Section C
The inflation target and the Monetary
Policy Committee
This section outlines the United Kingdom’s monetary policy framework. It tells
you about the inflation target, how the Monetary Policy Committee takes
decisions on Bank Rate and quantitative easing, and how it provides forward
guidance.
Monetary policy in the United Kingdom
33
Inflation targets
33
A symmetrical inflation target
33
From RPIX inflation...
33
...to CPI inflation
34
2.0% on average
34
Why is the target positive?
34
An independent Bank of England
36
The Monetary Policy Committee (MPC)
36
MPC meetings
37
Explaining the MPC’s views and decisions – public accountability
37
Quantitative easing – injecting money into the economy
38
What is quantitative easing?
38
Why was QE needed?
38
How does QE work?
38
How much QE is needed?
39
QE2 – a second round of asset purchases
39
Exiting QE as the economy recovers
39
Has QE worked?
40
The team’s policy decision
40
Monetary policy as the economy recovers
41
Fresh guidance
41
An expectation, not a promise
42
Recovery and the stock of purchased assets
42
The Chancellor’s remit for the MPC
43
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Section C The inflation target and the Monetary Policy Committee
31
Section C
Monetary policy in the United Kingdom
In the United Kingdom, the monetary policy framework has evolved to reflect
differing experiences and circumstances. But since the late 1990s an inflation target
has been the defining feature of the framework.
Inflation targets
A symmetrical inflation target
In 1992, the Government decided to adopt for the first
time an explicit target for inflation. Instead of targeting
something like the exchange rate as a means of controlling
inflation, a rate for inflation itself was targeted. Interest
rates were set to ensure demand in the economy was kept
at a level consistent with a certain level of inflation over
time. Similar policies were already operating in New
Zealand and Canada, and have subsequently been adopted
by other countries.
The Chancellor announced on 12 June 1997 that he was
setting an inflation target of 2.5%. The new target of
2.5% was quite a significant change from the previous
target of 2.5% or less. The Treasury felt there were
uncertainties about the old target – was it 2.5% or less
than 2.5%, and if so how much less? So the new target
was symmetrical. It was designed to give equal weight to
circumstances in which inflation is higher or lower than
the target rate. Inflation below the target was to be
judged as being just as bad as inflation above the target.
The first inflation target was set by the Chancellor of the
Exchequer to be an annual inflation rate of 1%–4%, with
an objective to be in the lower half of that range by the
end of the 1992–97 parliament. The inflation target was
subsequently revised to be 2.5% or less.
Interest rates are set to ensure demand in
the economy is kept at a level consistent
with a certain level of inflation
During this time, interest rate decisions were taken by the
Chancellor of the Exchequer. However, the Bank of England
was asked to publish its own economic appraisals in a
quarterly Inflation Report and was given the task of
deciding the timing of interest rate changes. Each month
the then Chancellor – Kenneth Clarke – met the then
Governor of the Bank of England – Eddie George – to
discuss the level of interest rates. Although the Governor
could offer the Bank’s advice about the level of interest
rates necessary to meet the Government’s inflation target,
the decision remained the Chancellor’s. These
arrangements continued until May 1997 when the new
Chancellor – Gordon Brown – announced a new policy
framework.
Bank of England and The Times Interest Rate Challenge 2014/15
The target was symmetrical – inflation
below the target was to be viewed in the
same way as inflation above it
So the remit was not to achieve the lowest possible
inflation rate – policy should not aim for an inflation rate
below the target. Interest rates should be set to ensure
the level of demand in the economy was consistent with
meeting the inflation target.
From RPIX inflation...
Between 1992 and 2003, the inflation target was
expressed in terms of an annual rate for a measure of
retail price inflation that excludes mortgage interest
payments. This is known as RPIX inflation – it is the
annual change in the Retail Prices Index (RPI) but does not
include one of the RPI's components – the interest paid on
mortgages. Mortgage interest payments are an important
Between 1992 and 2003, the inflation
target was expressed in terms of RPIX –
retail price inflation excluding mortgage
interest payments
Section C Monetary policy in the United Kingdom
33
part of household expenditure and so they are included in
the RPI. But they will tend to rise if interest rates go up.
So an increase in interest rates designed to reduce
inflation would have the perverse effect of initially
resulting in a rise in inflation.
