Charles Bean: The future of monetary policy
Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England,
at the London School of Economics, London, 20 May 2014.
* * *
I left the London School of Economics to become the Bank of England's Chief Economist
and a member of its fledgling Monetary Policy Committee (MPC) almost 14 years ago. The
Bank had not long been given the responsibility for determining interest rates but had at the
same time relinquished the responsibility for banking supervision. As I approach the end of
my tenure, the Bank looks rather different: banking supervision has returned; and a new
policy committee - the Financial Policy Committee - has been charged with preserving the
stability of the financial system.
As I look back, I think it is fair to say that it has been a pretty extraordinary - indeed unique -
period to be involved in economic policy. My first seven years were years of plenty: growth
was steady; unemployment was low; and inflation never strayed far from target (Chart 1).
From time to time, the MPC nudged Bank Rate up or down a quarter point, and the economy
obediently stayed on course. To economists, this period of unusual macroeconomic
tranquillity is known as the Great Moderation.
But the second seven years were years of famine, as the Great Moderation turned into a
Great Tribulation: the worst financial crisis for a century; the most prolonged downturn on
record; and inflation rising above 5%. The MPC slashed Bank Rate as low as it has ever
been in the Bank's 320-year history. To bolster demand further, we then injected new money
worth around a quarter of annual GDP through asset purchases. But despite the dosage,
output is only now approaching its previous peak.
This evening, I will reflect on some of the innovations in monetary policy that took place as a
result of the crisis. Then I will look at some of the broader changes in the framework it
prompted.
Dealing with the crisis led central banks to innovate in several ways. In the first instance, this
involved lending at longer tenors, against a wider range of collateral, and to a wider range of
counterparties in order to keep financial markets functioning. For our part, as well as offering
longer-term funding through our repo operations, we also introduced the Special Liquidity
Scheme (SLS) enabling banks to borrow liquid Treasury Bills against their illiquid
mortgagebacked securities. Later we introduced the Funding for Lending Scheme (FLS), providing
banks with cheaper funding and a financial incentive to expand lending. Some of these
facilities have since been made a permanent feature of our Sterling Monetary Framework.
Others, such as the SLS and FLS, are by their nature temporary.
More noteworthy from a monetary policy perspective, though, was the use of unconventional
tools to inject further stimulus when policy rates approached their zero lower bound. That
took the form of explicit guidance to depress expectations of future interest rates; and
largescale asset purchases financed by the issuance of reserves - colloquially known as
quantitative easing.
Let me start with forward guidance, which has particularly attracted academic interest.1 By
holding rates "lower for longer", the central bank can implement an optimal, yet time-
inconsistent, path for rates that boosts demand today, by lowering future nominal rates and
by raising future inflation. It is time inconsistent because, when the future comes, it will no
longer seem appropriate to go through with the promised inflationary episode. Because
policy committees cannot tie the hands of their successors, I do not believe such
timeinconsistent strategies can be credibly implemented other than over rather short horizons.
Of course, all central banks provide guidance regarding the economic outlook and the factors
determining policy so as to influence expectations. Several central banks, such as the
Reserve Bank of New Zealand and the Swedish Riksbank, go as far as providing forecasts of
their own future policy decisions. Until last August, the MPC had shied away from providing
such explicit guidance, lest it be misinterpreted as a promise independent of the state of the
economy. Instead we preferred to provide an implicit steer through the medium of the
projections contained in our quarterly Inflation Report.
Last August, however, the MPC decided that more explicit guidance about our reaction
function could be helpful. Rather than aiming to provide more stimulus as in the academic
literature, we were merely seeking to ensure that the recovery was not nipped in the bud by a
premature rise in market interest rates, despite there still being a significant margin of
economic slack.
