What is Monetary Policy?

What is 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

Inflation Rate in the UK Economy in Recent Years 5.0% 4.5% 4.0% 3.5% Source: Office for National Statistics A lower inflation rate means prices rise more slowly this is known as disinflation Inflation rate 3.0% 2.5% 2.0% CPI inflation target = 2% 1.5% 1.0% 0.5% 0.0% 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

What is Monetary Policy? Monetary policy involves changes in interest rates, the supply of money & credit and exchange rates to influence the economy Market interest rates Bank Lending / Credit Supply to Private Sector Currency markets e.g. external value of the Inflation targets e.g. 2% CPI target in the UK Bank of England is the UK s Central Bank European C entral Bank sets policy for Euro Zone

Examples of Interest Rates on Loans in the UK There are thousands of different interest rates in the economy! 12.00 10.00 8.00 6.00 4.00 2.00 0.00 Household deposit and lending interest rates Jan 06 Sep 06 May 07 Jan 08 Sep 08 May 09 Jan 10 Sep 10 May 11 Jan 12 Sep 12 May 13 Jan 14 Sep 14 May 15 Jan 16 10,000 unsecured loan Two- year, fixed- rate mortgage, 90% loan to value Two- year, fixed- rate mortgage, 75% loan to value New fixed- rate time deposit Savings rates Bank loans Mortgages Credit card rates Payday loans Corporate bonds Government bonds Latest UK interest rates Base interest rate 0.5% Two year fixed rate mortgage 2% 10k unsecured loan 5% Savings deposit 1.5%

Base Interest Rates and Mortgage Rates in the UK The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation target is set by the government. 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 Effective mortgage interest rate When the Bank s interest rate changes, most other loan and savings interest rates in the financial markets will also change too. The Bank of England has left the Base Interest Rate in the UK unchanged at 0.5% since March 09 the lowest since the Bank was founded in 1694 Base rate 0.0 19 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Base Interest Rates and Mortgage Rates in the UK The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation target is set by the government. 8.0 7.0 6.0 5.0 4.0 Effective mortgage interest rate Base rate 3.0 2.0 1.0 Even when the economy has returned to normal levels of capacity and inflation is close to the target, the appropriate level of Bank Rate is likely to be materially below the 5% level set on average by the Committee prior to the financial crisis (BoE) 0.0 19 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

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

Distinction between Nominal and Real Interest Rates The real rate of interest is important to businesses and consumers when making spending and saving decisions The real rate of return on savings is the money rate of interest minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% but price inflation is running at 3% per year, the real rate of return on these savings is only + 3%. Real interest rates become negative when the nominal rate of interest is less than inflation For example if inflation is 5% and nominal interest rates are 4%, the real cost of borrowing money is negative at - 1%. Price deflation can lead to an increase in real interest rates

Global Real Interest Rates

Factors Considered When Setting Policy Interest Rates The BoE sets policy interest rates consistent with the need to meet an inflation target of consumer price inflation of 2% 1. GDP growth and spare capacity / estimates of output gap 2. Bank lending, consumer credit figures, retail sales data 3. Equity markets (share prices) and trends in house prices 4. Consumer confidence and business confidence / sentiment 5. Growth of wages, average earnings, labour productivity and unit labour costs, surveys on labour shortages 6. Unemployment and employment data, unfilled vacancies 7. Trends in global foreign exchange markets (i.e. is sterling appreciating or depreciation against other currencies) 8. International data e.g. GDP growth rates in economies of major trading partners such as USA and Euro Area

UK Real GDP Growth Fan Chart The Monetary Policy Committee considers forecasts for the rate of short- run economic growth does it threaten rising inflation? 6 4 Percentage change on a year earlier 2 0-2 -4-6 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 Source: ONS, OBR

Projected Inflation for the UK Economy UK CPI inflation projection based on market interest rate expectations and 375 billion purchased assets (QE) May 16 For the last two years, CPI inflation has been well below the 2% target. Inflation forecast to rise back towards 2% from 17 onwards deflationary risks are receding.

