What did the monetarists
ever do for us? - speech by
Huw Pill
Given at Walter Eucken Institut / Stifung Geld und Währung Conference
- Inflation and Debt: Challenges for Monetary Policy after Covid-19
Published on 24 June 2022
Huw Pill talks about the challenges for monetary policy after Covid.
Speech
Good afternoon everyone.
It is a great pleasure to be here in Freiburg to attend this excellent and topical conference. My
thanks are due to the organisers, especially Professors Feld, Krause and Moellers, and to the
sponsoring institutions, the Stiftung Geld and Waehrung and the Walter Eucken Institut, for their
invitation and hospitality.
I am tempted to start my remarks with the phrase: 'And now for something completely different ...'.
In part, this is intended to signal a change of pace. After a series of outstanding presentations of
very high quality research papers, I am afraid that I will lower the tone somewhat by bringing more
of a policy orientation to the discussion.
But it is also a nod to the Pythonesque title assigned to my remarks.
I understand that Monty Python was (and is) very popular in Germany. But to avoid any mis-
understanding, I thought I should clarify from the outset that the title is an allusion to a famous
sketch from one of the Money Python films.
To incite rebellion against their Roman rulers during the time of empire, the rebel leader - played
by John Cleese - asks the question: 'What have the Romans ever done for us?', only to be met by
a long and impressive list of achievements and contributions made by the Romans to the quality of
life.
In asking a similar question about monetarism - or perhaps, more precisely, a question about the
role of monetary quantities in the design, conduct, transmission and presentation of monetary
policy - I seek to explore whether a similar conclusion can be drawn.
While monetarism remains unfashionable in academic and central banking circles, perhaps it has
contributed more to the past, present and potential future of monetary policy than we
conventionally admit.
No money, no inflation
Twenty years ago, the former Governor of the Bank of England (and now Lord) King published an
article in the Bank's Quarterly Bulletin entitled 'No money, no inflation - The role of money in the
economy'.[1]
This article addressed an apparent paradox.
On the one hand, Milton Friedman's famous monetarist dictum that 'inflation is always and
everywhere a monetary phenomenon' appeared to have become entrenched in the economics
profession's conventional wisdom.[2] As a result, in most advanced economies, monetary policy
had been assigned clear and independent responsibility for the maintenance of price stability. At
the time, this framework appeared to be delivering much better results than its various
predecessors: we were in the midst of the 'Great Moderation', enjoying the benefits of inflation
remaining low and stable around its target level.[3]
Yet, on the other hand, these favourable outcomes were typically accompanied by a lack of
reference to money in descriptions of the conduct or transmission of monetary policy - even when
those descriptions were offered by central bankers themselves.[4] In most jurisdictions, the
monetarist experiments of the late 1970s and early 1980s - which had placed monetary
aggregates at the heart of the design and communication of monetary policy strategies - were
seen as discredited. In the face of rapid financial innovation, the operation of Goodhart's Law had
rendered the controllability of those aggregates and / or the interpretability of their role in the
transmission mechanism sufficiently opaque for them to be deemed unreliable aids to the
formulation and presentation of monetary policy decisions.[5]
Lord King offered a reconciliation of these two observations. On my reading, the arguments he
made back at the turn of the century have stood the test of time.
Although not doing justice to the richness, breadth or quality of those arguments, one core theme
builds on the insights of Poole.[6] As in other fields, a form of 'duality' between quantities and
prices exists in monetary economics. When shocks to money demand are large, expressing the
stance of monetary policy in terms of an interest rate - in other words, as a price rather than as a
quantity - can help to insulate the wider economy and price developments from the volatility that
those demand shocks induce in monetary quantities.
This insight had long been embedded in central bank practice, with short-term interest rates being
the operational instrument of monetary policy. And it is now central to the canonical model of
monetary policy outlined in Woodford's magnum opus Interest and Prices, which both captures
and has catalysed the large and still growing literature on interest rate rules for monetary policy.
Three questions: Past, present and future
While I will revisit some of these arguments in what follows, you should not expect much innovation
from me on those dimensions. But, two decades on, a number of new questions have emerged,
which I do hope to address.
Past: What are the lessons of the past twenty years?
A natural focus is to explore how we should think about the expansion of central bank balance
sheets via quantitative easing (QE) and other mechanisms.
