The Bank of England’s Monetary Policy Committee has recently provided some explicit forward guidance regarding the future conduct of monetary policy in the UK. This column by the Bank's Chief economist explains how the MPC designed its forward guidance to respond to the unprecedented challenges facing the UK economy and argues that forward guidance allows the MPC to explore the scope for economic expansion without putting price and financial stability at risk.
At its meeting on 1 August 2013, the Monetary Policy Committee (MPC) agreed to provide state-contingent forward guidance concerning the future conduct of monetary policy. The aim was to provide more information to help financial markets, households and businesses understand the conditions under which the current stance of monetary policy would be maintained. In essence, the MPC judged that it would be appropriate to maintain the current exceptionally stimulative monetary stance until the margin of slack within the economy had narrowed significantly, provided that such an approach remained consistent with its primary objective of price stability and did not endanger financial stability.
In particular, the MPC outlined its intention neither to raise Bank Rate from its current level of 0.5% nor reduce the stock of asset purchases financed by the issuance of central bank reserves at least until the unemployment rate has fallen to a threshold of 7%.
The guidance linking Bank Rate and asset sales to the unemployment threshold would cease to hold if any of the following three 'knockouts' were breached:
- In the MPC’s view, it is more likely than not, that CPI inflation 18-24 months ahead will be 0.5pp or more above its 2% target.
- Medium-term inflation expectations no longer remain sufficiently well anchored.
- The Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability that cannot be contained by regulatory actions.
As noted by Bean (2013), the primary aim of the MPC’s forward guidance is to clarify its reaction function and thus make its current policy setting more effective. It is not an attempt to inject additional stimulus by pre-committing to a ‘lower for longer’ policy with the aim of pushing inflation above target for a period; raising inflation expectations and reducing real interest rates, such as that described by Woodford (2012). That is for two reasons. First, UK inflation has been above, rather than below, its 2% target for much of the period since 2007. Second, even if such a strategy were to be successful in boosting economic growth, there is no mechanism by which existing MPC members can pre-commit future Committee members to such a strategy.
The MPC believes its forward guidance should enhance the effectiveness of monetary stimulus in three ways. First, it provides greater clarity about the MPC’s view of the appropriate trade-off between the horizon over which inflation is returned to the target and the speed with which output and employment recover. Second, it reduces uncertainty about the future path of monetary policy as the economy recovers. And third, it better enables the MPC to explore the scope for economic expansion without putting price and financial stability at risk.
The MPC’s adoption of explicit forward guidance was motivated by the exceptional challenges facing the UK economy. Over the past six years, the UK economy has faced substantial demand and supply shocks. As a consequence, UK output growth has been weak compared with both previous recoveries and current recoveries in other countries (Figure 1): in 2013 Q2, UK real GDP was still more than 3% below its pre-crisis peak. The unemployment rate, at just a little below 8%, is around three percentage points higher than its average in the decade before the crisis.
This anaemic recovery has been accompanied by significant uncertainty regarding the evolution of the supply capacity of the UK economy. A period of weak output growth would normally be expected to result in a large margin of spare capacity. But business surveys suggest that spare capacity within companies has actually narrowed since 2009 (Figure 2), labour productivity has fallen back to 2005 levels, and domestic inflationary pressure has been stronger than expected. All of these factors are suggestive of a substantial weakening in supply capacity. But it is unclear how much of this weakness is directly related to demand and how much reflects other factors, such as problems in the banking sector. Consequently, a key uncertainty faced by the MPC currently is how productivity and supply will evolve as demand recovers.
Figure 1. Evolution of GDP around recessions(a) and banking crises
Sources: OECD, Reinhart, C.M and Rogoff, K.S (2008), Thomson Reuters Datastream and Bank calculations.
(a) Defined as at least two consecutive quarters of falling output
(b) Where data are available, covers the G20 advanced economies over the period from 1960 to 2006.
(c) Spain (1977), Norway (1987) Finland (1991), Sweden (1991) and Japan (1992), as defined in Reinhart, C.M and Rogoff, K.S (2008) ‘This time is different. Eight centuries of financial folly’.
(d) Zero denotes the pre-recession peak in GDP, or the peak in GDP during the year of the banking crisis, as listed in footnote (c).
Figure 2. Survey indicators of capacity utilisation(a)
Sources: Bank of England, BCC, CBI, CBI/PwC and ONS.
(a) Three measures are produced by weighting together surveys from the Bank’s Agents (manufacturing and services), the BCC (non-services and services) and the CBI (manufacturing, financial services, business/consumer services and distributive trades) using nominal shares in value added. The BCC data are non seasonally adjusted.
