Wednesday, February 16, 2011

Chancellor and Governor

Later in term we will spend some time thinking about monetary and fiscal policy; these are the two ways in which governments attempt to influence economic activity, wisely or otherwise.  Both are currently in the news regularly; fiscal policy because the Coalition is running a very tight fiscal policy in order to bring down the government deficit, and monetary policy because interest rates remain essentially at zero yet inflation is high.

The current monetary policy arrangements have the Bank of England commissioned by the government to set interest rates to achieve an inflation target of 1-3%.  However, for 20 of the last 30 months, that target range has been missed by the Bank.  Every time the target is missed, the Governor of the Bank of England, Mervyn King, must write a letter to the Chancellor explaining why the Bank has failed in its duty.  The Chancellor usually responds, and these letters, in the interests of openness, are published on the internet.  Here is George Osborne's recent response to King.

The interesting aspect of this letter is that Osborne suggests that by staying the course of the government's very tight fiscal policy, this will help monetary policy to be more effectively conducted because without it, inflation would surely happen.  Of course, there are plenty of counter arguments to this assertion, not least that given inflation is generally imported inflation currently (cost push), then it will not necessarily fall due to domestic actions by governments (unless they can increase the exchange rate).  Furthermore, such a contractionary fiscal policy could yet see the UK returning to a recession (we saw negative growth in the last quarter), in which case again if inflation is imported, there seems little reason why this would make the Bank's job any easier: Inflation will still be high, and the economy in a recession.

Furthermore, whatever the government does with fiscal policy, the Bank can always counteract with monetary policy: Assuming their efficacy, if fiscal policy was loose, then tight monetary policy would suffice to keep economic activity reasonably constant, and equivalently a tight fiscal policy could be counter-balanced with a loose monetary policy (so QE2 and more).

Thursday, February 10, 2011

The Bank of England's Big Decision

In about half an hour, the Bank of England will announce its decision on interest rates. Each month, on the first or second Thursday, the Monetary Policy Committee (MPC) of the Bank of England meets to decide on monetary policy. The main tool of monetary policy used by economies around the world currently is the interest rate, and the MPC will decide whether it is going to keep the interest rate on hold for another month at its lowest practical value of 0.5%, or whether it will increase interest rates. It faces a tough decision.

Later in term we'll talk quite a bit about monetary and fiscal policy and we'll start to understand just why this decision is so tough. In any state of the world it is hard to forecast and know what is going to happen in the future and hence know the right thing to do with monetary policy.

Currently the Bank has a problem in that economic growth is negative yet inflation is above its target (of 2%). In an ideal world, the Bank would have one of these two problems to deal with, because they demand conflicting responses. Negative growth demands loose monetary policy, hence low interest rates, in order to stimulate economic activity. But high inflation demands tight monetary policy, hence higher interest rates, in order to keep economic activity in check and thus keep inflation down.

There's another part of this difficult question though which the Bank must factor in: Much of our inflation is imported from abroad, as the pound has lost so much value in recent years. As we've learnt recently, if interest rates did rise here in the UK, it is possible that the exchange rate would appreciate, hence reducing that imported inflation effect.

Either way, we lie in wait for the decision, expected in about 24 minutes...