In Lord King's article, discussion of QE is limited to the case of Japan and treated as something
of an anachronism. But in the aftermath of the global financial crisis - with a long-term downward
trend in the equilibrium real interest rate, R-star; with nominal policy interest rates stuck for long
periods at their effective lower bound; and with disruptions in the financial sector impeding the
traditional transmission of monetary policy - the use of QE and other balance sheet policies by
central banks has become mainstream.
Pace Poole, QE policies have largely been expressed in quantitative terms (even if that approach
has been somewhat watered down over time). For example, at the Bank of England QE measures
have been announced in terms of changes in the stock of gilt holdings in the special facility
created to manage the asset portfolio. Such an approach inevitably begs the question of whether,
and if so in what form, monetary quantities have re-asserted themselves in the conduct,
transmission and communication of monetary policy.
More generally, the financial crisis and its aftermath have demonstrated that financial markets are
subject to periodic disruption. This questions the assumption - embedded in much of traditional
finance theory - that equilibrium yields are independent of the quantities of the supplies of
different assets. Failure of that assumption opens up scope for monetary quantities to have an
important influence over a wide range of asset prices and risk premia, and thereby play an
important role in monetary policy transmission.[7]
Changes in the structure of the financial sector - both secular trends and the consequences of
regulatory changes introduced following the crisis - have shifted activity away from banks to
nonbank financial institutions (NBFIs) (what we used to call 'shadow banks'). The NBFI sector has
become a more important part of the financial sector and, as a result, a more important channel of
monetary policy transmission.
For monetary policy makers, understanding transmission via the asset markets where NBFIs
operate has therefore become more important. How money flows within the financial sector -
among banks, among NBFIs, and between banks and NBFIs - influence asset prices are
becoming more central relative to the more traditional analysis of how financial flows between
banks, on the one hand, and households and firms, on the other, influence spending and pricing
decisions in the real economy. This has important implications not just for the character of the
analysis but also the definition of the relevant measures of money upon which focus is required.
While this shift has been evident for some time, the so-called 'dash-for-cash' episode at outset of
the Covid-19 pandemic brought home the potential magnitude of these effects. As the label itself
suggests, the conventional explanation of this event suggests a lack of safe and liquid monetary
assets fed market dislocation. This is an episode to which I will return later in the talk.
Present: What implications do the lessons of the past twenty years imply for our
assessment of the current situation and the challenges facing monetary policy
today?
We are not without advice on this dimension.
Some monetarists expressed concern that the expansion of central bank balance sheets via QE
during the financial crisis would trigger inflation. This fear proved mis-founded. More recently,
other monetarists have attributed the current strength of inflation to the expansion of bank deposits
associated with monetary easing and QE at the onset of the pandemic. Different diagnoses
reflect the existence of different sects within the overall monetarist doctrine, often associated with
varying focus on either narrow measures of 'outside' money (the monetary base, M0) or broad
measures of inside money (such as M4 in the UK or M3 in the euro area).
Interestingly, having been critical of the failure to tighten UK monetary policy in the face of strength
in broad money growth through the pandemic, one stream of British monetarist thinking now
advocates a gradual tightening of policy, despite the current elevated level of inflation. This
preference for gradualism stems from the view that monetary growth has eased of late and strong
policy action now risks tightening too much, inducing unnecessary macroeconomic volatility.[8] This
contrasts with the advice of others who advocate stronger immediate policy action in the face of
elevated spot inflation.
To take a parochial UK view for a moment, my own read is that - in line with recent MPC
communication and my own comments in previous talks and interviews - the elevated level of UK
inflation stems largely from the impact of external shocks, rather than excess money growth in the
past. Higher international energy and goods prices have raised UK inflation via the usual direct
and indirect effects. The overshoot of the 2% inflation target is substantial largely because the
magnitude of these external shocks has been substantial. Aggregate GDP is only now reaching
pre-pandemic levels, lending credence to the view that it is weakness in supply rather than
strength in demand that is driving the current strength of inflation. Given the tightness of the UK
labour market and perceived strength of pricing power in large parts of the corporate sector, the
threat exists that higher headline inflation leads to second round effects in prices, wages and
costs that exacerbate the magnitude and, crucially, the persistence of the target overshoot.
