Objectives and boundaries of monetary policy: A Governor to renew the Bank of England’s monetary vows
It is tempting to suggest that the new Governor of the Bank of England will pick up a very strong hand. As the minutes from the September meeting of the Monetary Policy Committee (MPC) make clear, UK inflation is more or less on target and we have full employment (Bank of England 2019). What’s more, the banking and financial system seems robust, even to Brexit complications, according to the 2018 stress tests (Bank of England 2018).
Alongside these pleasing developments, the Bank has expanded its remit and raised the level of its professionalism. But beneath the surface, the economy remains exceptionally vulnerable and in need of what might amount to not only a monetary policy-making revolution, but also a clarification of the boundaries of monetary and financial policy with respect to the real economy.
The first objective of the central bank is to remind society of the ‘timeless’ principle that good monetary policy is essentially neutral with respect to long-run economic activity (Hume 1752) and to deflect any attempts to expand its remit towards any direct fostering of the real economy. The question then for the new Governor is not so much whether to reform the monetary framework, but at what speed and in what manner should reform occur?
In a recent report (which I edited with Richard Barwell), we favour an open and transparent debate about objectives, instruments, communication and measurement (Barwell and Chadha 2019). While in the US, Clarida (2019) is leading a review of the Federal Reserve’s monetary policy strategy, tools and communication processes, in the UK and Europe there has been surprisingly little formal debate about these key aspects of monetary policymaking.
The Bank of England has enjoyed operational independence to pursue a democratically determined objective for price stability and financial stability for over 20 years. But the democratic objective was itself related to the consequence of a debate that we had in the UK in the decade or so leading up the adoption of a formal inflation target in October 1992, summarised by the Lord Kingsdown’s speech at the LSE (Bank of England 1992). As is now well documented, the pre-financial crisis settlement involved a separation of monetary from financial, with a microscopic focus on price stability.
But following the financial crisis, there has been a large shift towards constraining the activities of financial sector intermediaries to limit the scale of their risk-taking and any contingent claim on fiscal authorities (Mizen et al. 2018). But we find ourselves still saddled with large levels of private and public debt (much of the latter held by the central bank), continuing shortfalls in the quality of monetary policy communications and interest rates at historic and unusual lows.
That the economy cannot bear higher rates a decade on from the financial crisis is a severe concern. Indeed, that if anything there is continued downward pressure on rates towards negative territory indicates a serious change to ‘normality’, as it implies not only that we are providing a huge incentive to bring forward consumption or investment, but also that we might actually be content to accept negative consumption growth (Buiter 2009).
Rather than the compact set of New Keynesian frictions from price rigidities and monopolistic competition alone, monetary policy now has to confront the imperfect information and financial frictions that have substantially altered the policy landscape, as well as creating a direct motivation for considering household heterogeneities (e.g. Kaplan et al. 2018).
Chapters in our report consider answers to these problems. One might lie in exploring a change in the nominal target, perhaps even raising the inflation target; or providing a clearer commitment to the average inflation rate over time, so that bygones are no longer bygones. Until we get there, we may also need to work out how to break the zero bound for Bank Rate by breaking the exchange rate between cash and deposits.
The extent to which the Bank of England’s balance sheet may now become a permanent instrument in the toolkit also needs to be spelled out, whether to offer amplification of the monetary policy signal or to deal with questions of financial plumbing.
More effective policy guidance by publishing expected paths of Bank Rate could improve the Bank’s ability to influence the market curve and limit internal inconsistencies in the forecast process. External and internal members of the MPC may have to become more accountable for the level and path of Bank Rate they prefer, and to explain more clearly their assumptions and judgements, as well as providing their own articulated interest rate forecasts.
The Bank may also be able to play a greater role in fostering measurement of the economy and the use of soft data from surveys (for example, the Decision Maker Panel; see Bloom et al. 2019), textual analysis, web-scraping and granular data from large firms to provide better real-time indicators to support judgement. It is a daunting set of questions.
But the biggest danger is that the boundary between monetary and fiscal policies has not only been blurred, but that the traditional assignment may be about to be reversed. With monetary policy hampered at rates around zero and fiscal policy supposedly able to roam free in large amounts of space, we are not far from being driven towards the central bank issuing short-term debt instruments to help the government stabilise the economy with its own spending spree (Giles 2019) at low interest rates.
There is a clear danger that in the absence of an open and deep debate about the fundamental objectives of the central bank and the limits of independence, the political system will try to offload its obligations onto the central bank balance sheet. It may even seek to unwind achievable objectives by arguing that those were the problems of the past – or worse still, that those old objectives were the root cause of the problems we now face.
To be clear, they were not. Monetary stability and financial stability do not cause economic strife, but their absence surely will.
The genuine progress that has been made in the science of monetary policy may be threatened by a new era of economic populism. We have, of course and rightly, come a long way from the analysis of the 1950s when Ralph Sayers wrote that “a change in Bank Rate was no more regarded as the business of the Treasury than the colour which the Bank painted its front door” (Sayers 1957) – and many innovations of the monetary-financial constitution have been welcome.
But the lines between monetary stability and fiscal irresponsibility must not be rubbed out with a ‘people’s quantitative easing’ that may substantially expand the central bank balance sheet to mask government indebtedness or to dilute the Bank’s competences with attempts to broaden further the Bank’s remit to aspects of policy such as inequality and climate change. Such challenges desperately need to be addressed, but are best left to political choices in Whitehall.
As the search for a new Governor of the Bank of England has continued, we have often lamented the lack of a national debate on objectives, instruments, communication and measurement, and expressed the hope that those interested in the quality of public debate can create a dialogue.
While many of the issues I raise are common to advanced economies, the historic importance of the Bank of England means that we have a chance to lead the international debate. We can also support the continuation of excellence in the financial sector, whatever vicissitudes may result from the final settlement that we agree with the EU.
Bank of England (1992), “The case for price stability”, Bank of England Quarterly Bulletin, pp. 441-48.
Bank of England (2018), “EU withdrawal scenarios and monetary and financial stability”.
Bank of England (2019), “Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 18 September 2019”.
Barwell, R, and JS Chadha (2019), Renewing our Monetary Vows: Open Letters to the Bank of England Governor, NIESR Occasional Paper, LVIII.
Bloom, N, P Bunn, S Chen, P Mizen, P Smietanka and G Thwaites (2019), “The Impact of Brexit on UK firms“, VoxEU.org, 4 September.
Buiter, WH (2009), “Negative nominal interest rates: Three ways to overcome the zero lower bound”, The North American Journal of Economics and Finance 20(3): 213-38.
Clarida, RH (2019), The Federal Reserve’s Review of Its Monetary Policy Strategy, Tools, and Communication Practices, speech at the Bank of Finland Conference on Monetary policy and the future EMU.
Giles, C (2019), “Javid Review commits another £2bn to Brexit Planning”, Financial Times.
Hume, D (1752), “Of Money” and “Of Interest”, in E Rotwein (ed), David Hume, Writings on Economics, University of Wisconsin Press, 1970.
Kaplan, G, B Moll and GL Violante (2018), “Monetary Policy According to HANK”, American Economic Review 108(3): 697-743.
Mizen, P, M Rubio and P Turner (2018), Macroprudential Policy and Practice, Cambridge University Press.
Sayers, RS (1957), Central Banking after Bagehot, Oxford University Press.