01 January 2012
2011/12 Rybczynski Prize Essay
Samuel Tombs, Senior UK Economist, Capital Economics
For much of the period of remarkable macroeconomic stability in the 1990s and early 2000s, UK monetary policy was relatively predictable, stable and apparently successful. The Monetary Policy Committee (MPC) used one tool (interest rates) to achieve one outcome (low and stable inflation). Interest rates were moved gradually; Mervyn King expressed his desire to make monetary policy “boring.” In contrast, the recession of 2008/09 and subsequent economic recovery appeared to result in a significant change in central bank policy. Official interest rates were cut aggressively until they hit the zero lower bound; quantitative easing (QE) was adopted subsequently. Then, in contrast to previous recoveries, interest rates were left unchanged for a prolonged period, despite the persistence of above target inflation. It seemed as if policymakers had begun to act in a fundamentally different way. As we approach the 15th anniversary of the establishment of the MPC, it now seems to be a good time to look back and reflect on the consistency of monetary policy. Has a ‘regime shift’ in policymakers’ behaviour really occurred? Are we now in a new era of monetary policy where the pre‐financial crisis rules of thumb no longer apply? Does the MPC care less about inflation, as some have suggested? Does the Committee act in a more discretionary manner?
I conjecture that the answer to all these questions is a firm ‘no’. Instead, I argue that the period since the establishment of the MPC can still be seen as one where policymakers set interest rates – and then went on to provide QE – in a consistent manner. The old rules of monetary policy still seem to apply. Five sections follow. First, I provide a non‐technical summary of the theory of ‘Interest Rate Reaction Functions’ (IRRFs), also known as ‘interest rate rules’, for those unfamiliar with the literature. Next, I propose that the traditional emphasis that these rules place on central banks’ responsiveness to measures of the output gap is now misguided. Instead, I argue that rules should account for policymakers’ response to measures of inflation expectations in the private sector. Assessing the last fifteen years of monetary policy is not without empirical difficulties. Chiefly, how can QE be incorporated into an IRRF? I consider three different approaches to this question in section three. The fourth section focuses on the key results of estimating five different reaction functions for the period since the establishment of the MPC. I then conclude and use the proposed IRRF to infer the extent to which the MPC may react to economic shocks in the future, assuming that it acts in a way that is consistent with its past behaviour.
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