Paul Fisher: Current issues in monetary policy
Speech by Mr Paul Fisher, Executive Director for Markets of the Bank of England, at the
University of Bristol - London Alumni Event, Bristol, 26 February 2013.
* * *
Thank you very much for inviting me to speak to you this evening. The University of Bristol is
a very fine institution in a very fine city and I have extremely fond memories of my time there
from 1977 to 1980 as a student in Economics with Statistics. In music at that time we had the
latter stages of punk rock, and Bristol was also very good for folk music; in football I
remember watching Bristol City playing Tottenham at Ashton Gate in what was then the true
First Division; and in the economy there was continuing economic and social unrest (the
Winter of Discontent) with inflation and unemployment stubbornly high. I recall a flatmate
conducting a survey of students' inflation expectations in 1978 when RPI inflation had just
fallen below 8% for the first time since 1972. Unemployment was thought to be high at the
time, as a result of the first oil crisis but was to take a further upwards lurch in the early 80s
and I remember how lucky I was to get a research job at Warwick University when I left
Bristol - having spent the summer of 1980 painting rusty trolleys in a factory, which was itself
knocked down to create housing later in the 80s.
Whilst these may appear to be self-indulgent memories, the comparison of the economy then
and now does provide a thoughtful backdrop for what I want to discuss with you this evening.
Compared with the economy in the 70s, maybe things aren't as bad now as we sometimes
like to believe! The first topic I want to cover will be what central banks can do to help
achieve the holy grail of low inflation, stable growth and full employment. In particular I will
take a monetary approach to explaining the issues. Second, I want to talk about the
monetary policy decisions facing us right now and explain my own recent voting position.
Third, I want to give an update on our latest initiative, the "Funding for Lending Scheme".
Money and the balance sheet of the central bank
In the Acknowledgements to his 1988 classic "A Brief History of Time", Stephen Hawking
notes that he was told that each equation he included in the book would halve its sales. He
only included one.1 You may be relieved to hear that there are no equations in this talk
tonight. But I mention this because I am going to refer regularly to something which has been
empirically proven to send some journalists to sleep faster than counting sheep. The Bank of
England's balance sheet. I hope you are all still awake? Good, because the Bank's balance
sheet is actually where all the action is. It is what allows the Bank to deliver its core functions
including the issuance of banknotes, implementing monetary policy, and acting as lender of
last resort to the banking system. Only the central bank can undertake these tasks because
the central bank is the monopoly supplier of domestic currency: sterling in the UK. In this
context (leaving aside the small stock of coins in circulation2) sterling means banknotes and
commercial bank reserves held at the Bank of England, which in combination comprise
"base" or "narrow money"3. Notes and reserve balances form the vast majority of the liability
side of the Bank's balance sheet (see Chart 1) and these two types of money provide the
ultimate means of settling payments between individuals, commercial firms, the Government
and banks. I will talk about broader concepts of money, including commercial bank deposits,
a little later. The Bank of England can control the amount of sterling liabilities it issues and
thus decide the amount of narrow money in the economy and/or its price. That is unique to
the central bank and is the fundamental operational tool we have to implement monetary
policy.
Bank of England consolidated balance sheet(a)
Chart 1: Liabilities Chart 2: Assets
£ billions £ billions
450 450
Other assets
Other liabilities
400 400
Loan to APF (QE)
Reserve balances
350 350
Short-term repos
Notes in Circulation
Long-term repos
300 300
250 250
200
200
150 150
100 100
50 50
0 0
2007 2008 2009 2010 2011 2012 2013 2007 2008 2009 2010 2011 2012 2013
(a)
Weekly data to 13 February 2013
In addition to controlling the size of our balance sheet and/or the price of money, which may
affect the total supply of credit in the economy directly, we can alter the composition of the
assets held on the Bank's balance sheet, or conduct off-balance sheet operations, and so
affect the composition of private sector asset holdings. Executed judiciously, we can thus
influence the price and/or quantity of particular types of credit in the economy.
Finally, by talking about what we might do in the future, the Bank can influence the price and
quantity of money and credit for some time to come. The power of communications as an
operational tool should not be underestimated and the MPC has always used a range of
communication channels to help accomplish its objectives.
