Treasury CommitteeDr Mark Carney: Response to the Treasury Committee’s questionnaire
1. How has your experience to date prepared you for the role of Governor of the Bank of England, including chairing the Monetary Policy Committee (MPC) and Financial Policy Committee (FPC)?
As Governor of a G7 central bank, I have led a team with a proven track record of monetary policy management. I have extensive experience operating a Flexible Inflation Targeting regime. The Bank of Canada has consistently achieved its inflation target, while the Canadian economy has grown jobs and output at the fastest pace in the G7.
As Governor, I chair the Bank of Canada’s monetary policy committee and serve as the Bank’s principle spokesperson. As such, I must communicate complex economic and financial concepts to broader audiences through public speeches, outreach events with a wide range of domestic and international stakeholders, parliamentary testimony, press conferences and media interviews.
During my tenure, the Bank of Canada has renewed Canada’s monetary policy framework. The new framework better defines Flexible Inflation Targeting and clarifies the role of macroprudential instruments and objectives. Through a targeted and persistent public communications strategy, these changes were introduced to public acceptance. In addition, the Bank has developed an unconventional policy framework, including its approach to conditional guidance.1
As Governor, I chair the Bank of Canada’s Financial Stability Policy committee and am a member of the Canadian multi-agency committees for microprudential supervision, macroprudential oversight and deposit insurance.
As Chair of the Financial Stability Board (FSB), I have senior responsibility for developing and driving a broad-based multilateral agenda for strengthening the resilience of the global financial system. This work includes coordinating at the international level regulatory, supervisory and other financial sector policies of national financial authorities and international standard-setting bodies. I am fully engaged in the design, negotiation and implementation of some of the most complex current financial reforms ranging from OTC derivatives, Basel capital and liquidity accords and reforms to shadow banking as well as contingency planning for cross-border crisis management for globally systemically important institutions.
As FSB Chair, I jointly oversee the development of the FSB-IMF Early Warning Exercise, which presents emerging risks to the international financial system twice annually to Finance Ministers and Central Bank governors.
As Chair of the Committee on the Global Financial System at the Bank for International Settlements, I led senior central bank colleagues in identifying and assessing potential sources of stress in global financial markets and promoting improvements to the functioning and stability of these markets. I initiated working groups that led to reports addressing specific challenges such as: the interactions of sovereign creditworthiness and bank funding; the risks of fixed income strategies of insurers and pension funds in an environment of low interest rates for a long period; and the practical application of macroprudential instruments.
I have experience in risk management in the private sector and crisis management in the public sector. In Canada, I was part of a team, which rapidly assessed the risks and instituted an effective, coordinated response to the global financial crisis, despite Canada’s deep integration with the U.S. economy and financial system. I have worked closely with
Governor King and his colleagues throughout the crisis period on a series of unprecedented interventions, including a coordinated rate cut in October 2008, a series of coordinated provisions of emergency liquidity and a network of swap arrangements amongst major central banks.
I have a long history of close cooperation with the Bank of England on issues such as the reform of the international monetary system, cooperative oversight arrangements between our organisations (and with the FSA) and cross border liquidity arrangements. The Bank of Canada and Bank of England have also worked closely together in the design of a number of key financial reforms, ranging from OTC derivatives, Basel liquidity rules and bail-in debt.
2. What do you regard as the main challenges you will face as Governor of the Bank of England in the next five years? What criteria do you suggest should be used to assess your record as Governor?
The economic position and transformation of the Bank’s responsibilities mean that the challenges I will face are many and varied. They fall into two groups: policy challenges and institutional challenges.
The first core policy responsibility is to deliver price stability while promoting a timely, sustained recovery and the highest sustainable level of employment in the UK economy.
To achieve this in an environment of large external shocks and the ongoing rebalancing of the UK economy, a range of subsidiary challenges must be met:
First, the Bank must enhance its forecasting, building on the recent Stockton review to make forecasts more accurate, transparent and better integrated with policy analysis.
Second, the Bank will need to design, implement and ultimately exit from unconventional monetary policy measures in a manner that reinforces public confidence.
Third, the Bank must improve continually its understanding and management of the interaction between monetary policy and macroprudential instruments.
Fourth, given the international dimension to the crisis, the Bank will need to support the Government as it engages in efforts of the Euro Area to re-found the European monetary union, address global imbalances and build a better functioning international monetary system (see question 27).
Finally, the Bank will need to complement price stability with confidence in the integrity of the currency, by continuing to produce banknotes in which people can have the highest confidence.
The second core policy responsibility is to promote financial stability, by building a more transparently resilient domestic financial system that engenders confidence and is able to provide the credit growth necessary to support a sustained recovery. In this regard, there are several priorities:
First, the Bank, through the PRA, must implement effective microprudential regulation. That means fully implementing the PRA’s new judgement-based approach to supervision and establishing the new regime as tough but fair, transparent and accountable.
Second, distinct from PRA judgement with supervision, we need to build understanding of the new regime as one in which it is understood that financial institutions can fail but that, if they do, their failure will be controlled and will not threaten the system. The implicit state subsidy for banks needs to be removed. To do that, we need also to make the ICB proposals a reality and to establish a full and credible resolution regime to sort out failing banks without recourse to the taxpayer.
Third, the Bank must, through the FPC, establish macroprudential policy as a complement to microprudential regulation. We need to embed a culture that assesses emerging vulnerabilities, stress tests the financial system, and monitors the boundaries of what activities are and are not regulated. The FPC needs to question whether, even if individual firms are doing the right thing, the system is structured in the most resilient way.
Fourth, the Bank needs to continue to develop its market operations, building on the recommendations of the recent reviews by Bill Winters and Ian Plenderleith, so that those operations provide an effective liquidity backstop for the system in a way that does not encourage excessive risk-taking.
Finally, as with price stability, the international dimension to financial stability means that the Bank will need to engage with European partners, including the ECB, EBA, and the ESRB to develop an effective working relationship between authorities. The Bank must continue to play an important role in ongoing efforts to develop a more resilient and efficient international financial system (consistent with the FSB priorities described in response to question 17).
An overarching policy challenge for me as Governor will be to maximise the synergies from the Bank’s broad responsibilities, particularly through its new committee structure, while fully respecting the primary responsibility of each body. For example, the FPC can be an effective complement for the PRA, and both the PRA and the FPC can maximise the effectiveness of monetary policy stimulus, while minimising emerging vulnerabilities in a “low for long” environment.2
Transformed responsibilities will mean a transformed institution. The priority challenges here will be that:
A clear shared vision for the Bank needs to be established, synergies from the collection of policy functions maximised and the expanded senior management team melded into a cohesive unit.
Succession planning and talent management will be paramount. The Bank will need to attract, retain and promote an assertive, engaged, accountable staff at all levels. The Bank should develop its team culture that promotes timely, well-researched and consensus-based decisions.
The Bank will need to build an effective, efficient central support function to serve all areas of the expanded institution and fully leverage a new organisational structure, including a new Chief Operating Officer role, to ensure value for taxpayers.
The Bank must realise fully the complete potential of the accountability and governance changes instituted in the Financial Service Act to enhance the credibility of, and trust in, the institution.
Throughout, the Bank should reinforce its existing culture of excellence as a learning institution that engages with academia, other central banks and private sector experts in the pursuit of its core objectives.
