Authors: David Smith
In 1979 we had the second age – willing monetarism – under a Thatcher government philosophically committed to controlling the money supply as a means of limiting inflation. Despite being willing acolytes of Friedman, the Conservatives chose a ‘broad’ monetary target, sterling M3, which he would not have recommended. They then proceeded to undertake other policy actions, notably the abolition of exchange controls (limits on the amount of currency and capital that could be taken in and out of the country) and of the Bank of England ‘corset’ (controls on the banks’ lending), which made it impossible to hit the targets for sterling M3. To this day many people think monetarism has something to do with public spending cuts. This was because the Thatcher government’s choice of money supply target was linked to the level of public borrowing, and therefore the amount of government spending. This phase of willing monetarism lasted two or three years, before giving way to the third age – pragmatic monetarism.
By the early 1980s Charles Goodhart, then chief monetary adviser to the Bank of England, had come up with Goodhart’s Law, a kind of Murphy’s Law for economics. This did not say that if you drop a piece of toast it is bound to fall buttered side down but, rather, that any measure of the money supply you try to target will automatically become subject to distortions that make it hard to control. So the Conservative government adopted a more relaxed approach, making it clear that they still believed in controlling the money supply but also choosing to target a range of measures and not losing too much sleep if one or more of them missed the target. This approach worked pretty well. From 1982 until 1985 Britain had reasonable economic growth, albeit alongside high unemployment, and low inflation.
Unfortunately, sterling, the traditional Achilles heel of the UK economy, was still subject to periodic crises. January 1985, not long after I had joined
The Times
as economics correspondent, began with interest rates at 9.5 percent and ended at 14 percent, sterling having come within a whisker of one-to-one parity with the dollar in the process. These days we get excited when interest rates change by half a percentage point in a month. And so, in about 1985, Nigel Lawson, the then Chancellor, became rather keen on taking sterling into the European exchange rate mechanism – the system of ‘fixed-but-adjustable’ exchange rates in Europe that had come into being in 1979 as a forerunner to an eventual single currency. When Thatcher rebuffed him, he developed an alternative. Under the cloak of international efforts to stabilize currencies, the so-called G5 (Group of Five) and G7 (Group of Seven) Plaza and Louvre accords, that alternative was unofficial exchange rate targeting – shadowing the Deutschmark, my fourth age of monetary policy. How much was this responsible for the boom and bust of the late 1980s? Quite a lot. The earlier pragmatism was replaced by dogmatism, with dogma directed at preventing the pound from rising above three D-marks. The lessons of the early 1980s were forgotten, a kind of Goodhart’s Law applied to the exchange rate.
My fifth age is official targeting of the exchange rate – the ERM period. John Major was more successful than Lawson in persuading Thatcher of the virtues of joining the ERM, partly because he convinced her that it was the route to lower interest rates. And so, when in October 1990 it was announced that the pound would be joining the ERM at an exchange rate of DM2.95, it was also announced that interest rates would be reduced at the same time, from 15 to 14 percent. The problem with ERM membership was, however, the opposite of the one Major suggested. Far from being a route to lower interest rates, it blocked interest rate cuts at the very time they were needed. The combination of what was seen as a high exchange rate and the persistence of high interest rates meant that the period of ERM membership coincided with the 1990–92 recession, the longest in Britain’s post-war history. There was an additional complication. As a result of the pressures created by the unification of East and West Germany, German interest rates were higher than usual, and they set the pattern for the rest of Europe including, at the time, Britain. By the summer of 1992 the Conservative government, having narrowly won re-election in April 1992 (this time with Major as Prime Minister) was hanging on for dear life in the ERM. On 16 September 1992 the game was up. ‘Black’ Wednesday to the headline writers, ‘White’ or ‘Golden’ Wednesday to others, this was the day the Bank of England ran out of the reserves needed to prop up the pound within the system. It bought large quantities of sterling with its own foreign currency but, thanks to George Soros and other speculators, it was to no avail.
