have the moral However, a bank prefers to hold illiquid assets hazard incentive to operate with lower levels of as they yield higher interest. This is the equity in order to maximise their return on justification for the LCR which requires the equity, knowing that society bears the risk. This bank to hold ‘high-quality liquid assets’ is the justification for regulation that forces (HQLA) (mainly reserves and government banks to have minimum levels of capital. bonds) as a minimum percentage of its liquid liabilities. For instance, this percentage (the 8 The first international regulation, Basel I was ‘run-off’ rate) for deposits may be 3%, 5% or agreed in 1988 and widely implemented by 10% depending on the likelihood of withdrawal, 1993. Banks’ assets were subdivided into it is 40% for repo borrowing from the central classes, with each class assigned a weight bank for less than 30 days, and 100% for according to its perceived risk (e.g. lending to unsecured interbank borrowing. business 100%, mortgage debt 50%, government bonds 0%). Each bank was obliged Note that illiquidity may imply insolvency and to hold a minimum value of capital as a ratio vice-versa. If a bank is short of liquid assets, it (8%) of the total risk-weighted assets, where the may still try to satisfy deposit withdrawals by main components of ‘capital’ are shareholders’ selling its illiquid assets such as its loans. But equity (Tier 1) and subordinated debt (Tier 2). such sales, especially if undertaken quickly, After much revision and amendment, Basel I may raise less than the book value of the assets, was supplanted by Basel II in 2004-2008, the reducing the value of the bank’s equity and main change being in the methods of assessing moving it towards insolvency. Conversely, if risk weights and the definitions of permissible there are doubts about a bank’s solvency, its capital. depositors would tend to withdraw their deposits for fear that they would be lost: there However, these rules clearly failed to prevent would be a ‘run’ on the bank. Thus either the crisis, and the latest round, Basel III, has illiquidity or insolvency may be the root cause raised the capital ratios and made them of a bank’s failure. They tend to occur together. dependent on bank size and the state of the business cycle: banks are required to have more Another new ratio is the Net Stable Funding capital during periods of high economic growth Ratio (NSFR) which says a bank must hold which is then available to absorb losses in the long term liabilities (e.g. capital and time downturn. Basel III has also added further deposits) as a minimum percentage (100%) of regulatory ratios, notably the Liquidity its illiquid assets. Finally, the Leverage Ratio Coverage Ratio (LCR). sets a minimum ratio of capital to total assets (Basel says 3%; national regulators may set a Besides being solvent, a bank needs to be liquid higher percentage). (see Section 1.1) in order that it can make payments from its customers’ deposits as and All these ratios involve large numbers of when ordered to do so. It must have sufficient arbitrary parameters such as the capital risk- reserves (deposits at the central bank) and other weights, the LCR run-off rates and the liquid assets that are immediately saleable or allowable proportions of the different sorts of acceptable as collateral for (repo) borrowing capital. Moreover, there is clearly overlap from other financial institutions or the central between the different ratios. A bank that bank, such as government bonds and bills. satisfies the NSFR should necessarily also satisfy the LCR; if it does not, this is because these two ratios use different classifications of liquid and illiquid liabilities and assets. And the

8 The Basel Accords are the work of the Basel Committee capital ratio and leverage ratio both stipulate on Banking Supervision (BCBS), a subdivision of the minimum capital levels. The reason why the Bank for international Settlements (BIS). leverage ratio was introduced was that the

7 capital to risk-weighted asset ratio might be recommended that banks should ‘ring-fence’ treating some assets too leniently. their retail banking activity from other activities such as investment banking. As a final point of criticism, note that these new Basel III ratios only become 100% binding in Has this comprehensive regulatory onslaught year 2019, while several new rules and made banks safer? Probably, but the complexity amendments of existing rules are already under of the regulation and its continuous change discussion. Moreover, Basel III also contains makes banks less efficient and hinders their many other measures governing regulation and normal business of accepting deposits and supervision. In addition, there are national lending. The predictable result is regulations such as the wide-ranging Dodd- disintermediation: the shifting of financial Frank Act in the US which prohibits banks from intermediation into the less regulated ‘shadow trading on their own account, amongst other banking’ sector. things. In Britain, the Vickers report

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2. How does the central bank choose the interest rate?