Key Criteria to Measure Success
Achieve price stability measured by consumer price inflation without creating undesirable volatility in output and employment. This will need to be achieved in a rebalanced economy growing as fast as the potential of the economy will allow.
Confidence in banknotes as measured by surveys and counterfeiting statistics.
A financial system that is transparently resilient and robust to shocks. The system should be well-capitalised to withstand plausible stress tests. Credit growth should meet the needs of the real economy. Micro- and macroprudential regimes should be widely understood and effectively enforced/implemented.
Effective communications: monetary and financial policy that is well-understood by the public; trust is restored in the financial system and confidence that inflation will remain close to target.
More generally, I would like to achieve an exit in 2018 that is less newsworthy than my entrance. That can be achieved if:
the Bank’s existing functions are reaffirmed;
its new functions are embedded and understood;
a strong leadership team is in place;
the credibility of, and trust in, the institution are entrenched; and
there is increased recognition that while the Bank of England’s actions provide the cornerstones of British prosperity—price and financial stability—these are necessary but not sufficient conditions for growth.
3. How would you describe your leadership style? How will the Bank look and feel different under your leadership?
Given my background, I believe I know how to lead, when to delegate and how to forge consensus. I have long and varied experience chairing committees of independent experts (ranging from economists to national policy-makers, heads of global standard setters and senior representatives of international organisations) to develop timely, substantive policy conclusions across a range of monetary policy and financial stability issues.
My leadership approach has been to develop a shared vision for the organisation, set out clear priorities to achieve that vision, ask critical questions to engage colleagues and spur analysis, and work towards consensus to take actions. I am comfortable adapting my opinions in the face of superior argument and analysis, but am also disciplined in the need to come to timely decisions (as my experience in crisis management demonstrates). I believe that this combination of flexibility and focus has enhanced my effectiveness as a leader.
Both of the organisations I currently head operate on the basis of consensus. In my experience consensus can only be truly achieved if there is a shared understanding of objectives and all parties feel their views have been considered. In the end, effective central bankers must appreciate the inherent challenge they constantly face of making timely decisions under uncertainty. I am a firm believer in central bank accountability and I intend to do my part to ensure that the new accountability measures in the Financial Services Act are fully and effectively utilised.
My experience as Governor of the Bank of Canada demonstrates a willingness and ability to implement significant organisational change. I manage an organisation of about 1,200 people across six offices, four time zones and in two official languages. Upon becoming Governor, I initiated a major reorganisation of our four policy departments, clarified the lines of responsibility of senior policy-makers, streamlined and delegated operating management.
With the Senior Deputy Governor, I led a process to re-engineer the Bank’s administrative and support services. As a result of that process, the Bank has achieved ongoing annual savings of $15 million and reduced staff by 7%.
Since becoming Governor, our employee satisfaction has increased and we were for the first time recognised as a Top 100 employer in Canada. We have now held that position for the past three years running. I believe this reflects an enhanced focus on workplace environment, clearer lines of authority, the opportunity for greater personal initiative and a sustained focus on internal talent management and development.
I have a track record of attracting and retaining senior external talent to public life including leading academics, several managing directors from the financial sector and senior IMF staff. Since becoming Governor, the Chiefs of our four main policy departments have been developed and then internally promoted. We have instituted and extended a comprehensive talent management strategy for the top 50 employees.
Based on recommendations of a senior working group, I helped shepherd through the FSB and the G20 Leaders process a major package of reforms to enhance the FSB’s capacity, resources and governance. These substantial, detailed proposals are helping put the FSB on a more enduring footing, with clearer lines of accountability and formal governance, consistent with the proposals of Prime Minister Cameron at the Cannes summit.
I am not in a position to comment on differences in leadership style.
4. What is the reason for your decision to serve as Governor for five years rather than eight?
Serving as Governor of the Bank of England will mark the pinnacle of my career. I am a strong believer in the value of public service, and I firmly believe that this responsibility offers me the opportunity to contribute where I can make the greatest impact.
This is one of the most important positions in central banking. The Bank’s responsibilities are immense and varied. The role comes during a unique period in the Bank’s illustrious history as it takes on new responsibilities. The next five years will span a period that will be critical for the future development of the Bank of England itself, for the development of the British, European and global economies, as well as decisive for domestic and international financial reform.
My tenure will oversee a significant transition at the Bank. To be most effective, transitions need to be sharp, sustained and finite. A five-year term is the right managerial timeline to relaunch the Bank of England with its broader responsibilities, and to develop considerable talent, undertake targeted external recruitment, and build a succession plan. Over the five years, we can establish the full potential of the new institutional structure, which combines monetary policy, macroprudential and microprudential regulation. I can also give life to the crucial governance reforms promoted by the Treasury Committee and incorporated in the Financial Services Act.
As an outsider I can—for a period—bring different experiences and perspectives to help catalyse the necessary changes within the Bank to achieve these goals, and I look forward to working with employees of the Bank, the Court, the Government and the Treasury Committee to ensure that the full potential of all of these reforms is realised.
The next five years will also be a decisive period for domestic financial reform. By 2018, the ring-fencing of core banking activities recommended by the ICB should be well on the way to completion and, following agreement of the European Recovery and Resolution Directive, the UK’s Special Resolution Regime will have been developed to allow bail-in of banks’ unsecured creditors. We will have done much to solve the problem of banks that are too big to fail.
Over the next five years, the Bank has the ability to extend and broaden its position as a global leader (intellectually and effectively) amongst central banks. The next five years will be the decisive period for international financial reform after the crisis. By 2018, all elements of the Basel III reforms will be agreed and implemented, with capital requirements and the Liquidity Coverage Ratio supplemented with the Net Stable Funding Ratio and a common leverage ratio. A wide range of reforms to OTC derivatives trading will also have been introduced, including capital and margining requirements, measures to impose mandatory exchange trading and centralised clearing of standardised derivatives, and new transparency requirements. In addition, the framework that is being constructed for systemic institutions will have been extended to global insurers and key shadow banks.
Importantly, a five-year term corresponds with my maximum possible term as FSB Chair (terms are three years once renewable). Simultaneously serving in both roles will maximise intellectual, managerial and work process synergies at the Bank of England during the critical period for reform.
Finally, from a personal perspective, there are two considerations. First, at the end of a five-year the term, I will have served as a Governor of a G7 Governor central bank for over a decade. In my experience, there are limits to these highly rewarding but ultimately punishing jobs. Second, the five year term has advantages given the ages of my children and the disruption that is involved in moving schools and countries.
5. Which economist has influenced you the most, and for what reasons?
While I have been influenced by a very broad range of academic economists, I am not comfortable identifying a single one. No theorist captures, or would claim to do so, the complexities of modern central banking.
6. Which of your publications or papers are of most relevance to your future role as Governor?
Following are the more relevant speeches and papers while Governor of the Bank of Canada. I would add the obvious caveat that they naturally reflect Canadian institutional and economic perspectives and therefore are not simply transferable to the role and responsibilities of the Bank of England.
Guidance, Toronto, 11 December 2012.
A Monetary Policy Framework for All Seasons, New York, 24 February 2012.
Renewing Canada’s Monetary Policy Framework, Montréal, 23 November 2011.
Renewal of the Inflation-Control Agreement: Background Information —November 2011, Ottawa, 9 November 2011.