The MPC’s primary objective, as set by the Government, is to deliver price stability. The MPC’s remit also recognises that, when faced with adverse supply shocks, the Committee should vary the pace at which inflation is returned to the target so as to avoid generating undue volatility in output.
At the current juncture, with both inflation and economic activity far from desirable levels, explicit forward guidance can provide greater clarity about the MPC’s view of the appropriate trade-off between the horizon over which inflation is returned to the target and the support provided to output and employment. That greater clarity should help individuals to make better-informed expectations about future interest rates, which in turn influence households’ and businesses’ spending and saving decisions.
Moreover, as the UK recovery begins to gain traction, providing explicit guidance about the future path of monetary policy might be especially useful. In particular, there is a risk that households, businesses and financial market participants overreact to signs of a recovery, either in the UK, or in other countries where the economic recovery is more advanced. This might cause people to revise up excessively their expectations of the future path of Bank Rate, causing monetary conditions to tighten and so hindering the emerging recovery. By tying its guidance to the unemployment rate, the MPC has made clear that, even if a period of robust GDP growth appears likely, interest rates would be raised only if that were accompanied by a substantial decline in spare capacity in the labour market (subject to there being no material risks to either price or financial stability).
The scale of recent shocks, and the difficulty in knowing how effective supply will respond as demand picks up, means that the trade-off between the speed with which inflation is returned to the target and the scope for economic expansion is unusually uncertain. Attempting to return inflation to the target too quickly risks prolonging the period over which the nation’s resources are underutilised, which, in turn, might also erode the medium-term supply capacity of the UK economy. But returning inflation to the target too slowly might cause people to question the MPC’s commitment to keep inflation close to the target. Such a loss of credibility would make it more costly to keep inflation close to the target. Either outcome would lead to significant economic costs in the medium term.
In that context, forward guidance provides a robust framework within which the MPC can explore the scope for economic expansion without putting either price stability or financial stability at risk. If productivity were to recover more quickly than anticipated, unemployment would fall less rapidly, resulting in weaker inflationary pressure. In such circumstances, the MPC’s guidance implies that the accommodative stance of policy would be maintained for a longer time period. But if unemployment fell more rapidly and inflationary pressures began to emerge, the MPC’s guidance – including the price stability knockouts – would point to a faster withdrawal of policy stimulus.
Given the uncertainty surrounding the evolution of supply, the MPC judged that the unemployment rate was the most suitable indicator of economic activity to guide its policy. In particular, it seems likely that, as demand recovers, some of the spare capacity within companies will decline before, or at the same time as, the unemployment rate falls and slack within the labour market narrows. As such, by linking the path of Bank Rate to the evolution of unemployment, the MPC can set policy in order to reduce the degree of spare capacity in the economy, even if there is considerable uncertainty over the extent to which productivity will pick up as the recovery gathers pace.
The MPC have set the unemployment rate ‘threshold’ at 7%: lower than the current unemployment rate of 7.7%, but somewhat higher than Bank of England estimates of the medium-term equilibrium rate (6.5%).3 7% is not a target for unemployment, nor is it a trigger for immediate monetary action (indeed, it is likely that unemployment will eventually fall below that level). Instead, as noted by Carney (2013), it represents an appropriate point at which the MPC will reassess the state of the economy – taking account of a wide range of measures of economic slack and inflationary pressures – and consider whether or not it should start to withdraw the current extraordinary levels of monetary stimulus.
Price stability remains the MPC’s primary objective, and its policy guidance is conditional on two price-stability 'knockouts': one defined in terms of the MPC’s inflation forecast and one in terms of external measures of inflation expectations.
CPI inflation is close to 3% and is expected to remain so for much of the rest of this year. By setting its inflation forecast knockout at 2.5% or more at the 18- to 24-month horizon, the MPC sought to strike an appropriate balance between not bringing inflation back to the target so quickly as to threaten the recovery, and not bringing it back so slowly as to cause people to question its determination to hit the 2% target over the medium term.
When assessing the inflation expectations knockout, the MPC will consider: the level of inflation expectations; movements in uncertainty about future inflation; and the sensitivity of inflation expectations to economic news.