…to CPI inflation
On 9 June 2003, the Chancellor announced that he
planned to change the inflation target to one based on
the Harmonised Index of Consumer Prices – the HICP –
instead of RPIX. This would be the first major change to
the monetary framework introduced since 1997.
2.0% on average
Having a target for annual inflation of 2.0% does not
mean that the Monetary Policy Committee is expected
to hold inflation at 2.0% all the time. That would not be
possible or, in fact, desirable. Inflation might change
month to month for all kinds of reasons, many of which
will only have a temporary influence.
Stormy weather...
The inflation rate might change, for example, because of
the weather. If there had been a very wet or very dry
summer, we might expect this to result in bad food
harvests. Any resultant fall in the supply of food might
push some food prices higher for a time, and raise the
overall inflation rate. But we would not expect interest
rates to be changed because of this.
We do not want to force changes in demand and output
across the economy to get inflation back to 2.0% every
time it moves higher or lower. That would mean interest
rates going up and down all the time. This would create
great uncertainty and unnecessary volatility in the
economy. And, by the time the effects had worked
through the economy, inflation might well have changed
again for another reason. Remember, when interest rates
are changed, there is little immediate effect on inflation.
It takes time.
So we accept that the inflation rate will move up
and down because the economy is subject to all sorts
of influences and unexpected events. The aim is to set the
degree of policy stimulus that we think gives the best
chance of inflation being 2.0% in around two years’ time.
But we know it will not always be exactly that rate.
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When inflation does change, we need to understand why
and assess whether the change is likely to persist or if the
reasons for the change are likely to have a broader impact
on the economy and future inflation. But we do not need
to change interest rates every time this happens. In this
sense, monetary policy is aiming to ensure the inflation
rate is 2.0% on average over time.
Why is the target positive?
Why not have an inflation target of 0%?
Although the objective of stable prices actually means
no inflation, we do not aim for this. We prefer to have a
moderate amount of inflation rather than zero inflation.
There are a number of reasons for this, although
economists debate which matter most.
One consideration concerns the fact that interest rates
cannot fall below zero – banks cannot charge negative
interest rates. But what we call real interest rates – the
interest rate minus the inflation rate – can be, and often
are, negative. That is simply when the rate of inflation is
higher than the actual rate of interest. We call the actual
rate of interest – ie. what is paid in money terms – the
nominal interest rate.
When real interest rates are negative, there is a big
incentive for people to spend and borrow rather than save.
One hundred pounds might earn 5% interest if it was put
in a bank account for a year. But if the inflation rate is
10% in that year, the cash will be worth less in a year’s
time than it is now. The real rate of interest is minus 5%.
In this situation, people are likely to prefer to spend more
today rather than tomorrow. Having negative real interest
rates – when the nominal rate of interest is below the rate
of inflation – might be a useful policy option if demand in
the economy is very weak, such as during a recession.
Monetary policy is aiming to ensure that
the inflation rate is 2.0% on average over
time
However, if we have zero inflation, then the policy option
of having negative real interest rates is lost. Like nominal
interest rates, real rates could not be lower than zero.
Retaining this policy option is often cited as one of the
reasons for having an inflation target above zero.
Section C Monetary policy in the United Kingdom
34
Another reason that we do not have a target of zero
inflation relates to our ability to measure inflation
accurately. It is not possible or practical to record every
single price in the country every day of the week. So we
have to estimate inflation by taking a sample of prices.
This sample tries to be representative but it is only ever an
approximation of what people are spending their money
on and what prices they are paying.
It is generally recognised that the true level of inflation is
usually below the rate of inflation recorded by a measure
like the CPI – it overstates inflation to a small degree.
Some price increases will reflect improvements in quality.
For example, computers might include more features or
have faster processors; cars might be more reliable. So,
from year to year, prices might not be measured on an
identical like-for-like basis. It is difficult to incorporate
quality improvements in a price index although some
adjustments can be made. But we need to acknowledge
that some price increases will be due to quality
improvements – in other words, consumers are getting
more for their money.