The sixth age came after Black Wednesday and sterling’s departure from the ERM, and it can be called quasi Bank of England independence. In putting together a monetary policy framework out of the ruins of the ERM failure, and in doing it both quickly and in an environment where it seemed the government could fall at any moment, the Treasury and the then Chancellor, Norman Lamont, performed a minor miracle. That framework, adopting an inflation target instead of money supply or exchange rate targets, requiring the Bank of England to produce a quarterly inflation report, and getting the Bank to advise openly and regularly on interest rate changes (this became the ‘Ken and Eddie show’ after Kenneth Clarke, Lamont’s successor, and Eddie George, the Bank governor) was enormously successful. It paved the way for the 1990s to be a period, after the disasters at the start, of non-inflationary growth, the holy grail of economic policy. From there it was a relatively short step to giving the Bank the job.
The seventh age is thus operational independence for the Bank in which the Bank sets rates to meet an inflation target, 2.5 percent, set by the government. Is this the final resting place for monetary policy? One is tempted to say yes, and it certainly feels more permanent than its predecessors. There are, however, a couple of possibilities for change. The first one would be if, within the existing system, the Bank was not subject to a specific inflation target but was given the broad brief of achieving economic stability, of the sort the Bundesbank used to have and the Federal Reserve has. A second possibility, of course, is membership of Europe’s monetary union, the euro. Here, the governor of the Bank would simply become a voting member of a large European central bank council. That would look like a permanent resting place for monetary policy, although many – including some in the Treasury and the Bank – are not prepared to give up the present arrangements without a fight.
How does monetary policy work?
When the Bank of England’s monetary policy committee meets each month it is to make one of three decisions. To raise interest rates, to lower them, or to leave them the same. For all central banks leaving interest rates unchanged is the most common decision. To raise them or to lower them the economists and bankers on the committee need to be convinced that enough has changed since they last met to warrant a shift. That does not mean rate changes are a rarity. Most central banks prefer to operate on the principle of ‘little and often’ in altering rates, rather than go in for the big, bold gesture, although even in its relatively short history of independence the Bank did not adjust rates for twelve whole months between February 2000 and February 2001.
What is it about interest rates that gives them this influence on the economy? After all, the economy is made up of savers and borrowers, and their savings and borrowings roughly equal one another, so surely the net effect of a change in interest rates is zero. A rise in interest rates is good for savers but is a blow for borrowers, and vice versa for a fall. One man’s meat is another man’s poison. In fact it is a little more complicated than that, although not greatly so. The way in which interest rates affect the economy is called the ‘transmission mechanism of monetary policy’ and there is a very good paper on the Bank’s website (www.bankofengland.co.uk) with precisely this title.
Let us consider, first, what happens when the MPC decides to raise interest rates. It would do this because it believed there was a real danger of inflation rising above the 2.5 percent target – the inflation rate deemed by the government to be consistent with a stable economy. The first and most obvious effect on individuals would be to make saving more attractive by increasing the interest rates on saving accounts, and borrowing less attractive because it has become more expensive. People with savings are happy, because their income has risen. People with borrowings, and 80 percent of borrowings in Britain are in the form of mortgages, find that their monthly payments have increased. The consequence for them is that they have less to spend on other things. Why is this not exactly offset by greater spending by the savers whose income has risen? Here, it is necessary to make an assumption that is fortunately supported by the facts. It is that savers have a lower tendency to spend any extra income, a lower marginal propensity to consume, than borrowers. Why should this be? Under the life-cycle hypothesis, which we have already encountered, people’s lives divide naturally into periods of spending and periods of saving. In general, those aged forty and under are high spenders and low savers. From forty or so until retirement people save relatively more and spend relatively less; they are also less likely to have heavy borrowings. On retirement they start to draw down those savings. A cut in interest rates therefore has the neat effect of putting more money into the hands of those people who are most likely to spend it, those with high mortgages relative to income. A rise in rates has the opposite impact. There are other consequences for individuals. Higher interest rates will tend to make people think there are more difficult times on the way, and perhaps their job is at risk. They may also be associated with slower growth (or a fall) in house prices and the stock market, thereby affecting wealth. Wealth, and this distinction is not always made clear, particularly by journalists, is the
stock
of assets built up over time. Income is the
flow
of new money coming in. Roughly half of individual wealth in Britain is in housing, with most of the remainder held (often indirectly through pension funds) in stock market-related investments.
