Jan 20
Why is the Bank of England important?
By Mazen Badawy, Andy Koh, Sanah Suresh and Shahan Khan
What is a Central Bank and how is it structured?
Central banks are institutions that manage currency and monetary policy. They have the power to make changes to the money supply and regulate commercial banks. Central Banks tend to be nominally independent of party politics.
The Bank of England is structured in the following way:
- The Governor oversees its operation and high level decision-making
- The Court of Directors is responsible for overall strategy and budget
- The Prudential Regulation Authority regulates financial services and markets
- The Financial Policy Committee maintains stability in the financial system by identifying and mitigating systematic risks
- The Monetary Policy Committee is in charge of the bank rate and monetary policy initiatives. it will be discussed in more depth in the next slide
Monetary Policy Committee (MPC)
The MPC’s role is to make decisions about the bank rate, implement monetary policy and set interest rates. They also direct the quantitative easing (QE) and forward guidance areas of the country’s monetary policy framework, with the aim of keeping inflation low and stable. Another role is to support the government’s broader economic policies in order to achieve economic growth and employment targets.
The MPC is made up of nine members: the Governor, the three Deputy Governors for Monetary Policy, Financial Stability and Markets and Banking, our Chief Economist and four external members appointed directly by the Chancellor. Members are independent and have expertise in the field of Economics and monetary policy. Currently, the members are:
- Andrew Bailey
- Ben Broadbent
- Sir John Cunliffe
- Jonathan Haskel
- Catherine L Mann
- Huw Phil
- Sir Dave Ramsden
- Michael Saunders
- Silvana Tenreyro [1]
The MPC meets eight times a year to set and announce policies. They make decisions by, firstly, asking the Bank of England staff to present the latest economic data and analysis. Then there are three more meetings. In the first meeting, MPC members look at what has changed in the economy between meetings and its implications on economic growth and inflation. In the second meeting, every member gives their assessment of recent economic developments and says what monetary policy they think should be implemented by the Bank of England. In the final meeting, the Governor states what monetary policy action is likely to be supported the most by the members, then all members vote and anyone who disagrees with the majority view states the alternative approach they would support. Their decisions are then published[2]. Some of the monetary tools that the committee considers will be explored further below.
Monetary Policy Tools
Quantitative Easing
Quantitative Easing (QE) is a “monetary policy tool that central banks can use to inject money into the economy through the purchase of ‘financial assets,’ usually government bonds”[3]. The Bank of England (BoE) has implemented QE by overwhelmingly buying UK government bonds from the non-bank private sector[4]. To date, the BoE has bought £895 billion worth of bonds through QE, with £875 billion used to buy UK government bonds and £20 billion used to buy UK corporate bonds[5]. Figure 1 charts the BoE’s bond purchases from 2009 to 2020.
Central banks turned to unconventional monetary policy like QE in the aftermath of the financial crisis of 2007–8 because a zero lower bound on interest rates and a disconnection between official rates and market rates meant that conventional monetary policy would theoretically cease to be effective[7]. The BoE’s gilt purchases increase the quantity of bank deposits and reduce the stock of privately-held, long-dated assets. This reduces the term premium for all long-dated assets and makes it likely for their prices to rise. Companies will find it easier to raise funds and households holding these assets will enjoy capital gains. Increases in investment by companies and consumption by households should raise demand and GDP[8]. Figure 2 illustrates the effect of asset purchases by the BoE.
Joyce et. al. (2012) noted that “a casual reading of UK financial and macroeconomic developments since the crisis would suggest evidence in support of the efficacy of unconventional monetary policy”. In late 2008, interbank borrowing rates fell sharply in the wake of measures aimed at providing support and liquidity to the banking sector. In 2009, the timing of credit and QE policies coincided with a rally in asset prices and falls in government and corporate bond yields[10].
However, causal empiricism cannot be used to confirm QE’s efficacy. The fiscal authorities’ efforts to boost demand could also be a contributory factor. Quantifying the wider macroeconomic effects of QE is also challenging because of the lags before the effects get fully passed through and the lack of historical precedent compared to conventional monetary or fiscal policy[11]. Cui and Sterk (2018) noted that QE increases inequality, which can lower welfare[12]. This view is echoed by a report from the Economic Affairs Committee of the House of Lords, which also pointed out that more QE could be inflationary in light of factors like the growing economy, substantial Government spending and a recovery in demand after the COVID-19 pandemic[13].
