Feb 24
Analysing the Bank of England Monetary Report: November 2021
By Mazen Badawy, Andy Koh, Sanah Suresh and Shahan Khan
Information Set
Before making Monetary Policy (MP) decisions, the MPC members look more broadly at the following aspects:
- International economy
- Monetary and financial conditions
- Demand and output of government services (like healthcare), manufacturing and construction activity, output in business, transport and work-related services and sub-sections, such as food, accommodation, arts and recreation.
- Supply, costs and prices [1].
More specifically, the indicators MPC members look at include: GDP projections, the Labour Force Survey (LFS) and CPI inflation [2].
International Economy
The state of the international economy is considered by the MPC when making monetary policy decisions, because the UK’s interconnectedness with other countries is high, particularly when compared with other major economies [3]. The MPC considers it important to understand the impact of foreign developments, such as FX rates, net exports and foreign inflation, as they are key determinants of inflation [4]. For example, through trade channels, UK exports could be impacted if a trading partner’s economy is experiencing a downturn, which would reduce demand for UK exports and, ceteris paribus, result in deflationary pressure [5]. Alternatively, if there is a depreciation in the pound, imports become more expensive and exports become cheaper, which results in imported inflation [6].
Monetary and Financial Conditions
It is important for MPC members to know the leverage ratios of commercial banks. The leverage ratio is ‘the ratio of a measure of a bank’s capital resources to a gross measure of its exposures or assets’ [7]. Knowledge of the leverage ratio is important because if there is excessive leverage, known as ‘debt overhang’, it prevents firms from borrowing money from banks to finance investment. This in turn results in underinvestment and a misallocation of resources, something which has chain effects on economic activity and employment rates. This is one reason why it is important for MPC members to look at leverage ratios [8].
It is also important for the MPC members to control the money supply because, for instance, an increase in money supply lowers the interest rate, which encourages investment and spending, thereby having a large impact on economic activity. Additionally, during the expansion and boom phases of the business cycle, stock market prices are likely to rise and firms issue equity and debt. Therefore, if money supply continues to expand and prices rise, the public begins expect inflation and the MPC will have to implement monetary policy to respond accordingly [9].
Demand and Output
The MPC’s role is to keep inflation at its target, but also to support the government’s broader economic policies, including economic growth, which is reflected through the GDP. By examining the current level of output, estimations can be made about the output gap, thus the policies that are needed to raise the level of aggregate demand in the economy.
The Bank of England defines GDP as ‘a measure of the size and health of a country’s economy over a period of time (usually one quarter or one year)’. There are three ways that GDP can be calculated:
- The total value of goods and services produced;
- Everyone’s income;
- Or spending by everyone in the country [10].
Currently, UK GDP increased in Q3 this year, but at a slower pace than projected in the August Report [11].
Supply, Costs and Prices
In order to make policy decisions effectively, the MPC needs to consider what inflation and growth are likely to look like in the economy in the coming years [12]. Therefore, the supply capacity of goods is explored through the quantity of labour and capital available in the economy, the productivity of workers and the efficiency with which businesses combine them [13].
If the impact of supply chain disruptions on CPI inflation is only short-lived, then implementing monetary policy would only increase the volatility and by the time the policy takes effect, the impact of the disruption is likely to have faded (time lag) [14]. However, if the supply disruption is more persistent, then the central bank can tighten or ease the bank rate. For example, if there are supply bottlenecks, then to keep supply growing, it is important to encourage capital spending by easing and tightening the bank rate at the right time and speed, to encourage investment but not choke demand [15].
The LFS is used to measure the level of unemployment in the economy and the survey is carried out quarterly with 44,000 households being surveyed [16]. Recently, the LFS unemployment rate fell to 4.5% in the three months to August, but initial indicators suggest that the unemployment will rise in Q4, 2021 [17].
CPI inflation is a measure of inflation/ price level in the economy. It is defined by the OECD as ‘the change in the prices of a basket of goods and services that are typically purchased by specific groups of households [18]. The inflation target is set at 2% in the medium term. However, CPI inflation in September was 3.1% and is expected to peak at 5% around April 2022 [19].
Decision-Making Process
Growth and employment mandates:
The MPC makes monetary policy decisions with the intention of fulfilling its mandates of meeting the 2% inflation target and maintaining economic growth and employment.
The BoE’s analysis says that the reason that their predictions of UK and global GDP growth were lower than expected were due to to supply chain disruptions. There were also supply shortages in some sectors due to increased global demand. The BoE predicts that the supply bottlenecks will limit growth in the short-term, but there will be a strong UK and worldwide recovery early in Q1 2022 — “UK GDP is projected to get back to its 2019 Q4 level in 2022 Q1.” In Q3 the unemployment rate fell to 4.5%, but it is still higher than pre covid rates. The BofE expects that it will “increase slightly” in Q4 2021 which is still an acceptable level in their eyes. It is projected to remain between 4 and 4.5% until 2024.
Inflation mandate:
In Q3 2021 the inflation rate fell by 0.1% to 3.1%. It is expected to rise to 4.5% this month and remains at similar levels through to the end of Q1 2022, then peak at 5% in April 2022. The MPC expects it to fall back to near-2% within 24 months. These projections for the inflation rate in the next 18 months are evidently far off of the BoE’s mandated 2% rate. The BoE argues that the unprecedented supply and demand shocks due to covid necessitates deviating from the target — they “will as always focus on the medium-term prospects for inflation, including medium-term inflation expectations, rather than factors that are likely to be transient.” This led them to make the decision to maintain loose monetary policy, which will be discussed further by Andy in Final Decisions.