2.1 The effects of changes in interest rate: more. There are also other influences on the transmission mechanism of monetary demand which are not easily measurable or policy predictable such as ‘habits’ and ‘confidence’.9 In recessions, when individuals and firms are The next task is to consider how the central not confident about their future incomes they bank should choose the value of its control are naturally reluctant to incur further debt, instrument: the nominal short-term interest and so lower rates may have little effect on rate (Bank Rate in the UK). For this purpose, spending. Japan has been suffering from this the objective of monetary policy needs to be malaise for a number of years during which defined and and it is generally a target for interest rates have hardly risen above zero. inflation. The target may be explicit, such as the UK’s inflation target of 2% (consumer Consider the consequences of a reduction in price index) with a margin of error of ± 1 %, the Bank of England’s official Bank Rate. or it may be stated more loosely as in the Most bank loans in the UK are at a variable directive to the European Central Bank to aim interest rate, such as variable-rate mortgage for “low and steady inflation” which it loans for house purchases and overdraft loans interprets as below but close to 2%. which are the main type of finance for smaller firms. As the cost of this finance falls, this The central bank may also be instructed to aim tends to cause an increase in borrowing, both for high economic growth and employment, as for consumption and investment. The in the US, but a single instrument (the interest reduction in interest rates also reduces the rate) cannot be used to target more than one reward to saving, which also encourages objective at the same time. Raising growth spending.10 would call for lower interest rates, while reducing inflation would require higher Another important influence on demand is the interest rates. In practice, even though central wealth effect. When interest rates fall, the banks are always conscious of the effects of prices of both physical and financial assets their interest rate choices on economic growth, rise. Financial assets such as bills and bonds the main focus is on inflation. are claims to specified future nominal amounts of cash; hence their nominal values rise to To fulfil its mandate to control inflation, the bring the return on these assets into line with central bank needs to know how inflation is the lower rate of interest. For physical assets affected by its interest rate choices. The main such as property, prices rise from raised impact of interest rate changes is on aggregate demand due to the lower cost of borrowing. demand: a reduction in interest rate tends to raise demand, and vice versa. Depending on supply capacity, higher demand leads to higher 9 A more complete description of the effects of interest real output or higher inflation or both, where rates is in “The Transmission Mechanism of Monetary the change in real output is usually thought to Policy”, Bank of England Quarterly Bulletin, 39.2 (May be temporary as described by Phillips Curve 1999), p.161-70. theory. 10 While this is believed to be the dominant effect of a reduction in interest rates on savings, it could be the However, there is considerable uncertainty in opposite. Lower interest rates may cause greater saving the magnitude and timing of the response to rather than less, if savers want to maintain a given income stream from their interest payments. The interest rate changes: the peak of the response outcome depends on the relative magnitudes of the of inflation to a change in short-term interest ‘income and substitution’ effects in standard rate is thought to be lagged by 18 months or microeconomic theory of intertemporal choice.

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The higher value of these assets makes by the central bank (Bank Rate is an overnight individuals and firms more confident about rate), at a level that is designed to cause the spending and also provides increased collateral inflation rate to converge towards its target; security for increasing their borrowing. therefore, an important influence on long-term rates is the expectation of future inflation. If A further influence on demand works through the expectation of future inflation is revised the foreign exchange rate: a lower interest rate upwards, this raises the expectation of a higher is usually associated with a lower foreign Bank Rate in the future and this, in turn, will exchange value of the currency which raise current long-term rates. stimulates demand for exports. However, this linkage is unreliable because there are other It also follows that, when Bank Rate changes, stronger influences on the return to investment this can cause changes in long-term rates in in foreign currencies. either direction, depending on how the change These are the main channels whereby interest in Bank Rate causes expectations of future rates are understood to influence aggregate Bank Rates to be revised. If a change in Bank demand. Despite the uncertainties, there is Rate is fully anticipated and therefore does not agreement that lower interest rates stimulate affect expectations, longer-term rates are demand and vice versa, as would be indicated unaffected. But if a Bank Rate change is a by any standard model of the ‘IS’ curve. surprise, or smaller or larger than expected, this represents new information and longer Another matter that needs attention is that rates also change. An unexpected fall in Bank Bank Rate is a short-term rate while much Rate, for instance, would cause longer rates expenditure, particularly for investment, is also to fall; a fall in Bank Rate that is smaller more dependent on longer-term rates. We must than expected would cause longer rates to rise. consider how the yield curve (the relationship Clearly, all information that causes a revision between interest rates of different maturities) of expectations of the future path of Bank Rate is influenced by expectations of future short- is important. If, for instance, the governor of term rates. the central bank makes a statement implying