Some Considerations on Using Monetary Policy to Stabilize Economic Activity, Jackson Hole, 22 August 2009.
Inflation Targeting in a Global Recession, Halifax, 27 January 2009.
Flexibility versus Credibility in Inflation-Targeting Frameworks, Lucerne, 27 June 2008.
Global Imbalances/International Monetary System
Financing the Global Transition, Halifax, 21 June 2012.
The Paradigm Shifts: Global Imbalances, Restoring Faith in thePolicy, and Latin America, Calgary, 26 March 2011 The Evolution ofInternational Monetary System, Calgary, 10 September 2010 Rebalancing thethe International Monetary System, New York, 19 November 2009 The New International Monetary Order,Global Economy, Montréal, 11 June 2009 Toronto, 23 November 2004 (Delivered while in role as Senior Associate Deputy Minister of Finance).
Growth in the Age of Deleveraging, Toronto, 12 December 2011.
Global Liquidity, London, 8 November 2011.
Living with Low for Long, Toronto, 13 December 2010From Hindsight to Foresight, Toronto, 17 December 2008.
Principles for Liquid Markets, New York, 22 May 2008.
Addressing Financial Market Turbulence, Toronto, 13 March 2008.
Some Current Issues in Financial Reform, Montréal, 8 November 2012.
Some Current Issues in Financial Reform, Washington 25 September 2011.
Bundesbank Lecture 2010: The Economic Consequences of the Reforms, Berlin, 14 September 2010.
Looking Back, Moving Forward: Canada and Global Financial Reform, Geneva, 9 November 2010.
The G20’s Core Agenda to Reduce Systemic Risk, Montréal, 10 June 2010.
Reforming the Global Financial System, Montréal, 26 October 2009.
What Are Banks Really For?, Edmonton, 30 March 2009.
Building Continuous Markets London, England, 19 November 2008.
7. What is your view of the monetary policy framework in the UK, and what assessment have you made of the merits of altering it?
In my view, flexible inflation targeting—as practiced in both Canada and the UK—has proven itself to be the most effective monetary policy framework implemented thus far. As a result, the bar for alteration is very high. In any possible review, it would be vital to recognise that long and varied experience demonstrates that delivering price stability is the best contribution that monetary policy can make to the economic welfare of citizens.
I have not made an assessment of the merits of altering the monetary policy framework in the UK, and of course any change to the Monetary Policy framework would be the sole responsibility of HM government. I do think, however, that it is important that the policy framework is reviewed periodically. In Canada, the framework is reviewed every five years. That process helps to reaffirm our remit and to focus our research efforts. Our most recent review, completed in November 2011, intensively examined alternatives to our current framework, including a lower inflation target and moving to a price-level target. The Bank of Canada worked with the Government of Canada in a calm, reasoned examination of these options and in full consideration of the lessons of the financial crisis. At its conclusion, we reaffirmed Canada’s flexible inflation targeting framework with a deeper collective understanding of the power as well as the interaction between monetary and macroprudential policies.
I can therefore report on my thoughts of the monetary policy framework in Canada and the assessment we made of the merits of alternative frameworks, recognising that the same assessment may not apply to the UK.
Bank of Canada’s Monetary Policy Framework
The Bank of Canada conducts monetary policy aimed at keeping inflation, as measured by the total consumer price index (CPI), at 2%, with a control range of 1 to 3% around this target.
The inflation target is symmetric, which means that the Bank is equally concerned about inflation rising above or falling below the 2% target. The Bank uses core inflation as an operational guide for its monetary policy because it is an effective indicator of the underlying trend in CPI inflation in Canada. Core inflation, along with other measures of inflationary pressures, is monitored to help achieve the target for total CPI inflation; it is not a replacement for the latter.
As in the UK, a flexible exchange rate is a core element of Canada’s monetary policy framework. A floating Canadian dollar plays a key role in the transmission of monetary policy and allows the Bank to pursue an independent monetary policy. It also helps to absorb shocks to the economy. Movements in the exchange rate serve as automatic buffers, helping to insulate the economy from external and internal shocks (See response to question 10).
At the end of the process of review in Canada, we reaffirmed our commitment to this framework.3 We did so because, in a complex and continuously evolving world that no one can predict with certainty, policy-makers need a robust framework; one that remains appropriate no matter the circumstances. Inflation targeting, as practised in Canada and the UK is disciplined but flexible. It allows central banks to deliver what is expected while dealing with the unexpected.
There are two crucial features of that regime. The first is that that the central bank must be flexible about the horizon over which it returns inflation to its long-run target. The second is clear and open communication.
A Central Bank Should be Flexible Regarding the Time Horizon to Return Inflation to Target
The way in which a central bank achieves its inflation target can be adjusted, depending on the circumstances.
Under flexible inflation targeting, the central bank seeks to return inflation to its medium-term target while mitigating volatility in other dimensions of the economy that matter for welfare, such as employment and financial stability. For most shocks, these goals are complementary. However, for shocks that pose a trade-off between these different objectives, or that tilt the balance of risks in one direction, the central bank can vary the horizon over which inflation is returned to target.
Typically, the Bank of Canada seeks to return inflation to target over a horizon of six to eight quarters. However, over the past twenty years, there has been considerable variation in the horizon, in response to varying circumstances and economic shocks. This flexibility is required because, when taking monetary policy actions to stabilize inflation at target, the
Bank must also manage the volatility that these actions may induce in the economy. These trade-offs will differ depending on the nature and persistence of the shocks buffeting the economy. For example, in the projections published since 1998 in its Monetary Policy Reports, there were eight occasions when the Bank extended the horizon beyond two years and nine times when it was shorter than a year and a half. In other words, more than a quarter of the time, the Bank has used greater-than-normal flexibility.
There are, broadly speaking, three sets of circumstances under which it may be desirable to return inflation to target, from above or below, over a horizon that is somewhat longer than usual.
First, the unfolding consequences of a shock could be sufficiently large and persistent that a longer horizon might be warranted in order to provide greater stability to the economy and financial markets. Stability considerations could lead the Bank to accommodate over a somewhat longer period, for example, the inflationary consequences of an unusually large and persistent increase in oil prices, or the disinflationary consequences of a severe global slowdown, including the possible constraints of the zero lower bound on interest rates.
Second, through a longer targeting horizon, monetary policy can also promote adjustments to financial excesses or credit crunches. For instance, there could be situations where, even though inflation is above target, ongoing monetary policy stimulus and a somewhat longer horizon to return inflation to target would be desirable in order to facilitate the adjustment to broad-based deleveraging forces that are unfolding.
On the flip side, a tighter monetary policy that allows inflation to run below target for a longer period than usual could help to counteract pre-emptively excessive leverage and a broader build-up of financial imbalances. In recent months, the Bank of Canada has used such guidance to reinforce macroprudential measures implemented by the Government of Canada. By indicating that some tightening of monetary policy may be necessary, a degree of prudence in household borrowing has been encouraged. For example, the rate of household credit growth has decelerated and the share of new fixed rate mortgages has almost doubled to 90% this year.