Forward Guidance
Forward guidance is defined as “central bank communication about future monetary policy, which has many forms including announcements about objectives, contingencies, policy actions, and speeches”[14]. Its purpose is to anchor the private sector’s expectation of the future path of monetary policy, which is important for investment, consumption and employment decisions[15]. In addition, this affects expected returns through arbitrage and consequently long-term yields today.
Forward guidance is a tool employed by the BoE. For example, the Monetary Policy Committee revealed in their September 2020 minutes that they “did not intend to tighten monetary policy until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably”. This provided a commitment not to tighten monetary policy until the MPC had seen clear evidence of recovery, which reinforced then market expectations that the Bank Rate would remain low for some time. In addition to anchoring expectations, the MPC sees forward guidance as a valuable tool in reinforcing the effect of other monetary tools[16].
However, the effectiveness of forward guidance is debatable. McKay et. al. (2016) and Werning (2015) agree that forward guidance is likely to be an effective monetary tool[17]. In contrast, Hagedorn et. al. (2019) concludes that forward guidance is not an effective tool of monetary policy as promises of future interest rates have only negligible effects on current output and employment[18].
Loss Functions
A Loss function is another tool that is commonly used by central banks. To start with some context, a central bank has preferences with which it makes decisions on the bank rate and other monetary policy tools. They primarily want to minimise any deviation from their inflation and output targets in the economy. These preferences are presented in a loss function — if there is more loss for example, the central bank is not sufficiently close to its inflation and output targets. If a certain country’s central bank was more concerned with unemployment than inflation, it would tolerate more deviation from its inflation target compared to its output target. This can be measured easily since the Loss Function comprises a sum of these inflation and output components. Rules to oversee a given central banking objective can therefore be governed by the use of the Loss function. It is used for this purpose together with the Taylor Rule as explained below.
The Taylor Rule
The Taylor Rule is an interest rate forecasting model that suggests how central banks should change their interest rates depending on the rate of inflation relative to its target and the level of output relative to trend[19].
It also acts as a guide to gauge the proper level of money supply. According to the Taylor Rule, interest rates should be increased when inflation is above target or GDP/ economic growth is greater than the long-term trend growth and lower interest rates if the conditions are the opposite[20].
The Taylor model can be both a forward or backward-looking model/assessment of inflation, as it says central banks could predict future inflation rates or look in the past and change interest rates based on past movements in inflation[21,22].
The Taylor Rule formula is:
Where:
- i is the nominal interest rate
- p is the annual inflation rate
- p* is the target inflation rate
- r* is the equilibrium real interest rate
- (Y-Y*)/Y* is the output gap
- W₁ and W₂ are weights given to the deviations of output and inflation from their respective trend and target[23]
The Taylor Rule is a simple rule in that it is based on data outturns and offers a summary of the main macroeconomic influences on policy. It complements other variables that the Bank of England uses[24]. It is often thought that the rules are a good approximation, given the small number of variables used. Defenders of the rule argue that the rule is only meant to be a guideline, so other variables other than inflation and output gap could also be responded to by policy makers. However, Svensson argues that ‘the Taylor rule is “incomplete” and “too vague to be operational”: “some deviations are allowed, but there are no rules for when deviations from the instrument rule are appropriate”[25]. Another point Svensson (2003) argues is that the Taylor rule does not allow policy makers to react to changes in the transmission mechanism or shocks in the economy [26].
An instance in which the Taylor Rule worked was during the UK’s membership of the European Exchange Rate Mechanism (ERM), where the Taylor Rule followed actual interest rates closely throughout, as seen in Figure 3 [27]. Nelson (2000) used Quarterly data from 1992 Q4 to 1997 Q1 to estimate the Taylor Rule, finding the long-run estimated coefficients on inflation and the output gap were 1.27 and 0.47, respectively. These values are very close to the (1.5, 0.5) combination used by Taylor (1993) [28].
However, a point to note is that the data is likely to be revised after the first publication. By looking at the time period of 1986–88, in which GDP data had been heavily revised, the Taylor rule indicated that interest rates were lower than actual interest rates. In 1996, the revised data indicated a level of interest rates around 100 basis points higher than the first estimate in 1988. Therefore, the rules are very sensitive to the assumptions they are based on. Although this is true for any model in the economy [30].
During the financial crisis in 2007/2008, it was thought by some that the central bank’s decision to keep interest rates low following the dot-com bubble, resulted in the housing bubble, which led to the housing crisis. Had the interest rates been higher, in accordance with the Taylor Rule, then fewer people would have been incentivised to take out a mortgage (as the cost of borrowing would have been greater) and the housing bubble would have been smaller [31].
