The monetary policy strategy of the Bank of England in 2020–21: An assessment

Excessive money creation during the Covid pandemic has resulted in Britain's worst episode of inflation since 1990–91. The backdrop to this failure of monetary policy is the Bank of England's aggregate demand/aggregate supply framework together with the Monetary Policy Committee's neglect of broad money. An alternative way to operate monetary policy is urgently needed. A significantly improved monetary policy outcome could be achieved by shifting from trying to steer the economy using interest rates and quantitative easing or quantitative tightening to reliance on the relative stability of income velocity (the ratio of nominal GDP to broad money) as a means of managing aggregate demand.     

Optimal fiscal and monetary policy with occasionally binding zero bound constraints

This paper studies optimal fiscal and monetary policy when the nominal interest rate is subject to the zero lower bound (ZLB) constraint in a stochastic New Keynesian economy. In the baseline model calibrated to match key features of the U.S. economy, it is optimal for the government to increase its spending when at the ZLB in the stochastic environment by about 60 percent more than it would in the deterministic environment. The presence of uncertainty creates a unique time-consistency problem if the steady state is inefficient. Although access to government spending policy increases welfare in the face of a large deflationary shock, it decreases welfare during normal times as the government reduces the nominal interest rate less aggressively before reaching the ZLB.     

Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

How does the need to preserve government debt sustainability affect the optimal monetary and fiscal policy response to a liquidity trap? To provide an answer, we employ a small stochastic New Keynesian model with a zero bound on nominal interest rates and characterize optimal time-consistent stabilization policies. We focus on two policy tools, the short-term nominal interest rate and debt-financed government spending. The optimal policy response to a liquidity trap critically depends on the prevailing debt burden. While the optimal amount of government spending is decreasing in the level of outstanding government debt, future monetary policy is becoming more accommodative, triggering a change in private sector expectations that helps to dampen the fall in output and inflation at the outset of the liquidity trap.     

Long-term interest rates,risk premia and unconventional monetary policy

We study two kinds of unconventional monetary policies: announcements about the future path of the short-term rate and long-term nominal interest rates as operating instruments of monetary policy. We do so in a model where the risk premium on long-term debt is, in part, endogenously determined. We find that both policies are consistent with unique equilibria, that, at the zero lower bound, announcements about the future path of the short-term rate can lower long-term interest rates through their impact both on expectations and on the risk premium and that long-term interest rate rules perform as well as, and at times better than, conventional Taylor rules. With simulations, we show that long-term interest rate rules generate sensible dynamics both when in operation and when expected to be applied.     

Fear of floating or monetary policy as usual? A structural analysis of Mexico's monetary policy

This paper uses Bayesian methods to estimate a small open economy dynamic stochastic general equilibrium (DSGE) model for the period in Mexico after the 1994 crisis. I consider a Taylor rule as the expression of the evolution of monetary policy to gauge its response to the exchange rate in the post-crisis period. The estimation results favor a consistent response of the nominal interest rate to the short-run nominal exchange rate after 1994. Although fear of floating is present, Mexico's monetary policy has taken steps toward a credible free-floating exchange rate that targets inflation.     

The London Business School with Gower Publishing

The current economic outlook is dominated by fears of continued industrial unrest and uncertainty regarding wage increases. The key issues for output and expenditure will be the outcome of the almost inevitable conflict between the monetary objectives and wage inflation. The most recent indicators provide some evidence of the type of problems the economy will face during 1979. The figures for industrial output and consumption suggest that, by end of 1978, the growth of output was slowing down and the figures for wholesale and retail prices suggest that inflation was picking up. Adherence to the monetary targets is already, on a short-term basis, requiring little or no growth in the real money supply and accompanying high interest rates. The latest official longer-term indicators also point to a slowdown in domestic demand.
Inflation would probably have increased by now had it not been for the recent tight monetary policy and the resulting stability of the exchange rate. We have earlier argued that earnings increases of about 12% will be consistent with the current financial background. But earnings increases of 15% or more will put extreme pressure on the company sector and would bring into sharp focus the choice between finanacing wage increases and letting the exchange rate fall with resulting higher inflation rates: or holding the monetary targets and accepting the short-term consequences for output and unemployment.     

Ramsey policies in a small open economy with sticky prices and capital

This paper analyzes jointly optimal fiscal and monetary policies in a small open economy with capital and sticky prices. We allow for trade in consumption goods under perfect international risk-sharing. We consider balanced-budget fiscal policies where authorities use distortionary taxes on labor and capital together with monetary policy using the nominal interest rate. First, as long as a symmetric equilibrium is considered, the steady state in an open economy is isomorphic to that of a closed economy. Second, sticky prices’ allocations are almost indistinguishable from flexible prices allocations both in open and closed economies. Third, the open economy dimension delivers results that are qualitatively similar to those of a closed economy but with significant quantitative changes. Tax rates are both more volatile and more persistent to undo the distortions implied by terms of trade fluctuations.     