We said then that we would not even countenance a rise in Bank Rate until unemployment
had fallen to 7%, subject to overrides relating to excessive upward movements in inflation
expectations and to the risks to financial stability, the latter being policed by the Financial
Policy Committee. We chose unemployment in part because its behaviour is directly linked to
one of the key uncertainties at the current juncture, namely the scope for a recovery in
productivity. This has been unusually weak since the onset of the crisis for reasons we do
not yet fully understand (Chart 2). If productivity rebounded, then unemployment would fall
slowly. But in that case, there would also be more scope to maintain an expansionary policy
before inflationary pressures began to rise. The opposite holds if productivity growth remains
weak: unemployment falls more quickly, but we would then also need to begin raising Bank
Rate earlier.
Shorter-term market interest rates have moved higher since guidance was introduced, but no
more so than is justified by a string of unexpectedly strong activity indicators. And there is
persuasive survey evidence that businesses have both understood the message (Chart 3),
and that it has made them more prepared to hire and invest (Chart 4).
In the event, though, unemployment fell rather faster than expected, reaching the 7%
threshold in the data release for the three months to February. In anticipation of that, in our
February Inflation Report, we provided further guidance, not only on the conditions that
would lead the Committee to begin tightening, but also the likely trajectory thereafter.
Regarding the first question, while unemployment provides a useful conditioning variable for
not tightening, the decision of when to tighten needs to take account of other margins of
slack as well. These can arise in both the labour market - for instance, discouraged workers
temporarily out of the labour force and those who are underemployed - and inside firms.
The amount of slack in an economy is necessarily a fuzzy concept, as potential output
cannot be observed and can be inferred only indirectly. Nevertheless, given the transmission
lags, monetary policy makers cannot avoid forming a judgement about the level of activity
consistent with inflation sustainably remaining at target, and thus of the margin of economic
slack.
Our central view is that the margin of slack is presently around 1-11⁄2% of GDP, though I
should stress the considerable degree of uncertainty around that estimate. I should also
stress that this is a short-run concept, relevant to inflationary pressures a year or so ahead,
and does not incorporate any endogenous improvement in productivity that may materialise
in the wake of faster growth over a rather longer horizon. We have said that we are aiming to
close this gap over the next two or three years, while keeping inflation at around our 2%
target.
We have also said that when Bank Rate does rise, it is likely to do so only gradually and to a
level that is likely to remain materially below its pre-crisis average of 5% for some while. That
reflects: the continuing headwinds from public and private de-leveraging and continued weak
growth in the euro area; continued downward pressure on global interest rates from high
Chinese net savings; and the undue compression of risk premia during the run-up to the
crisis.
Let me now turn to asset purchases, our preferred tool for adding stimulus when Bank Rate
reached its effective lower bound. Under this programme, the Bank acquired £375 billion of
longer-term UK government debt - equivalent to around 25% of annual GDP - comprising
£200 billion purchased between March 2009 and February 2010 and another £175 billion
acquired between October 2011 and November 2012. By depressing the term premium on
gilts, the purchases lowered the long-term safe rate of interest. Such purchases also led to
lower spreads on risky assets as investors rebalanced their portfolios. In addition, the extra
liquidity in the banking system may have helped boost credit supply. Finally, such purchases
may also have reinforced market perceptions that policy would remain loose for an extended
period - the so-called "signalling channel".
Analysis by Bank staff suggests that the first phase of our asset purchases lowered long
rates by around a percentage point; other studies find a similar impact from the Federal
Reserve's asset purchases.2 The impact of the second round is harder to isolate because
some of the effect was probably already priced into the market when the programme was
reactivated, but there are good reasons to believe the impact was smaller because markets
were less dysfunctional than after the collapse of Lehman's. There is also considerable
uncertainty about the impact on growth and inflation, but our present central assessment is
that the programme had a peak impact on GDP of around 21⁄2% and raised inflation by a little
more than 1 percentage point.
Since the evidence suggests that asset purchases lower longer-term rates and stimulate
demand, should they be a permanent part of the central bank's armoury? Or should they be
reserved for emergencies?