So, higher interest rates will, through these various routes, tend to slow consumer spending, while lower rates will tend to speed it up. Similar principles apply, although in a slightly different form, when it comes to firms. As the Bank of England itself puts it:
An increase in the official interest rate will have a direct effect on all firms that rely on bank borrowing or on loans of any kind linked to short-term money-market interest rates. A rise in interest rates increases borrowing costs. The rise in interest rates reduces the profits of such firms and increases the return that firms will require from new investment projects, making it less likely they will start them. Interest costs affect the cost of holding inventories [stocks of components or finished goods], which are often financed by bank loans. Higher interest costs also make it less likely that the affected firms will hire more staff, and more likely that they will reduce employment or hours worked. In contrast, when interest rates are falling, it is cheaper for firms to finance investment in new plant and equipment, and more likely that they will expand their labour force.
From growth to inflation
This is all very well, but where does inflation come into it? So far, all we have seen is that interest rates affect the growth of the economy, either for good or bad. The essential requirement, therefore, is that growth and inflation are linked, and for this we need another couple of tools. The first is the notion of the economy’s long run, or ‘trend’ growth rate, which in Britain’s case is thought to be 2.5 percent. The second is what is called the ‘output gap’. This needs explanation. Suppose that, year in, year out, the UK economy grew by 2.5 percent a year. The economy would be growing exactly on trend and the output gap would be zero. Now suppose there are three consecutive years of zero growth. The consequences of this would be rising unemployment and spare capacity. It would also be low inflation. The more slack there is in the economy the weaker, other things being equal, are the inflationary pressures. Output would have dropped significantly below trend. An output gap, economy-wide spare capacity, would have been created. In this case three years of growth at 5 percent a year would be required to get the economy back on track, and the Bank need not worry too much about such a rapid rate of expansion. If we take another situation, however, when three years of 5 percent growth started from the point when the economy was already on trend, it would be a different story. The effect would be a sharp drop in unemployment, probably serious skill shortages, and pressures on capacity elsewhere. A ‘negative’ output gap – in other words an economy operating well above its cumulative trend – would have emerged. Higher inflation would be expected and the Bank’s response would be to raise interest rates to get the economy back on trend as quickly as possible.
These things can never, of course, be purely mechanical. Successful monetary policy requires skill and touch, as well as an ability to interpret the economic numbers. But this, in a nutshell, is the way it works. A rapidly growing economy which is at or above trend is likely to be heading for higher inflation, and a hike in interest rates should be the policy response, and vice versa.
There is one other transmission route from interest rate changes to inflation to consider, and that is the exchange rate. In Britain’s case, because of the openness of the economy (exports and imports are each the equivalent of just under a third of GDP), the pound’s performance has traditionally been very important. Many of the best-laid plans of governments, as we saw in the seven ages of monetary policy, have been upset by sterling’s unwillingness to behave. In normal circumstances, a rise in UK interest rates should push the pound higher, while a reduction will have the opposite effect. This is because, in theory, international investors are always scanning the world to look for the best returns. If the Bank of England pushes up rates, that is a signal to those investors to shift their money to London. It does not always work out like this. In September 1992 even 15 percent interest rates did not push the pound higher, because the international financial community was convinced sterling was about to be devalued (so holders of sterling would have been left much poorer). Leaving such circumstances aside, and assuming higher interest rates do indeed lead to a stronger pound, it is not hard to see why this should be associated with lower inflation. There is a direct link to prices, because when sterling rises against other currencies, the effect is to reduce the cost of imports, right through from commodities to cars. There is also an indirect effect, via growth. A higher pound makes exports more expensive and therefore hurts exporting companies, while benefiting firms in other countries (those selling to Britain or competing with UK exports in other markets). These effects can be powerful, although the size of them depends on circumstances. With sterling’s 1992 departure from the ERM and its subsequent large depreciation, many feared a sharp rise in inflation. (A depreciation is when a currency slides lower until it finds its level, a devaluation is when it is moved by the authorities from one fixed rate to a lower one. The last formal devaluation in Britain was in 1967, when sterling was devalued from $2.80 to $2.40.) It did not happen, because the economy was just recovering from a severe recession. There was, in other words, a large output gap.