Having a positive inflation target allows
real interest rates to be negative which
might be a useful policy option when
demand is weak
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The measured rate of inflation tends to
overstate the true inflation rate
Because of this and other reasons, the measured rate of
inflation tends to overstate the true rate of inflation to a
small degree. So if we had a zero inflation target, we
would be targeting falling prices. A general fall in prices –
what we call deflation – could cause demand to fall if
people expect prices to be lower in the future and
consequently decide to delay their spending.
Why not have an inflation target of 5% or 10%?
Many of the costs of inflation are associated with its
unpredictability. But if we could be sure that inflation
could be held at 5% or 10% a year, then the costs of
higher inflation might not be as great. However, it would
be odd to be using money as a standard measure of value
for goods and services if its value was going to decline by
5% or 10% every year. We would continually have to
adjust the value of everything by 5% or 10%. Because
having higher inflation would bring no lasting benefit – in
terms of output and employment – we would have to ask
why not aim for something lower, which was more
consistent with stable prices? In practice, the higher
inflation is, the more uncertain and volatile it tends to be.
Having high and stable inflation might not be an option.
Section C Monetary policy in the United Kingdom
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Section C
An independent Bank of England
In 1997, the Government gave the Bank of England independence to set interest rates.
This was a major change in the policy framework. It meant interest rates would no
longer be set by politicians. The Bank would act independently of Government,
though the inflation target would be set by the Chancellor. The Bank would be
accountable to parliament and the wider public.
The objective given to the Bank of England was initially
explained in a letter from the Chancellor. This objective
was then formalised in the 1998 Bank of England Act.
The Bank has ‘to maintain price stability, and, subject to
that, to support the economic policy of HM Government
including its objectives for growth and employment’
(Bank of England Act 1998).
The Bank’s remit recognises the role of price stability in
achieving economic stability more generally, and in
enabling sustainable growth in output and employment.
It also recognises that the inflation target will not be
achieved all the time and that, confronted with
unexpected developments in the economy, striving to
meet the target in all circumstances might cause
undesirable volatility of output.
The Chancellor restates the inflation target each year.
From June 1997 to December 2003 the target was 2.5%
for RPIX inflation. The Chancellor, on 10 December 2003
changed the target to 2.0% for CPI inflation. The most
recent policy statement is reproduced on page 43.
Dear Chancellor
If the inflation target is missed by more than 1 percentage
point on either side – in other words, if the annual rate of
CPI inflation is more than 3.0%, or less than 1.0% – the
Governor of the Bank, as Chairman of the MPC, must
write an open letter to the Chancellor explaining the
reasons why inflation has increased or fallen to such an
extent and what the Bank proposes to do to ensure
inflation comes back to the target. This does not mean
that the Bank has a target of 1.0%–3.0%. The target is
2.0%. But if inflation varies by more than 1 percentage
point from the target, the Bank has to explain why.
So far the Governor has written fourteen open letters to
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the Chancellor. CPI inflation on all of these occasions was
more than 1 percentage point above the 2% target. In his
letter of February 2012, the Governor said that the MPC’s
best collective judgement was that CPI inflation would
continue to fall back to around the target by the end of
2012. In coming months, that further moderation was
likely to reflect the declining contributions from petrol
prices and any remaining VAT impact, together with
recently announced cuts to domestic energy prices. But
the pace and extent of the fall in inflation remained highly
uncertain.
The Monetary Policy Committee
The Chancellor instructed the Bank to create a new
committee to set interest rates – the Monetary Policy
Committee (MPC). The Committee consists of nine
independent members – five from the Bank of England
and four external members appointed by the Chancellor.
The appointment of external members to the Committee
is meant to ensure that the MPC benefits from thinking
and expertise in addition to that gained inside the
Bank of England. The membership of the MPC changes
from time to time. The current members are:
Mark Carney, Governor
Ben Broadbent, Deputy Governor
Sir John Cunliffe, Deputy Governor
Nemat Shafik, Deputy Governor
Kristin Forbes
Andy Haldane
Ian McCafferty
David Miles
Martin Weale
Each member of the MPC has expertise in the field of
economics and monetary policy. Members do not
Section C An independent Bank of England
36
represent individual groups or areas. They are independent.
Each member of the Committee has a vote to set interest
rates at the level they believe is consistent with meeting
the inflation target. The MPC’s decision is not a consensus
of opinion. It reflects the votes of each individual member
of the Committee.
A representative from the Treasury also sits with the
Committee at its meetings. The Treasury representative
can discuss policy issues but is not allowed to vote.