1st
I should also note that, from April this year, the new Financial Policy Committee (the FPC)
of the Bank will also have statutory responsibility and powers to make the financial system
more resilient through macroprudential policies,4 and the Prudential Regulation Authority (the
PRA) within the Bank of England will take over from the Financial Services Authority the job
of micro-prudential supervision of firms. These functions do not depend on the central bank
balance sheet and so, in principle, do not need to be undertaken by the central bank. But
they are being put in the central bank for very good reasons, which include, for example,
exploiting the synergies with central bank operations and skills, and eliminating the underlaps
that arise from separate institutional arrangements. Because they do not necessarily involve
the Bank in conducting financial operations, I will say no more about macro- or
microprudential polices today. (Else I will still be going at midnight!)
In summary, the primary operational policy levers available to the Bank of England to
influence the macroeconomic outlook are: setting the price or quantity of money; influencing
the price and quantity of credit; and the communication of our actions, analysis and views5.
Let me unpack these policy operations a little further.
Our monetary policy objective is set in the annual Inflation Target Remit given to us in a letter
from the Chancellor.6 The Remit requires the Monetary Policy Committee to target a 2%
inflation rate in the Consumer Price Index, but it is also made clear that we should avoid
volatility in output" events or temporary
"undesirable which might arise from "external
difficulties" beyond the control of the monetary framework.
In order to steer inflation towards the 2% target, in effect we can control either the price or
the supply of narrow money. Prior to 2009, we would set Bank Rate and then adjust the
supply of commercial bank reserves to guide overnight interest rates towards it. To do this
the Bank would conduct Open Market Operations (OMOs) in which we lend to, or borrow
from, the commercial banks so as to increase or decrease the level of reserve balances in
aggregate, in line with the banks' stated targets. We would adjust those operations precisely
to ensure that short-term market rates are driven towards the rate we pay on those reserve
balances - which is Bank Rate. Since we also charge Bank Rate in our routine OMOs, Bank
Rate is essentially the anchoring price of short term money. I am not going to go into details
tonight about the precise economic mechanisms which make overnight market rates
converge on Bank Rate, but there is plenty of technical material available on that if you wish
to know precisely how that works.7
In my first week as Markets Director of the Bank of England, in March 2009, we set Bank
Rate at 0.5% where it has remained ever since; a record low for the policy rate in the Bank's
history of over 300 years. Since that left little scope to adjust the price of money downwards
directly, we switched at that point to directly affecting the supply of narrow money. The Asset
Purchase Programme - more popularly called "Quantitative Easing" or just "QE" - has since
reached of total of £375bn, the vast majority of which has been by purchasing gilts, financed
by increasing the supply of reserve balances (net of other flows across the Bank's balance
sheet - see Charts 1 and 2).
The economics of QE is actually more simple than is often portrayed: by buying a large
amount of assets from the market, in exchange for cash, we can greatly increase the amount
of sterling in the economy. We inject the most liquid asset of all - short-term sterling reserve
balances - and take out of circulation a long-maturity, less liquid asset, gilts. That switch in
maturity and liquidity leads to a range of effects, as the economy has to rebalance its
holdings of financial assets. As people try to move out of cash deposits and into typically
higher yielding assets, QE will reduce liquidity and term premia, push up a range of asset
prices and bring down interest rates at a wide range of maturities. All of that will benefit
borrowers, increase wealth and help to stimulate nominal demand. Injecting money is
actually not so different from cutting its price (Bank Rate).
There are some very important caveats however and I will focus on three. First, monetary
stimulus works by giving an incentive to businesses and households to spend now rather
than in the future. That creates only a temporary boost to growth. To carry on influencing
growth, the stimulus needs to get ever larger. But we know that ultimately, the sustainable
growth rate in the economy depends not on monetary conditions but on real factors. I shall
return to this point later. Second, and relatedly, a monetary injection can create extra nominal
demand for goods and services, but the precise split between real growth and price inflation
is unfortunately out of our control. Taking these two points together, the creation of extra
money can surely be relied on to prevent deflation, but even if it provides a temporary boost
to real activity it can't guarantee sustaining a particular real growth rate. Third, the split into
prices and real output and the overall outturn for the economy, depend on what else is
happening at the same time: monetary policy is just one of the various forces at work
shaping the pressures on output and inflation. We don't conduct monetary policy in a
scientific laboratory where everything else can be held constant.
