Quarterly Bulletin
Monetary Policy Articles

The Monetary Policy Committee of the Bank of England: ten years on (850k)
Compared to past performance, UK inflation has been low and unusually stable since the inception of inflation targeting, while GDP growth too has been remarkably stable. In part that reflects the effectiveness of the inflation-targeting framework and the current institutional arrangements, particularly by anchoring inflation expectations and reducing the sensitivity of inflation to demand and cost shocks.

But other factors have also provided a benign context for the MPC's efforts: cheaper imports and increased competitive pressures associated with globalisation; and increases in labour supply, associated in part with inward migration. Both have dampened inflationary pressures and reinforced the changes in the inflation process associated with the change in monetary regime. The environment is unlikely to be so benign in the future.

The submission also covers the impact on monetary policy of a number of particular issues that have been relevant to the MPC's deliberations over the past decade: the balance of demand and the exchange rate; money supply and liquidity; asset prices; household debt; and investment.

Introducing the Agents’ scores (708k)
(by Colin Ellis of the Bank’s Inflation Report and Bulletin Division and Tim Pike of the Bank’s Agency for the South East and East Anglia). Each month, the Bank’s twelve Agents make quantitative assessments of economic conditions as seen from their respective countries and regions. These scores provide numerical measures of the intelligence that the Agents gather from month to month, and cover some areas of the economy where there are no official statistics. The scores are also timely and some have a high correlation with subsequently published ONS data. As such, they can be useful indicators of the current economic conjuncture. This article examines the scores that have been used in the regular MPC process since 1997. From January 2006, the scores will be published on the Bank’s internet site.

Do financial markets react to Bank of England communication? (294k)
(by Rachel Reeves of the Bank’s Structural Economic Analysis Division and Michael Sawicki of the Bank’s External Monetary Policy Committee Unit). Communication by the Bank of England’s Monetary Policy Committee (MPC) can convey information to market participants about the economic and policy outlook. In an inflation-targeting framework, clear communication by the central bank has an important role in explaining interest rate decisions and in helping to anchor inflation expectations. This article explores how financial markets react to different forms of communication by the MPC. The article finds that markets react to collective forms of communication such as the MPC Minutes and Inflation Report. But reactions to what might be called individual forms of communication - speeches and testimony to parliamentary committees - are more difficult to discern. Compared with a similar study for the United States, the results for the United Kingdom are less pronounced.

Financial stability, monetary stability and public policy (151k)
(by Chay Fisher, System Stability Department, Reserve Bank of Australia and Prasanna Gai of the Bank’s Systemic Risk Assessment Division). The interplay between financial and monetary stability has received considerable attention in recent times, from policymakers and academics alike. This article reviews the broad themes that have emerged in the recent literature and highlights several key issues that merit attention by researchers. In particular, the optimal combination of instruments designed to achieve these twin goals of policy simultaneously remains a relatively underexplored area of research.

Assessing the MPC’s fan charts (885k)
(by Rob Elder of the Bank’s Inflation Report and Bulletin Division, George Kapetanios of the Bank’s Conjunctural Assessment and Projections Division and Tim Taylor and Tony Yates of the Bank’s Monetary Assessment and Strategy Division). The MPC places considerable weight on its economic forecasts when setting monetary policy. But there is inevitably uncertainty around the outlook for the economy, and to communicate this, the MPC publishes its projections as fan charts. This article discusses some of the issues that must be taken into account when assessing those fan charts, it reports a range of formal and informal tests of various aspects of the MPC’s fan charts, and it discusses developments in the economy that may have pushed outturns away from the MPC’s central projections. With only six years of fan chart projections that can be compared with outturns, the sample is too small to draw strong conclusions. But to date, at most forecast horizons, inflation and output growth outcomes have been dispersed broadly in line with the MPC’s fan chart bands. That suggests that the fan charts gave a reasonably good guide to the probabilities and risks facing the MPC.

The inflation-targeting framework from an historical perspective (583k)
(by Luca Benati of the Bank’s Monetary Assessment and Strategy Division). This article provides an historical perspective on the post-1992 inflation-targeting regime in the United Kingdom. It assesses nearly 400 years of UK economic history using three alternative gauges of stability: business-cycle fluctuations, the Phillips correlation between inflation and unemployment and the degree of inflation persistence. The first of these measures suggests that the inflation-targeting regime has been characterised by the most stable macroeconomic environment in recorded UK history. The second points to a significant improvement in the stability of the Phillips inflation-unemployment correlation during the post-1992 period. The third stability measure suggests that inflation persistence in the United Kingdom has been the exception, not the rule.