Analysis in Practice: a few samples of evidence of their decision making processes
- They said that energy prices will play a significant role in expected pickup then decline in inflation. — “Developments in energy prices are expected to account for a significant proportion of the projected pickup in inflation in the near term, and its subsequent decline.”
- They have confidence in current predictions on price levels due — “Inflation expectations are judged to remain well-anchored and the MPC will continue to monitor a range of indicators closely.”
- Uncertain on the effect the end of furlough will have on unemployment- “The UK furlough scheme closed at the end of September, and there is uncertainty about the impact of that on unemployment.”
- Expect that the labour force participation rate will decrease, partly due to Covid — “Participation is expected to trend downwards due to demographic changes, and Covid may accelerate this.”
Final Decisions
According to the November 2021 Monetary Policy Report, the Monetary Policy Committee (MPC) decided on three policy actions. Firstly, the MPC voted 7–2 in favour of maintaining the Bank Rate at 0.1%. Secondly, the MPC voted unanimously in favour of the Bank of England (BoE) maintaining the stock of sterling non-financial-grade corporate bond purchases, financed by the issuance of central bank reserves, at £20 billion. Thirdly, the MPC voted 6–3 in favour of the BoE continuing with its existing programme of UK government bond purchases, financed by the issuance of central bank reserves, maintaining the target for the stock of these purchases at £875 billion.
The MPC judged that the existing stance of loose monetary policy remained appropriate. According to the meeting minutes, the seven members of the MPC that voted in favour of maintaining the Bank Rate at 0.1% wanted to observe the effect of the end of the furlough scheme on unemployment before deciding whether a rate rise was needed. Hence, labour market uncertainty appears to be the rationale behind the MPC’s decision to keep monetary policy unchanged.
While the latest Monetary Policy Report did not explicitly state the purpose of loose monetary policy, it would be reasonable to assume that the purpose remained unchanged, given that the policy itself remained unchanged. Hence, we could infer the purpose of loose monetary policy by referring to earlier reports. For context, the Bank Rate was lowered from 0.75% to 0.1% on 19 March 2020 in response to the economic shocks wrought by the Covid-19 pandemic and has since been maintained at 0.1%. The BoE also implemented quantitative easing via the purchase of UK corporate and government bonds. According to the May 2020 Monetary Policy Report, monetary policy was aimed at “supporting businesses and households through the crisis, and limiting any lasting damage to the economy”. Monetary policy loosening would bolster households’ and businesses’ cash flows, help maintain the flow of credit and support asset prices. This would mitigate the tightening of financial conditions that could amplify the initial contraction in activity and help ensure that financial conditions were appropriate to support economic recovery. In addition, loose monetary policy aimed to limit longer-term damage to the economy inflicted by “hysteresis” effects, which could arise from business failures and an increase in unemployment.
In conclusion, it is likely that the MPC decided to keep monetary policy loose to support economic recovery from the Covid-19 pandemic and viewed that it was premature to tighten monetary policy due to labour market uncertainty.
This article was written by: Mazen Badawy (Head of Bank of England Monetary Policy Research), Andy Koh (Research Associate, Bank of England Monetary Policy Research), Sanah Suresh (Research Associate, Bank of England Monetary Policy Research), and Shahan Khan (Research Associate, Bank of England Monetary Policy Research). This article was reviewed by Roberto Patiño (Head of Monetary Policy Research).
References
Bank of England. (2020). Monetary Policy Report: May 2020. Retrieved from https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2020/may/monetary-policy-report-may-2020.
Bank of England. (2021). Monetary Policy Report: November 2021. Retrieved from https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2021/november/monetary-policy-report-november-2021.pdf.
Elliott, L. (2021). Bank of England keeps UK interest rates on hold at 0.1%. The Guardian. Retrieved from https://www.theguardian.com/business/2021/nov/04/bank-of-england-uk-interest-rates-on-hold-at-01
[1] https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2021/november-2021
[4] https://www.investopedia.com/articles/forex/080613/effects-currency-fluctuations-economy.asp
[6]https://www.economicshelp.org/blog/1605/economics/higher-inflation-and-exchange-rates/https://www.investopedia.com/articles/forex/080613/effects-currency-fluctuations-economy.asp
[7] https://www.bankofengland.co.uk/-/media/boe/files/statement/2015/the-financial-policy-committees-powers-over-leverage-ratio-tools.pdf -pg.18
[8] https://www.levyinstitute.org/pubs/wp_849.pdf — pg.12
[9] https://www.econlib.org/library/Enc/MoneySupply.html
[10] https://www.bankofengland.co.uk/knowledgebank/what-is-gdp
[12] https://www.bankofengland.co.uk/monetary-policy
[13] https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2021/november/monetary-policy-report-november-2021.pdf?la=en&hash=72336FA2809F28D79CA9C1274ED3851261C61CA9 -pg.41
[15] https://www.ft.com/content/84c2555b-68f0-4654-bb73-d1b995d45bc2
[16] https://www.tutor2u.net/economics/topics/labour-force-survey-1
