Introducing the Bank of England
By Sheryl Dong, Birce Akay, Daniel Carey and Dillon Oppon-Ferguson
A central bank is a financial institution that manages the currency and monetary policies of a state or a formal monetary union, and oversees their commercial banking system. Hence, the main responsibilities of the Bank of England (BoE) include setting interest rates, issuing banknotes, processing electronic payments, providing gold reserves, managing foreign reserves, controlling money supply, overseeing possible risks in the financial system and acting as the lender of last resort. Monetary policies have been set independently from the UK government since May 1997.
The BoE is chaired by its current Governor Andrew Bailey who is directly responsible for the Monetary Policy Committee (MPC), the Financial Policy Committee (FPC) and the Prudential Regulation Committee (PRC). There are five main departments inside BoE: Markets & Banking, Monetary Policy, Financial Stability, Prudential Regulation and Operations. Internal audit and the setting of budget are taken by the Court of Directors, which consists of five executive members from the bank and up to nine non-executive members.
Regarding monetary policy, the 1998 BOE act laid out the central bank’s primary mandate:to maintain stable prices and subject to that, to support other government policies. The act further specified that the exact definition of these above objectives is to be stated in a yearly remit letter from the chancellor to the governor of the Bank.
As of the 2020 remit, the top priority of the MPC is defined as a 2% increase over 12 months in the consumer price index (CPI). This target is to be considered ‘symmetric,’ such that deviations either side are undesirable and ‘forward-looking,’ so the Bank should attempt to anchor inflation expectations over the medium term. This second condition allows the MPC to deviate from this target during shocks and thus avoid excessive output volatility. Yet on such occasions, the explicit reasoning and horizon over which inflation will return to target are to be sent in an open letter to the chancellor. While the government also aims for sustainable and balanced growth, it believes that price stability is a necessary precondition, and should therefore be the prime focus of the monetary policy framework.
Monetary Policy Committee:
The Monetary Policy Committee (MPC) is a group of 9 individuals who decide what direction monetary policy will take, such as interest rate cuts or continuing Quantitative Easing (QE), inside BoE. The current members are the Governor of the Bank of England, Andrew Bailey, the three Deputy Governors for Monetary Policy, Financial Stability and Markets and Banking, Ben Broadbent, Sir Jon Cunliffe and Sir Dave Ramsden, the bank’s Chief Economist, Andy Haldane, and four external members selected by the Chancellor who are Michael Saunders, Silvana Tenreyro, Jonathan Haskel and Dr Gertjan Vlieghe. The reason for expertise from outside the bank is to make sure that policy decisions are varied and have the influence of people both inside and outside the bank.
The MPC monitors developments in the economy and decides what monetary policy action to take in order to meet the Government’s inflation target of 2%. The Committee announces policy eight times a year and a series of meetings are held usually in the week that leads up to the public announcement. Before the formal decision-making process starts, members are briefed on the most recent data and analysis on the economy by Bank of England staff (this is called ‘pre-MPC meeting’). After that, the Committee has three meetings. At the first meeting, which is normally held on the Thursday a week before the announcement, committee members look at what has happened since their previous announcement and discuss the data. Inflation and growth projections are considered since it can take around two years for monetary policy to have its full effect on the economy. At the second meeting, which is normally held on the Monday before the announcement,each individual is invited to give their assessment of recent economic developments and suggest a monetary policy action. At the final meeting, which is on Wednesday, the Governor of the Bank of England, Andrew Bailey, recommends the policy he thinks will be supported by the majority, then all the members vote on it (the Governor’s vote acts as the casting vote in case of a tie) and monetary policy is determined. The next day (Thursday, 12 noon), the MPC’s decision and the minutes of the meetings are published. Furthermore, the Inflation Report, which includes the economic analysis and inflation projections used by the Committee to make its decisions, is published every three months.