Third, as the Bank of Canada has observed, the optimal inflation-targeting horizon will vary with the evolution of the risks to the outlook.4 Shocks to the economy, both observed and prospective, are inevitably subject to a degree of uncertainty. In some situations, risks to the inflation outlook could be skewed to the downside. In these cases, a balance must be struck between setting monetary policy to be consistent with the most likely outlook and the need to minimize the adverse consequences in the event that downside risks materialize. This would warrant a more stimulative setting for monetary policy than would otherwise be desirable in the absence of the downside risks. However, if the downside risks fade away rather than materialize, the resulting stronger inflationary pressures would merit returning inflation to target over a longer horizon. The opposite would be true under circumstances where risks to inflation are skewed to the upside.
In short, changing economic circumstances could demand some flexibility in the horizon over which the Bank seeks to restore inflation to target.
There are limits to this flexibility. The Bank’s scope to exercise it is founded on the credibility built up through its success in achieving the inflation target in the past, and its clarity in communications when it uses it. That links to the second important feature of a flexible inflation target regime—clear and open communication.
Clear and Open Communication Matters
Clear and open communication enhances the effectiveness of monetary policy. In particular, successful monetary policy requires transparency around two aspects of the policy approach —what the central bank is trying to achieve and how it goes about achieving it.
With respect to the former, Canada has benefitted from a clear objective for monetary policy since the adoption of an explicit inflation target in 1991. As Canadians have come to understand the Bank’s policy objective and have gained confidence in its attainment over time, inflation expectations have become firmly anchored around the 2% target.
This confidence allows households and firms to make longer-term plans with greater certainty, aligning their savings, investment and spending decisions with a common inflation-control objective. These actions collectively serve to make the inflation target self-reinforcing. They also give the Bank greater latitude to respond aggressively to economic shocks without fear of dislodging longer-term inflation expectations. In short, the common understanding of our monetary policy objective makes its attainment easier.
Of course, it would be quite remarkable if simply communicating the monetary policy objective were sufficient to ensure its achievement. The conduct of policy obviously matters as well. The Bank of Canada implements policy through changes in the target overnight interest rate, which has a limited direct impact on saving, investment and spending decisions. Far more important is the impact the central bank’s actions have on the broader spectrum of market interest rates, domestic asset prices and the exchange rate.
What matters to these asset prices, however, is not so much the current setting of the policy interest rate but, rather, its expected path over time. Thus monetary policy affects the economy primarily through policy-rate expectations.5 The more those expectations are aligned with the policy path necessary to achieve the policy objective, the higher the probability the policy objective will be achieved.
One goal therefore of central bank transparency is to allow markets and the public to “think along with us”, not only promoting the appropriate formation of policy expectations given current information, but also allowing those expectations to evolve efficiently as new information is received.
Central banks would have an easy time communicating our “reaction function” if they followed a simple mechanical rule. Unfortunately, life is not that simple. Achieving an inflation target thus requires that central banks take a flexible policy approach, one informed by considered analysis and judgement. That is one reason why transparency—and occasionally guidance—matters.
Monetary policy actions take time to work their way through the economy and to have their full effect on inflation. For this reason, monetary policy must always be forward looking, with the policy rate set based on the central bank’s judgement regarding how inflation is likely to evolve in the future. Making that assessment requires a careful examination of the economic evidence pertaining to the balance of supply and demand in the economy and other factors affecting underlying inflationary pressures.
To exploit fully the power of this framework, guidance about future policy actions, leveraging central bank communications, may be effective. These I discussed in a speech in December.6
Fully Leveraging Central Bank Communications under Flexible Inflation Targeting
In a perfect world, guidance would be unnecessary. The inherent uncertainty in economic outcomes and thus in the policy path would be widely understood. With full information and efficient markets, monetary policy expectations would effectively take care of themselves— knowing a central bank’s inflation objective and its reaction function would be sufficient for markets and the public to form and evolve their expectations, without the need for any direct guidance from the central bank.
In the real world, monetary policy guidance can be useful in providing additional information. This is particularly the case when policy is at the zero-lower bound (ZLB) on nominal interest rates.
When conventional monetary policy has been exhausted at the ZLB, the additional stimulus that is likely to be called for is impossible to achieve using the conventional interest rate tool. Extraordinary forward guidance is one unconventional policy tool, along with quantitative easing and credit easing.
The Bank of Canada used extraordinary forward guidance in April 2009, when the policy interest rate was at its lowest possible level and additional stimulus was needed. At the time, we committed to holding the policy rate at that level through the second quarter of 2010, conditional on the outlook for inflation (so-called “time contingent guidance”). In effect, we substituted duration and greater certainty regarding the interest rate outlook for the negative interest rate setting that would have been warranted but could not be achieved. The Bank’s conditional commitment succeeded in changing market expectations of the future path of interest rates, providing the desired stimulus and thereby underpinning a rebound in growth and inflation in Canada.7 When the inflation outlook—the explicit condition—changed, the path of interest rates changed accordingly.
The Bank of Canada’s conditional commitment worked because it was exceptional, explicit and anchored in a highly credible inflation-targeting framework. It also worked because we “put our money where our mouths were” by extending the almost $30 billion exceptional liquidity programs we had in place for the duration of the conditional commitment. And it worked because it reached beyond central bank watchers to make a clear, simple statement directly to Canadians.
One shortcoming of conditionality is that it ultimately limits the effectiveness of the commitment. This is one reason why doing more may require overcoming the familiar monetary policy challenge of time inconsistency—but not as it has been conventionally understood.
To achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up. Market participants may doubt the willingness of an inflation-targeting central bank to respect this commitment if inflation goes temporarily above target. These doubts reduce the effective stimulus of the commitment and delay the recovery.
To “tie its hands”, a central bank could publicly announce precise numerical thresholds for inflation and unemployment that must be met before reducing stimulus (so-called “statecontingent” guidance).8 This could reinforce the central bank’s commitment to stimulative policy in the future and thus enhance the impact of its policies in the present.
The Federal Reserve has done exactly this with its state-conditioned threshold, specifically committing not to begin to consider raising its federal funds rate “at least as long as the unemployment rate remains above 6–1/2%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored”.
Thresholds exhaust the guidance options available to a central bank operating under flexible inflation targeting. If yet further stimulus were required, the policy framework itself would likely have to be changed.
Beyond Flexible Inflation Targeting
If governments chose to go beyond flexible inflation targeting, there are two possible avenues. The first is to target a higher rate of inflation at all times. The second is to target not the growth rate of prices but the level of prices or nominal incomes.
Targeting a Higher Inflation Rate
Some have suggested that central banks should target an inflation rate higher than 2%. Two arguments are put forward. First, a higher inflation target might reduce the frequency and severity of encounters with the ZLB in the future. Second, and more immediately, a higher inflation target may be a way out from the burden of excessive debt in those countries struggling with deleveraging.
In my view, moving opportunistically to a higher inflation target would risk de-anchoring inflation expectations and destroying the hard-won gains that have come from the entrenchment of price stability. Moreover, if inflation is both higher and more uncertain, a higher inflation risk premium might result, prompting an increase in real rates that would exacerbate unfavourable debt dynamics across public and private borrowers.
These problems have led some academics, policymakers and private sector analysts to propose other mechanisms that may allow a different path of inflation in the short term, but maintain a long-run commitment to a fixed low inflation rate. There are several mechanisms—including targeting the level, rather than growth rate, of prices or nominal GDP—that could allow greater flexibility and deliver better outcomes for inflation and growth without a permanent change to the inflation target. These policy frameworks have the potential to achieve better outcomes in part because they add “history dependence” to monetary policy.