The UK Wage Phillips Curve 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Unemployment Rate and Annual % Change in Regular Pay 01 Q1 01 02 Q1 02 03 Q1 03 04 Q1 04 05 Q1 05 06 Q1 06 07 Q1 07 08 Q1 08 09 Q1 09 10 Q1 10 11 Q1 11 12 Q1 12 13 Q1 13 14 Q1 14 15 Q1 15 16 Q1(a) Unemployment rate Regular pay growth

Annual Change in UK House Prices 12 month percentage change in average UK house prices 15 10 5 0-5 House prices falling - 10-15 04 Jan 04 Jun 04 Nov 05 Apr 05 Sep 06 Feb 06 Jul 06 Dec 07 May 07 Oct 08 Mar 08 Aug 09 Jan 09 Jun 09 Nov 10 Apr 10 Sep 11 Feb 11 Jul 11 Dec 12 May 12 Oct 13 Mar 13 Aug 14 Jan 14 Jun 14 Nov 15 Apr 15 Sep 16 Feb

A Falling Exchange Rate Raises Import Prices 15 Sterling Exchange Rate Index and Annual Change in UK Import Prices % change on same month previous year, UK, January 10 to March 16 10 5 0-5 - 10 10 January 10 April 10 July 10 October 11 January 11 April 11 July 11 October 12 January 12 April 12 July 12 October 13 January 13 April 13 July 13 October 14 January 14 April 14 July 14 October 15 January 15 April 15 July 15 October 16 January Trade weighted exchange rate Import prices

Estimated Size of the Output Gap 3.0 Output Gap (Actual Potential GDP, measured as % of potential GDP 2.0 1.0 0.0-1.0-2.0-3.0-4.0-5.0 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Actual and Potential GDP for the UK Economy 130.0 Actual (non- oil) GDP and estimated Potential GDP for the UK, Index: 03=100, Source: ONS and OBR, March 16 125.0 1.0 115.0 110.0 105.0 100.0 95.0 03 04 05 06 07 08 09 10 11 12 13 14 15 16 Output (non- oil GVA) Potential output

Recent Changes in Global Oil Prices 140.0 Global oil price $ per barrel 1.0 100.0 80.0 60.0 40.0.0 0.0

Transmission Mechanism of Monetary Policy 1 / Change in market interest rates Normally a change in policy interest rates feeds through to borrowing/saving rates 2/ Impact on aggregate demand Effect on spending, saving, investment and exports Is there an expansion of production and employment? 3/ Effect on output, jobs & investment Rate changes then affect two of the key macro objectives 4/ Real GDP and the rate of Price Inflation It can take between 12-24 months for the full effects on real GDP and the inflation rate after a change in policy interest rates

When Interest Rates Fall A reduction in interest rates or an increase in the supply of money and credit is an expansionary or reflationarymonetary policy Cost of servicing loans / debt is reduced boosting spending power Consumer confidence should increase leading to more spending Effective disposable income rises lower mortgage costs Business investment should be boosted e.g. Prospect of rising demand Housing market effects more demand and higher property prices Exchange rate and exports cheaper currency will increase exports An expansionary monetary policy is designed to boost consumer confidence and demand during a downturn / recession

Evaluation: 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 when 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

The Keynesian Liquidity Trap A liquidity trap occurs when low interest rates and a high amount of cash balances in the economy fail to stimulate aggregate demand In normal circumstances it is possible to boost demand by cutting interest rates. But for most countries there is a zero floor for nominal interest rates Even if interest rates can be lowered this may have little effect if people cannot or will not borrow. This is known as the liquidity trap. At this point, AD can only be boosted by the Government borrowing more, either to spend directly or to give to others via tax cuts Keynesians believe that size of the fiscal multiplier effect is higher for government spending than it is for tax cuts When private sector demand for goods and services is persistently low, the government needs to find a compensating source of demand to rebalance the economy and the solution comes from the government in the form of higher borrowing or less saving.