A. Interest Rates:
- Interest rates are the primary procyclical tool the Bank of England uses to influence aggregate demand within an economy by changing the cost of borrowing, or the reward for saving. Interest rates are mainly seen on a micro-level whereby commercial banks and other financial intermediaries offer interest rates on top of their initial deposits as an incentive for people to hold their money in certain banks or savings accounts. The alternative appearance of interest rates is in the form of repayment of debt i.e. with mortgages whereby people are charged an additional rate of interest as well as the initial value of mortgage, to make lending more profitable.Interest rates are the primary procyclical tool the Bank of England uses to influence aggregate demand within an economy by changing the cost of borrowing, or the reward for saving. Interest rates are mainly seen on a micro-level whereby commercial banks and other financial intermediaries offer interest rates on top of their initial deposits as an incentive for people to hold their money in certain banks or savings accounts. The alternative appearance of interest rates is in the form of repayment of debt i.e. with mortgages whereby people are charged an additional rate of interest as well as the initial value of mortgage, to make lending more profitable.
How it works in the UK:
- The BoE uses interest rates to primarily control inflation. This is done by the central bank setting the bank rate when they announce the interest rate, as shown in figure 1. The bank rate, also known as the discount rate, is the rate at which central banks lend their funds to commercial banks. Since all banks are required to have a minimal amount of reserves, once this requirement is met commercial banks can start lending to other banks and individuals, gaining funds from either the central bank at the bank rate or other banks at the interbank rate (the rate charged by other banks for lending funds, determined in the market). Once the bank rate has been set, the base rate then gets adjusted accordingly. The base rate being what commercial banks charge individuals for borrowing their funds or pay out individuals for keeping their deposits in the banks’ accounts. Due to parallel movements between the bank rate and the base rate, aggregate demand can be influenced by either the lowering or increasing of the interest
- In the scenario whereby the interest rate increases, the central bank increases their bank rate to commercial banks. This would incentivise commercial banks to hold more of their reserves in the BoE due to higher interest, so the rate at which banks lend to other banks would reduce affecting individuals who wish to spend as their commercial bank would instead encourage them to hold their money in the bank’s deposits by increasing the base rate. Ultimately decreasing consumption levels in the economy as banks lend less and individuals spend less, leading to a fall in the price level. Conversely, a lowering in the announced interest rate causes the bank rate to fall. This would lead banks to hold less deposits within the central bank and increase the rate at which they lend to other banks. Since funds become more easily accessible, commercial banks decide to lower the base rate to individuals resulting in increased levels of consumption and a rising price level.
Assessment of effectiveness:
- To some extent, the tool of interest rates has been effective if we look at the period of the 20th century. Inflation was kept low during periods whereby interest rates were moderately high and allowed to rise when interest rates were relatively low (with the exception of the world war era’s). Looking at the stagflation era of the 70’s with high inflation and unemployment, interest rates immediately increased in the 80’s seeing inflation fall from rates of 20%, in 1976, to rates of less than 5% in 1984, showing their effectiveness in this case. However, in the 21st century the effectiveness of interest rates has been questioned as periods of a lowered interest, has not seen the expected rise in inflation especially after the financial crisis. This was the result of damaged consumer confidence and the hoarding of money by banks, despite all-time low interest rates of 0.5% announced in March 2009. Even more so, interest rates have recently fallen to 0.1% due to the COVID pandemic but despite efforts from the BoE, inflation has fallen close to 0%, with rates of 0.5%. Ultimately showing that the effectiveness of interest rates has more recently been limited because of pessimism within the UK economy.
B. Forward Guidance
- The bank conducts forward guidance through their openness on policy and outlining the likely course of monetary policy in the future. This is done by the MPC providing its views on trade-offs between maintaining inflation at the desired level and encouraging output growth, and how it is setting monetary policy in that direction. Then, investors would have a lower perceived expectation of where rates would go in the future. This reduced uncertainty for investors increases their demand for longer-term investments as reduced short-term rates, announced by the central bank, lead to a fall in expected rates and perceived long-term yields for investors. Since investment is a component of aggregate demand, increased investment would stimulate aggregate demand thus causing upward inflationary pressure on prices and increased real output growth. Before the introduction of forward guidance, investors were not entirely certain about how the MPC wished to set out policy for the future so their perceptions on rates both in the short and long term, would be higher than seen today.