The purpose is to ensure that the MPC is fully briefed
on fiscal policy developments and other aspects of the
Government’s economic policies, and that the Chancellor
is kept fully informed about monetary policy.
MPC meetings
The MPC meets every month to set monetary policy.
Throughout the month, the MPC receives extensive
briefing on the economy from Bank of England staff. This
includes a half-day meeting – known as the pre-MPC
meeting – which usually takes place on the Friday before
the MPC’s interest rate setting meeting. The nine members
of the Committee are made aware of all the latest data on
the economy and hear explanations of recent trends and
analysis of important issues. The Committee is also told
about business conditions around the country from the
Bank’s regionally-based Agents.The Agents’ role is to talk
directly to business to gain intelligence and insight into
current and future economic developments and prospects.
differences of view. They also record the votes of the
individual members of the Committee. The Committee
has to explain its actions regularly to parliamentary
committees, particularly the House of Commons’ Treasury
Committee. MPC members also speak to audiences
throughout the country, explaining the MPC’s policy
decisions and thinking. This is a two-way dialogue.
Regional visits also give members of the MPC a chance to
gather first-hand intelligence about the economic situation
from businesses and other organisations.
In addition to the monthly MPC minutes, the Bank
publishes its Inflation Report every quarter. This report
gives an analysis of the UK economy and the factors
influencing policy decisions. The Inflation Report also
includes the MPC’s latest forecasts for inflation and output
growth. Because monetary policy operates with a time lag
of about two years, it is necessary for the MPC to form
judgements about the outlook for output and inflation.
The MPC uses a model of the economy to help produce its
projections. The model provides a framework to organise
thinking on how the economy works and how different
economic developments might affect future inflation.
But this is not a mechanical exercise – forecasts are not
produced by feeding data into the model and pressing a
computer button to get the answer. Given all the
uncertainties and unknowns of the future, the MPC’s
forecast has to involve a great deal of judgement about
the economy. There are no crystal balls to tell the
Committee what the future will be.
Two days – one decision
The monthly MPC meeting itself is a two-day affair. On
the first day, the meeting starts with an update on the
most recent economic data. A series of issues is then
identified for discussion. On the following day, the
Governor summarises the previous day’s discussions and
the MPC members individually explain their views on what
policy should be. The Governor then puts to the meeting
the policy which he believes will command a majority and
the Committee takes a vote. Any member in a minority is
asked to say what level of interest rates he or she would
have preferred, and this is recorded in the minutes of the
meeting. The Committee’s decision on Bank Rate and the
level of asset purchases is announced at 12 noon on the
second day.
We tell you more about the MPC’s projections for growth
and inflation on pages 55–56. We do not want teams to
produce forecasts and you do not need to understand how
the MPC produces its projections. But we will tell you
something about the factors that might affect inflation in
one or two years’ time – so teams can form their own
opinions and make their own judgements.
The Bank of England is charged with the task of
meeting the Government’s inflation target, which is
2.0% based on the CPI measure of inflation. The
target is symmetrical – inflation below or above the
target is viewed as equally undesirable. Inflation will
not always be 2.0%. The aim is that it is 2.0% on
average over time.
Explaining the MPC’s views and
decisions – public accountability
The MPC goes to great lengths to explain its thinking and
decisions. The minutes of the MPC meetings are published
two weeks after the interest rate decision. The minutes
give a full account of the policy discussion, including
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Section C An independent Bank of England
37
Section C
Quantitative easing – injecting money into the economy
The Monetary Policy Committee announced in March 2009 that it would start to
inject money directly into the economy to boost spending – a policy often known as
quantitative easing. The Committee continues to set Bank Rate each month, and the
objective of monetary policy is unchanged – to meet the government’s 2% inflation
target.
What is quantitative easing?
In March 2009, the Bank’s Monetary Policy Committee
(MPC) began purchasing financial assets funded by the
creation of central bank reserves. These reserves are new
money that the Bank creates electronically. Often known
as quantitative easing (QE), the Bank’s asset purchases are
designed to inject money directly into the economy to
raise asset prices, boost spending and so keep inflation on
track to meet the 2% target.