that Bank Rate will be lower in the future and

this statement is believed, then this also 2.2 The role of expectations reduces long-term rates. For a time, this The pure expectations hypothesis of the term connection was exploited deliberately in the structure of interest rates states that the interest US and the UK as ‘forward guidance’: the rate for a (risk-free, zero-coupon) loan of central banks attempted to hold down long- maturity T years is an average of current and term rates by making explicit promises that, expected future short-term rates over the T- subject to conditions, the policy interest rate year period.11 The very short-term rate is set would not rise during some specified future period.

11 While the expectations hypothesis is valuable for The general pattern is that long-term rates explaining the term structure of interest rates, there are follow short-term rates (Figure 4) as would be other influences. The rates for government bonds, for instance, are influenced by the supply of bonds by the predicted by the expectations hypothesis. Over government and the demand for them by investors. time, a lower Bank Rate is associated with Yields also include a premium for default risk, which lower interest rates across the term structure, can be large for ‘junk’ corporate bonds and even some and lower interest rates tend to stimulate governments. The yields on government debts of several demand and inflation, albeit with a high degree ‘peripheral’ eurozone countries such as Greece and Italy remain elevated relative to Germany, reflecting the ongoing risk of default or leaving the euro. Finally, ‘term premium’ to compensate for the higher sensitivity yields on long maturity bonds are presumed to include a of their price to interest rate changes.

10 of uncertainty, as analysed above (section 2.1). forecasts can be used as a guide, the choice of It is against this background that the Bank of central bank policy rates has to rely on England must choose the Bank Rate that is judgement. In the UK this judgement is the most appropriate for achieving its inflation work of the members of the Bank of England’s objective. monetary policy committee.

The purpose of central bank independence is to insulate monetary policy choices from interference from the government, which may desire lower interest rates than would be consistent with the inflation target. It is often assumed that governments might be tempted to hold down interest rates to stimulate spending ahead of an election, disregarding the longer-

term potential consequence of inflation.

Figure 4. Two points on the £-sterling yield curve: Bank Rate and the yield on 10-year UK government debt. source: Bank of England

2.3 The central bank’s choice of interest rate

Many central banks are now independent (the Bank of England has been independent since 1997). This means that the government chooses the objective of monetary policy, Figure 5. Bank of England forecasts of usually specified as an inflation target as CPI inflation. Note the wide uncertainty described above, while the task of the central (the ‘fan chart’ includes 90% of the bank is to choose a time path for Bank Rate probability distribution). that is most likely to achieve that objective. Source: Bank of England inflation report, As a result of the lags in the response to November 2016 interest rate changes, the practice of the central bank may be regarded as inflation forecast targeting. The Bank of England, for instance, r−=π r* + 0.5( yy − ) + 0.5(ππ − *) where r is uses its macroeconomic model to forecast the central bank’s policy rate (Bank Rate),π is the inflation up to 2 years in the future (Figure 5) inflation rate, r * is the long-run equilibrium real rate of interest, y is real output, y is the natural rate of real and, if the mean 2-year forecast differs from output and π * is the inflation target. This says r should the target, Bank Rate should be adjusted −π 12 be set so that that the real rate of interest r is accordingly. In practice, while inflation above (below) its long-run level when output is above (below) its long-run level and/or inflation is above (below) target. While there is evidence that the Taylor 12 Much research has been directed towards devising rule may have been a reasonable description of past ‘monetary policy rules’ which might direct central central bank interest rate policy, it is not used by central banks in their choices of optimal interest rates to reach a banks as a prescription to guide their choices, one given target. One such rule is the : problem being measurement of y and r * .

