THERE were many positive aspects to Mark Carney’s first speech as new Bank of England governor, held in Nottingham yesterday. It was broadcast over the internet. He took questions from the audience and then gave a press conference afterwards. All this was accessible to the public at large via the Bank’s website. This is a more open and media-friendly style of governorship – showing the Bank is moving with the times in terms of its communications strategy.
But the content of the speech may worry those who suspect that the Bank is drifting away from its objective of targeting low inflation. Yes, the inflation target was mentioned from time to time. But monetary policy is now being directed to support economic growth – the primary motivation behind the new policy of forward guidance, shorthand for keeping interest rates at current extremely low levels.
Monetary policy can support growth by helping the economy ride out a financial storm, as we saw in late 2008 and 2009. Then, central bankers around the world showed that they had learned the lessons of the 1930s, when their predecessors were reluctant to ease monetary policy in the face of a major financial crisis. This time round, emergency monetary policies – dramatic interest rate cuts and quantitative easing – succeeded in stabilising economies and providing a platform for a return to growth.
But this encouraged central bankers to believe that they could do more to support growth – even when interest rates had been cut to near-zero levels. This may prove to be unrealistic. There are limits to what monetary policy can achieve.
Conventional economic theory suggests that the main effect of changing monetary policy is “intertemporal substitution” – economic-speak for shifting spending to/from the future. When interest rates are raised, individuals and businesses postpone spending. And when rates are cut, spending is brought forward. But this trick cannot be repeated indefinitely. Once interest rates have been cut to near-zero, borrowers have brought forward as much spending as they would like. And once the realisation of a near-zero interest rates world is appreciated by savers, they are likely to cut back on spending as their interest income declines, countering the growth benefits of the low interest rate policy.
So even though the objective of the new monetary policy of forward guidance is to support growth, it may not be effective and might even be counter-productive. The financial market reaction to recent Bank statements has been to push up longer-term interest rates – which either reflects lack of confidence in the policy, or a view that stronger growth or higher inflation means interest rates will rise more quickly in the future.
Monetary policy is most effective when it sticks to its primary objectives – controlling the value of money, and maintaining price stability. If it strays into the territory of trying to fine-tune economic growth, there may be dangers ahead. We discovered this when inflation ran out of control in the 1970s, and when loose monetary policy supported the credit boom that preceded the recent financial crisis.
Andrew Sentance is senior economic adviser at PwC, and a former member of the Bank of England’s Monetary Policy Committee.