The Bank has injected money into the
economy to boost spending to meet the
inflation target
Once Bank Rate had reached 0.5%, the MPC considered
this to be the practical limit to how far it could cut
nominal interest rates. But the outlook for demand and
inflation in March 2009 suggested the need for further
monetary stimulus. So the MPC decided to inject
additional money directly into the economy through a
programme of financial asset purchases funded through
the creation of central bank reserves.
In 2009 money was not growing quickly
enough to keep inflation close to the
2% target
How does QE work?
The Bank buys financial assets from banks who may be
selling on their own behalf or, more likely, on behalf of
their clients, such as insurance companies, pension funds
and non-financial firms. The proceeds of the sale are
credited to the seller’s bank account. Most of the assets
purchased since the start of the programme in
March 2009 have been British government bonds (gilts).
Why was QE needed?
Spending in the economy slowed very sharply in the
latter part of 2008 and during 2009 as the global
recession gathered pace. This threatened a downward
spiral through a combination of contracting real output
and price deflation. The MPC responded decisively, cutting
Bank Rate from 5% to 0.5% – its lowest ever level – in
just five months in order to support activity and thus
reduce the risk of inflation falling below the 2% target in
the medium term.
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The MPC’s purchases of financial assets can boost nominal
spending in the economy in a number of inter-related
ways. The immediate effect of buying large quantities of
gilts is to raise their prices and lower their yields relative
to other assets. In response, investors are likely to adjust
their portfolios, for example by buying other financial
assets like shares or company bonds – the return on which
is likely to be more attractive. This increased demand for
those assets pushes up their prices, and lowers their yield.
In this way, the effect of the MPC’s purchases of gilts
spreads out across all other asset markets.
At the same time, those selling assets to the Bank have
more money in their bank accounts and commercial banks
hold more deposits at the Bank of England.
Section C Quantitative easing
38
As a result of QE, asset holders in general – including
ordinary households and businesses – will have portfolios
with higher value and more liquidity. If they feel wealthier
and have more money immediately available, then they
are likely to increase their spending which boosts the
economy directly, or else to take on more risk by
increasing their lending to consumers and businesses. In
turn, consumers and businesses may be encouraged to
take on more debt because lower yields on financial assets
– lower interest rates in other words – bring down the
cost of borrowing.
But there are factors that may work to dampen the
effects of QE. An obvious example lies in the banking
sector. The boost to the value of banks’ asset holdings and
their holdings of liquid assets as a result of QE, by itself,
might be expected to make them more willing to lend.
But in the wake of the financial crisis, banks are concerned
about their financial health and as a result are wary of
expanding their lending. For this reason, the MPC did not
expect QE to result in a material expansion of bank
lending. The Bank has acquired most of the assets from
financial businesses other than banks.
Charlie Bean – the Bank’s Deputy Governor for
monetary policy at the time the policy was initiated –
said that ‘the objective of QE is to work around an
impaired banking system by stimulating activity in the
capital markets’. As a result, companies, particularly larger
companies, wishing to raise money have not had to
depend as much on the banks as they might have done in
the absence of QE, raising funds instead from bond and
share issuance.
How much QE is needed?
There was a lot of uncertainty over the appropriate scale
of asset purchases. When the MPC first discussed the
scale of asset purchases in March 2009, the Committee
noted that spending in the economy had grown each year
by around 5% since 1997 and, over that period, inflation
had been close to target. At that time, it appeared likely
that spending would contract without additional policy
stimulus. That suggested asset purchases needed to be
large enough to boost spending growth back to around
5% a year, bearing in mind reductions in Bank Rate and
other factors influencing the economic outlook.
So at its meeting in March 2009, the MPC voted to
reduce Bank Rate to 0.5% and to spend £75 billion on
asset purchases. Subsequently, at its meeting in May that
year, the outlook for the economy looked somewhat
bleaker than in March. Consequently, the MPC voted to
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keep Bank Rate at 0.5% and to undertake a further £50
billion of asset purchases – bringing total purchases to
£125 billion.
At its meeting in August 2009, there were still few signs
of the fall in economic activity coming to an end. So the
Committee again voted to keep Bank Rate at 0.5% and to
make another £50 billion of asset purchases, so that total
purchases increased to £175 billion. In November the MPC
voted to increase total purchases to £200 billion, and to
keep Bank Rate unchanged. Those purchases were
completed early in 2010.