How it works in the UK:
- This tool was recently introduced to the BoE in 2013 by Mark Carney with intentions of influencing expected rates in the short, medium and long term. Examples of forward guidance are seen in the BoE’s ‘Inflation Report’, like the decision to keep the interest rate at 0.1% until conditions in the UK economy started to improve again because inflation had fallen below the target of 2%, to 0.5%, reported in the November Inflation Report. The BoE said it looks to signals of sustained increases in consumer price index inflation and better conditions in financial markets, as an indicator for potential increases in the interest rate. Other examples are presented in the minutes of the MPC’s monthly meetings and speeches by individual committee members. Forward guidance was initially used to help recover the UK economy back to pre-financial crisis levels in regards to potential output, incomes and employment however, the policy now serves the purpose of providing greater stability to yield markets and influencing the term structure of interest rates.
Assessment of effectiveness:
- The effectiveness of forward guidance is measured on two factors; how stable expected rates have been before and after the introduction of FG, and whether it has successfully influenced the way interest rates are conducted by the BoE. In regards to observing the volatility of expected rates in yield curves, before the introduction of forward guidance we saw expected rates to be relatively more volatile than after the introduction of forward guidance. Which goes to show that FG does work to reduce investors perceived expectations of rates but, this depends upon the level of confidence investors hold. In respects to influencing the term-structure of interest rates, forward guidance has helped banks and individuals have a better idea of the future path of monetary policy so adjust their investment and spending decisions but, there have been slight changes in monetary policy with further rate cuts, in 2020 and a larger asset-purchasing programming. These actions, though, haven’t differed much from the intention of keeping interest rates low enough to stimulate the UK economy back to pre-financial crisis levels. Therefore showing forward guidance to bring some stability to expectations in the market and having influence on how interest rates are conducted in the short, medium and long term.
C. Quantitative Easing (QE):
- The goal of QE is to lower long-term interest rates and boost Aggregate Demand (AD) when conventional policy (lowering short-term rates) is constrained by the zero lower bound. Haldane et al (2016) name six theoretical transmission mechanisms in which QE may affect AD. These are given below, followed by explanations:
- The portfolio balance channel
- The bank lending channel
- The liquidity premia channel
- The signalling effect
- The exchange rate channel
- The confidence channel
- (1) operates by raising the price, and cutting the yield, of safe assets. Agents with “preferred-habits” for such assets are incentivised to reallocate capital towards riskier investments, causing rates on private bonds to fall. (2) is caused by the expansion of bank liquidity leading to lending in the real economy. (3) works counterproductively, although there is no indication the effect is non-negligible. By increasing the ease with which an investor’s assets can be traded, QE may decrease the liquidity premium of govt securities (that part of their price determined by their uniquely liquid properties), causing prices to fall and yields to rise.
- (4) through (6) are less unique to unconventional policies. (4) is the result of information agents drawing about the long-term position of monetary policy from QE. If investors believe purchases signal a looser policy position for longer, they will relax their own rates in response. (5) is the result of a devalued exchange rate and (6) is like (4), although regarding improved investors’ confidence in the entire economy.
How it works in the UK:
- In the UK, Quantitative Easing (QE) or the Asset Purchase Program (APP) is the process by which the Asset Purchase Facility (APF), a subsidiary of the BoE, uses newly created bank reserves to buy long term financial assets from private institutions. Most of these assets are government gilts of over three years maturity, such that the primary (direct) participants are non-bank financial institutions (e.g. pension funds). These institutions are more likely to hold long-term government securities, and it is believed they will have stronger transmission to the real economy than banks. Commercial banks still play a ‘market maker’ role, acting as intermediaries between the APF and bondholders. Fisher (2010) reveals the purchase of non-government liabilities was to ensure the smooth functioning of key markets, not market-neutral interest rate changes. However, the MPC believed said markets were important in stabilising and stimulating investment across the economy.