The current challenge for UK monetary policy is to contain those second round effects and return
inflation to target as global energy and goods prices stabilise or revert in the coming years. As the
MPC stated last week, in doing so it will be 'particularly alert to indications of more persistent
inflationary pressures, and if necessary act forcefully in response'. Just to emphasise for anyone
listening in from London today: no news in my assessment of the outlook for monetary policy here.
Where analysis of monetary transmission matters is in calibrating any policy response. The MPC
needs to ensure that the monetary impulse transmitted through asset prices helps navigate the
narrow course between, on the one hand, preventing above target inflation from becoming
embedded in expectations and, on the other, introducing unnecessary volatility into activity and
employment, and adding to any undershoot of the inflation target at longer horizons. Crucial to this
is ensuring monetary developments do not accommodate price, wage and cost setting behaviour
inconsistent with achieving the 2% inflation target. And one aspect of that assessment is how the
evolution of the stock of assets held by the central bank as a result of QE plays out.
At the Bank of England, we stopped buying assets through the creation of central bank reserves
last December. The process of shrinking the QE asset portfolio - so-called quantitative tightening
(QT) - commenced in February, as we ceased reinvestment of maturing bonds from that portfolio.
And we are currently considering whether - and, if so, how - to begin sales of gilts held in that
portfolio. (The MPC has promised to report further on its prospective approach to sales at its
August meeting.)
Thinking through the implications of QT for the overall stance of monetary policy is therefore key to
our current policy analysis. I hope to shed some light on my considerations in that regard.
Future: What implications can we draw for the future?
Re-reading Lord King's article from today's perspective, I am struck by the concerns he identified
in his conclusion.
He expressed a fear that relegating money to a behind-the-scenes role in the formulation and
analysis of monetary policy entailed three dangers: (1) by obscuring the classical dichotomy,
people would be misled into thinking that there is a permanent trade-off between inflation, on the
one hand, and output and employment, on the other; (2) by discussing monetary policy in terms of
real rather than monetary variables, the impression would be given that monetary policy can be
used to fine tune short-run movements in output and employment, in denial of the 'long and
variable' lags in monetary policy transmission; and (3) by dropping money, those parts of the
monetary transmission mechanism that operate through the impact of monetary quantities on risk
and term premia - which would necessarily come to the fore as policy rates reached their
effective lower bound - would be neglected.
With all the caveats of the preceding discussion, circumstances have dictated that the lattermost
danger has been managed. Following the financial crisis, central banks have reduced policy rates
to their effective lower bound, and become dependent on monetary transmission via precisely the
risk and term premia channels that might otherwise have been neglected. Whether the academic
and central banking community has its analysis of those channels correct is open to question, but
the voluminous literature on the impact of QE on yields is testament to an absence of neglect,
even if we are still working towards definitive answers on many fronts.
But the first two dangers remain relevant.
In pursuing our inflation target at the Bank of England, our core modelling framework employs what
is essentially a real framework to model the transmission mechanism of monetary policy. This is
founded in the canonical new Keynesian model: prices are set as a mark-up over marginal cost,
with that mark-up varying cyclically. The main policy implication is straightforward: in order to
stabilise inflation at target, keep aggregate demand in line with aggregate supply.
This framework assumes longer-term inflation expectations are, and will remain,
well-anchored. That is certainly the ambition of the MPC. Monetary policy actions are always
aimed at ensuring so: following its June meeting, the MPC stated that monetary policy is acting to
ensure that longer-term inflation expectations are anchored at the 2% target. But we cannot rely on
our forecasts of inflation returning to target to reassure ourselves that inflation expectations are
well-anchored, since such anchoring is one of the assumptions underlying those forecasts. That
would be circular reasoning.
Ensuring the institutional and analytical framework for monetary policy is robust to potential shifts
in inflation expectations is key. The potential for money to play a role as 'nominal anchor' to the
economy, outside the standard forecasting framework - as it often has in the face of elevated
levels of inflation, such as during the experiments with monetary targetry from the late 1970s -
remains an open and challenging question.