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Another reason why governments might be European Central Bank, whose governing prepared to tolerate some inflation is that it can council contains representatives from all the help the government budget. At a higher level 19 national central banks of the eurozone. of prices, the demand to hold currency is Although the Maastricht Treaty specifically higher, so inflation provides governments with states that the ECB must be strictly extra seigniorage (the income from issuing independent of national interests, the political currency). Inflation also reduces the real value dimension is always present and there have of (home-currency, non-indexed) government been tensions. debt. But for this to be of benefit to the government, inflation expectations must be The ECB’s choice of the euro interest rate is low when the government borrows (by selling supposedly designed to achieve the euro fixed-interest bonds); if high inflation were inflation target (below but close to 2%). expected, bond rates would also be higher to However, as inflation rates differ across the reflect this. eurozone countries, the single official euro interest rate can never be appropriate for all. It Hence, a government may try to induce the is the average inflation rate across countries belief that there will be low inflation so that that the ECB tries to steer towards the target, long-term rates are low and it can borrow and since Germany is the largest eurozone cheaply, then to cheat by allowing inflation to economy, the ECB’s choices of the euro write down the real value of its debts. But this interest rate have suited Germany better than strategy cannot be repeated indefinitely other countries. For example, the low ECB because expectations catch up, causing new policy rate (2%) during 2003-05 may have borrowing to be more expensive and negating been appropriate for Germany which was the advantage. suffering from slow economic growth but it exacerbated inflation in the southern eurozone This is the main justification for central bank countries (Italy, Spain, Greece, Portugal). independence: central bank independence is supposed to give credibility to monetary Whether or not central banks can be or should policy. If the central bank is insulated from be wholly independent, independence does incentives that tempt the government, people seem to have been helpful in reducing inflation are more likely to believe that it will genuinely in developed Western economies from the try to meet its inflation target. high levels that prevailed in the 1970s and 1980s (chart, page 8). This is important because the expectation of inflation exerts a strong influence on actual The greater present danger, since the financial inflation, as recognised in Phillips Curve crisis reached its height in 2008-10, may be theory. Sellers of goods tend to build the the opposite condition of deflation, in which expected rate of inflation into their price the general price level of goods and services increases, and inflation expectations are also falls over time. Deflation is a problem because built into wage agreements. This leads to it raises the real value of debts which reduces persistence in the observed time path of demand (through the wealth effect, section 2.1 inflation. Successful control of inflation is above) which, in turn, leads to greater therefore enhanced by the central bank’s deflation. Moreover, with interest rates in the reputation for being able to hold inflation on UK, US and eurozone close to zero and high target. government debt levels, there is limited scope for any further attempts at stimulus, either Is full independence for the central bank from monetary or fiscal policy. actually possible? It is hard to ensure that the individuals who make up the monetary policy Inflation in the UK and the US is currently committee are wholly insulated from political (November 2016) near the target level of 2%. influence. This is especially relevant to the However, eurozone inflation (measured as an

12 average over euro member states) is barely of Bank Rate in the UK) has been at 0.25% above zero; there are fears that the eurozone since late 2008 (it was raised to 0.5% in may go the way of Japan where interest rates January 2016). To maintain its stimulus, the and inflation rates have been close to zero for Fed used Large Scale Asset Purchases to two decades. acquire around $4 trillion of assets between 2008 and 2014. These purchases were split roughly 60:40 between government debt and 2.4 Quantitative easing mortgage-backed securities.