I think there are a couple of reasons why they should be seen as just an emergency weapon
for use when policy rates reach the effective lower bound. First, we have less of a handle on
their impact than we do changes in short-term policy rates and, as I just indicated, that
impact may well be less when markets are functioning normally. Second, if the central bank
routinely deals in large quantities of government debt, it may find itself more open to
pressure from the fiscal authorities, while market participants are more likely to fear that the
debt will be permanently monetised.
That brings me naturally to the topic of unwinding our present large stock of asset purchases.
We have committed to maintaining the stock, including reinvesting the cash flows associated
with maturing gilts, at least until the first rise in Bank Rate. But at some stage thereafter, as
part of the transition back to normality, we expect to start running down the portfolio and
withdrawing the associated bank reserves.
In principle, we could do this just by letting the gilts mature. However, as Chart 5
demonstrates, it would take a long time to run off organically in its entirety because of the
relatively long average maturity of the gilts held: the weighted average maturity of the
portfolio is more than 12 years. So more active sales may be called for at some stage,
though the MPC would be unlikely to initiate such a programme until Bank Rate was high
enough that it could be cut to maintain demand if conditions deteriorated. Such a programme
of sales could be expected to put upward pressure on yields, though by much less than the
purchases pushed down on yields because markets would be functioning more normally.
In addition, both heightened risk aversion and regulatory changes mean that banks will want
to hold significantly more high-quality liquid assets than in the past; Chart 6 shows these
holdings had shrunk to less than 1% of bank assets pre-crisis. That means an additional
source of demand for gilts and other highly liquid assets that can be easily sold or repo'd.
That should also attenuate the upward pressure on yields from running down the portfolio.
In case this all sounds rather sanguine, I should say that I do not expect central banks'
collective management of the exit from the present exceptionally stimulatory monetary
stance will be easy. The bumpiness of the incoming data, allied to a state-contingent reaction
function, means that market interest rates are bound to become more volatile along the exit
path, however well central banks communicate their intentions.
We have already seen the sensitivity of markets to changes in the expected path of US
monetary policy during the "taper tantrum" last spring and its attendant consequences for
other countries - especially, but not exclusively, in the emerging economies. Movements in
yield curves have been strongly correlated across countries, not only at the long end, which
is not too surprising, but also at the short end of the curve, where domestic monetary policy
considerations ought to dominate.
Another reason the exit may be bumpy stems from the starting point. Implied volatilities in
many financial markets have been at historically low levels for some time now (Chart 7).
Together with low safe interest rates in the advanced economies, that has underpinned a
renewed search for yield and encouraged carry trades. Taken in isolation, this is eerily
reminiscent of what happened in the run-up to the crisis. Episodes like the "taper tantrum",
which produced a short-lived bout of volatility but no major disruption may also be
contributing to a sense of complacency and an underestimation of market risk by investors.
It is inevitable that at some stage market perceptions of uncertainty will revert to more normal
levels. That is likely to be associated with falls in risky asset prices and could be prompted by
developments in the Ukraine, the fault lines in the Chinese financial sector, monetary policy
exit in the advanced economies, or something else. But it will surely come at some point.
The bottom line is that we may yet encounter a few potholes on the way to the exit. But the
good thing is that banks are better capitalised now than in the run-in to the crisis, leverage is
lower, there is better visibility of counterparty exposures, and we are better placed to deal
with financial institutions that get into trouble. So the risk of major financial problems
crystallising in the advanced economies should be much lower. Those emerging economies
that have financed large external deficits through the accumulation of foreign currency debt
may be more vulnerable, however.
Let me turn now to the impact of the crisis on the monetary policy framework itself. Before
the crisis, the conventional wisdom in central banks was that monetary and financial stability
were largely complementary in nature. The maintenance of price stability would help foster
stable macroeconomic conditions more generally by anchoring expectations. And the
consequent reduction in macroeconomic volatility should help reduce the likelihood of
episodes of financial instability. All that was necessary was for banking supervisors to ensure
that individual financial institutions followed responsible lending policies and all would be
well.
