Understanding Monetary Policy: a synthesis of the old and the new

IMG_2494 EmmaI was debating with a member of the Monetary Policy Committee, in front of an audience of students and bankers, and I explained why it is not necessary to use interest rates to control aggregate monetary demand.  After I had finished my explanation, the MPC member stood up and said, “John could be right, but if he is then every single central bank in the world has got it wrong.”  I replied that his observation was correct and all central banks have this part of monetary policy wrong and this is why:

Monetary demand is made up of two components, the stock of money (money supply) and the flow of money, which is the velocity of circulation of that supply.  The stock of money is made up of two components and that is the printed and minted cash and the money created by retail bank lending.  In the UK the broad money aggregate is about 5% cash and 95% bank loans. The most commonly referred to measure of broad money is £M4.  This does, however, include some near money which is basically deposit money that is one step removed from being used to directly purchase products.  In the 1980’s there was a significant debate about whether base money (cash) should be used to control the total money supply or whether interest rates should be used to manage retail bank lending.  Interest rate controls won the debate, against my better judgement at the time, and the current (temporary, emergency, seven year) rate of 0.5% with no sign of ever changing, is beginning to convince me that I was right.

To explain this further, it is necessary to consider two points: firstly the Bank of England has total control over the supply of cash, and the supply of cash can be used to control the total amount of money supply.  This last point is currently the centre of a debate, but I can accept its use in current situations and it can be reinforced in a fairly simple way as I will explain later.  Secondly the Bank is competing with the market to determine interest rates and without any intervention at all there would always be a market rate of interest between borrowers and savers and it is this that is distorted when Bank rate moves too far above or below (as in the current situation)  of the market rate.  This means that the Bank has three ways to control monetary demand.  The first is by managing cash stocks and they have 100% control over this if we ignore counterfeiting.  The second is by adjusting interest rates, which gives them much less control as we have seen.  The third is trying to manage the velocity of circulation or flow of money by directives and quantitative guidance (who remembers Forward Guidance?).  Here they have virtually no control.

The current interest policy of bank rate at 0.5% is not having the desired effect of keeping the UK at target inflation (2%) and it is producing malinvestments in already owned assets rather than new investments, as well as creating asset bubbles.  There is a simple inverse relationship between the rate of interest and the price of an asset, and asset prices, including stock markets and property, are currently in the bubble.

Managing the amount of cash in the money supply is relatively easy.  It was always done by open market operations (OMO) where buying into, and selling out of, government debt would change the amount of cash circulating in the economy.  This was fairly precisely controlled in the 1960’s when retail banks were required to keep 8% of all assets in cash and I know that the Bank has considered re-introducing a similar control.  All that is necessary in the current situation is to choose any number close to what is currently being held by banks, as this will cause least disruption, and ask them to stick to that percentage ratio for the foreseeable future.  The other control over cash is quantitative easing (QE) and if we add quantitative tightening (QT) then we have both sides of the old OMO system.  The only problem is that OMO’s were carried out in secret and, because QE is transparent and misunderstood, I anticipate that central banks will be discouraged from using QE and QT when the time is right for fear of a media backlash.

The question to answer now is what is an effective monetary policy? In other writings I have explained how important monetary policy is by dismissing fiscal policy and establishing monetary policy as the single most important macroeconomic policy. Having said that, I need to stress that it is important in a rather benign way in the sense that the only thing it can do is manage the rate of inflation.  However if it gets that wrong then there can be very damaging consequences for the economy.  If the Bank gets it right, then consistently achieving its 2% target will create the right economic environment to inspire confidence in relative price changes which, in turn, will foster growth and employment.

The economy needs the level of aggregate monetary demand to grow slightly faster than the rate of growth of output. Stated crudely this means if monetary demand grows at 5% and the real economy grows at 3% then inflation will hit target at 2%. I have argued that the Bank creates distortions in the form of bubbles and recession if it uses interest rates to manage bank lending. It must therefore play down Bank rate and perhaps give it a new name, say the rediscount rate.  It then needs to target volume of money using a range of tools, excluding interest rates. Ideally it could return to using OMOs secretly through its broker and ignore the QE/QT route. The easiest way to do this will be to re-establish a cash to assets ratio for all banks under the control of the Bank of England.

And there we have it, a better monetary policy going forward.

John Hearn 8/4/2015


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