Our review of the Canadian policy framework considered this option. In contrast to inflation-targeting where bygones are bygones, under Price Level Targeting (PLT), monetary policy would seek to make up for past deviations in order to restore the price level to a predetermined path. For example, following a period of below-target inflation, policy would seek a period of above-target inflation in order to ensure that average inflation corresponds to targeted inflation (the desired rate of change in the price level) over time. The more the price level were to undershoot the target, the more the central bank would need to stimulate the economy to make up the undershoot, and the more inflation expectations would thus be expected to rise and real interest rates to fall, supporting spending and prices. This “automatic” provision of added stimulus could be particularly useful when conventional monetary policy is exhausted at the ZLB, while the rise in near-term inflation expectations would be self-limiting by design, unwinding as the price level approached the desired path.
PLT may merit consideration as a “temporary” unconventional policy tool in countries faced with extraordinary circumstances, notably those with policy at the ZLB and with a heavy burden of debt.9 However, it also relies on inflation already having undershot the long-run target so that the price level is today below trend. That is not the case in the UK, where price pressures since the onset of the financial crisis have not, in fact, been weak.
Nominal GDP Level Targeting
The next step from Price Level Targeting is a target for the level of nominal GDP (NGDP). Under NGDP level targeting, the central bank is compelled to make up for deviations of the level of nominal GDP from some pre-determined trend. In theory, committing to restore the level of nominal GDP to its pre-crisis trend could raise expected inflation over the short and medium term but keep longer-term expectations well anchored. That would reduce real interest rates for a time, providing added stimulus to the economy.
Of course, the effectiveness of this strategy depends crucially on how expectations adjust. To reap the potential gains from NGDP-level targeting, expectations would have to adjust the way theory says they should. That requires the change in policy regime to be both credible and well understood. The public would need to be fully conversant with the implications of the regime and trust policy-makers to live up to their commitment. These conditions may not be met. In the worst case, if nominal GDP targeting is not fully understood or credible, it can, in fact, be destabilizing and damaging to the central bank’s credibility.10
Bank of Canada research shows that, under normal circumstances, the gains from better exploiting the expectations channel through a history-dependent framework are likely to be modest, and may be further diluted if key conditions are not met. Most notably, people must generally understand what the central bank is doing—an admittedly high bar. However, when policy rates are stuck at the ZLB, there could be a more favourable case for NGDP-level targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.11
Like flexible inflation targeting, NGDP-level targeting can be effective in dealing with so-called negative “supply shocks”, such as a sharp rise in oil prices. It may also deal well with positive supply shocks (a productivity-enhancing new technology, for example) that boost real GDP growth while lowering inflation. A central bank that targets the level of NGDP would to some extent look through this “good deflation”, thus avoiding a potential problem of helping to sow the seeds of an asset bubble.
The main drawback of an NGDP level target in this regard is that it imposes the arbitrary constraint that prices and real activity must move in equal amounts but opposite directions. As potential real growth changes over time, either the nominal target will have to change or else it will force an arbitrary change in inflation in the opposite direction. The challenge of determining the UK’s potential growth rate at present highlights that this is not an academic concern (see answer to question 23). Another consideration is that statistics like nominal GDP are subject to revision, and these revisions can be large.
Conclusion: The Bar for Change is Very High but Review and Debate can be Positive
There are reasons why central banks have preferred to support employment and output by targeting price stability, rather than more directly through an approach like nominal GDP targeting. Central banks can neither determine the appropriate path for these real variables nor control them over the long run, and to imply that they can, could have negative consequences for economic stability and central bank credibility.
The benefits of any regime change would have to be weighed carefully not only against the potential risks but also against the effectiveness of other unconventional monetary policy measures under the proven, flexible inflation-targeting framework. Although the bar for change to any flexible inflation-targeting framework should be very high, it seems to me important that the framework for monetary policy—rightly set by Governments and not by central banks—is reviewed and debated periodically. That process, which in Canada is undertaken every five years, has yielded valuable insights on how we can best operate our framework in a way that maximises the welfare of Canadian citizens. Similar insights may be possible in the UK given both the length of time since the inception of the inflation-targeting framework and the current extraordinary economic circumstances, which could not have been envisaged at its inception.
8. What is your view of the measures of inflation used in the UK?
I do not yet have a well- developed view of this, and I would note that the choice of price index used to define the MPC’s “price stability” objective is for the Government. My preliminary view is that, in terms of methodology, the Consumer Price Index is the best available measure of price increases over a basket of goods and services typically purchased by consumers. Its main omission is of course that it excludes housing costs for owner-occupiers, but I understand that a new index—CPIH—will be launched next year incorporating these costs. This will be a useful development.
In general, my view is that to the extent possible the characteristics of a good measure of inflation to target are:
It is representative of the costs facing households;
It is well-understood and widely accepted as the relevant measure;
It is produced by an independent statistical agency, and
It is not subject to revisions.
In making judgements about the outlook for inflation, monetary policy should look through the temporary effects of, for example, energy and commodity price changes and variations in indirect taxes. At the Bank of Canada, we believe that measures of “core” inflation, which exclude certain volatile items from a price index, can be useful operational guides for policy, even though they are not appropriate definitions of long run price stability. If movements in commodity and food prices, for example, are judged to be temporary, a core measure that excludes those items can be a guide to where inflation will head once the effect of those movements has passed. These can complement other measures of underlying inflation pressures, such as growth rates of pay and unit labour costs.
9. What consideration should be given to asset prices, including house prices, within the framework for inflation targeting? In particular, how should monetary policy react to asset price bubbles?
To the extent that asset prices, including house prices, contain useful information about the future evolution of inflation at the usual monetary policy horizon (normally one to two years), this information should be considered in policy decisions in a manner analogous to any other indicator. In other words, asset prices may contain unique information that, when correctly interpreted, can lead to better inflation outcomes. However, it is important to distinguish asset prices as a useful leading indicator for achieving the inflation target from asset prices as the central bank target. No explicit recognition should be given to asset prices in the target index, beyond that accorded via their direct weight in the consumer price basket, such as the price of housing services in the CPI.
Certain asset prices, but more importantly measures of credit growth, may also provide a useful signal about potential risks to price stability beyond the usual inflation target horizon. Indeed, experience has shown that imbalances fuelled by a credit boom, which may manifest themselves in asset-price movements, pose the greatest medium-term risk to the economy, because of the powerful deleveraging process they induce when they unwind.12 In principle, this means that, in responding to financial imbalances such as excessive credit growth, the central bank should take into account not only their direct effect on output and inflation at the usual horizon, but also any macroeconomic effects that could materialize later on, when these imbalances unwind. There is thus no inherent inconsistency between inflation targeting and the use of monetary policy to counteract financial imbalances, provided the time horizon is long and flexible enough. From this perspective, a lesson from the recent crisis is not that we need a different policy framework to address financial stability concerns, but that we need better analysis of the macroeconomic effects of financial imbalances.
Experience suggests that prolonged periods of unusually low interest rates can cloud assessments of financial risks, induce a search for yield, and delay balance-sheet adjustments. There are several defences.
The first line of defence is built on the decisions of individuals, companies, banks and governments.