Sources of the great moderation: A time-series analysis of GDP subsectors

Recent work finds evidence that the volatility of the U.S. economy fell dramatically around the first quarter of 1984. We trace the timing of this so-called “Great Moderation” across many subsectors of the economy in order to better understand its root cause. We find that the interest rate sensitive sectors generally experience a much earlier volatility decline than other large sectors of the economy. The changes in Federal Reserve stabilization policies that occurred during the early 1980s support the view that an improved monetary policy played an important role in stabilizing real economic activity. We find only mild evidence that “good luck” was important and little evidence to support the claim that improved inventory management was important.     

International linkages between short-term real interest rates

Whereas previous studies have focused on the causal relation between nominal interest rates, this paper examines causal relationships between real rates for the United States and six other countries. Based on evidence from our full sample we find that U.S. and foreign interest rates are not highly informative for one another. This would suggest that even if the United States is regarded as a large player in international financial markets this does not necessarily translate into the transmission of U.S. real interest rates to other countries. However, an examination of various sub-periods of our sample reveals that this conclusion may be sensitive to the U.S. monetary policy regime. We also report results for linkages between European countries which indicate that Germany provides some information on real interest rates in France and the United Kingdom, but not in Italy. An analysis of various sub-periods for the European countries show that the result for France is not robust, with German rates having an impact only in the first period through March 1983. This latter evidence does not provide strong support for the hypothesis that Germany's monetary policy plays a dominant role in the European Monetary System. In general, we would argue that domestic factors play a prominent role in determining real interest rates, quite independently from the influence of interest rates from abroad.     

Search for yield and business cycles

In the ultra-low interest rate environment after the financial crisis, it has been often pointed out that the “search for yield” behavior of financial institutions might have been intensifying interest rate decreases. One hypothesis to explain search for yield is that banks try to buy longer-term bonds even when they recognize negative term premiums in long-term rates because they myopically care about current portfolio income, not just expected holding-period returns. I study the potential impacts of this behavior on U.S. business cycles and long-term bond’s ex-post term premiums. I find that in an economy in which banks are exposed to the value-at-risk constraint, the existence of these myopic banks provides realistic moments of ex-post term premiums. In addition, their existence could generate higher output persistence under a productivity shock compared to an economy without them. This is because the difference between a myopic long-term bond pricing and a realized deposit rate path affects banks’ net worth. I study policy implications, too. In response to changes in the strength of banks’ capital regulation, the existence of myopic banks amplifies business cycles. Regarding monetary policy, it is necessary to consider ex-post term premiums, because ex-post term premiums tend to move in the same direction as the short-term interest rate and amplify business cycles in that direction when myopic banks exist.     

Residential investment and house prices in a multi-sector monetary business cycle model

This paper develops a three-sector quantitative dynamic stochastic general equilibrium model to account for some of the salient business cycle properties concerning residential investment and house prices. We depart from the traditional Real Business Cycle setup by incorporating monetary frictions and credit market activities into the model economy. The model generates the high volatility of residential investment and hours worked in the house investment goods producing sector, as well as the procyclicality of house prices. The lead-lag pattern of house investment also roughly conforms with the data. We find that monetary policy and nominal interest rates play a special role in the determination of house prices. Money shocks generate remarkably volatile residential investment and house prices.     

In search for yield? Survey-based evidence on bank risk taking

Monetary policy can have an impact on economic and financial stability through the risk taking of banks. Falling interest rates might induce investment into risky activities. This paper provides evidence on the link between monetary policy and bank risk taking. We use a factor-augmented vector autoregressive model (FAVAR) for the US for the period 1997–2008. Besides standard macroeconomic indicators, we include factors summarizing information provided in the Federal Reserve’s Survey of Terms of Business Lending (STBL). These data provide information on banks׳ new loans as well as interest rates for different loan risk categories and different banking groups. We identify a risk-taking channel of monetary policy by distinguishing responses to monetary policy shocks across different types of banks and different loan risk categories. Following an expansionary monetary policy shock, small domestic banks increase their exposure to risk. Large domestic banks do not change their risk exposure. Foreign banks take on more risk only in the mid-2000s, when interest rates were ‘too low for too long’.     

Monetary policy with interest on reserves

I analyze monetary policy with interest on reserves and a large balance sheet. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though higher interest rates raise output and then inflation. The conventional sign requires a coordinated fiscal–monetary policy contraction. I show how conventional new-Keynesian models also imply strong monetary–fiscal policy coordination to obtain the usual signs. I address theoretical controversies. A concluding section places our current regime in a broader historical context, and opines on how optimal fiscal and monetary policy will evolve in the new regime.     

Germany — the next Japan?

The German economy is in a hole, and it can’t stop digging. The tools that normally help an economy to get out of a hole are digging Germany further in. Hamstrung by the terms of the Stability and Growth Pact, it is planning a substantial tightening of fiscal policy over the next few years. And, with inflation below the Eurozone average and falling, and nominal interest rates set by the ECB, real monetary conditions are tightening as well: this at a time when Germany is already in recession. How long before the German economy sets off on the deflationary path trodden in Japan over the last decade?     