QE is often described as being a great experiment. In fact, the theory of monetary policy in
the economic textbooks that I was brought up with at Bristol, and later, all considered the
supply of money to be the central bank's primary policy instrument. The use of interest rates
to set monetary policy appeared to be viewed by many academic authors as something of a
slightly unfortunate and uninteresting practicality8.
I want to be clear about one very important point: for monetary policy to stimulate the
economy, the Bank of England has to cut interest rates and/or increase the supply of money.
That gives firms and households an incentive to spend rather than to save. And it works in
part by shifting net interest income from those who do save to those who borrow (and hence
are more likely to spend out of marginal income). Not surprisingly, loosening monetary policy
is often unpopular with savers, just as tightening policy is unpopular with borrowers. We have
every sympathy for those who are net savers and especially if they rely on investment
income, but we have to set policy for the good of the economy as a whole, in line with our
Remit. Ultimately, economic recovery is in everyone's interests.
Monetary policy famously has "long and variable lags". One of the main reasons why is
because the demand for money depends on many other factors in the economy outside of
the central bank's control. There are other forms of money apart from sterling as I have
defined it so far. Economic activity is also supported by the extent of deposits created by the
commercial banks. Various measures of this are available, usually labelled "broad money"
and the definition most commonly used in the UK is known as M49. Ideally, that wider
definition of money is what we would like to boost to ensure an increase in nominal demand
for goods and services.
In the UK it has been clear over the past four years that while we have been busy increasing
the supply of narrow money, the growth of broad money has remained weak. Broad money
demand will fall if individuals or firms use the increased cash injected into the system to pay
down bank debts, or simply seek to borrow less. Similarly the supply side of broad money
can contract if banks consciously shrink their balance sheets. That would happen, for
example, if the banks are short of capital or funding, or simply can't earn sufficient return on
their assets. All of these demand and supply factors have been at work in recent years. As a
result, the balance of forces between the demand and supply of broad money against the
injection of narrow money has meant that growth in the stock of broad money in the economy
has remained weak.
That does not mean that QE has been unsuccessful, as many commentators seem to
conclude. Without QE, the amount of broad money in the economy would clearly have
shrunk much further than it did - it actually held up reasonably well while the economy was
contracting. Had broad money shrunk a lot further, the resulting deflation would have meant
that the outcomes for output and employment in the UK would have been far, far worse than
they have been. I will say more on the causes of deflationary forces a bit later, but this
analysis partly explains why the Bank of England has also been engaged on special
operations to support the liquidity, funding and capital positions of the banks through,
respectively, the Special Liquidity Scheme, the Funding for Lending Scheme and the capital
recommendations by the FPC.
What of our ability to influence credit markets directly? I want to argue that it largely reflects
how we go about changing the supply of money. On the one hand, to increase the quantity
of money in scale, quickly and safely, it is quite clear that gilts are the best instrument to buy:
there is a large market and there is no resultant private sector credit risk taken by the public
sector. Many financial instruments tend to be priced by reference to the interest rates on
sovereign debt and so changing gilt yields will have effects across sterling markets.
In addition to buying gilts to inject money, we can consider two other ways to affect credit
markets. First we can buy financial instruments outright. If particular markets have become
dysfunctional so that general monetary expansion doesn't help, relatively small amounts of
direct purchases may unblock the relevant markets. Second we can lend liquid assets
- including cash - against assets that are, or have become illiquid. That is what we did with
the Special Liquidity Scheme and more recently the Funding for Lending Scheme.
In 2009 the Bank launched two schemes making outright purchases of assets other than
gilts.10 We started to buy sterling commercial paper (up to 3 months maturity) and investment
grade corporate bonds. At that time, in the worst conditions of the recession, the markets for
these financial instruments had not been functioning normally. An increased demand for
liquidity and heightened concerns about counterparty risk, caused many markets to dry up
and asset prices to fall. By intervening as "Market Maker of Last Resort" the Bank was able,
over about a 12-18 month period, to support the markets for both commercial paper and
corporate bonds and drive prices back to more appropriate levels. The commercial paper
scheme came to a natural end as prices rose and our holdings - which peaked at about
£2.4bn in 2009 - matured. The corporate bond scheme is still in operation. Each week we
offer to buy from a list of bonds, or sell from our stock. After reaching a peak in 2010 of some
£1.5bn in holdings, the revitalized market has steadily bought the bonds back from us so that
our stock is now only around £20mn.