The MPC’s remit also recognises that attempts to keep inflation at the target could generate risks to future financial stability. The Financial Services Act 2012 established an independent Financial Policy Committee (FPC) at the Bank of England charged with identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system. One of the tasks of the FPC will be to alert the MPC publicly if the stance of monetary policy poses a significant threat to financial stability that cannot be contained by the substantial range of mitigating policy actions available to the UK regulatory authorities. That is because financial instability could have lasting effects on the economy, damaging growth and endangering price stability. In such circumstances, monetary policy may have an important role to play as a last line of defence in mitigating risks to financial stability.
Bean, C (2013), "Global aspects of unconventional monetary policies", Federal Reserve Bank of Kansas City Symposium, Jackson Hole.
Carney, M (2013), "Crossing the threshold to recovery", Speech at a business lunch hosted by the CBI East Midlands, Derbyshire and Nottinghamshire Chamber of Commerce and the Institute of Directors.
Financial Policy Committee (2013), ‘The Financial Policy Committee’s powers to supplement capital requirements: a draft policy statement’.
Monetary Policy Committee (2013), "Monetary policy trade-offs and forward guidance".
Woodford, M (2012), ‘Methods of policy accommodation at the interest-rate lower bound’, Federal Reserve Bank of Kansas City Symposium, Jackson Hole.
© VoxEU.org Used with permission.
The IMF loans to Greece, Ireland and Portugal are considered controversial by some analysts. This column argues that these loans – granted without having agreed on convincing paths to manageable debt levels – constituted a substantial departure from IMF principles. The situation is costly for Europe and, having now permanently changed the principles guiding large IMF loans, it will be costly for crises to come. A serious rethink of the management and decision-making structure of the IMF is needed.
The IMF will live with the legacy of its role in the European debt crisis for years — if not decades.
- One obvious part of this legacy will reside in the outcome of the crisis for the European periphery — more likely to be a lost decade than an example of efficient crisis management.
- Another part, which will be more important from a systemic perspective, is the fundamental change that took place in the rules of the game for the IMF’s role in crisis management.
Specifically, the decision to lend to Greece, Ireland and Portugal without having agreed on a convincing path back to a manageable level of debt was a substantial departure from agreed principles for the IMF. It was costly for Europe and, now as a precedent for the future, it will be costly for crises to come in other parts of the world (Schadler 2013).
To understand the seriousness of this change in the rules of the game, it is useful to ask what is the value added of the IMF. What does the IMF bring to crisis management that would be absent, or present in a far less effective form, if the IMF did not exist? Financial resources to support countries in crisis are of course important. But since the 1950s, the IMF has been far more than a simple reserve pooling arrangement. It brings experience with financial crises around the globe and a significant degree of objectivity on the feasibility of any plan for restoring a manageable level of public debt (or in IMF parlance, debt sustainability).
Seen in the starkest light, three interactive components are at stake in devising such plans:
- The regimen of policy changes, encompassing, fiscal austerity, strengthening the banking system, and structural reform.
- A set of 5-10 year macroeconomic and debt forecasts taking into account the effects of the agreed policy changes.
- Restructuring public debt (in extreme circumstances).
All the policy changes and restructuring options have strong opposing interest groups, so pressure for optimistic forecasts — a gamble for redemption — is powerful. The country may get lucky and the optimistic forecasts turn out to be accurate or, in worse outcomes, the can is at least kicked down the road. The unique contribution of the IMF is its expertise on the efficacy of policy changes and its objectivity in preventing optimistic forecasts from obscuring the need for stronger policies or, in extreme circumstances, debt restructuring.
Protecting this role for the IMF has long been a concern of global policymakers. The spate of severe crises in the 1990s raised questions about whether the IMF had adequate protection from pressures to gamble for redemption.
In 2003, agreement was reached on a set of four criteria that must be met for the IMF to extend exceptionally large loans. They require that:
- the country experiences exceptional balance-of-payments pressures;
- a “rigorous and systematic analysis indicates that there is a high probability that the country’s “public debt is sustainable in the medium term”;
- “the country has prospects for gaining or regaining access to private capital markets within the timeframe when Fund resources are outstanding”; and
- the country’s policy programme “provides reasonably strong prospects of success” (IMF 2002).
The four criteria are excellent public policy. They avoid arbitrary quantitative limits and instead specify parsimonious conditions that are fully consistent with the IMF’s mandate to provide financing only as a bridge to a country’s return to normal market financing.