Today, there is a tendency to claim that the crisis revealed a fatal flaw in focussing on price
stability as the primary object of monetary policy, namely a failure to recognise that it could in
some circumstances actually be detrimental to financial stability. While the years before the
crisis were characterised by stability in the evolution of the market for goods and services,
asset markets were anything but stable. In particular, there was a massive expansion in
credit, particularly within the financial system in many of the advanced economies,
accompanied by upward pressure on a range of asset prices, including real estate. There
was a boom in asset markets, even if there was no corresponding boom in the real economy.
To some people, the relatively low level of interest rates necessary to maintain price stability
was instrumental in generating this boom in credit and asset prices by encouraging an
aggressive search for yield.
While there is some truth in this charge, I think it would be a mistake to conclude that
monetary policy was the sole, or even the prime, cause of the crisis. Several factors
coincided to form a potent cocktail. There were other factors that depressed the yield on safe
assets, including high savings rates in China and a more general demand for US Treasuries
as emerging economies accumulated larger stocks of foreign reserves in the wake of the
Asia Crisis. Equally important, in my view, was the impact of the Great Moderation itself on
risk-taking behaviour, as low volatility encouraged an underestimation of the likelihood and
severity of adverse tail risks crystallising. Seen in this light, the Great Moderation sowed the
seeds of its own destruction.
On top of this, of course, there was a litany of microeconomic features that aggravated the
crisis, including: the development of complex securities that were impossible to value in
stressed conditions and connected financial institutions in unexpected ways; disguised
leverage through the use of securitisation vehicles, whose primary aim was regulatory
arbitrage; remuneration packages encouraging positions that generated decent returns most
of the time but high losses in some states of the world; excessive reliance on credit-rating
agencies; defective risk management; weak funding structures; and insufficient high-quality
bank capital to absorb losses.
That said, the experience of the past few years does appear to suggest that monetary policy
ought to take greater account of financial stability concerns. Ahead of the crisis, Bill White
and colleagues at the Bank for International Settlements consistently argued that when
leverage was becoming excessive and/or asset prices misaligned, central bankers ought to
"lean against the wind" by keeping interest rates higher than necessary to meet the price
stability objective in the short run.3 Just as central banks are willing to accept temporary
deviations from their inflation targets to limit output volatility, so they should also be willing to
accept temporary deviations to attenuate the credit cycle. Essentially it is worth accepting a
little more volatility in output and inflation in the short run if one can thereby reduce the size
or frequency of asset-price busts and credit crunches. Such a view ran counter to that
espoused by many central bankers, most notably Federal Reserve Chairman Alan
Greenspan, who questioned the feasibility of addressing such financial imbalances with
preemptive monetary policy; in his view, monetary policy should instead focus on minimising the
fallout from any subsequent correction - the so-called "cleaning" approach.4
While the logic of leaning against the wind is sound in principle, the key question is whether a
monetary tightening of plausible magnitude is likely to be effective in attenuating an
established credit boom. Even if policy rates may appear with hindsight to have been held
too low for too long in the years preceding the crisis, particularly in the United States, the
empirical evidence suggests that they would need to have been significantly higher to have
had a meaningful impact on the rate of credit expansion.5 It is a brave central banker who
would deliberately induce a recession in order to head off the mere risk of a future financial
correction.
That explains the interest in deploying additional policy instruments that are better suited to
restraining the build-up of dangerous financial imbalances and contributing to the
maintenance of financial stability - so-called macroprudential tools. With two targets - price
and financial stability - one really wants another instrument, or set of instruments, to
complement monetary policy. In the new arrangements established following the crisis, the
deployment of such instruments falls to the Bank's Financial Policy Committee.
There are several potential macroprudential tools to deal with such cyclical risks, but they are
of broadly two types: those that increase the resilience of the system; and those that work
pre-emptively against a build-up of leverage. In addition, measures may be targeted or more
general in impact.