- Since March 2009, the bank rate has sat below 1%. While this has undoubtedly supported demand during a period of stagnant growth, it has left little room for further cuts. As such, the MPC has often turned to QE at times of difficulty. QE1 (2009) supported recovery from the financial crisis. QE2 (2011) and QE3 (2012) were an attempt to stimulate the lagging economy. QE4 (2016) was a response to panicked markets after the Brexit referendum and recent QE has been to mitigate the economic damage of COVID-19. Currently, the BoE target for bond holdings is about £895bn, a £450bn rise since March 19th 2020.
Assessment of effectiveness:
- A fair amount of research examining the effectiveness of the APP exists, but the difficulty in identifying its success is clear in the literature. Studies often focus on specific channels ((1), (2) and (4) are the most discussed and are explored below) using various econometric techniques and event study comparisons in an attempt to gauge their relative strengths.
- The portfolio balance channel is perhaps the most often discussed, although findings here differ. Joyce et al (2012), estimated 10-year corporate bond yields were around 1% lower due to QE1’s £200bn of purchases, and Fisher (2010) noted corporate spreads fell and bond and equity issuances were at record rates in 2009. However, Martin and Milas (2012) note subsequent studies found the effect to be lower than 1% by about half, a result of slightly shorter periods of observation. It is impossible to establish whether the longer periods of observation were capturing the effect of QE on bond prices to a fuller extent, or exogenous dynamics in bond markets. Significantly, Haldane et al’s (2016) paper observes a reverse of the observation-length disparity regarding the £70bn of purchases announced August 2016. This could be due to a couple of reasons. Either the original differential was due to exogenous effects on bond prices during the longer period, or given the greater size of QE1 purchases, it took more time for markets to price in the effect. Hopefully further empirical work around the numerous purchase announcements of 2020 will help clear up the issue.
- In contrast, the bank lending channel seems to have had no impact during QE1. In a recent BoE working paper, Giansante, Fatouh and Ongena (2020) suggest risk-based capital constraints may have caused relevant banks to invest new liquidity in foreign government bonds, instead of domestic assets. It is safe to say, as the MPC suspected, increased bank liquidity does not have significant ledning effects into the real economy.
- Meanwhile, Broadbent (2018) claims the signalling effect was far stronger for QE1 when the policy was considered radical by markets compared to subsequent rounds. Martin and Milas (2012) suggest there is slim evidence post-QE1 (up to 2012) asset purchases had much impact on bond prices, in large part due to a weaker signalling effect. Yet Haldane et al (2016), observed a notable flattening of the yield curve (by 10–20bps across all eligible maturities) after the unanticipated announcement of only £70bn of new purchases in 2016, a relatively small 18.7% increase in the BOE’s holdings. It is therefore plausible to assert the anticipation of QE (and by extension the signalling effect) has a noteworthy impact on the movement of yields. However, this final point deserves clarification, as it is not at all grounds to dismiss QE2 and QE3. The fact the signalling effect may have been weaker suggests markets may have already priced the asset purchases into bonds. Had no QE taken place, this theory implies a rise in bond yields would have occurred.
- Overall, the portfolio balance channel (exaggerated or diminished by agents expectations) appears to be the main conduit through which Q.E. affects interest rates and the real economy. While cutting firm’s credit costs by 50–100bps would be unlikely to cause an economic recovery in of itself, it is a reasonable part of a larger stimulus package.
D. Central Bank Swap Lines:
- A swap line is a currency-repo agreement between two Central banks (CBs). The ‘source’ CB lends its currency to a ‘recipient’ CB, with the recipient’s currency as collateral. The source bears almost no credit risk and earns interest on the fixed date the principal is repaid (swapping back with the collateral). In the interlude, the recipient can use the foreign funds to keep domestic firms dealing with foreign denominated contracts liquid, through lender of last resort operations. These loans support both domestic institutions of the recipient country and financial markets in the source country. Given the increase in off-shore dollar funding, swap-lines represent a natural adaptation of CBs lender of last resort functions.