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
[1] “Monetary Policy Committee”, https://www.bankofengland.co.uk/about/people/monetary-policy-committee
[2] “Monetary Policy”, https://www.bankofengland.co.uk/monetary-policy
[3] Economic Affairs Committee, “Quantitative easing: a dangerous addiction,” HL Paper 42 (2021): 8.
[4] Michael Joyce, David Miles, Andrew Scott and Dimitri Vayanos, “Quantitative Easing and Unconventional Monetary Policy — An Introduction,” The Economic Journal 122, no. 564 (2012): 274.
[5] Bank of England, “What is quantitative easing,” https://www.bankofengland.co.uk/monetary-policy/quantitative-easing
[6] Bank of England, “What is quantitative easing,” https://www.bankofengland.co.uk/monetary-policy/quantitative-easing
[7] Joyce, “Quantitative Easing and Unconventional Monetary Policy,” 276.
[8] Joyce, “Quantitative Easing and Unconventional Monetary Policy,” 279.
[9] Joyce, “Quantitative Easing and Unconventional Monetary Policy,” 278.
[10] Joyce, “Quantitative Easing and Unconventional Monetary Policy,” 281.
[11] Joyce, “Quantitative Easing and Unconventional Monetary Policy,” 281–4.
[12] Wei Cui and Vincent Sterk, “Quantitative Easing,” CFM Discussion Paper Series (2018): 1.
[13] Economic Affairs Committee, “Quantitative easing: a dangerous addiction,” 3–5.
[14] Benjamin D. Keen, Alexander W. Richter and Nathaniel A. Throckmorton, “Forward Guidance and the State of the Economy,” Economic Inquiry 55, no. 4 (2017): 1593–1624.
[15] Marcus Hagedorn, Jinfeng Luo, Iourii Manovskii and Kurt Mitman, “Forward guidance,” Journal of Monetary Economics 102 (2019): 20.
[16] Dave Ramsden, “The Monetary Policy Toolbox in the UK,” https://www.bankofengland.co.uk/-/media/boe/files/speech/2020/the-monetary-policy-toolbox-in-the-uk-speech-by-dave-ramsden.pdf
[17] Alisdair McKay, Emi Nakamura and Jón Steinsson, “The Power of Forward Guidance Revisited,” The American Economic Review 106, no. 10 (2016): 3133–158; Iván Werning, “Incomplete Markets and Aggregate Demand,” National Bureau of Economic Research (2015).
[18] Hagedorn, “Forward guidance,” 20.
[19] Stuart, “Simple Monetary policy Rules”, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1996/simple-monetary-policy-rules.pdf, 281
[20] Twomey, “The Taylor Rule: An Economic Model forMonetary Policy”, https://www.investopedia.com/articles/economics/10/taylor-rule.asp
[21] Stuart, “Simple Monetary policy Rules”, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1996/simple-monetary-policy-rules.pdf, 285
[22] Carlstrum and Fuerst, “Forward-Looking Versus Backward-Looking Taylor Rules”, http://pages.stern.nyu.edu/~dbackus/Identification/CarlstromFuerst_forwardlooking_00.pdf 1
[23] Stuart, “Simple Monetary policy Rules”, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1996/simple-monetary-policy-rules.pdf, 282
[24] Stuart, “Simple Monetary policy Rules”, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1996/simple-monetary-policy-rules.pdf, 281–282
[25] Smith, “Policy Reaction Functions: Inflation Forecast Targeting and Taylor Rules” https://warwick.ac.uk/fac/soc/economics/staff/jcsmith/policy/4taylor.pdf, 5
[26] Smith, “Policy Reaction Functions: Inflation Forecast Targeting and Taylor Rules” https://warwick.ac.uk/fac/soc/economics/staff/jcsmith/policy/4taylor.pdf, 7
[27] Stuart, “Simple Monetary policy Rules”, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1996/simple-monetary-policy-rules.pdf, 283–284
[28] Nelson, “UK Monetary Policy 1972–97: a guide to using Taylor Rules”, https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.195.2424&rep=rep1&type=pdf, 26–27
[29] Stuart, “Simple Monetary policy Rules”, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1996/simple-monetary-policy-rules.pdf, 283
[30] Stuart, “Simple Monetary policy Rules”, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1996/simple-monetary-policy-rules.pdf, 284
[31] Bernanke, “The Taylor Rule: A benchmark for monetary policy?”, https://www.brookings.edu/blog/ben-bernanke/2015/04/28/the-taylor-rule-a-benchmark-for-monetary-policy/