Curiously, we still get people advocating the purchase of corporate bonds in large scale as
well as gilts. But it is not clear to me what this would be intended to achieve. Apart from the
simple fact that the Bank is already in the market every week offering to buy corporate
bonds, and we have been doing that for nearly four years, this aspect of the capital markets
is functioning well in terms of providing credit to businesses. Any firm that has an issuance
programme - typically the larger firms with credit ratings - can issue whenever and whatever
bonds they choose at historically low interest rates. The backstop to corporate bonds
provided by the Bank's operations is still there - but it is not being used much because it is
not needed.
The power to intervene in credit markets is one to use cautiously. Any intervention by the
public sector carries the risk of creating distortions. Usually, we intervene because there is a
demonstrable failure of private markets - so that the central bank is undoing distortions
caused by other factors. Buying private sector paper also carries the risk of credit losses -
ultimately of public money. And it is a very short step to cross the boundary from seeking to
improve credit supply generally to determining the credit allocation between individual
borrowers - which the central bank is neither equipped nor empowered to do. That is best
left to private markets.
When a central bank - or any public authority - takes actions, it has to remember that the
precedent of that action can be as powerful as the action itself. Market participants - and
indeed the general public - will learn about the authorities' behaviour and shape their own
accordingly. Moral hazard is one aspect of this - that can lead to market participants taking
more risky actions because of the perceived backstop provided by the central bank.
More generally, communications strategies can be a positive part of the toolkit, in particular
by giving out information about the central bank's monetary policy "reaction function". For the
most part it is helpful for markets to be able to predict what the central bank will do. That way
one can often hope to generate the desired responses with less severe policy actions than
otherwise. Credibility matters. For example, if people believe that inflation will be 2% in the
medium term, and act accordingly, it is much more likely that inflation will stay close to 2% in
practice without big swings in monetary policy. Keeping inflation under control is much more
costly for the economy if expectations become de-anchored from the official target.
But how explicit do we need to be about our forward plans? This is a very live policy debate.
The recovery in financial markets that we have seen in the past 6 months or so, is in part
driven by the statement that the ECB will do "whatever it takes" to keep the euro area
together and the perceived commitment that the Fed will do whatever it takes to restore
growth in the US. The belief in these policy approaches has been immensely powerful. But it
must be backed not only by perceived intent but also by capability and delivery if needed -
and economies always generate some surprises. If the actions don't follow the words when
necessary, then similar policy statements in future will be less effective.
In the UK, market expectations are already consistent with monetary policy remaining very
supportive for some time to come, indicating no change in Bank Rate until well into 2015. Yet
there is still a debate about whether the MPC should give more "forward guidance". In
practice we have being doing this through the Inflation Report. The most recent edition
makes it clear that we do not see much pressure arising from domestically generated
inflation. Rather, we continue to see inflation being driven by factors such as tax changes,
higher commodity and energy prices, and other external influences. These and similar
adverse relative price changes have made us all financially worse off and contributed to
keeping inflation higher than target over the past few years. In response, the Bank could
have chosen to tighten monetary policy to keep measured inflation rates down. But that
would have meant deliberately trying to weaken output growth and seeking to raise
unemployment so that domestic inflationary pressures were lower. The relative price
changes would still have happened, albeit at a lower overall inflation rate (wage growth
would also have been lower). That would not have been consistent with the Remit that the
MPC has been given and I doubt it would have been a more attractive outcome to most
people.
The current policy debate
Despite the medium-term limitations of monetary policy, my own view is that QE has
nevertheless been a powerful force in supporting the economy at crucial points over the past
4 1⁄2 years. Given the shocks that have hit the UK since 2008, and the dependence of the UK
on financial services, output could have fallen much, much further than the 6% fall from peak
to trough that is actually recorded, and the unemployment rate could easily have peaked well
into double figures instead of the 8 1⁄2% that actually transpired. But I have also made clear
that I do not think monetary policy can itself guarantee sustained real growth in the
mediumterm. It can provide a temporary stimulus and the right monetary conditions for a recovery,
but sustained real growth will depend on real factors such as real external demand for
UKproduced goods and services. We need real productivity growth to make UK production
competitive and we need real supply-side reforms to boost expected future real incomes.