To give some examples, first consider the Basel III counter-cyclical capital buffer,
implemented in the European Union under the Capital Requirements Directive. By forcing
banks to hold extra high-quality loss-absorbing capacity during a credit boom that can be
released during a subsequent downturn, this primarily improves resilience. But because it
raises the marginal cost of bank funds, the counter-cyclical capital buffer should also inhibit
the build-up of leverage in the first place. There are several reasons why debt finance is
cheaper than equity finance, including the implicit subsidy from being Too Big To Fail, and
the advantageous tax treatment of debt. Moreover, debt pays the same return in all states of
the world except when default takes place, while the return on equity will vary; that makes
debt more attractive for some investors, especially during financial booms when the
probability of default appears low.
Raising the capital requirements on particular components of banks' balance sheets by
varying sectoral risk weights is different in that it alters the relative attractiveness of different
sorts of lending. Assuming that the increase in capital requirements is targeted at those
sectors where the risks are most material, then not only is resilience increased but it also
encourages substitution towards safer forms of lending and thus has a pre-emptive
character.
Finally, there are tools that directly target borrowing, such as loan-to-income or loan-to-value
caps, and restrictions on the share of banks' portfolios that can be allocated to high
loan-toincome or loan-to-value lending, as recently introduced by the Reserve Bank of New
Zealand. By acting directly on the riskiest segments of lending, such tools are more obviously
pre-emptive in nature.
Importantly, while monetary policy is well-suited to dealing with the problems that arise from
sluggish wage and price adjustment, a good macroprudential tool will be one that is well
targeted at dealing with a particular financial market failure, such as the underestimation of
risk.
To see, in a highly stylised way, how monetary and macroprudential tools can be combined,
as well as the appropriate instrument assignment, consider first Chart 8. The left-hand panel
is relatively conventional and portrays the market for goods and services. IS is an aggregate
demand schedule, with demand a decreasing function of both the policy rate, R, and a
macroprudential instrument, K. PC is an expectations-augmented Phillips curve, in which
inflation expectations are assumed to be anchored at the inflation target.6 For any given set
of shocks to aggregate demand and supply, the inflation target can be achieved by the set of
pairs of R and K along the downward sloping schedule PS (for Price Stability) in the
righthand diagram. An increase in demand resulting from, say, an increase in the propensity to
invest, would shift this schedule out to the right.
Turn now to the credit market. Conventional macroeconomic analyses of the market for
loanable funds tend to focus on the flow of funds from saving households to businesses
undertaking capital expenditures. But, as Chart 9 makes clear, such lending constitutes only
a small fraction of the assets held by UK banks. The vast majority of loans are instead
provided to finance the acquisition of existing assets, especially real estate.
This should be borne in mind when contemplating the factors behind the demand and supply
of credit, shown in the left-hand panel of Chart 10 as CD and CS respectively. Demand
decreases with the cost of borrowing, and supply increases with the return on bank debt
RB
(including deposits), RD, which for simplicity is taken to move in line with the policy rate R. In
addition, there is a spread between and reflecting expectations of default not only by
RB RD,
end borrowers but also by the financial intermediary. In credit booms, this spread is often
unsustainably compressed, while during credit crunches it widens sharply. Our
macroprudential instrument, K, is assumed either to reduce the demand for credit, or to
increase the spread between and or both. Either way it reduces the total quantity of
RB RD,
credit, C.
Now unlike macroeconomic stability, which can be characterised as output being at its
sustainable level once nominal wages and prices have adjusted and inflation is at target,
there is no corresponding simple characterisation of financial stability. But for simplicity, let
us assume that the authorities have in mind some maximum level of leverage that is
consistent with the risks to future financial stability remaining acceptable. Then we have the
downward-sloping frontier FS (for Financial Stability) in the right-hand panel that shows the
minimum acceptable level of the policy rate for any given setting of the macroprudential tool.
A reduction in perceived risk leading to excessive exuberance on the part of investors or
borrowers would shift this frontier to the right.