The Bank of England is currently in its third In the eurozone, the European Central Bank programme of quantitative easing (QE), only began Q in 2015, although it had earlier purchasing assets in the secondary market conducted several rounds of 3-4-year long- which are mainly medium and long-term UK term repo lending to the banks, which amount government bonds (gilts). It pays for these to QE with a contract that the purchases be purchases with its own reserve liabilities: the reversed. Then in March 2015, the ECB began seller of the bonds receives a deposit in its purchasing €60bn per month of eurozone commercial bank and the bank, in turn, government debt, later increased to €80bn (in receives a claim on the Bank of England in the reality, the purchases are made by the National form of reserve deposits. Central Banks of the eurozone countries and the assets purchased are mainly the countries’ In the first QE programme in 2009-10, the own government debt). The total purchase to Bank bought £200bn of gilts. This was raised date (November 2016) is €1.4 trillion and the to £375bn during 2011-12, then held at this scheme is due to continue at least until March level by issuing new debt to replace existing 2017. holdings as they matured. In August 2016, the Bank began a third programme of purchases to The particular difficulty with QE in the raise its stock of gilts to £435bn, in order to eurozone is that the eurozone contains 19 provide stimulus in the wake of the ‘Brexit’ countries. How should the €80bn purchases be vote. The value of government debt held by divided amongst them? In the event, the ECB the Bank of England is currently (November determined that the purchases should be 2016) about 26% of the total debt outstanding proportional to the size of each country’s (see balance sheet, page 1). economy as measured by its share in the capital of the ECB. But this means that the The Bank has used QE because Bank Rate has main stimulus is felt in Germany and the other been close to its zero lower bound since 2009 ‘core’ countries that do not need it, with less (it is currently 0.25%, November 2016). stimulus in struggling ‘peripheral’ countries Therefore there has been little scope to use its such as Spain and Portugal. Another difficulty usual method of stimulating economic activity, is a shortage of assets for purchase; the ECB which is reducing Bank Rate. QE may thus be has addressed this by declaring certain considered as an extension of monetary policy; corporate bonds to be eligible for purchase. it is effectively the same as textbook ‘open market purchases’. However, it might also be The country that has conducted the largest viewed as fiscal policy as it provides amount of QE, relative to country size, is ‘monetary finance’ for the government budget, Japan. Starting in 2013, the Japanese central casting doubt on the central bank’s bank now holds some ¥400 trillion ($3.6 independence. trillion) of Japanese government bonds.

QE has also been used elsewhere, in similar To the extent that QE has had useful effects, circumstances, and brief descriptions follow. the main channel by which it has worked is In the US, the interest rate paid by the Federal thought to have been via a reduction in Reserve on excess reserves (the US equivalent medium and longer-term rates of interest. QE

13 causes greater demand for government debt, reserves means an increase in the monetary raising its price and reducing its yield (see base, M0 (defined as banknotes and coin plus footnote 10). As an example, interest rates on bank reserves) and the quantity theory of long-dated UK government bonds fell by money says that the price level rises roughly in about 1% during 2009 and corporate yields proportion to the money supply, measured as also fell as investors sought substitutes for the M0 or some broader measure such as M4 bonds bought by the Bank of England (the which includes deposits in banks (see ‘portfolio balance’ effect). While monetary appendix on monetary base control). policy in ‘normal’ times is the choice of Bank Rate which is an overnight interest rate, QE may provide an additional handle over longer- term interest rates.