Monetarism revisited
Before addressing these questions, it is worth recalling the central tenets of the monetarist
approach to monetary policy. Foremost among these are:
First, a focus on price stability as the objective of monetary policy, reflecting the 'classical
dichotomy' at the heart of most macroeconomic models. In the long run, money and monetary
policy are neutral: they have no influence over real variables, such as output and employment, but
pin down the evolution of the price level.
Second, a preference for using rules rather than discretion to direct monetary policy. Policy
decisions need to be credible and consistent if they are to be effective. Assigning responsibility
for monetary policy to an independent central bank, largely insulated from short-term political
pressures and given the freedom to employ judgment flexibly as necessary, supports this
systematic approach to policymaking.
Third, a medium-term orientation of monetary policy, recognising the famous long, variable and
less-than-fully predictable lags in the transmission of monetary policy to price developments.
Owing to these lags, monetary policy cannot control high frequency inflation developments on
(say) a month-to-month basis. Rather monetary policy actions need to be calibrated to impart the
appropriate impulse to inflation at the 18-24 month horizon when the lags in policy transmission
unwind.
Fourth, emphasis of the need for a nominal framework within which to analyse and communicate
monetary policy.
And fifth, adherence to the view that monetary quantities (i.e. specific safe and liquid liabilities on
the balance sheets of the central bank and/or commercial banks) play an important and distinct
role in the transmission mechanism of monetary policy actions to the price level. The key assertion
here is not that the central bank should use a quantity measure of money as its policy instrument
rather than a short-term interest rate - that is something resolved pragmatically through the Poole
considerations discussed above. Instead it is the contention that failure to incorporate monetary
quantities in models of monetary transmission excludes important channels through which
monetary policy works: policy analysis without money is subject to specification bias.
Viewed from today's perspective, the striking thing about this list - in particular, given the doctrinal
tensions between monetarist and Keynesian camps of monetary and macro economists in the
1970s - is how many of the monetarist tenets have become mainstream.
Any reputable modern monetary policy framework or strategy purports to embrace the first four of
these elements, albeit with some of the flexibility needed to turn an academic argument into a
policy programme.
For sure, how these elements are presented and communicated varies across jurisdictions,
reflecting different histories, experiences and contexts. The ECB's monetary policy strategy has
been described as 'rule-based, but not rule-bound' approach, while the Bank of England's flexible
inflation regime has been characterised as an expression of 'constrained discretion'.[9] There is a
tendency in the academic literature to emphasise differences in policy framework, but these two
expressions reflect a common pursuit of systematic yet pragmatic monetary policies in pursuit of
price stability. Indeed, the most striking tendency in the design of monetary policy frameworks
across advanced economies over the past thirty years has been convergence towards such a
common approach, which embraced many monetarist tenets.[10]
The notable exception to this pattern is the fifth and final element of the monetarist agenda listed
above: the central role for monetary quantities in the analysis and presentation of monetary policy
transmission. This part of the monetary framework is widely seen as
dis-credited, largely on the back of the poor experience with intermediate monetary targetry in
many countries from the mid-1980s onwards. Monetary quantities have not played a significant
role in monetary policy decisions.
Does experience with QE policies imply this outcome should be reviewed?
Encompassing QE
Colleagues recently published a survey of research into QE conducted at the Bank and
elsewhere, building on previous similar exercises.[11] They identified a number of channels
through which QE influences asset prices and yields, including: (a) increasing demand for longer
maturity or riskier assets (the 'portfolio balance' channel); (b) lowering market liquidity premia (the
'liquidity' channel); and (c) influencing expectations of future policy rates (the 'signalling' channel).
For a moment, I will focus on the portfolio balance channel. QE entails buying government bonds
from the market using central bank reserves created for the purpose. Let's imagine for the time
being that these bond purchases are made from asset managers such as insurance companies
or pension companies (NBFIs), who indeed hold large quantities of such instruments.
The implementation of QE shrinks NBFIs holdings of longer-term bonds and substitutes them with
liquid, short-dated and capital certain assets (bank deposits) on NBFI balance sheets. For NBFIs
to be willing to hold a larger proportion of money in their overall portfolio, other things equal the
return to holding bonds rather than money must decline, implying a rise in government bond prices
and thus a decline in sovereign bond yields. To the extent that NBFIs try to diversify out of money
into other longer-term assets, they will also increase the price of those assets (and thereby raising
equity prices and lowering corporate bond yields). In short, portfolio rebalancing in the aftermath of
a QE operation weighs on yields and eases financial conditions.