Monetary policy news and market reaction to the Inflation Report and MPC Minutes (279k)
(by James Bell of the Bank’s Conjunctural Assessment and Projections Division and Rob in Windle of the Bank’s Sterling Markets Division). This article describes the results of analysis carried out as background for the speech ‘Inflation targeting in practice: models, forecasts and hunches’, by Rachel Lomax, Deputy Governor for Monetary Policy, which is reproduced in this edition of the Quarterly Bulletin. It examines the reactions of both economists and financial markets to different MPC announcements: the policy statement release immediately after the interest rate meeting; the Minutes of that meeting; and the Inflation Report. This article also examines whether the amount of perceived ‘news’ contained in interest rate decisions has changed since the MPC was established in 1997.

No money, no inflation—the role of money in the economy (177k)
In this article, Mervyn King, Deputy Governor, examines the apparent contradiction that the acceptance of the idea inflation is a monetary phenomenon has been accompanied by the lack of references to money in the conduct of monetary policy during its most successful period. The disappearance of money from the models used by economists is, however, more apparent than real, with official interest rates playing the leading role as the instrument of policy, with money in the wings off-stage. Nevertheless, there are real dangers in relegating money to this behind-the-scenes role.

Financial market reactions to interest rate announcements and macroeconomic data releases
(47k)
(by Andrew Clare and Roger Courtenay of the Bank's Monetary Instruments and Markets Division). At 11.00 am on 6 May 1997 the new UK government announced that it had granted the Bank of England operational independence with respect to the implementation of monetary policy, subject to an RPIX inflation target of 2½% per year. This change was designed to improve the credibility and transparency of the monetary policy process. The Bank of England's aims were stated clearly, and the voting record and discussions of the members of the Monetary Policy Committee (MPC) were to be published shortly after interest rate decisions had been made.

Our aim in this study is to investigate whether there has been a systematic change since Bank independence in the way that market participants incorporate information from monetary policy announcements, and from other important macroeconomic data announcements, into financial prices. We use intra-day price data (rather than daily data, which are sometimes used in this context) because markets receive many different pieces of news throughout the trading day, and so the impact of a particular announcement may be obscured by using daily price series. We therefore concentrate on the minutes immediately preceding and following these announcements.

Our study uses high-frequency data on short and long-term LIFFE interest rate futures contracts, on the LIFFE FTSE 100 stock index futures contract, and on the dollar/sterling and Deutsche Mark/sterling exchange rates. We monitor the behaviour of these financial prices around the times of interest rate announcements and key macroeconomic data releases over two periods: from January 1994 to 6 May 1997 (pre Bank independence), and from 7 May 1997 to June 1999 (post Bank independence).

Our empirical results do not yield simple definitive conclusions about whether monetary policy is now better understood by financial market participants as a result of Bank independence. The total (cumulative) reaction of the LIFFE contracts and exchange rates to interest rate decisions appears either unchanged or lower in the post Bank independence period, depending on the market observed. This supports the idea that the news content of monetary policy announcements has fallen. However, while the total reaction supports this view, the immediate reaction in the first 5 minutes is larger in all of the markets studied here. With respect to interest rate decisions, it appears that the news contained in the decisions is incorporated into financial prices more quickly than in the pre Bank independence era. One possible explanation for this is that pre-positioning in the financial markets ahead of the decision has become more sophisticated since Bank independence, with the publication of a clear, unambiguous timetable for the announcement of interest rate decisions.

Looking at exchange rate responses, there is evidence to support the idea that FX market agents now pay more attention to macroeconomic data announcements. This evidence appears to suggest that the underlying economic data have become more important in these markets relative to the key monetary policy announcement.

A different picture emerges when we consider the impact on the LIFFE contracts of the same set of non monetary policy related announcements. For the short sterling and long gilt contracts these reactions are lower in the post Bank independence period. Since the total impact of interest rate announcements is also lower following May 1997, it is difficult to make any clear statements about the relative importance of monetary policy for LIFFE fixed-income market participants. We can say that all announcements now appear to have a lower impact upon the two interest rate contracts that we consider. Finally, there is a significant decline in FTSE 100 volatility around the set of macroeconomic announcements.