In this regard, the Bank of Canada’s advice to Canadians has been consistent. Canada has weathered a severe crisis—one that required extraordinary fiscal and monetary measures. Extraordinary measures are only a means to an end. Ordinary times will eventually return and, with them, more normal interest rates and costs of borrowing. It is the responsibility of households to ensure that in the future, they can service the debts they take on today. Similarly, financial institutions are responsible for ensuring that their clients can service their debts. More broadly, market participants should resist complacency and constantly reassess risks. Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning.
The second line of defence is enhanced supervision of risk-taking activities. Stress testing in major economies should focus on excessive maturity and currency mismatches, look for evidence of forbearance (such as ailing industries receiving a disproportionate share of loans or the loosening of standards for existing debtors) and analyse the impact of sharp moves in yield curves.
These efforts will be aided by the imposition of the new Basel III regulations. Measures, including a leverage ratio, new trading book rules and liquidity standards, will help curtail excessive leverage and maturity transformation.
The third line of defence is the development of and selected use of macroprudential measures. In funding markets, the introduction of through-the-cycle margining can help curtail liquidity cycles.13 In broader asset markets, counter-cyclical capital buffers can be deployed to lean against excess credit creation.
In the housing market, the Canadian government has taken a series of important measures to address household leverage (see question 16). In addition, the Bank of Canada’s interest rate increases reminded households of the interest rate risks they face. These have contributed to a more sustainable evolution of the housing market.
These defences should go a long way to mitigate the risk of financial excesses. But the question remains whether there will still be cases where, in order to best achieve long-run price stability, monetary policy should play a supporting role by taking pre-emptive actions against building financial imbalances.
The Interaction Between Macroprudential and Monetary Policies
The Bank of England has been assigned full responsibility for macroprudential policy. Specifically, the Financial Policy Committee (FPC) within the Bank is responsible for identifying, monitoring and addressing risks to the financial system as a whole. The FPC will address systemic risks using powers given to it by Parliament to make recommendations and directions. Alongside the FPC, the Prudential Regulatory Authority will be created as an operationally independent subsidiary of the Bank, responsible for supervising the microprudential soundness of individual firms. This institutional framework provides important advantages over other arrangements, including centralizing responsibility for macroprudential and microprudential regulation together within one institution, thereby reducing the risk of coordination failure between monetary and macroprudential policy institutions, as well as reducing the potential for “regulatory gaps” in which no single authority is in charge of controlling systemic risk. Such gaps are believed to have played an important role in the 2008 financial crisis.
The Bank of England’s institutional structure also facilitates coordination in the MPC to help ensure a complementary role, if this is required. To be clear, I view monetary policy as the last line of defence against financial imbalances.
The effectiveness of monetary policy in in this regard depends on the nature of the imbalances, the influence of monetary policy and prudential tools on these imbalances, and the interactions between them. When financial imbalances remain concentrated in a specific sector, well-targeted macroprudential tools should usually be sufficient. Monetary policy is not well suited to address such imbalances, since monetary policy affects the entire economy, meaning that the interest rate increase required to curtail sectoral imbalances would come at the cost of undue restraint on the economy as a whole.
A credit-fuelled housing bubble is a particularly relevant example of a financial imbalance. Bank of Canada research suggests that a significant increase in interest rates could be required to stem the build-up of credit, with material consequences for output and inflation.14 This illustrates that monetary policy might be too blunt a tool to stem financial imbalances emerging in a specific sector.15 By contrast, macroprudential policy is as effective in addressing financial imbalances in the housing market without causing any undershoot in output or inflation. Rather, macroprudential in this scenario acts as a complement to monetary policy dampening the increase to output and inflation generated by the shock.
In this way, prudential measures will go a long way to mitigate the risk of financial excesses, but in some cases, monetary policy may still have to take financial stability considerations into account. For instance, where imbalances pose an economy-wide threat and/or where the imbalances themselves are being encouraged by a low interest rate environment, monetary policy might itself be the appropriate tool to support financial stability. Such could be the case when the risk-taking channel of monetary policy is present. The stance of monetary policy may itself lead to excessive risk taking by economic agents, which, in turn, can lead to financial instability.16 Specifically, monetary policy could influence the degree of risk that financial institutions decide to bear by influencing their perception and pricing of risk.17 This can take place through three broad types of mechanisms: (i) the perceived predictability of monetary policy, (ii) the search for yield, and (iii) the insurance effect of monetary policy. The first two mechanisms incite more risk taking in a low-interest-rate environment, while the third provides incentives for financial institutions to take more risks through the moral hazard created by the authorities’ perceived reaction function. These three mechanisms can lead financial institutions and economic agents to take on too much leverage and the associated maturity mismatches, which, in turn, can generate financial imbalances.
Because the consequences of financial excesses may be felt over a longer and more uncertain horizon than other economic disturbances, the potential may exist for tension among output, inflation and financial stability considerations over the typical two-year monetary policy horizon. In these circumstances, it may be appropriate to bring inflation back to target over a somewhat longer horizon, consistent with the longer-run pursuit of low, stable and predictable inflation. But that flexibility does not exist in a vacuum, and should never be used by stealth. Open and transparent communication is essential.
This timing difference can be partially bridged in a couple of ways. First, housing prices can be incorporated in the consumer price index, as they are in Canada and as is under consideration in the U.K. Second, monetary policy communications can adapt to reflect the behavioural dynamics of financial systems, including clearly communicating any change in the expected time required for inflation to return to target as a result of financial stability considerations. This has been the case in Canada. The Bank of Canada’s recent policy guidance does this when it states: “If the Bank were to lean against such imbalances, we would clearly say we are doing so, and indicate how much longer we expect it would take for inflation to return to the 2% target”.
To summarize, monetary policy should not target asset prices. Central banks, however, should be alive to the information contained in asset prices and wary of the impact on financial stability of excess credit growth.
Flexible inflation targeting is the standard approach to bridge the different time horizons for financial and price stability. However, there are limits. The time frame for inflation targeting can be stretched, but the credibility essential for its success may be undermined if such flexibility is taken too far or deployed too frequently. The paramount goal of monetary policy in Canada has been, and remains, price stability. The primary tools to deal with financial stability are micro- and macroprudential regulation and supervision. Macroprudential tools are not a substitute for monetary policy in controlling inflation, and monetary policy cannot substitute for proper micro- and macroprudential supervision and regulation in maintaining financial stability.
10. The UK has a flexible exchange rate. Are there circumstances where you might use Bank of England reserves to affect the exchange rate?
A floating exchange rate is, in both the UK and Canada, an important element of the monetary policy framework, allowing the central bank to pursue a monetary policy appropriate to its own economic circumstances. A floating exchange rate provides a buffer, helping economies to absorb changes in the international environment. It also helps economies adjust to domestic and global economic forces, signalling to shift resources into sectors where demand is strongest and minimising adjustments needed in other areas of the economy. The sharp fall in sterling since the onset of the financial crisis, for example, has helped to signal and promote the required shift in resources, away from domestic consumption and towards net exports. The necessary adjustment and rebalancing of the global economy would be assisted by the same degree of exchange rate flexibility in all major economies.