What is striking about this account of the transmission of QE is its fundamentally 'monetarist'
nature.
After all, the seminal Friedman description of monetarist transmission starts from the premise that
money is an imperfect substitute for a wide range of financial and real assets, including bonds,
equity, physical capital and durable goods.[12] A policy-induced injection of money into the
economy in that setting triggers a train of complex and inter-related portfolio rebalancing across
sectors. These affect spending and pricing decisions both directly (via the impact of asset price
changes on wealth and substitution between holdings of financial and real assets (such as durable
goods)) and indirectly (via changes in asset prices, yields and spreads - a broad measure of
'financial conditions' - that are relevant to expenditure decisions).
Substitution from money holdings directly into consumer spending has formed one part of our
assessment of whether savings accumulated in the household sector during the pandemic
lockdowns will spur or sustain aggregate demand. The monetary overhang held by the household
sector is potentially an important influence over spending and saving decisions in the face of the
current real income squeeze, even though the consumption boom anticipated by some last year
on account of it has failed to materialise thus far.
But, reflecting the changes in financial structure I mentioned earlier, our starting point is that the
strongest channel of QE transmission operates through portfolio rebalancing within the financial
sector. Indeed, one of the conclusions of the recently published Bank survey is that QE is mainly
transmitted via changes in asset prices and yields that follow from these effects.
Brunner and Meltzer's classic monetarist account emphasises the importance of a rich set of
credit, term and liquidity premia in monetary policy transmission. These premia drive the spreads
between the policy rate established by central bank and the interest rates at which firms and
households borrow, which are most relevant for spending and pricing decisions in the real
economy. Brunner and Meltzer conclude that these spreads are largely unobservable - in
particular, in a bank-centred financial system they will be codified in loan covenants and pricing
that are proprietary and/or confidential. Monetary quantities play an important role in
characterising the transmission mechanism because they both influence and summarise this body
of information in spreads and premia in a way that is both accessible and relevant.
Changes in financial structure over recent decades have implications for the Brunner / Meltzer
motivation of monetarist transmission. Not only are credit conditions surveys and bank level data
on funding costs and the pricing of loans more readily available, but the greater importance of
asset markets and NBFIs in the provision of external finance to firms implies that spreads and
premia are more often transparently priced in open markets. The focus has correctly shifted
towards NBFIs. This has led to the construction of weighted averages of asset prices - so-called
Financial Condition Indices (FCIs) - as an alternative to monetary aggregates for capturing the
impact of financial pricing on monetary policy transmission.[13] But the weights assigned to
different asset prices are controversial and experience with such indices has been mixed.
Research at the Bank exploits micro-level information to give more insight into NBFIs portfolio
decisions, in the hope of better understanding how spreads and premia will evolve. The
confluence of, on the one hand, better data resulting from post-financial crisis increased regulatory
scrutiny of NBFIs and a shift towards more centralised and transparent trading at CCPs and, on
the other hand, greater computing power and advances in data analytics has permitted a much
more disaggregated assessment to be made.
Studies have identified more precisely the 'preferred habitats' of various NBFIs across the
spectrum of available assets, as well as the cascades of asset sales underlying the
so-called 'dash-for-cash' at the outset of the pandemic.[14] Better understanding the financial
frictions that explain these features of portfolio choices and market behaviour is central to
developing a more structural view of monetarist channels in the transmission mechanism of
monetary policy.
After all - and as Lord King identified two decades ago - if monetary quantities affect the
magnitude and incidence of transaction costs in financial markets, they will influence spending
and pricing decisions - and thus inflation - via channels that are not captured simply by changes
in policy rates. Understanding those frictions and how money can alleviate them constitutes the
route to developing a structural understanding of QE transmission.
At the macroeconomic level, we are still some way short of having that structural view. As reflected
in assessment presented in the recent Bank survey paper I mentioned, the empirical evidence on
QE largely stems from 'event studies' analysing the impact of QE announcements.[15]
This approach is a practical response to the challenges QE poses for researchers. There have
been only five episodes of QE in the UK since 2009. The evidence base for QE is therefore
narrow, certainly narrower than that available for assessing conventional interest rate policy (a
'small sample' problem). Moreover, QE has been implemented in the face of economic and
market disturbances. It is difficult to distinguish the impact of the QE implemented in response to
those disturbances from the impact of the disturbances themselves (an 'identification' problem).