Yet in 2010 in the first serious test of the criteria, the IMF failed. Under pressure from European members, in the highly unusual Troika arrangement (Pisani-Fierry et al. 2012), the IMF introduced the possibility of a waiver of the second of the four criteria: in cases where there is a risk of international spillover effects, there does not have to be a high probability of debt sustainability (IMF 2010). This waiver was invoked for Greece (and subsequently Ireland and Portugal), allowing the Fund to sidestep its responsibility to insist on measures (specifically, more money from the EU and/or an early restructuring of private debt) that were essential to rendering debt sustainable over the medium term. Debt restructuring — widely seen from the outset as inevitable by commentators outside the IMF (see, for example, Eichengreen 2010) — was kicked down the road (and ultimately occurred two years after the first disbursement of the IMF loan). As the amendment of the criteria was permanent, it has revised the rules of the game for future crises.
Even the application of the waiver in the euro crisis has been slipshod. All crises severe enough to require exceptionally large IMF lending have international systemic spillovers. This is virtually definitional. The critical question is which course of action is likely to minimise them. But the IMF has provided no comparative analysis of likely spillover effects for different courses of action. At a minimum, the IMF needed to consider and present estimates of adverse spillover effects in scenarios for alternative policy strategies — for example in Greece, of a scenario with early restructuring, a gamble for redemption (the actual strategy adopted), and debt relief from other EU members. Without such analysis, the bar for invoking the systemic waiver criterion is absurdly low.
Unfortunately for Europe, the use of the waiver, attractive as it was from a short-term perspective, cost dearly. The fundamental problem in Greece — an unsustainable debt burden even if the programme of policies had been pursued to the letter — was not addressed, leaving financial markets with excessive uncertainty about the end-game of the crisis (would there be more money from Europe or restructuring?) and allowing nimble investors to reduce exposures. Portugal may get by without a restructuring, but will pay for the prolonged uncertainty with a longer recovery than was necessary. Ireland appears to be on the mend, but again with more severe costs for economic activity than if the debt overhang had been addressed at the outset.
These poor decisions to support countries in the absence of debt sustainability will have even longer-term consequences. The Fund has effectively jettisoned the four criteria and now will enter the next debt crisis with no procedural anchor. In short, the IMF has no formal mandate requiring that a rigorous analysis find a high probability that debt sustainability will be restored. Without a formal limit on its discretion, the IMF is fair game for any national or regional political interests intent on securing IMF support to support a gamble for redemption and delay restructuring when it is needed. Interim periods of uncertainty with IMF funding to support fleeing investors will inevitably be as costly as they have been in Europe.
What is the way forward?
- First, reinstate an anchor to the IMF when it lends into severe debt crises.
Restore the essential principle — without which IMF lending does not make sense — that the programme of policies to which a severely indebted sovereign commits provides a high probability that the country will return to a manageable debt position within the life of the IMF loan.
- Second, start the process of agreeing on procedures and institutions for debt standstills and restructuring when debt sustainability during the life of the programme is not highly likely.
- Third, make arrangements for a very short-term facility — ideally funded by national central banks — for emergency financing when failing to meet immediate debt servicing obligations would be unduly costly.
Such circumstances are unusual, but can arise — for example, if a crisis were to unfold exceptionally quickly and in unpredictable circumstances or, as in Greece, institutional arrangements (ECB rules on accepting paper of downgraded sovereigns) meant that a standstill before those arrangements were changed would have inflicted severe costs on the economy. The goal would be to prevent such short-term exigencies from ensnaring the IMF in commitments to fund 3-4 year programmes without good prospects for debt sustainability.
- Fourth, the euro crisis raised profound questions about the independence of the IMF – how much independence is essential for the IMF to play a useful role in a crisis and how to prevent the subversion of that role in the euro crisis from becoming the new norm.
These questions go well beyond consideration of how the “rules of the game” should be crafted. They go to the heart of the optimal decision-making structure of an institution whose effectiveness can easily be compromised by political pressures. The experience in Europe reinforces the arguments for a serious rethink of the management and decision-making structure of the IMF.
Eichengreen, B (2010), “It’s not too late for Europe”, VoxEU, 7 May 2010.
IMF (2002), Access Policy in Capital Account Crises, July 29.
IMF (2010), Greece: Staff Report on Request for Stand-By Arrangement, IMF Country Report 10/110, May.
Pisani-Ferry, J, A Sapir and G Wolff (2013), EU-IMF Assistance to Euro-Zone Countries: An Early Assessment, Bruegel Institute, Volume XIX, May.
Schadler, S (2013), “Unsustainable Debt and the Political Economy of Lending: Constraining the IMF’s role in Sovereign Debt Crises”, CIGI Papers, No 19, October.
© VoxEU.org Used with permission.
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