How it works in the UK:
- The generation of modern swap lines came about after 2007, as a result of dollar funding issues with European institutions, but encompassed 170 bilateral agreements by 2020 (Bahaj and Reis, 2020). The BOE has a network of swap lines with the Fed, ECB, SNB, BOC and BOJ. Most utilization of the Fed swap line occurred during 2009 (Bahaj and Reis, 2020). However, COVID-19 forced the bank to start dollar swaps again on March 17th 2020, with quantities quickly rising to levels not seen since 2010 (Avdjiev, Eren and McGuire, 2020). This was encouraged by an enthusiastic Fed, who eased the terms for all participants. The swap rate fell to the US OIS rate plus 25bps (instead of plus 50), while the length of deals and the frequency with which they could be agreed both increased (Bahaj and Reis, 2020).
Assessment of Effectiveness:
- After a short review of the literature, Eguren-Martin (2020) finds a consensus that Fed swap lines do ease the terms by which forieng firms can get dollar funding when U.S. money markets are nervous. Specifically, Bahaj and Reis (2020) argue that this effect (given the prevalence of dollar-funding) makes swap lines an important part of modern lender of last resort actions. Regarding recent theoretical work, Eguren-Martin (2020) builds a 2 country, infinite horizon new keynesian model with financial frictions to explore the role of swap lines. Notably, a floating exchange rate sees far smaller shocks to investment, consumption and output from a ‘dollar-shortage’ than when exchange rate management is given a greater role in the Taylor rule. Limiting his view to partially-managed exchange rates, Eguren-Martin shows maximum utilization of the swap line cushions forieng currency liquidity shocks by about 20%. Central banks would seem to agree with the theory, considering the growth in swap lines since 2007 and the quick re-engagement during the COVID-19 panic. Such consensus and common use suggest swap lines have already become a conventional tool of monetary authorities’ crisis response.
A. Taylor Rule:
How it works in the UK:
- John B. Taylor has suggested a simple rule, called the Taylor rule which proposes that the level of interest rates should depend on the rate of inflation relative to its target and the level of output relative to trend. However, in the United Kingdom, monetary policy decisions are based on a thorough assessment of the prospects for inflation (discretionary policy) rather than on one simple rule or single indicator. Nevertheless, the analysis of policy rules can provide useful guidance in the exercise of discretion.
- There are several versions of the Taylor rule. According to Taylor’s original version of the rule, the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:
In this equation, both coefficients should be positive (particularly, the coefficient for inflation, should be greater than 1). In fact, Taylor (1993) proposed that both coefficients = 0.5 fitted well when applied to historical data for the United States, so 0.5 is a reasonable weight to assume. The rule recommends an increase in interest rates (a “tight” monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure and it recommends a fall in interest rates (“easy” monetary policy) in the opposite situation. As long as is positive, the adjustment of the base rate should be more than the deviation of actual inflation rate from the target rate.
Assessment of effectiveness:
- Although the Taylor rule is a simple and mechanical rule that provides a useful benchmark for policymakers, it has certain limitations. For instance, as shown above, the original Taylor rule uses current levels of inflation and the output gap, but, in practice, outcomes for the current inflation rate and output gap are known only with a lag. Therefore, the inflation and output data can be included after a lag of one quarter in a different version of the Taylor rule. Another difference between the versions of the rule might be the measure of inflation used. Taylor (1993) used the GDP deflator, however under some circumstances, Retail Price Index excluding mortgage interest payments (RPIX) can be used. Moreover, determining the appropriate level for the equilibrium real interest rates is likely to be difficult in practice.
- Chart below compares the actual nominal interest rates and two Taylor rules which use different measures of inflation, RPIX and RPIY (=RPIX — indirect taxes) between 1985 and 1996 in the UK. It can be seen that the Taylor rule was fairly close to actual policy, especially from 1989 to 1996. Therefore, although the monetary policy is discretionary in the UK, the Taylor rule is a fairly good estimator of the actual interest rates over the given period.