The empirical analysis presented is based on a relatively short sample, including a period when the markets will have been learning about the new monetary policy framework. The results can only be suggestive rather than the basis for firm conclusions. Nevertheless, there is some evidence that interest rate announcements have become less important for some financial markets, and no more important for others, since May 1997.

The main aim of this article is to assess whether the data on bank and building society lending to private non-financial corporations (PNFCs) and households contain information that could improve our understanding of the links between monetary policy and aggregate demand.

The article demonstrates that it is possible to estimate relationships that explain lending to firms and households, and that lending is driven by the same factors that drive the more intensively researched categories of money demand, consumption and investment. The results have improved our understanding of the links between money and credit and the spending decisions of households and firms. There do appear to be significant interactions between lending to firms and households, and money, consumption and investment. The estimated system of equations potentially gives a framework that helps us to interpret the likely impact of observed credit growth on future spending. These estimates are tentative and require further empirical verification. Notwithstanding these reservations, channels that involve credit as well as money balances appear to matter for the transmission mechanism of monetary policy.

Government debt structure and monetary conditions
(33k)
(by Alec Chrystal of the Bank's Monetary Assessment and Strategy Division, Andrew Haldane of the Bank's International Finance Division, and James Proudman of the Bank's Monetary Instruments and Markets Division). In June 1998 the Bank of England organised a conference on 'Government debt structure and monetary conditions'. The aim of the conference was to discuss the interactions between the size and structure of government debt and the concerns of monetary policy. The proceedings of the conference will be published shortly. This article summarises the issues discussed.

The article identifies three main channels through which government debt structure might influence monetary conditions. These are the potential effects of:

• the quantity of debt;
• the composition of debt (eg short versus long-maturity, index-linked versus conventional); and
• the ownership of debt (eg by banks or non-banks).

Taking each of these in turn, the following conclusions about the effects of government debt structure on monetary conditions are drawn:

• Effects of the quantity of debt. The consensus at the conference was that the insights of Michael Woodford were interesting but controversial and, as pointed out by Ben Friedman, were not of great current relevance to the UK conjuncture. Rather, as Charles Goodhart argued, new financial instruments, new issuing techniques and new capital market structures since the 1980s have all helped to reduce concerns about how the quantity of debt impinges on monetary control, to the point where the two issues could now be seen as almost distinct.
• Effects of the composition of the debt. Changes in the composition of debt might affect expected asset returns and the incentives facing the central bank. But the consensus at the conference appeared to be that the size of these effects was small, at least in response to marginal shifts in government portfolios. There was nevertheless a need for monetary policy makers to monitor changes in the composition in the debt portfolio carefully, to be alert to possible effects on the monetary aggregates.
• Effects from the ownership of debt. Most of the work on this topic has been done on the United States, where there were suggestions (for instance in the work of Kuttner and Lown) that government debt taken up by banks was a substitute for loans to the private sector. For the United Kingdom, the available evidence was consistent with the view that debt sales to banks had only a small impact on either money supply growth or bank lending. But little detailed empirical work has been done to support this result. So that view can, at most, be tentative.

Overall, the economic research discussed at the conference suggested that changes in debt management policy at the margin were unlikely to have first-order effects upon monetary conditions in normal circumstances. But two important caveats are needed. First, many aspects of the transmission mechanism and optimal debt management are not well understood, and policy should aim to be robust to a variety of different assumptions and models. Second, there are few, if any, examples of extreme changes by governments in debt management policy. So it is less clear that large changes in the quantity or composition of the debt will not have implications for monetary conditions. For these reasons, the effects of changes in debt management policy on monetary aggregates need to be monitored and interpreted with care.