Researchers at the Bank and elsewhere have made valiant efforts to address these challenges,
reflected in the studies summarised in this article. But drawing robust and universal conclusions is
difficult.
Nonetheless, those event studies suggest that QE does lower yields, and thus supports an easing
of financial conditions that supports the pursuit of the inflation target once policy rates have
reached their effective lower bound.
But these conclusions are the empirical analogue to former Federal Reserve Chairman Ben
Bernanke's famous statement that 'the problem with QE is that it works in practice, but doesn't
work in theory'. That didn't seem a very satisfactory place on which to base monetary policy
decisions at the time. And - eight years on from when the remark was made - it seems even less
satisfactory now.
We need a more structural view of QE transmission. In the annex to this paper, we sketch out a
very simple monetary framework as a starting point.[16]
That monetary framework may help answer important questions about the dynamics of these
polices. As we will see in the next section, such a model helps address questions such as: what is
the relative importance of the stock of purchases announced versus the flow of purchases
conducted? Does the impact of QE fade over time? What influences the relative potency of QE
over time? By their nature, event studies cannot answer such questions.
I apply this highly stylised model to the current situation in the next section, in order to develop and
illustrate some high-level views about the potential conduct and impact of QT.
Thinking about QT
Just to be clear from the outset, the discussion here is not intended to front-run the MPC's
discussion of asset sales and quantitative tightening. As I have already said, in February the MPC
decided to start shrinking its holdings of gilt accumulated via QE by ceasing to reinvest the
proceeds of maturing bonds. Bank staff have been commissioned to think about the potential
modalities of gilt sales in the future. But no decisions have yet been made about whether or, if so,
how to conduct gilt sales.
Nor is the discussion here intended to develop a quantitative view of QT transmission. We are
working with a 'toy model' to make a few illustrative high level points around which to frame the QT
discussion.
I leave the details of the model to the Annex and discuss the intuition here. The starting point is a
money demand equation for an NBFI. This relates the NBFI's money holdings to the overall size of
its portfolio and the relative return on money and risky assets.
The implementation of QT implies that the NBFI will hold less money and more risky assets (the
mirror image of the thought experiment that I discussed to describe the portfolio balance channel
of QE transmission in the previous section). In order to persuade the NBFI to accept this shift, the
return on the risky asset must rise relative to that on money.
If a QT sale is announced and implemented simultaneously, the price of bonds must fall
immediately in order to generate expectations of a holding period return in the future that will justify
holding onto a greater share of risky assets in the portfolio following QT.
The subtlety in the model is to observe that the holding period return on this risky asset will reflect
(at least in part) an expected capital gain as the price of the asset changes. This matters
particularly for the asset price impact of pre-announced sales.
If a QT sale is pre-announced ahead of implementation, the initial fall in bond prices will result in a
pre-implementation increase in the share of money in the overall portfolio: money is capital
certain, whereas the value of bonds will be lower on announcement because of the expectation
that bond prices will fall on implementation.
To justify that relative increase in money holding ahead of the implementation of QT, the expected
return on bonds must be lower in the post-announcement / pre-implementation period, requiring
an expected capital loss in the period up to implementation. So the
post-announcement fall in the bond price must be smaller than the implementation fall in the bond
price, to create the expectation that bond prices will fall - there is some 'undershooting' in
announcement effect relative to the implementation effect.
Applying this logic over a longer time scale implies that an earlier announcement will lead to a
smaller initial impact on asset prices followed by a larger number of periods where the asset price
falls ahead of implementation.
Furthermore, the greater the substitutability between money and bonds in the NBFI's portfolio, the
less the expected capital loss on bonds required to sustain the higher relative holdings of money
in the post-announcement / pre-implementation phase. By implication, a greater part of required
overall downward adjustment in bond prices can happen up-front on announcement. Greater
substitutability between money and bonds - something which might be seen as symptomatic of
'well-functioning markets' where financial frictions are modest - will reduce the overall impact of
QT since less capital gain is required to sustain the higher holdings of bonds after
implementation, but implies that a larger propo