1. How Effective has UK Monetary Policy been ? To see more of our products visit our website at www.anforme.co.uk Brian Ellis and Colin Ellis

2. For ten years the picture looked good. The Bank of England Monetary Policy Committee was established in 1997. Its success shifted expectations towards low and stable inflation. This in turn moderated pricing decisions and wage demands and made the MPC’s job easier.

3. By 2010 the wheels of the monetary policy machine had not completely come off but had started wobbling. This was contributed to by a fall in sterling which pushed up import prices. There was also a rise in world commodity prices, especially oil. Throughout 2010 inflation was above the CPI target of 2% and above its acceptable range of 1-3%. The government itself also raised VAT from 15% to 17.5% in January 2010.

4. MPC has continued to forecast a fall in inflation. They have not taken anti-inflationary measures partly because of the time lag of about one year before monetary policy takes effect. The Bank’s August 2010 prediction was that inflation would not return to target until the start of 2012. The Bank Rate has stuck at 0.5% although the MPC has been divided.

5. Monetary policy works by influencing aggregate demand. The link between changes in the base rate and aggregate demand is summed up by the monetary policy transmission mechanism. Here a rise in the base rate will lead to a rise in other interest rates in the economy. Households will then find saving more rewarding and borrowing more expensive. This should case a fall in consumption, which is the biggest component of aggregate demand.

6. The plunge in the base rate as a result of the recession reduced rates to savers. Typical savings accounts now offer about 1% interest, whilst CPI inflation is over 3%. The real return on saving has now been negative for 18 months. Classical theory suggests consumers should spend more and save less as a result. In reality UK savers have saved more of their income than when previously there was a positive return on saving.

7. Before the recession the UK experienced negative saving where household borrowing exceeded saving. But in 2009 the savings ratio went above 8%. This shows that other factors can have more influence than interest rates.

8. Looking at borrowers we can see that there are even more problems with the transmission mechanism. Recession has made people more risk averse, so borrowing is less attractive. Also, commercial banks lending rates have not exactly followed base rate downwards as theory predicts.

9. 0.5% is considered as being as low as base rate can go. Even this did not generate as much stimulus to aggregate demand as the MPC considered desirable. They therefore introduced quantitative easing (QE). The MPC appreciates that ‘expansionary’ low interest rates and QE have had only limited impact in reviving the economy. QE involves the Bank of England buying bonds from sellers who then initially deposit the payment into their bank accounts. These deposits are liquid assets which enable banks to lend more if they wish to.

10. GDP is only expected to return to pre-recession levels by 2012. On a narrow view the MPC is not concerned with recession, just inflation. However, the Monetary Policy Framework says that: “The (MPC) remit recognises the role of price stability in achieving economic stability more generally, and in providing the right conditions for sustainable growth in output and employment.”

11. The medium-term priority of the Chancellor of the Exchequer is to remove the Public Sector Borrowing Requirement and stop growth in the national debt. This approach reflects the divide between two major approaches to macroeconomic policy. It could be that spending cuts and tax increases perpetuate weakness in aggregate demand, leading to capacity being scrapped and increased unemployment and skill loss. Keynesians believe that weak aggregate demand can be boosted by government fiscal injection. This could lead to higher employment and tax receipts and lower benefit payments. The Public Sector Borrowing Requirement should then fall automatically.

12. Some broadly ‘classical’ economists welcome a reduction in the size, role and spending of the public sector. The UK spending cuts and tax increases of autumn 2010 are expected to lead to nearly one million job losses, particularly in the public sector. The Chancellor believes the private sector will expand to take up the slack. But, public sector cuts will reduce both household disposable income, and hence consumption, and government spending.

13. Other governments in Europe are also planning to reduce fiscal deficits. But Japan has a gross national debt in excess of 250% of GDP yet continues with expansionary measures. The USA has a public sector deficit of more than $1,000 billion per annum, and seems headed for policy deadlock between ‘hawks’ and ‘doves’.

14. The Bank of England and the MPC should not discuss fiscal policy, much less oppose it. Using monetary policy to counteract government fiscal tightening would raise serious questions about the MPC’s role. But, those MPC members considering additional QE are concerned with the impact of weak demand on medium-term inflationary pressures. Weak demand could push inflation below target, once the current short- term dynamics abate. However, some MPC members worry about second-round effects, where above-target inflation triggers strong earnings growth, pushing inflation higher in turn.

15. How far is the MPC fully independent of the government? To what extent can fiscal and monetary policies operate independently of each other? After recent difficulties, how might the MPC rebuild confidence that it has control of inflation? Does increasing international integration leave price levels in one country at the mercy of global markets? Will economists ever resolve the tension between those who favour a ‘classical’ approach which gives maximum freedom to market forces and others who favour more regulation and government intervention?