In this piece David Cobham assesses the contribution of monetary policy to the economic recovery. He argues that once the basic choice of fiscal austerity had been made the authorities searched, largely in vain, for ways to make monetary policy boost demand in compensation. No doubt the recession would have been even worse without the monetary expansion that was implemented, but there is no sense in which normal operations have been restored.
Cobham’s paper on monetary policy under the last Labour government is free to view until the election, via the Labour government page. See also this short piece on common misconceptions about the crisis: http://www.taxresearch.org.uk/Blog/2015/04/16/seven-conservative-claims-that-labour-should-have-nailed-long-ago/
The role of monetary policy over this period was determined from the start by the government’s basic choice of ‘austerity’ in the sense of fiscal consolidation: with the economy in a deep recession (though it had been recovering before the election) and fiscal policy affecting aggregate demand negatively, monetary policy needed to be made more expansionary even though the policy interest rate was already (since March 2009) at its effective lower bound of 0.5%.
The government therefore sought a significant increase in ‘monetary policy activism’. In the short term the Bank of England embarked on further rounds of quantitative easing, while the Treasury offered credit subsidies in the form of Funding for Lending and Help to Buy, and the government appointed a new governor from June 2013 who was known to support ‘forward guidance’ and duly introduced it in the UK.
1. Quantitative easing (QE) and monetary growth
When interest rates cannot be reduced further, monetary expansion can be delivered most obviously by expanding the money supply through the process called quantitative easing. In the first round of QE before the election, between March 2009 and January 2010, the Bank of England had bought £200 bn of financial assets (mostly UK government bonds). Two further rounds of QE, referred to as QE2 and QE3, involved another £175 bn of asset purchases between October 2011 and November 2012.
Such purchases lead to increases in the bank deposits of the non-bank private sector (initially the deposits of the non-bank financial institutions that sell their gilts to the Bank of England, mainly pension funds and life assurance companies). These deposits are part of the broad money supply. At the same time the asset purchases bring about increases in the deposits of the banks at the Bank of England.
Figure 1 shows the four-quarter growth of the Bank of England’s preferred measure of broad money, M4ex, and its two principal ‘credit counterparts’, bank lending to the non-bank private sector and the public sector’s contribution to monetary growth (the budget deficit minus borrowing from the non-bank private sector), in each case as a percentage of the outstanding stock of M4ex.
Three things stand out from this graph. First, in the period before the crisis the growth of M4ex closely reflected the growth of M4ex lending (bank lending to non-banks), but that collapsed in the crisis. Second, the public sector’s contribution, which had been minimal before the crisis, became very large in 2009-10 and large again in 2012 (as the result of QE), offsetting the negative or very low levels of bank lending and ensuring that the money supply did not fall. And third, bank lending has still not returned to anywhere near the level it maintained throughout the pre-crisis ‘Great Moderation’ period.
There is considerable agreement that QE1 had a positive effect on GDP growth. Initial studies from within the Bank identified significant effects of QE on long-term bond yields, but the Bank’s later studies of the wider macro effects estimated that QE raised GDP, relative to what it would otherwise have been, by 1½ to 2% and inflation by ¾ to 1½% (Joyce et al., 2011). Some other studies found larger effects: Cobham and Kang (2012) estimated that in the absence of QE nominal GDP in 2010 Q1 might have been between 3% and 11% lower, while Baumeister and Benati (2013) thought that without QE inflation could have fallen to minus 4% and real GDP growth to minus 12% at an annual rate.
However, non-Bank of England observers were less convinced of the effectiveness of the asset purchases in QE2 and QE3 (Goodhart and Ashworth, 2012; Martin and Milas, 2012): yields seemed less affected, the rise in corporate issuance of equity and bonds during QE1 was not repeated, and the international climate (the eurozone crisis) made it harder to isolate the effects of UK QE. In addition, while the large depreciation of sterling in 2007-8 may have contributed to the higher growth ascribed to QE1, it did not recur in a way that would have affected the outcome for QE2 and QE3.
At intervals from late 2012 there was speculation about a further round of QE, and three of the nine members of the MPC voted for (smallish) additional asset purchases in each of the meetings between February and June 2013. But there was never a majority for this, and after June 2013 the issue was dropped. On the other hand, there has been little discussion so far of unwinding the asset purchases, that is, selling off the gilts the Bank had acquired. It is generally understood that interest rates would be raised first, and assets resold only later, in a controlled and orderly process.
2. Funding for Lending and Help to Buy
In July 2012 the Bank of England and the Treasury launched the new Funding for Lending Scheme (FLS) which provides banks with a source of funds other than that obtained from retail deposits or wholesale markets. These funds would be made available more cheaply, and in larger amounts, to banks which increased their lending to households for mortgages, to companies and to buy-to-let landlords: banks were given an incentive to lend more. The scheme was extended in 2013 and again in 2014.
