Speech
Good morning. It’s a pleasure to be here at Gresham College, a place that has held public lectures on important societal questions for over four hundred years. That makes it one of the few City institutions that’s been around longer than the Bank of England. I would also like to thank both NIESR and the Money, Macro and Finance Society (MMF) for organising the event. Over the years the work of both institutions has been invaluable to the UK policy community.
We are living through the most extraordinary – and in many ways an extraordinarily unwelcome – time. Russia’s unprovoked attack on Ukraine has brought war to Europe for the first time in decades, with all its terrible humanitarian consequences.
From an economic perspective, coming on top of what was already a very steep rise in the cost of globally traded goods, in the wake of the pandemic, the invasion has led to substantial rises in the cost of energy and other commodities. As a big net importer of manufactures and commodities it’s doubtful that the UK has ever experienced an external hit to real national income on this scale. From the narrow perspective of monetary policy it will result in the near term in the difficult combination of even higher inflation but weaker domestic demand and output growth.
However, the MPC has already said quite a bit about these things, individually and collectively, and – dramatic though its economic effects have been – my topic today is not this awful conflict or the immediate questions it poses monetary policy. I’ve no doubt we will discuss these things in the Q&A. Instead, I wanted to talk about something more general, namely the communication of monetary policy, and specifically the role of “forward guidance”. I will take this to mean statements by monetary authorities about future policy.
The question “what’s going to happen to interest rates?” is asked of us routinely. (Sometimes it’s phrased directly, sometimes more circuitously, but it always seems to come in one form or another.) And perhaps it’s understandable that people should want to know, particularly in an environment as uncertain as this. If it were possible to eliminate or reduce at least one source of unpredictability, wouldn’t that be a good thing? And since the MPC is in control of interest rates why can’t it just tell us what it’s going to do?
The problem is that we can’t be sure. Interest rates are not an end in themselves. They’re a means of meeting our objectives: the stabilisation of inflation over the medium term and, subject to that, the stabilisation of economic activity. And because there are lots of unpredictable shocks hitting the economy, things that would otherwise (and often do) move output and inflation around, the appropriate path of interest rates is necessarily unpredictable as well. The skipper of a boat, adapting to a skittish wind, and interested in making the journey as smooth as possible, may have perfect control of the tiller. But that doesn’t mean she can tell you exactly which position it will be in at every point in the future. That will depend on the direction of the wind at the time.
It’s not that monetary authorities are unconcerned about expectations of future interest rates. Quite the opposite: these expectations are central to the transmission of policy. We directly determine only one particular – and very short-term – interest rate (what commercial banks get paid on their overnight deposits, or “reserves”, at the central bank). But demand and spending depend more on longer-term interest rates. In the UK, around half of corporate borrowing has a maturity of three years or more. Some mortgages have interest costs tied directly to Bank Rate but most are now fixed for at least two years. And these longer-term rates depend in their turn on expectations of how the short-term interest rate evolves over the future. So they matter.
Equally, however, these expectations should – and generally do – respond to the news about the economy of their own accord, without the need for any explicit prompting by the central bank. The private sector forms its own views about how the economy might evolve over the future, views that are continually adjusted as new information comes in. As long as people also understand the objectives of the central bank, and therefore the appropriate response of policy, they should then be able to work out for themselves what that news means for the likely path of interest rates.
Sometimes, when economic conditions are relatively stable, there isn’t that much to work out, as one can observe the central bank’s “reaction function” – how it responds to incoming data – pretty much directly. In the years prior to the financial crisis, official interest rates in the UK were very tightly correlated with economic activity (and exhibited very little dependence on anything else). Chart 1 is one way of representing that relationship: it plots the change in the average interest-rate vote on the MPC, in basis points, against a survey-based measure of economic growthfootnote [1]. At least until 2008 the correspondence was extremely tight.