The MPC kept the level of Bank Rate and asset purchases
unchanged for almost two years after its meeting in
November 2009. The Committee believed that the
stock of past purchases, together with the low level of
Bank Rate, continued to provide a substantial stimulus to
the economy.
This extended pause in monetary loosening did not
necessarily mean that the MPC’s asset purchase
programme had come to an end, but it gave the MPC the
opportunity to take stock of the effects of QE so far.
QE2 – a second round of asset
purchases
At its meeting in October 2011, the Committee decided
that the outlook for output growth had weakened so
that the margin of slack in the economy would probably
be greater and more persistent than previously thought.
This made it more likely than not that inflation would
undershoot the 2% target without further monetary
stimulus. Overall, the case for an expansion of the
Committee’s programme of asset purchases was
compelling and it voted unanimously to purchase a
further £75 billion of gilts, bringing the stock of purchases
since March 2009 to £275 billion.
Subsequently, at its meeting in February 2012 the
Committee voted to make an additional £50 billion in
asset purchases, and in July it judged again that further
stimulus was required to meet the inflation target and
voted to buy another £50 billion in gilts to bring the total
stock of asset purchases to £375 billion.
Exiting QE as the economy recovers
As the recovery in the economy becomes stronger and
more enduring, the appropriate settings of monetary
policy needed to deliver the inflation target will change.
This means at some point the MPC will begin to tighten
Section C Quantitative easing
39
policy by increasing Bank Rate and, later, by selling assets.
In its May 2014 Inflation Report, the MPC said that it is
likely to defer asset sales at least until Bank Rate has been
increased to a level from which it could be cut materially,
were more stimulus required.
Has QE worked?
Monetary policy affects inflation with a long and variable
time lag. So asset purchases – like changes in Bank Rate –
take their time to work through the economy to have
their full effect on inflation. But what impact has the
Bank’s asset purchases had to date?
QE is untried previously in the UK, so there’s little past
experience to go by. The economic circumstances that
necessitated the use of QE were also unprecedented.
The evidence suggests that the first round of QE in 2009
raised the level of real GDP by 11/@% to 2% and increased
inflation by 3/$ to 11/@ percentage points. The Bank’s
forecasting model suggests that a 1 percentage point cut
in Bank Rate increases CPI inflation by about 1/@ a
percentage point, so that the effect of the first round of
QE in 2009 was equivalent to a 11/@ to 3 percentage point
cut in official interest rates.
Taking the MPC’s current plan for asset purchases as its
starting point, the team can decide to maintain or
increase the stock of asset purchases, or to make asset
sales. It is difficult to offer precise guidelines about how
much money needs to be injected into – or withdrawn
from – the economy to keep inflation on track to meet
the target.
For instance, if you think that growth in the economy
could be very low and inflation is set to fall below 2%,
you might decide that justifies more asset purchases. If
you think economic recovery is likely to be strong and
enduring with upward pressure on inflation, that might
suggest asset sales.
But there is no right answer. Deciding on the level of asset
purchases or of Bank Rate is a matter of judgement and,
like the real policymakers, team members may disagree.
So the team may choose to vote on Bank Rate and on
quantitative easing. If this results in a tie, the team
captain will have the casting vote. If there is a split
decision, both sides of the argument must be explained in
the presentation to the judges.
Key resources for the team’s decision
Teams may vote on Bank Rate and the
level of asset purchases
The team’s policy decision
In each round, the team should take the MPC’s interest
rate on the day of its presentation as its starting point,
and decide whether to change Bank Rate and, if so,
whether to increase it or decrease it, and by how much. In
addition to setting Bank Rate, teams may – like the MPC –
wish to consider the option of injecting or withdrawing
money from the economy to meet the inflation target.
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• Watch the Bank’s short animated film,
‘Quantitative easing – How it works’.
www.bankofengland.co.uk/education/Pages/
inflation/qe/video.aspx.
• Read ‘The impact of asset purchases in the MPC’s
projections’ on page 41 of the May 2014 Inflation
Report
www.bankofengland.co.uk/publications/Documents
/inflationreport/2014/ir14may5.pdf.