Interest rate risk in an emerging economy

The sharp decrease in inflation over the last decade—from 26% in 1990 to 4% in 2001—led the Central Bank of Chile to set its monetary policy interest rate in nominal terms since August 2001. This paper analyzes the effect of nominalization on the behavior of nominal, inflation-linked, and real interest rates, and its subsequent effects on the financial market. We find that nominalization has made nominal interest rates less volatile, while the opposite holds for inflation-linked interest rates. The effect on real interest rates is less unambiguous, but nominalization appears to have increased the cost of borrowing.     

Optimal monetary policy under incomplete markets and aggregate uncertainty: A long-run perspective

This paper examines the role of monetary policy in an environment with aggregate risk and incomplete markets. In a two-period overlapping-generations model with aggregate uncertainty, optimal monetary policy attains the ex-ante Pareto optimal allocation. This policy aims to stabilize the savings rate in the economy by changing real returns of nominal bonds via variation in expected inflation. Optimal expected inflation is procylical and on average higher than without uncertainty. Simple inflation targeting rules closely approximate the optimal monetary policy.     

The Dollar, the Oil Price and Policy Divergence

There is currently a clear divergence of policy between the United States, Japan and Germany. With the US in recession and concern growing over the severity of the slump, interest rates have been cut in a move to revive the economy. In contrast Japan and Germany are both experiencing strong growth and monetary policy remains tight to combat inflation. This divergence was seen most clearly when the Federal Reserve Board lowered its discount rate to 6 per cent on 1 February, the day after the Bundesbank had raised its Lombard rate to 9 per cent. With G7 increasingly concerned about domestic factors, less emphasis is placed upon stable exchange rates and as a result the dollar is at an all-time low. The last two G7 communiqués have stressed ‘stability oriented monetary policies’, an ambiguous phrase which fails to define ‘stability’ either in terms of exchange rates, inflation or growth. Thus both the German and Japanese policy of high interest rates to reduce inflation and low US interest rates aimed at stimulating the economy can be termed as ‘stability oriented’. This analysis focuses on these divergent policy responses in two alternative scenarios to the world forecast we presented last month. The first scenario considers what might happen if the Federal Reserve Board were to stimulate the US economy by further cuts in interest rates, whilst Japanese and German rates were unchanged in the face of inflationary pressures. This case may be relevant if the recent US loosening of monetary policy is not sufficient to encourage growth because of a ‘credit crunch’, so that a more expansionary policy is required by the Fed. As a consequence, policy diverges further and the dollar weakens. The second scenario focuses upon a reduction in inflationary pressures in Japan and Germany brought about by an oil price fall. In this case we assume that US policy is already loose enough to avoid a prolonged recession, but that German and Japanese monetary policy is relaxed as inflationary forces recede. In this case policies converge. Each scenario thus concentrates on one of !he two features which are causing the policy divergence amongst G3 countries: recession in the US, inflation in Germany and Japan.     

The difficulty of discerning what’s too tight: Taylor rules and Japanese monetary policy

Observers have relied increasingly on simple reaction functions, such as the Taylor rule, to assess the conduct of monetary policy. Applying this approach to deflationary or near-zero inflation environments is problematic, however, and this paper examines two shortcomings of particular relevance to the Japanese case of the last decade. One is the unusually high degree of uncertainty associated with potential output in an environment of prolonged stagnation and deflation. Consequently, reaction function-based assessments of Japanese monetary policy are so sensitive to the chosen gauge of potential output as to be unreliable. The second shortcoming is the neglect of policy expectations, which become critically important as nominal interest rates approach zero. Using long-term bond yields, we identify five episodes since 1996 characterized by abrupt declines in Japanese inflation expectations. Policies undertaken by the Bank of Japan during this period did little to stabilize expectations, and the August 2000 interest-rate increase appears to have intensified deflationary concerns.     

The effective of China's monetary policy: Quantity versus price rules

This paper deduces an open economic DSGE model and explores two monetary policy rules for China, the quantity and price rule. The empirical results indicate that (1) monetary policy with money supply as instrument seems increasingly difficult to conduct in China than before, (2) the linkage between money supply and output becomes weaker over time, and (3) the effects of a price rule on the economy seem to have become more significant than those of a quantity rule. The findings seem to favor the government’s intention of liberalizing interest rates and making a more active use of the price instrument as the economy becomes more market-oriented in recent years.     

Optimal discretionary monetary policy in a micro-founded model with a zero lower bound on nominal interest rate

This paper investigates optimal discretionary monetary policy under the zero lower bound on the nominal interest rate (ZLB) in the case of a distorted steady state due to monopoly and taxation. Solving a fully nonlinear micro-founded (FNL) model using a global method, I find that the central bank in a more distorted economy would cut the interest rate less aggressively under a particularly adverse demand shock. This occurs because inflation and nominal interest rates are higher on average, making the ZLB less likely to bind and causing the economy to escape from the ZLB sooner. However, the social planner would choose the optimal inflation rate of approximately zero. The result emerges because the unconditional benefit of avoiding the ZLB is not big enough to offset the cost of higher relative price dispersion when inflation is significantly positive. In addition, I show that the conventional linear-quadratic (LQ) method is inaccurate in the case of a sufficiently distorted steady state.