The Help to Buy (HB) scheme was started in April 2013 (in England but later schemes covered the rest of the UK too). At that time it offered equity loans of up to 20% to first-time buyers and people buying new-build homes, but the scheme was extended to provide mortgage guarantees of up to 15% to lenders where buyers put down deposits of 5%, so that lenders could offer better terms.
Both these schemes are essentially subsidies to particular types of credit, and their likely effect on house prices – if borrowers can borrow more easily, then they can bid more for the properties they seek to buy – was widely criticised. While it is not possible to be sure of the causes, house prices began to rise more strongly in 2013 and especially 2014, with a peak in 12-month growth of 12.1% in September 2014 (UK, all dwellings, ONS data).
House price growth was higher in London, the East and the South East of England, but much lower in Wales and the North West, with other regions in between. Concerns about a fresh house price bubble led to mortgage lending being made no longer eligible under the FLS in the autumn of 2014.
Bank lending, on the other hand, remained (in total) well below the period before the crisis, as is clear from Figure 1: as a percentage of M4ex, bank lending to the non-bank private sector (four quarter change), which had fluctuated around 15% between 2000 and 2007 and collapsed in 2009-10, became positive again in late 2011 and 2012 (with a peak of only 1.7%), but went negative again in 2013 before returning to the positive in the second half of 2014. While we cannot be sure how much banks would have lent in the absence of FLS and HB, it is clear that there has not been a significant revival of lending.
Figure 1: Growth of money supply and its main credit counterparts (growth since four quarters earlier, %)
3. Forward Guidance
Mervyn (now Lord) King’s second term of office as governor of the Bank of England came to an end in June 2013, and he was succeeded by Mark Carney, who was appointed in November 2012 while he was still governor of the Bank of Canada. Carney was known for pioneering ‘forward guidance’ at the Bank of Canada and for his position as chair of the international Financial Stability Board, and from his appointment it was expected that he would introduce some forward guidance in the UK. The MPC unveiled its forward guidance policy in August 2013.
The MPC said that interest rates would not be raised until the unemployment rate came down to 7%, unless (a) its inflation forecast for 18-24 months ahead was 0.5 or more above its 2% target, and/or (b) inflation expectations were no longer ‘well anchored’, and/or (c) the Financial Policy Committee decided that the current interest rate level was posing a threat to financial stability which could not be dealt with by other (macroprudential) means.
Technically this is a ‘state-contingent’ rather than open-ended or time-contingent type of forward guidance, that is one where a rise in interest rates would depend on the state of the economy. The policy was justified by the MPC in three ways: (1) it would give greater clarity about the trade-off between the speed at which inflation should be returned to target and the speed with which economic growth recovered, (ii) it would reduce uncertainty about the future path of monetary policy, and (iii) it would allow the MPC to explore the scope for expansion without jeopardising price and financial stability.
However, it should be noted that the 7% was a threshold not an automatic trigger, that inflation expectations would be monitored via a range of indicators (survey data, extrapolations from financial market data), and that MPC members would make up their own minds as to whether the ‘knockout clauses’ had been breached. Thus the information conveyed in the guidance was hardly clear-cut or precise, in which case its contributions to controlling inflation expectations and reducing uncertainty could be expected to be limited. [I have suggested elsewhere that the initial guidance was so opaque because it emerged from a policy disagreement between a Treasury pushing for the Bank to introduce the policy and MPC members trying to formulate an intellectually respectable version of it. See Cobham (2013).]
In the event the unemployment rate fell more quickly than expected, going below the 7% threshold in the period December 2013-February 2014, but by then the MPC had issued fresh guidance which emphasised the continuing spare capacity in the economy, to be assessed by a range of indicators including the growth of wages. As of March 2015, the unemployment rate was well below 6% and expectations were for interest rates to rise only some time in 2016. However, the initial confusion over the meaning of the guidance and the subsequent changes to that guidance make it difficult to regard the policy as coherent or, given the speed and quality of the recovery, successful.
4. Alternatives and debates
The crisis and the difficulties of the recovery period have stimulated debate on possible alternative frameworks for monetary policy, other than the inflation targeting which the UK has pursued since the 1990s. There has been discussion of price-level targeting and nominal income targeting (growth and level), but these alternatives each have their disadvantages (Goodhart et al., 2013) and no consensus has developed.
A general problem with each of these is that a higher rate of monetary expansion might be required in order to attain the new targets, but – with the effects of QE waning, credit subsidies having failed to revive bank lending and forward guidance largely incoherent – the monetary authorities lack adequate instruments to bring that about. There have also been calls for modifications of current arrangements in the form of a rise in the inflation target (Ball, 2014), the continued use of the central bank balance sheet as an extra instrument (Friedman, 2015) and the formal adoption by the Bank of England of a secondary concern with asset prices (e.g. Cobham, 2015).