Monetary policy can help, and it can underpin the economy by preventing a slide into
deflation. So support from monetary policy is necessary but won't be sufficient to restore
sustained real growth until these real determinants are also pushing the economy forwards.
One way to think about what has happened during the past 4 years is that there has been a
need for balance sheet rebuilding across the economy. The shocks of 2008 revealed that
many parts of the economy had become over-extended: some UK commercial banks are still
rebuilding their balance sheets; the Government will take several more years to rebalance
expenditure and income; households are still increasing savings rather than spending in
aggregate; and some corporates are reluctant - or unable - to take on new debts. And given
a very large trade deficit built up prior to the crisis, the overall UK economy had to rebalance,
away from domestic demand towards net exports. These are real adjustments that need to
be made within the economy. Growth should return, but it is likely that growth can only be
sustained at a satisfying pace once the drag on demand and supply from rebalancing
lessens. Monetary policy can play a supporting role because the extra liquidity in the
economy allows the necessary rebalancing to happen without a disorderly adjustment (eg in
asset prices). But patience will be required.
One detailed factor that has complicated monetary policy recently is the effects on measured
retail price inflation of regulated and administered prices such as above-inflation rises in
utility bills, university tuition fees, rail fares etc. Individually these may be perfectly sensible
public policy choices and I do not want to be interpreted as criticising their motivation. But the
effect on CPI inflation is important. These prices - which are about 16% of the CPI basket -
will contribute around one percentage point to the CPI inflation rate in the next couple of
years, largely regardless of what happens to domestic demand. Pushing inflation down to 2%
would require very low price rises in the other 84%. The risk of overall deflation is much less
likely as a result.
At our February meeting we faced, as so often in the recent past, a difficult choice. Should
we offer more monetary stimulus, or should we not? My own choice, on a balanced
assessment of the risks, was that we could and should do more now to support a nascent
recovery with a further monetary injection. I do not believe the assertions of those who claim
that that QE is noticeably less powerful than previously - although I have noted that there are
limits to what monetary policy can be expected to achieve on real growth and it is impossible
to measure the impact of monetary policy with any degree of precision. As with changing
interest rates, the precise effects will always depend on the state of the economy. I judge that
there are some upside risks to inflation, should confidence about achieving the 2% inflation
target in the medium run be lost. But there are also downside risks if growth remains very
subdued. As long as medium-term inflation expectations do remain consistent with our
objective - in particular as long as wage growth remains so weak - I believe that we can and
should continue to support the economy through the supply of money. But there is a case for
taking a slightly longer-term approach than previously.
Because of the underpinning from regulated and administered prices, and the fact that the
economy is currently flat rather than contracting, I think the risk of deflation is considerably
reduced. Rather than a very large, rapid programme of asset purchases to avoid an
imminent slump - as was needed in 2009 and again in 2011/12 - a slower, more gradually
supportive policy might be more appropriate and less risky to nurse the economy through the
next phase of recovery. It is sustained momentum that the economy needs now rather than
emergency action.
Because of that, in February I voted for an additional £25bn over 3 months thinking that this
could be the first instalment of a more prolonged run of purchases at a somewhat slower
pace than previously, and with a relatively modest addition to the total by the end. If we were
to do that, then it would be straightforward to accelerate or to stop purchases as the
economic outlook developed and the risks became clearer. In fact this is not so different from
what we have done before. Although we have always decided on asset purchases for a 3 or
4 month period at a time, we have often rolled into further purchases. The total amount is
only decided - and then only temporarily - at the point we stop! So we could contemplate a
rather longer horizon for asset purchases, even if we continue to cautiously decide on a few
months at a time.
The majority of the MPC took a view in February not to make any more purchases. I accept
that there was a good case to be made for that position, even if on balance I took a different
view. But I think we need to keep under review whether there is merit in undertaking more
asset purchases under a slightly different dynamic approach. Indeed the February meeting
Minutes made it clear that the Committee will keep all its options open.