It is true that exchange rates can be volatile. However, countries cannot avoid adjustment; the question is simply how they adjust to global economic forces. With a fixed exchange rate, the adjustments would have to come through movements in overall output and in wages and prices. History has shown that these adjustments are more protracted and more difficult than exchange rate adjustments. For example, the current hybrid system of fixed and floating exchange rates in the international monetary system has not allowed the world economy to adjust efficiently to large shocks, such as the integration of China into the global economy, thus allowing the occurrence of large and unsustainable current account imbalances.
The absence of a target for the exchange rate does not mean a central bank should be indifferent to exchange rate movements. Inflation-targeting central banks care about the potential effect on output and inflation in order to set a course for monetary policy that keeps total demand and supply in balance and inflation on target. This means that they have to make judgements about the causes and likely persistence of exchange rate movements, the speed and degree to which the exchange rate changes “pass through” to domestic prices, and the possible impact of exchange rate movements on confidence and, through confidence, on consumption and investment.
A central bank’s regular policy decisions, including both changes in interest rates and other measures such as asset purchases, will affect economic conditions through the exchange rate. In addition, the MPC has the right, in order to pursue its remit, to intervene in currency markets, either by drawing on, or adding to, the Bank’s $6bn of foreign currency reserves. I do not, in general, think such action should be pursued when other instruments are available. In addition, consideration of any such action must take into account the G7 convention against unilateral currency intervention. The Bank must pursue concentrated and sustained efforts with its G20 partners to ensure all systemically important currencies adjust appropriately.
However, in an extreme scenario, if other avenues had been exhausted and the MPC were to judge that such intervention was necessary to achieve its objectives, I would recommend that the Bank of England exercise that right.
11. How important are current measures of inflationary expectations when considering the outlook for future inflation?
Perhaps most importantly, medium and longer-term inflation expectations are a key indicator of the confidence that households, firms and financial markets have in the ability and willingness of a central bank to meet its price stability objective. They can tell us whether the target is effectively “anchoring” inflation expectations. As such, inflation expectations are key indicators of the credibility of the inflation target and the monetary regime.
The achievement of price stability in the medium term rests on the existence of a widely held belief that monetary policy will bring inflation back to target. Significant moves in longer-term inflation expectations away from target may indicate an underlying threat to price stability—especially if there is evidence that this is having an effect on wage and price setting.
Shorter-term measures of inflation expectations are in principle a guide to inflation in the near term because they will affect company pricing decisions and wage negotiations. But in a credible, flexible inflation-targeting regime, in which inflation is allowed to deviate from the target in response to temporary shocks, such as movements in commodity prices, short-term inflation expectations should move up and down without leading to significant changes in wages and other prices. For that reason, there tends not to be a strong relationship between measures of short-term inflation expectations and underlying inflation pressures.
More generally, inflation expectations affect real interest rates, and through that incentives to save, spend and invest. As such they are an important input to a consideration of the outlook for growth and inflation.
In view of the information inflation expectations contain about prospects and the credibility of the regime, monetary policy-makers should review a broad range of market and survey indicators when making their decisions. In practice we have to interpret measures of expectations with care.
Surveys can show a consistent bias in reported expectations. For these measures, short run expectations will naturally move around as near-term inflationary pressure varies, for example due to movements in commodity prices or the exchange rate. In fact measures of UK households’ and companies’ short-term inflation expectations have generally fallen back over the past year, reflecting the decline in actual inflation. Longer-term expectations measures suggest that UK inflation expectations are well anchored at present, despite current above-target inflation.
Financial market measures can also be distorted. In Canada, the market-based measures of inflation expectations rely on quoted Yields-to-Maturity (YTM) of Real Returns Bonds (RRBs) and YTM of nominal government bonds. The difference between the real and nominal yields, the so-called break-even inflation rate (BEIR), reflects long-horizon inflation expectations as well as duration mis-match, liquidity risk/market segmentation, inflation risk and variations in short-term expectations.
In this regard, caution must be used in interpreting short term market moves and changes in market-based measures can sometimes be more informative than absolute values.
12. Are there circumstances where you might tolerate higher than target inflation for wider economic reasons?
Please see answers to questions 7 and 9.
13. What is your assessment of the effectiveness of the policy of quantitative easing in the UK, and of what needs to be considered when preparing for the UK’s eventual unwinding of quantitative easing? What is your view of the distributional effects of QE?
Asset purchases (QE), in addition to their direct effect of increasing the price of the purchased assets (eg gilts) and lowering their yields, affect the economy through multiple channels, including:
Portfolio rebalancing—investors are incentivised to rebalance their portfolios towards riskier higher-return assets, thus exerting upward pressure on their prices and resulting in lower yields across a range of assets;
Higher asset prices boosting financial wealth, supporting consumption and domestic demand;
Lower yields feed directly to lowering debt-service costs and a lower cost-of-capital, spurring investment;
Downward pressure on the exchange rate, which supports net exports and favours domestic demand for domestically-produced outputs;
Improved confidence as the central bank demonstrates that it would do whatever is necessary to meet its objectives;
Anchoring inflation expectations, thereby holding down real interest rates.
All of these channels are difficult to quantify, but it is very likely that had the Bank of England not introduced such unconventional measures as short-term interest rates reached their lower bound, the result would well have been a deeper recession, higher unemployment and very weak underlying domestic inflation pressures.
The studies by the Bank of England and Federal Reserve of their respective Asset Purchase programmes are broadly consistent. It is clear that the programmes have had some positive effects. They find the effects on financial markets to be material. Gilt yields were reduced. Corporate investment grade and high-yield spreads also fell markedly. The evidence is that the simulative effects then fed into equity prices. I do not think there is such a thing as a fixed “multiplier” from asset purchases to other financial asset prices. It seems to me likely that the scope to influence financial markets varies with market conditions. Asset purchases probably have a greater effect when markets are functioning poorly and liquidity premia are high.
It is even more difficult to judge how those effects in financial markets, whatever their magnitude, have transmitted to the macroeconomy. The weakness of growth since QE was introduced is not itself a reason to doubt that it is an effective policy. There seems to be some evidence that large scale asset purchases have boosted the demand for riskier assets, allowing those companies with access to capital markets to access funds more cheaply than otherwise. That probably includes banks, who have benefitted both from higher demand for their debt and from an improved liquidity position through the boost to their holdings of reserves at central banks. What is less clear is the extent to which that has translated into an expansion of bank lending.
The benefits of large scale asset purchases, and indeed persistently low interest rates, need to be judged against the potential costs of having a very stimulative policy for a very long time. Such policies can encourage excessive risk taking, distort the functioning of sovereign debt markets, and build vulnerabilities in the financial sector. In addition, central banks need to be mindful of the potential impact of very large purchases on market functioning.
The potential costs of QE and the uncertainty about the effect of QE on bank lending behaviour are solid reasons for supplementing QE with the Funding for Lending Scheme.
Given the scale of the expansion of central bank balance sheets, it is understandable that there are concerns about the exit from unconventional policies. The primary objective of unwinding the stock of purchased assets is to maintain price stability as the economy recovers. A credible plan is needed in advance in order to maintain confidence. The exit needs to be achieved without disrupting the gilts market. Such disruption could lead to sharp movements in a range of other asset prices, or possibly threatens to financial stability.