Section C Quantitative easing
40
Section C
Monetary policy as the economy recovers
The financial crisis and the deep recession that followed prompted exceptionally
loose monetary policy. Now that the economy has begun to recover, the MPC has
provided ‘forward guidance’ on how it will adjust monetary policy to keep inflation
close to the 2% target.
Forward guidance is a statement by the MPC on the
future path of monetary policy. It’s designed to help
people understand how the MPC sets interest rates, so
that households and businesses can spend and invest with
more confidence.
Forward guidance is a statement by
the MPC on the future path of monetary
policy
The MPC first provided forward guidance on monetary
policy in August 2013. At that time, there were early signs
of recovery, but the degree of spare capacity or ‘slack’ in
the economy remained large.
The Committee framed its guidance in terms of the
unemployment rate. It said it would leave interest rates
and the stock of asset purchases unchanged, at least until
the unemployment rate had fallen to 7% – provided this
didn’t pose risks to the outlook for inflation or financial
stability.
The MPC’s forward guidance has
prompted companies to bring forward
spending and increase hiring
Although not a comprehensive measure of slack, the
Committee selected the unemployment rate because it’s
less volatile and prone to revision than other measures,
and is widely understood.
Bank of England and The Times Interest Rate Challenge 2014/15
When it provided its policy guidance, the MPC said that
once unemployment had fallen to 7%, it would assess the
state of the economy more broadly, drawing on a wide
array of indicators.
Evidence collected from business surveys shows that the
MPC’s forward guidance has prompted companies to bring
forward spending and increase hiring.
Fresh guidance
By February 2014, unemployment had fallen close to 7%
and the MPC decided to offer further guidance on future
monetary policy.
The Committee believed there remained spare capacity in
the economy equal to about 1%–1½% of GDP. On that
basis the MPC judged there was scope to absorb more
spare capacity before raising Bank Rate. And the
Committee would maintain the stock of asset purchases
at £375 billion, at least until Bank Rate had begun to rise
from 0.5%.
The Committee said that once it begins to raise Bank
Rate, it expects it will do so only gradually. And when the
economy has finally returned to normal capacity and
inflation is close to target, the appropriate level of
Bank Rate is likely to be materially below the 5% level
set on average by the Committee prior to the crisis.
The Committee said that once it begins
to raise Bank Rate, it expects it will do so
only gradually
Section C Monetary policy as the economy recovers
41
An expectation, not a promise
In its August 2014 Inflation Report the MPC said that the
central message in its previous guidance remained: given
the headwinds holding the economy back, Bank Rate
would rise only gradually and was expected to remain
below historical levels for some time to come.
The Committee’s guidance on the likely
pace and extent of increases in Bank Rate
‘was an expectation, not a promise’.
However, the actual path for monetary policy would
depend on economic conditions. In other words, the
Committee’s guidance on the likely pace and extent of
increases in Bank Rate ‘was an expectation, not a
promise’.
Recovery and the stock of purchased
assets
A factor influencing increases in Bank Rate will be the
speed and timing at which the MPC sells its stock of
purchased assets. Sales of assets represent a tightening of
monetary policy because they withdraw money from the
economy. Therefore asset sales are likely to be associated
with a lower path of Bank Rate than would otherwise be
the case.
Bank of England and The Times Interest Rate Challenge 2014/15
The MPC has said it is likely to defer sales of assets at
least until Bank Rate has reached a level from which it
could be cut materially, were more stimulus required.
Bank Rate will be the ‘active marginal instrument’ for
monetary policy. This means that once asset sales have
begun, the Committee will loosen policy by cuts in Bank
Rate, rather than through new purchases of assets.
Recent Bank publications on monetary policy
guidance
• ‘Influences on policy in the medium term’,
pages 42–43 in the August 2014 Inflation Report.
See
www.bankofengland.co.uk/publications/
Documents/inflationreport/2014/ir14aug5.pdf.
• ‘Monetary policy as the economy recovers’,
pages 8–9 in the February 2014 Inflation Report.
See
www.bankofengland.co.uk/publications/
Documents/inflationreport/2014/ir14febo.pdf.
• ‘The impact of asset purchases in the MPC’s
projections’, page 41 in the May 2014 Inflation
Report. See
www.bankofengland.co.uk/publications/
Documents/inflationreport/2014/ir14may5.pdf.
Section C Monetary policy as the economy recovers
42