Section B Monetary policy setting interest rates to control inflation

Monetary policy setting interest rates to control inflation Monetary policy is about setting interest rates to control inflation. It sounds straightforward enough. But to undertake the Interest Rate Challenge, participants will need to have some understanding of what inflation is and how it occurs. And they will need to know how monetary policy works. This section provides some background to set teams on their way. What is inflation 21 The inflation rate 21 Price indices 21 Changes in the inflation rate 21 What causes inflation? 23 The gap between demand and supply 23 Inflation expectations and monetary policy 24 What is monetary policy for? 25 Price stability 25 Monetary policy, prices and output 25 Why do we want stable prices 26 The value of money 26 The role of prices 26 Economic stability 26 How do interest rates affect inflation? 28 Bank Rate 28 From Bank Rate to inflation 28 The effects on demand 28 How long do these effects take to work? 29 Section B Monetary policy 19

What is inflation? Inflation is a general rise in prices across the economy. This is distinct from a rise in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices and preferences, and changing costs. If the price of one item say a particular model of car increases because demand for it is high, we do not think of this as inflation. Inflation occurs when most prices are rising by some degree across the whole economy. The inflation rate We often hear about the rate of inflation being 2% or 2.7% or some other number. The inflation rate is a measure of the average change in prices across the economy over a specified period, most commonly 12 months the annual rate of inflation. We typically hear about the annual inflation rate for a particular month. If, say, the annual rate of inflation in January this year was 3%, then prices overall would be 3% higher than in January last year. So a typical basket of goods and services costing, say, 100 last January would cost 103 this January. Price indices There are a number of different measures of inflation in use today. The most familiar measure in the United Kingdom is the Retail Prices Index (RPI). But monetary policy is now based on the Consumer Prices Index (CPI). Both measure the prices of products and services that consumers buy. A price index is made up of the prices of hundreds of goods and services from basic items like bread to new products, like ebooks. Prices are sampled up and down the country every month; in supermarkets, petrol stations, travel agents, insurance companies and many other places. All these prices are combined together to produce an overall index of prices. The goods and services included in the index are chosen and weighted on the basis of the spending patterns of UK households for example, if gas bills account for around 1% of consumers total spending, then gas prices will account for about 1% of the total index. The percentage weights are revised annually to reflect changes in spending patterns. Sometimes new goods and services are added and sometimes they are taken out. Nail varnish is now included in the basket to represent the increasing amount of public spend on it. The inflation rate is a measure of the change in prices over a specified period Until December 2003, UK monetary policy was based on a measure of inflation called RPIX. RPIX inflation is almost the same as RPI inflation but it excludes one component namely mortgage interest payments. But on 10 December 2003 the Chancellor of the Exchequer announced that in future monetary policy would be based on the Consumer Prices Index (CPI) which is explained on page 34. Changes in the inflation rate Any individual price change could cause the measured rate of inflation to change, particularly if it is large or if the item has a significant weight in the price index. But we are more interested in the general increase in prices rather than individual price changes. A large rise in the price of petrol, for example, might affect the overall rate of inflation. But unless this price carried on rising, the annual rate of inflation would eventually fall back again the example in the box below explains this, if you want to know more. Events affecting a range of prices can also result in a change in the inflation rate. For example, a rise (or fall) in oil prices might affect the price of other goods if producers pass on the increase (or decrease). But, again, unless the oil price continues to rise (or fall), this influence on the inflation rate will eventually wear off after a time. Section B What is inflation? 21

Similarly, if the value of the pound falls against other currencies ie. the exchange rate depreciates the price in the shops of some imported goods might rise. But only if the exchange rate keeps falling will this influence on inflation continue. A change in price If petrol prices had been 1.25 a litre for some time and then they increased in, say, February 2015 to 1.50 a litre while no other prices changed, the annual rate of consumer price inflation would increase. If petrol prices remained unchanged after that, the annual rate of inflation would then fall back in February 2016. That is because the annual rate of inflation in February 2016 measures the change in prices between February 2015 and February 2016, during which time the price in our example has stayed the same at 1.50 a litre the rise in petrol prices recorded in February 2015 drops out of the calculation. So, although the price of petrol remains at the higher level, annual inflation is not higher after a year or more. Price changes like those described can have other indirect effects on inflation. But individual price changes in themselves do not have a lasting impact on the inflation rate. The rate of inflation in a particular month will depend on movements in all prices. But we need to distinguish between individual price changes which might change the measured rate of inflation for a period and the notion of inflation as an ongoing, general increase in prices. Section B What is inflation? 22