Funding for lending
Finally, I want to turn to our most recent approach to credit easing. The Funding for Lending
Scheme (the FLS) was launched in 2012 jointly with HM Treasury after we saw that interest
rates being charged to borrowers had been rising at a time when our asset purchase
programme should have been bearing down on market rates. The principal reason for rising
lending rates was that bank funding costs were being kept high by the continuing crisis in the
euro area.
The FLS offers banks cheap funding for up to 4 years - with the price linked to how much
lending a bank makes to UK firms and households. It is carefully designed to provide
incentives to all banks to lend more than they would have done in its absence. The actual
mechanism is a liquidity upgrade as we lend 9-month Treasury bills against illiquid loan
collateral.11 The Treasury bills can easily and cheaply be converted into cash, thus reducing
the banks' reliance on more expensive market funding.
How successful has it been? The impact comes in three phases. First of all the FLS tackles
the problem at source by cutting the funding costs of banks. That phase has been
remarkably successful. Market-based measures of UK bank funding costs have fallen across
all sources: secured and unsecured term debt; inter-bank borrowing; deposit rates and so on.
It has no doubt helped that coincidental developments in Europe have brought down bank
funding costs there. But in the UK they fell quickly once the FLS was first announced, and
generally by more for UK banks than for their European peer group.
The next stage is for banks to pass on lower funding costs to their customers. This is
happening, albeit a bit more slowly. Of course it is only the banks' marginal funding costs
which are reduced. Their pre-existing stock of funding will reflect historical borrowing costs.
So the largest falls in loan costs are directed at new lending, rather than the stock. The
impact is also more obvious on mortgage than on corporate lending. Three quarters of total
lending is to households rather than to firms, and it is easier for banks to launch new offers in
that sector. In the corporate sector, we have seen banks take different approaches to SME
lending: one bank offers a cash back scheme; another has scrapped arrangement fees; a
third is offering guaranteed discounted borrowing costs. The true impact for corporate
customers is not easily measured in "standard" interest rate data, but the potential economic
benefit is there. Overall, we think there is more action to come in lower lending rates.
The final stage is the impact of lower lending rates on the quantity of credit. That will take
some time to work through from applications to approvals to actual lending and is the most
uncertain leg. The FLS has clearly shifted the supply of credit: loans are generally available
at lower cost than previously. That in itself is a monetary boost as new borrowers will be
better off than they were before because they are paying lower interest rates. But whether
there is more borrowing in total will depend on the demand for credit and the
creditworthiness of borrowers. If firms or households, for whatever reason, are reluctant to
borrow, a change in the marginal interest rate may not make much difference. For example I
have personally heard from small firms who say they do not want to "get in hock to their
banks again" and so they are turning to alternative funding sources or simply not investing at
all.
And from the lender's point of view, they still have to judge the chances of getting their
money back. Again this is more complicated for lending to businesses than for households -
especially small businesses which are much more diverse. At the margin there will be some
individual business credits which look a better bet at a lower interest rate, but some other
businesses won't get credit at any price. In aggregate, corporate lending is also probably
being held back by the fact that the commercial property market is still weak. Nearly 50% of
bank and building society lending to corporates is to the property sector and a good part of
the rest will be secured on property. Given losses suffered by most banks on their
commercial property portfolios, they are reluctant to increase lending for that purpose.
Finally, some banks have had to cut back particular forms of lending as a result of State Aid
rulings, so they will struggle not to reduce their total lending, even if they use the FLS to the
full to support their core activities.
We do need to keep the pressure on the banks individually and collectively to make sure that
they continue to pass through lower funding costs and are lending where they can. The Bank
has made the funds available to support lending to UK households and businesses, it is up to
the banks to deliver. That is one reason why we are publishing bank-by-bank outcomes
under the Scheme.
We wait to see what the impact is of the FLS on the stock of lending. The next data release
on 4 March will be for end-December data. Even though lending rates have fallen, that is still
quite early for much extra money to have flowed from the application stage into actual loans,
compared with previous plans which showed that lending was most likely to fall in aggregate
without the FLS. I would not expect to see a return to rising aggregate quantities until we
start getting data for 2013 at the earliest. Indeed the aggregate data which have been
published already - for all ban