(Some changes to taxes, which had an impact on RPIX, were implemented in 1990, this can partly explain the relatively high peak in the rule based on RPIX.)
B. Loss Functions:
How it works in the UK:
- The BoE intends to find the optimal monetary policies in order to minimise the quadratic loss function. As can be clearly seen in the equation, BoE suffers from short-run trade-offs between growth and inflation.
- According to BoE’s remit, it ensures the following things:
- Independence of BoE from HM treasury;
- Flexible inflation target of 2%, which allows discretion to stabilise the economy when encountering a shock.
The BoE follows a quintessential flexible inflation target regime.
Assessment of effectiveness:
- There are no direct assessments of effectiveness, however discussion and evidence around whether the loss function is minimised could be conducted in the following perspectives:
- UK has experienced a stable and moderate inflation around 2% and unemployment around 6% since 1998 after BoE’s independence, showing that the BoE is trying to minimise its loss function;
- Since 2009, inflation has remained substantially high in the UK on average more than a percentage point above the BoE’s target of 2%. However, the BoE provided further monetary stimulus, retaining its low level of base rate of 0.5% and increasing the size of its balance sheet to around 25% of UK’s nominal GDP by massive asset purchases, which was against its major inflation objective but followed its discretion regime to minimise welfare losses. This was due to the fact that MPC anticipated the inflation overshoot to be temporary and thus calibrated its policy action to bring inflation down to target towards the end of its forecast horizon a few years later. Inflation went down to 2% in 2013 and further down to 0% in 2016, then increased along with a further cut in base rate after Brexit Referendum.
- A general problem: the temptation to aim for a slightly higher inflation in exchange for higher growth leads to the inflation bias among the public, which exaggerates the time inconsistency problem.
- Miles (2013) argues that the loss function the BoE is trying to minimise may be different from the traditional model. Via an endeavour to derive the optimal monetary policy, he constructed the model into four separate steps.
- Describe the changes in monetary policy on the change in demand and output as
- Derive a backwards-looking Philips curve, which links the lagged output gap to inflation. Here, forward-looking variables in the inflation equation are neglected as the author was skeptical about their relevance. The equation is shown as:
- Describe how the economy’s supply capacity evolves as
- Finally, derive the loss function for the central bank:
- The inclusion of last term is due to the fact that the author believed the supply capacity is endogenous to the output growth.
- This loss function was proven to be in line with the Inflation Report published by the BoE in February 2013 when the initial output gap is distributed uniformly in [0 ; 3%]; the annual growth rate of supply capacity at unchanged policy is set to 1%; the annual growth rate of output at unchanged policy is distributed uniformly in [0 ; 3%]; the impact of a 1% change in monetary policy (that is a 1% change in the stock of asset purchases) on the growth rate of output is distributed uniformly in [0 ; 0.06%]; the impact of the deviation of the growth rate of demand from its expected value on supply capacity is distributed uniformly in [0 ; 1]; the slope of Phillips curve is set to -0.1; inflation in the first period is set to 3%; the inflation inertia coefficient is set to 0.95 (this is a quarterly inertia rate; equivalent to about 0.8 for annual data); and the constant term in the inflation equation to 0.1%.
- Miles (2013) conducted detailed analysis using different and 𐊄 values, and gave different interpretations of getting the optimal monetary policy using the loss function derived. There are other papers questioning the weight on inflation gap and output gap in the loss functions. Traditional monetary theories assume an equal weight with =1. Micro-founded new Keynessian models tend to suggest a very low output gap weight with =0.1(Woodford, 2003). Overall, there are no set rules for the exact values used for the BoE.
This article is written by: Sheryl Dong (Head of UK Monetary Policy Research), Birce Akay (Research Associate, UK Monetary Policy Research), Daniel Carey (Research Associate, UK Monetary Policy Research) and Dillon Oppon-Ferguson (Research Associate, UK Monetary Policy Research).This article is reviewed by Jason Jia (VP, Monetary Policy Research).
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