The MPC has stated that its strategy will be to announce in advance a schedule of asset sales, co-ordinated with the Debt Management Office. That seems to me an appropriate way to manage down the balance sheet. To ensure the MPC retains adequate room to respond to developments in economic conditions, it will be sensible for any tightening in monetary conditions to come about first through an increase in Bank Rate that could, if necessary, be reversed easily. In systems like the Bank of England’s, in which reserves at the central bank are remunerated, there is no obstacle to raising short-term interest rates before the size of the central bank’s balance sheet is reduced.
It is my intention that the MPC periodically revisits its exit strategy and updates the public, reporting any changes in a timely and transparent manner.
It is important to remember that all forms of monetary policy, conventional or otherwise, have unavoidable distributional effects. These effects, significant though they may be for individuals, are small when compared to the distributional consequences of the macroeconomic instability that would have ensued had policy not been so stimulative. In the absence of such policies, in the UK and the rest of the world the resulting collapse in demand, confidence and financial stability would have harmed almost everybody: young and old, savers and borrowers, rich and poor. Any assessment of distributional effects needs to be seen in the context of avoiding these outcomes.
In normal cycles, the distributional effects of monetary policy are not long-lasting. The difference now is that policy has been so stimulative for so long. Some of the biggest distributional effects now stem not from QE but from the “conventional” monetary stimulus in the form of very low short-term interest rates, which have reduced the income of those who have deposits and boosted the incomes of those who have variable-rate loans.
Long-term interest rates and annuity rates have been driven down by the expectation that those low short-term interest rates will persist and, in addition, by the effect of asset purchases on term premia. That raises the cost of purchasing a given pension income at retirement, but at the same time, monetary policy has driven up the prices of a wide range of assets, so those about to retire have greater financial wealth than they would have had in the absence of the stimulus. Depending on the composition of the assets used to purchase the annuity, those two effects—the higher cost of an annuity and higher asset values—can be broadly offsetting for those about to retire.
For the same reason, those that operate defined benefit pension schemes need not have suffered as a result of the monetary stimulus. Both assets and liabilities have increased. However, for pension funds that are already in deficit, even proportional increases in the values of assets and liabilities will make that deficit worse. The burden of closing the deficits—the extent of which depends on accounting treatments—will fall on future employees and employers.
More generally, although the Bank of England’s analysis for the Treasury Committee of the distributional consequences of QE seems valuable not least because monetary policy-makers need to be conscious of the effects of their actions, policy should always be set consistent with the remit from Parliament for the economy as a whole. It is for others to decide whether to offset the distributional effects using other instruments.
14. What do you regard as the strengths and weaknesses of the work undertaken by the interim Financial Policy Committee?
This is an area where I do not yet have a well-developed view. My initial impressions are that the Financial Policy Committee will fill an important gap in the pre-crisis regulatory architecture—macroprudential regulation. Although to date in non-statutory form, the FPC seems to have provided leadership in developing a framework for macroprudential policy in the UK and in developing the toolkit that it should have to achieve its objectives.
My understanding from future colleagues in the Bank of England and FSA is that the FPC has strengthened the interaction between the central bank and the regulators. That has been an important step in the transition to creating the Prudential Regulation Authority as part of the Bank, a key benefit of which will be close co-ordination between micro- and macroprudential policies. The most notable example of that co-ordination to date has been on liquidity buffers. In June 2012 the FPC and FSA provided clarity about how banks could expect to use their liquidity buffers; the FSA loosened its stance; and the Bank of England launched its extended collateral term repo operations to provide a more substantial liquidity backstop for banks.
There is no doubt that, in its infancy, the FPC has faced a challenging set of circumstances as the banking system moves along the Basel III transition path, from its weakened position after the crisis, towards a more transparently resilient position. That transition is taking place against a backdrop of large and persistent risks from the euro area and weak credit growth in the UK. The FPC has been forced to focus on the shorter-term need to tackle the difficult challenge of achieving greater resilience without holding back lending and growth. As time goes by, it should be able to move some of its focus towards ensuring the structure of the financial system is as resilient as possible—an issue that will not be the primary responsibility of micro supervisors. A key example will be the risks posed by institutions—such as shadow banks, discussed further in my answer to question 21—that are just outside the scope of regulation.
The FPC has necessarily been learning as it goes, designing and implementing policy at the same time. As it develops, we should seek to continue to improve the clarity and strength of the FPC’s messages. That is not straightforward when recommendations are balancing objectives, for example to raise capital in ways that will not encourage deleveraging, and when Committee members—rightly—have a range of perspectives and are individually accountable. My approach, which I outline further in my answer to question 32, will be to work wherever possible towards consensus.
1 Bank of Canada, “Framework for Conducting Monetary Policy at Low Interest Rates,” Monetary Policy Report, April 2009.
2 M. Carney, “Living with Low for Long” (speech to the Economic Club of Canada, Toronto, 13 December 2010).
3 Bank of Canada, “Renewal of the Inflation-Control Target: Background Information—November 2011.
5 J. Boivin, “How People Think and How It Matters” (speech to the Canadian Association for Business Economics, Kingston, Ontario, 23 August 2011).
6 M. Carney, “Guidance”(speech to the CFA Society, Toronto, Ontario, 11 December 2012).
7 Z. He, “Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy,” Discussion Paper No. 2010–11, Bank of Canada, 2010; and M. Woodford, “Methods of Policy Accommodation at the Interest-Rate Lower Bound,” paper presented at the Jackson Hole Symposium, “The Changing Policy Landscape,” Jackson Hole, Wyoming, 31 August—1 September 2012.
8 See, for instance, C. L. Evans, “Perspectives on Current Economic Issues” (Speech to the Bank of Ann Arbor Breakfast, Ann Arbor, Michigan, 18 September 2012).
9 C. Evans, “Monetary Policy in a Low-Inflation Environment: Developing a State-Contingent Price-Level Target”(speech to the Federal Reserve Bank of Boston’s 55th Economic Conference, Boston, Mass., 16 October 2010).
10 S. Murchison, “Consumer Price Index Targeting,” Bank of Canada Working Paper (forthcoming).
11 See footnote 10.
12 See for example, C. Reinhart and V. Reinhart (“After the Fall,” Macroeconomic Challenges: The Decade Ahead, Federal Reserve Bank of Kansas City Economic Policy Symposium, Jackson Hole, Wyoming, 26–28 August 2010.
13 See “The Role of Margin Requirements and Haircuts in Procyclicality,” a report prepared by a Study Group chaired by David Longworth and published by the Committee on the Global Financial System of the Bank for International Settlements as CGFS Papers No. 36, 23 March 2010.
14 See for example J. Boivin, T. Lane and C. Meh, “Should Monetary Policy Be Used to Counteract Financial Imbalances?” Bank of Canada Review (Summer 2010): 23–36, ).
15 See, for example, C. Bean et al, “Monetary Policy after the Fall,” (speech to Federal Reserve Bank of Kansas City Annual Conference, Jackson Hole, Wyoming, 28 August 2010).
16 M. Carney, “Some Considerations on Using Monetary Policy to Stabilize Economic Activity,” (speech to symposium sponsored by the Federal Reserve Bank of Kansas City Annual Conference, Jackson Hole, Wyoming, 22 August 2009).
17 See T. Adrian and H. S. Shin, “Money, Liquidity, and Monetary Policy,” Federal Reserve Bank of New York Staff Report No. 360, 2009 and C. Borio and H. Zhu, “Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism?” Bank for International Settlements Working Paper No. 268, 2008.