Interest Rates and the Distribution of Income When interest rates fall, there is a re- distribution of income away from lenders and savers towards borrowers with loans / debt Incomes of savers If the interest on savings is less than inflation, savers will see a reduction in their real incomes Incomes of home- owners with mortgages If interest rates fall, the income of home- owners who have variable- rate mortgages will increase Interest rates on unsecured debt Lower interest rates on loans such as credit cards and bank loans will fall

Quantitative Easing (QE) When policy interest rates are at zero or close to zero, there is a limit to what conventional use of monetary policy can do In March 09 the BoE started quantitative easing for first time. The main aim of QE is to support aggregate demand and avoid the risk of a recession becoming a deflationary depression The Bank of England uses QE to increase the base supply of money in the banking system and encourage banks to lend at cheaper interest rates i.e. to small & medium sized businesses The Bank does not print new 10, and 50 notes, it uses money created by the central bank to buy government bonds There are doubts about the effectiveness of quantitative easing bank lending has struggled to recover since the end of the last recession. In the summer of 15, QE in the UK totalled 375bn

How Quantitative Easing (QE) is meant to work The central bank creates new money electronically by adding money to their balance sheet This money is then used to buy financial assets - Mainly the purchase of government bonds More demand leads to higher prices for assets e.g. bond prices. Rise in price of bonds leads to a lower yield (%) on government bonds The effect of QE can feed through to a fall in long term interest rates e.g. mortgages and corporate bonds Lower interest rates and increased cash in the banking system should then stimulate AD through a rise in consumption and investment

Key Challenges Facing the Bank of England Maintaining price stability i.e. avoiding deflation / accelerating inflation rates Supporting a sustainable / durable recovery a return to normal conditions Helping to re- balance the economy towards exports (X) and capital investment (I) Financial stability building a more secure banking / credit system for the future

Has the Bank of England s Monetary Policy helped? Case for the Bank of England Criticisms of the Bank s policy Avoided a damaging depression after the worst of the 08 crisis Inflation allowed to rise well above target in 08 and 12 Avoided sustained deflation + faster growth than many EU nations More competitive currency has helped export sector to recover Haven t raised interest rates too early responding to Euro Crisis Growing signs of another unsustainable housing boom Low interest rates have become less effective e.g. in stimulating investment Britain has record current account deficit symptom of wider structural problems

Base Interest Rates and Mortgage Rates in the UK The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation target is set by the government. 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 Effective mortgage interest rate When the Bank s interest rate changes, most other loan and savings interest rates in the financial markets will also change too. The Bank of England has left the Base Interest Rate in the UK unchanged at 0.5% since March 09 the lowest since the Bank was founded in 1694 Base rate 0.0 19 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

What might happen if UK interest rates rise again? MPC raises base interest rates This signals a tighter monetary policy Market interest rates increase (over time) Causes a possible slowdown in housing market Main effect will be through via mortgage rates Cost of borrowing rises And a contraction in the growth of retail credit Higher rates might also cause a currency appreciation This makes UK exports more expensive in overseas markets

Forward Guidance when setting interest rates Forward Guidance was introduced by Mark Carney in August 13 It has been signalled that the Bank of England will leave their policy interest rates unchanged as long as the unemployment rate is above 7.0% and inflation is under control The main aim is to build confidence by signalling that interest rates would stay at low levels for some time In 14, Mark Carney signalled that forward guidance would evolve LFS unemployment is not the sole data measure to be used they will look at a range of measures of spare capacity

Evaluation Points on Interest Rates & Monetary Policy Time lags should be considered when analyzing effects of interest rate changes Monetary policy is not an exact science consumers and businesses don t always behave in a standard textbook way! Many factors affect costs and prices which can change the inflation risks in a country Monetary policy does not work in isolation! Consider how fiscal policy can also affect aggregate demand, output, jobs & prices Objectives of monetary policy can change e.g. the USA Federal Reserve s mandate is maximum employment, stable prices, and moderate long- term interest rates