The only area on which the Bank of England has concurred and progress has been made is in the introduction of new ‘macroprudential’ instruments by which the new Financial Policy Committee of the Bank of England might try to head off various possible sources of financial instability. These instruments include the ability to vary the amounts of own capital the banks are required to have relative to their outstanding loans, and the ability to limit loan to value and debt to income ratios in the mortgage market.
While such measures seem eminently desirable, there are open questions about how the Financial Policy Committee will interact with the Monetary Policy Committee (Shakir and Tong, 2014), and since the effects of these instruments are likely to vary with the state of the economy (Harlmohan and Nelson, 2014) it is arguable that monetary policy will need to be kept as a backstop policy for financial stability (in addition to its role as principal instrument for price stability).
Figures 2 and 3 show the outcomes for the level of GDP and the rate of inflation in the UK, the Eurozone and the US. Figure 2 makes clear that the UK had a much deeper fall in GDP from the crisis than the Eurozone (as a whole – individual countries had different trajectories) or the US, which moved remarkably closely together until the end of 2011 when the US began to recover strongly while the Eurozone stagnated. The UK recovered somewhat in 2010 but between late 2010 and late 2012 its recovery was meagre, and it was only in 2013 that a more substantial recovery got under way.
This pattern is consistent with the view that the Coalition’s choice of austerity in the early years reduced UK growth in 2010-11 and 2011-12 (see Simon Wren-Lewis’s piece in this collection), while the resumption of growth from 2013 is consistent with the view that austerity had been quietly put on hold from 2012, together with the slow and partial bounce-back that can be expected of squeezed market economies.
Figure 2: GDP levels, UK, US and Eurozone
Source: International Financial Statistics (IMF)
Figure 3 shows that the UK experienced much the worst inflation over these years of the three currency areas shown, with a sharp peak in late 2008 and a more long-lasting rise in late 2011, which may have reflected the sterling depreciation of late 2007 and 2008 as well as fluctuations in world commodity prices (and the January 2011 rise in VAT). The recent further sharp fall in UK inflation, which has enabled a limited recovery in living standards after years of decline, is also heavily international in origin.
Figure 3: Consumer price inflation UK, US and Eurozone
Source: International Financial Statistics (IMF)
The monetary history of this period is a history of a search for ways to make monetary policy more expansionary, to overcome the drag on growth due to fiscal austerity measures which, as Wren-Lewis points out, were not required by the Coalition government’s new fiscal rules and are hard to explain. The search included further quantitative easing, the credit subsidies of FLS and HB, and forward guidance (facilitated by the appointment of a new governor), but there remains a shortage of effective monetary instruments.
The overall framework for monetary and financial policy was changed by the establishment of the Financial Policy Committee at the Bank, whose new macroprudential focus had its first test in trying to head off a nascent house price bubble caused, at least in part, by the credit subsidies. The monetary policy developments were mostly responses to short term problems, and not very successful ones at that, but the changes to the framework are likely to outlast the Coalition.
- Ball, L. (2014), ‘The Case for a Long-Run Inflation Target of Four Percent’, IMF Working Papers 14/92
- Baumeister, C., and Benati, L. (2013), ‘Unconventional Monetary Policy and the Great Recession: Estimating the Macroeconomic Effects of a Spread Compression at the Zero Lower Bound’, International Journal of Central Banking, 9(2), 165-212
- Cobham, D. (2013), ‘Forward guidance in the UK: holding rates down till something happens’, in W. Den Haan (ed.), Forward Guidance, VoxEU ebook
- Cobham, D. (2015), ‘Multiple objectives in monetary policy: a de facto analysis for ‘advanced’ countries’, forthcoming in Manchester School
- Cobham, D., and Kang, Y. (2012), ‘Financial crisis and quantitative easing: can broad money tell us anything?’ Manchester School, 80 (s1), 54-76
- Friedman, B. (2015), ‘Has the financial crisis permanently changed the practice of monetary policy? Has it changed the theory of monetary policy?’, forthcoming, Manchester School
- Goodhart, C., and Ashworth, J. (2012), ‘QE: a successful start may be running into diminishing returns’, Oxford Review of Economic Policy, 28(4), 640-70
- Goodhart, C., Baker, M., and Ashworth, J. (2013), ‘Monetary targetry: possible changes under Carney’, Morgan Stanley Research Europe
- Harlmohan, R., and Nelson, B. (2014), ‘How might macroprudential capital policy affect credit conditions?’, Bank of England Quarterly Bulletin, Q3, 287-303
- Martin, C., and Milas, C. (2012), ‘Quantitative easing: a sceptical survey’, Oxford Review of Economic Policy,28(4), 750-64
- Shakir, T., and Tong, M. (2014), ‘The interaction of the FPC and the MPC’, Bank of England Quarterly Bulletin, Q4, 396-408