Putting these two policy relationships, PS and FS, together we get Chart 11. The respective
slopes of these two schedules depend on the relative impact of the policy rate and the
macroprudential tool on aggregate demand and on the quantity of credit. A well-chosen and
well-designed macroprudential tool is one that has a relatively large effect on the quantity of
credit but only a modest impact on aggregate demand. That would generate a relatively flat
FS schedule. Moreover, since changes in policy rates also affect aggregate demand through
routes other than the credit channel, such as the exchange rate, it seems reasonable to
assume that the PS schedule is relatively steep. That is the configuration of relative slopes
shown in the Chart. Provided the two schedules do not coincide, both price and financial
stability objectives can be achieved simultaneously.
With this configuration, it is natural to assign the monetary instrument to the pursuit of price
stability and the macroprudential instrument to the pursuit of financial stability. Moreover, with
these slopes and this assignment, no active co-ordination in the setting of the instruments is
strictly necessary: a process whereby each instrument is set independently, taking the other
as given would converge on the equilibrium, A. That said, appropriate co-ordination and
information exchange is desirable to achieve it efficiently and is facilitated in the real world by
housing the MPC and the FPC in the same institution, with overlapping memberships, and
the scope to meet jointly when required.
Some sorts of shocks will involve a tightening in both instruments. For instance, consider a
bout of "irrational exuberance" on the part of households, businesses and investors. The
increased optimism is associated with an increase in the demand for goods and services
from households and businesses, together with increased demand for credit and a reduction
in the credit spread. So both PS and FS shift out to the right, as in Chart 12. As drawn, both
instruments are therefore tightened.
In other cases, it will be appropriate for the instruments to move in opposite directions. For
instance a beneficial supply shock will usually generate disinflationary pressure requiring
lower interest rates, other things equal. So the price stability schedule shifts in. But it may
well also encourage increased borrowing and a compression in spreads, leading the financial
stability frontier to shift out. In this example, monetary policy is loosened at the same time as
macroprudential policy is tightened (Chart 13). Superficially this could look as if the monetary
and macroprudential policymakers are at odds with each other, though such a rebalancing of
the mix of policies is in fact entirely appropriate.
There are, however, important qualifications to this somewhat Panglossian view of the ability
to maintain both price stability and financial stability by assigning monetary policy to the
former and macroprudential policy to the latter. Compared to the impact of changes in
interest rates, we have relatively little experience of deploying macroprudential instruments.
And there will often be scope for those affected to work out ways to circumvent them,
including by moving activities outside the regulatory perimeter. As Federal Reserve Board
Governor Jeremy Stein has noted, monetary policy may be a blunt tool for addressing
financial stability risks, but it does have the virtue that it "gets in all of the cracks".7 So, there
may well be times when monetary policy is the only game in town to guard against incipient
financial stability risks. In that case, we are back in the world where monetary policy makers
need to be prepared to consciously lean against the wind by deliberately undershooting their
inflation target in the near term in order to reduce the likelihood of something nastier down
the road.
This thinking has now been embodied in the Chancellor's remit for the MPC, which sets our
objectives each year. It notes that "circumstances may arise in which attempts to keep
inflation at the inflation target could exacerbate the development of imbalances that the FPC
may judge to represent a potential risk to financial stability. The FPC's macroprudential tools
are the first line of defence against such risks, but in these circumstances the MPC may wish
to allow inflation to deviate from the target temporarily." The remit also directs the MPC to
have regard for the actions of the FPC and vice versa.
I opened my remarks tonight by observing that my time at the Bank has neatly fallen into two
halves. Seven years of unparalleled macroeconomic stability have been followed by seven
years characterised by financial instability and a deep recession. It was a salutary lesson for
those, like me, who thought we had successfully cracked the problem of steering the
economy, and highlighted the need to put in place an effective prudential framework to
complement monetary policy. Policy making today consequently looks a much more complex
problem than it did fourteen years ago.
In Genesis, following his interpretation of Pharaoh's Dream, Joseph is made the most
powerful bureaucrat in Egypt, in which position he ensures that enough grain is hoarded
during the seven years of plenty to provide sustenance during the seven years of famine that
followed. That is a parable on the value of prudence that the central bankers of the future
would do well not to forget. Thank you for your attention!
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