Lower long-term rates are helpful to businesses that can finance themselves by issuing debt. A more important channel may be the ‘wealth effect’ (Section 2.1), whereby the raised asset prices stimulate spending. Another possible channel is that lower yields tend to weaken the foreign exchange value of the currency. Figure 6. UK money supply growth and It was also hoped that QE would encourage inflation banks to increase their lending, given that it source: Bank of England and Office for National causes the banks to have new reserves, created Statistics to pay for the central bank’s asset purchases (balance sheet, page 1). However, UK bank The problem with this reasoning is that it lending remains weak. Still conscious of losses ignores the mechanism by which inflation is since the crisis, banks are looking more caused. Inflation is rising prices of goods and carefully at risk, and retail lending margins services, and it is caused by excess demand for remain high (Section 1.3). Higher regulatory goods and services, of which there is little capital requirements are also adding to the evidence at present. Consistent with this, banks’ cost of funds. despite large increases in M0, average M4 growth has been low or negative for much of While the early programmes of QE may have the last 10 years (Figure 6) because bank succeeded in stimulating economic activity, lending has been subdued, even though yields on government and corporate debt have monetary policy has never before been so now reached very low levels in all developed stimulatory. economies and particularly in the eurozone, and there are therefore doubts about the No central bank has yet begun to reverse QE. usefulness of any further QE. However, if and when inflation threatens to return, the Bank of England says it will Indeed, suspicions have also been voiced that gradually do this – i.e. sell government debt further QE could cause a return of inflation. back into the market. Even without a reversal This inflation worry arises from the claim that of QE purchases, the Bank still has its interest QE constitutes ‘monetisation’ of government rate instrument: it can cause market rates to debt – the Bank of England is paying for rise by raising Bank Rate, given that Bank government spending with new ‘money’ (bank Rate is paid on reserve balances. reserve deposits). The increase in bank

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Appendix: monetary base control

The usual textbook treatment of monetary policy To reproduce a typical textbook presentation, claims that the central bank chooses the amount of suppose that for every £100 of their money, the monetary base M0 (alias ‘reserve base’ or ‘high individuals choose to hold £5 as currency and £95 powered money’; defined as currency issued by the as a bank deposit. Of this £95, suppose banks’ central bank, plus the banks’ reserve balances at required reserves and desired excess reserves the central bank). M0 is the central bank’s together come to £5. Then £100 of money is instrument rather than the interest rate, and the associated with £10 of monetary base: the ‘money- money supply M (defined as currency plus deposits multiplier’ is 10. When the central bank wants to in banks13) is assumed to be caused by the raise the money supply, it raises the monetary base monetary base via a predictable ‘money multiplier’ by buying government bonds from the private relationship. In turn, according to the quantity sector in exchange for new reserves (an ‘open theory of money, an increase in the money supply market purchase’).14 The money supply is then is supposed to cause a proportional increase in supposed to rise through the ‘deposit expansion’ nominal output. Formally, this theory is a process, as follows. statement that the velocity of money V in the equation MV=PY stays constant where M is the When the central bank buys government bonds, money supply, P is the price level and Y is real deposits in banks rise and this is reflected as an output. increase in excess reserves. Banks now have more reserves than they want, so they find willing The point of this appendix is to show that this is a borrowers and they lend. But people borrow for the poor description of reality. Further, it would not be purpose of paying for goods and services, which possible for the central bank to operate by setting means that the borrowed funds are paid into some the monetary base. Essentially, this is because other individual’s or firm’s bank deposit, or they bank deposits are claims to currency which only may be used to repay a loan. Either way, banks the central bank can supply. Hence, in order to will again find they have more reserves than they ensure that banks can honour their obligations to want which then causes more lending. Each time convert deposits into currency, the central bank the same initial reserves are lent and re-deposited, must stand ready to issue whatever quantity of a proportion is kept as currency (5%, in then above currency is demanded; it cannot choose the example), and a further proportion (another 5%) is quantity of currency it issues and must therefore absorbed as required reserves and desired excess set the cost of its lending, i.e. the interest rate. reserves, and it is therefore unavailable for lending. In this way, deposits and the money stock M In more detail, the money multiplier theory is as continue to increase by decreasing amounts, as is follows. With the central bank setting the value of laboriously described in most textbooks. The the monetary base, it is obviously no longer expansion process terminates when the money lending (providing liquidity) to banks on demand, stock has risen by the ‘multiplier’ (10 in the above and banks are therefore presumed to keep enough example) multiplied by the injection of new excess reserves to satisfy deposit withdrawals. The reserves. amount of this desired fractional reserve would be based on the observed statistics of deposit One problem with this process is that banks do not withdrawals, balanced against the loss of income have a pool of approved borrowers queuing up for from foregone lending In this scenario, the loans and waiting until the banks have funds to wholesale (interbank) interest rate becomes lend. As mentioned above, banks offer credit when market-determined at a value that equates the given stock of reserves with banks’ demands for it.