The use of explicit targets for monetary policy: practical experiences of 91 economies in the 1990s
(50k)
(by Gabriel Sterne of the Bank of England's Centre for Central Banking Studies). In June 1999 the Bank of England hosted its sixth Central Bank Governors' Symposium. This year the subject was 'Monetary policy frameworks in a global context', based on a report prepared by DeAnne Julius of the Bank's Monetary Policy Committee and Maxwell Fry, Lavan Mahadeva, Sandra Roger and Gabriel Sterne of the Bank's Centre for Central Banking Studies (CCBS). In this article Gabriel Sterne draws on one of the chapters of the report. The report uses a survey of 91 central banks to assess developments in monetary frameworks across a wide cross-section of economies. The final report, along with a selection of papers originally presented at a CCBS Academic Workshop in November 1998, will be published by Routledge in mid 2000.

A monetary policy framework comprises 'the institutional arrangements under which monetary policy decisions are made and executed' (McNees (1987), page 3). Following the breakdown of the Bretton Woods system of exchange rates, policy-makers have employed a variety of monetary frameworks in order to increase the credibility of monetary policy. Since the key characteristic of the framework is often an explicit target for monetary policy, the aim of the article is to assess the use of such targets in a range of economies in the 1990s. The analysis is based on data provided by 91 central banks that responded to a questionnaire on monetary policy frameworks circulated by the Bank of England in late 1998.

Explicit monetary policy targets have become more widely used in the 1990s than at any time since the Bretton Woods era. In the survey of 91 central banks, 96% (all but four countries) were using some form of explicit target or monitoring range in 1998. This contrasts sharply with 1990, when only 55% had an explicit target or monitoring range.

The article assesses in detail the use of explicit targets. The first section of the article argues that the choice of policy target rests not just on the likelihood and utility of hitting a single number. Other important roles for explicit targets may include defining informal or formal contractual relationships between institutions, and focusing analysis on particular economic indicators.

The second section goes on to examine which targets have been adopted in the 1990s by the 91 countries sampled, and the degree of flexibility with which they have been implemented. The announcement of an explicit target can represent full commitment to a particular outcome, or it may be no more than a benchmark used to explain deviations from the target. The sample provides extremes of experience that include rigidly fixed exchange rates on the one hand, and loose monitoring ranges for one or all of the exchange rate, money and inflation on the other. In the case of domestic monetary targets, the data used in the article relating to the deviations of outcomes from targets indicate that, in many cases, targets have been implemented quite flexibly.

The transmission mechanism of monetary policy
(56k)
This report has been prepared by Bank of England staff under the guidance of the Monetary Policy Committee in response to suggestions by the Treasury Committee of the House of Commons and the House of Lords Select Committee on the Monetary Policy Committee of the Bank of England.

The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels, which are known collectively as the 'transmission mechanism' of monetary policy.

The purpose of the paper is to describe the MPC's view of the transmission mechanism. The paper is in two parts.

Part I describes the links from official interest rate decisions to economic activity and inflation. It discusses aspects of these links such as the distinction between real and nominal interest rates, the role of expectations, and the interlinking of many of the effects mentioned. There is also a discussion of the role of monetary aggregates in the transmission mechanism.

Part II provides some broad quantification of the effects of official interest rate changes under particular assumptions. There is inevitably great uncertainty about both the timing and size of these effects. As to timing, in the Bank's macroeconometric model (used to generate the simulations shown at the end of the paper), official interest rate decisions have their fullest effect on output with a lag of around one year, and their fullest effect on inflation with a lag of around two years. As to size, depending on the circumstances, the same model suggests that temporarily raising rates relative to a base case by 1 percentage point for one year might be expected to lower output by something of the order of 0.2% to 0.35% after about a year, and to reduce inflation by around 0.2 percentage points to 0.4 percentage points a year or so after that, all relative to the base case.

Monetary policy and the yield curve (33k)
(by Andrew Haldane of the Bank's International Finance Division and Vicky Read of the Bank's Foreign Exchange Division). This article examines and interprets movements in the yield curve at the time of changes in monetary policy. A perfectly transparent, fully credible monetary policy will insulate the yield curve from jumps at the time of monetary policy changes. Indeed, stability of the yield curve around the time of monetary policy changes provides one measure of the degree of transparency and credibility of a monetary regime.

Most monetary regimes are less than perfectly transparent and credible. Typically, the yield curve does jump at the time of official rate changes. But evidence in the United Kingdom suggests that these yield-curve shifts have been dampened considerably since the introduction of inflation targeting and the transparency reforms that have accompanied it. Greater transparency has manifested itself in greater stability in the yield curve, especially at the short end. As the credibility of the inflation-targeting regime grows, longer-maturity yields might also be expected to be more stable following policy changes.