14 In this description, the tools of monetary management 13 There are several definitions of ‘money’: M1 is are open market operations by which the central bank currency held by the public + short-term deposits, M2 is changes the monetary base, the required reserve ratio M1 + medium term deposits etc. The reported measure which affects the value of the multiplier, and the central in the UK is M4 – ‘broad money’ – which also includes bank’s ‘discount’ rate for ‘last resort lending’ which long-term deposits in banks and building societies. For affects the multiplier by influencing the amount of this discussion we can think of money as being M1. excess reserves that banks choose to hold.

15 a potentially profitable lending opportunity arises, causing a loss of confidence in the banks and then find the funds in the money-market. breakdown of the payments system. In the absence of access to central bank lending, the only way for Clear evidence that this multiplier process is not banks to be wholly confident of meeting all operating has been provided by the Bank of possible withdrawals of currency would be for England’s recent programmes of quantitative them to hold reserves at least equal to their short- easing: under QE, the monetary base (M0) has term liabilities. This arrangement, known as 100% risen greatly while broad money (M4) has hardly reserve banking, would be a radical departure from changed. current practice.

A more obvious problem would arise in the It might then be argued that the central bank could opposite case of a shortage of reserves, which fix the amount of monetary base but undertake to might be caused by a rise in currency demand, or a lend extra reserves only in an emergency or truly deliberate reduction in monetary base by means of ‘last resort’ situation. But the only consistent a central bank open-market sale. criterion for identifying such an emergency would be if there is a shortage of reserves. As soon as If an individual bank found its reserves falling banks became confident of such support, at below its desired level, its reaction would be to sell whatever interest rate the central bank may choose, liquid assets in the money-market. If banks excess reserve holdings could be reduced back to collectively suffered a reduction in their reserves, zero, and we revert to the present system in which competition to raise funds by selling assets would the interest rate for central bank lending is the cause a rise in wholesale interest rates. With an monetary control instrument. acute shortage of reserves, it might be argued that interest rates would rise sufficiently to persuade The upshot is that the central bank cannot fix the some individuals to deposit their currency monetary base. Unless the central bank is prepared holdings, thus relieving the shortage.15 A more to let banks fail because of a shortage if reserves, it plausible outcome is that the banks’ behaviour must provide reserves on demand: it must finance would lead depositors to doubt the banks’ ability to money-market shortages in full against whatever pay, inducing them to withdraw more currency collateral the banks are able to offer. In doing so, it rather than depositing. cannot avoid setting its interest rate for this finance: Bank Rate in the UK. Even if banks generally were holding large stocks of excess reserves, and even if the central bank Of course, this does not prevent the central bank never attempts to reduce the monetary base, there from targeting the monetary base. The central bank will always be a non-zero probability that net may target any variable, meaning that it chooses currency withdrawals will exceed the banks’ the path of its interest rate instrument over time in aggregate excess reserves and vault currency. If attempt to achieve some desired value or range of this happened, banks would no longer be able to values of the target variable. Monetary base pay out currency to their depositors, immediately targeting (and money supply targeting) has indeed been practiced from time to time by various central banks in the belief that this was a good method of 15 If one follows the textbook story strictly, a shortage of achieving some desired inflation rate. The reserves would put the deposit expansion process into reverse: banks would attempt to regenerate their prevalent current practice is rather to target the reserves by calling in loans which would reduce inflation rate itself. deposits causing a further reduction in loans etc. However, while banks could halt new lending, it would be out of the question for them to call in loans unless this is for non-performance. As stressed above, bank loans are generally illiquid because they have been used to purchase firms’ capital stock and individuals’ properties. When a bank liquidates a non-performing loan, it usually recovers considerably less than the book value of the loan, the process takes time, and it may push the borrower into bankruptcy if the borrower is not already bankrupt.

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