Monetary policy and uncertainty (50k)
(by Nicoletta Batini, Ben Martin and Chris Salmon of the Bank's Monetary Assessment and Strategy Division). This article describes various types of uncertainty that policy-makers may face. It summarises analysis, including recent work by Bank staff, that shows how different forms of uncertainty could lead to different policy responses.

The article reviews how economic theory suggests that monetary policy-makers should take account of different types of uncertainty. This is an area where economic theory lags behind practice. Policy-makers have always had to make allowances for all the uncertainties that they perceive.

Theoretical analysis has tended to consider only very specific and tightly defined forms of uncertainty. A key result- that policy-makers should act as if certain - is applicable only when policy-makers have considerable information about the structure and state of the economy. The second section of this article shows how this certainty-equivalence result breaks down once it is assumed that policy-makers are unsure about the relationship between variables in the economy or, in some circumstances, on account of measurement error, about the current state of the economy. Such uncertainties by themselves are likely to result in smaller policy responses to economic developments. The results from the studies summarised in the third section of the article provide some evidence of this effect.

But these studies take account only of the effect of parameter uncertainty. In practice, policy-makers' uncertainty is likely to be deep-seated, not least because they are unsure about the basic structure of the 'true' economy. Neither these studies, nor other empirical work, provide a unified analysis of the effects of all forms of uncertainty upon policy. In short, a consensus view has yet to emerge from the academic literature as to how policy-makers should deal with uncertainty.

Comparing the monetary transmission mechanism in France, Germany and the United Kingdom: some issues and results (142k)
(by Erik Britton and John Whitley of the Bank's Conjunctural Assessment and Projections Division). In this article, Erik Britton and John Whitley analyse the importance of structural differences between the economies of the United Kingdom, France and Germany for the response of output and prices to changes in monetary policy. They review previous studies and report results from a complementary empirical approach, summarising the evidence as inconclusive. They argue that some of the commonly cited differences are not really structural and that even where they are, they do not automatically imply that one economy will be more sensitive than another to a change in monetary policy.

Executive summary of the single monetary policy in Stage 3 (15k)
This is a summary published by the European Monetary Institute (EMI) of its report on the alternative strategies for conduct of a single monetary policy by the European System of Central Banks (ESCB) in Stage 3 of Monetary Union. This follows the article in the previous edition of the Quarterly Bulletin which gave the Bank's views on the EMI's proposals for the operational framework.

Monetary policy implementation in EMU-a Bank of England perspective on the EMI's proposals (32k)
(by David Rule of the Bank's Gilt-Edged and Money Markets Division). This article summarises and explains the European Monetary Institute's (EMI) proposed operational framework for the European System of Central Banks (ESCB) to conduct a single monetary policy in Stage 3 of Economic and Monetary Union (EMU). The framework would apply in the United Kingdom from 1 January 1999 if the United Kingdom fulfilled the necessary conditions to adopt the euro and the UK Government and Parliament decided to move to Stage 3. The article sets out the areas where agreement has been reached between EU central banks and gives the Bank of England's views on the issues that remain to be settled by the European Central Bank (ECB) after it becomes operational.

The industrial impact of monetary policy (81k)
(by Joe Ganley of the Bank's Markets and Trading Systems Division and Chris Salmon of the Bank's Monetary Assessment and Strategy Division).
This article investigates the disaggregated effects of monetary policy on the output of 24 sectors of the UK economy. The purpose of the analysis is to identify the speed and magnitude of firms' reactions in these sectors to an unexpected monetary tightening; and to examine whether these responses provide any evidence on the transmission mechanism of monetary policy. The results indicate that the sensitivity of output to changes in monetary conditions differs markedly across industries.

Simple monetary policy rules (51k)
(by Alison Stuart of the Bank's Monetary Assessment and Strategy Division).
This article describes two simple rules, the McCallum rule and the Taylor rule, that could in principle be used to guide monetary policy. It then applies the rules to past UK data. In the United Kingdom, monetary policy decisions are based on a thorough assessment of the prospects for inflation rather than on one simple rule or single indicator. But simple rules can have a useful complementary role alongside all the other information within a pragmatic approach to monetary policy.