What causes inflation? The measured inflation rate at any point in time will be made up of an array of individual price changes. But the amount of inflation in the economy is about more than just the sum of all individual price changes. Something more fundamental determines the amount of inflation in the economy whether it is 1%, 10% or 100%. Demand One of the underlying causes of inflation is the level of monetary demand in the economy how much money is being spent. We can demonstrate this by considering what happens when the prices of some products are rising. Imagine the price of cinema tickets has risen. If consumers want to buy the same amount of all goods and services as before, they will now have to spend more because the price of one of the products they consume has risen. This will only be possible if their incomes are rising, or alternatively if consumers are prepared to spend a bigger proportion of their incomes, and save less. But if total spending does not rise, then higher prices will mean consumers will either have to buy fewer cinema tickets or buy less of something else. Any fall in demand for goods and services will put downward pressure on prices. So although higher costs or other factors might cause some prices to rise, there cannot be a sustained rise in prices unless incomes and spending are also rising. On the other hand, if the price of some goods falls, people will need to spend less to buy the same amount of all goods and services as before. But if people still earn the same, they will have the same amount of income as before. So they will be able to buy more of those goods or of something else. Demand in the economy will rise and this, in turn, might cause some prices to rise. The underlying causes of inflation relate to the amount of demand in the economy Of course, this process takes time. And the situation will be complicated if some people s incomes are affected by the falls in prices say because lower import prices cause firms competing with imports to lose sales and reduce the number of people they employ. However, it demonstrates a key feature of inflation that it relates to the amount of demand in the economy. and supply But inflation is not just about demand in isolation. Inflation reflects the amount of demand in the economy relative to the available supply of goods and services in other words, the amount of money people are spending relative to what can be produced. Inflation tends to rise when, at the current price level, demand for goods and services in the economy is greater than the economy s ability to produce goods and services its output. One of the original descriptions of inflation remains valid that too much money chases too few goods. The gap between demand and supply How much the economy is able to produce will reflect the rise of the working population. Increases in output will also depend on factors that enable more output to be produced from available resources in other words, productivity increases. The amount the economy is able to produce, ie. supply, might increase due to the introduction of new technologies, extra investment in new equipment, improved methods of production and distribution or by enhancing the skills of the workforce. These things can all lead to higher productivity. There will be some price level at which there is a broad balance between the demand for, and supply of, goods and services. At this point there tends to be no upward or downward pressure on inflation. Firms will be working at their normal capacity producing everything they can in the most efficient way with their existing resources. Section B What causes inflation? 23

Too much demand But what happens if there is an increase in demand for some reason, for example due to a reduction in income tax, or because consumers suddenly feel more optimistic and start spending more money rather than saving? When demand rises above what firms can produce at their normal level of operation, there tends to be upward pressure on costs and prices Firms can usually increase production to meet higher demand. But this may only be possible by incurring higher costs. For example, it might be necessary to introduce overtime working or hire extra people. If many firms are trying to recruit extra people in order to produce more, wages might start to rise. And firms might have to pay more for additional materials or run their processes and machinery in a less efficient way. So to produce more, firms increase their demand for resources, and this may result in upward pressure on production costs and prices for example, the price of bricks and the wages of bricklayers might rise if there is high demand for the construction of new buildings such as houses or offices. At the same time, imports are likely to rise and the gap between what the country imports and exports its trade balance might widen. Higher prices in general might lead people to demand higher wages so they can still buy the same amount of goods and services. An increase in wage costs might then feed through to a further rise in prices. The inflation process can then continue until prices have risen to such a level that demand is once again equal to supply. too much supply The opposite to this is when there is slack ie. spare capacity in the economy. That is when the amount that can be produced is greater than demand. In this situation, there tends to be downward pressure on costs and prices. Inflation is usually generated by an excess of demand over supply To contain inflationary pressures in the economy, demand needs to grow roughly in line with output. Output grows over time at a rate which largely depends on factors which increase productivity. If demand grows faster than this, unless there is spare capacity in the economy such as after a recession inflation is likely to rise. We say more about demand, output and inflation on page 25 and in Sections D and F. Inflation expectations and monetary policy Even when demand and supply (output) are roughly balanced, inflation will not necessarily be zero or indeed particularly low and stable. When firms and employees negotiate wages and when companies set their prices, they often consider what inflation might be in the period ahead, say the next year. Expected inflation matters for wages and prices because future price rises reduce the amount of goods and services that today s wage settlement can buy. So, if inflation is expected to be high, employees might push for a higher wage increase. If wage settlements build in these expectations, then firms costs increase, which in turn could be passed on to customers in higher prices. So if people expect inflation, their behaviour can lead to inflation. If people expect inflation, their behaviour can lead to inflation What determines the expected rate of inflation? The simple answer is monetary policy and how much people believe in the ability and commitment of the authorities the government and the central bank to achieve their inflation objectives. People have to believe that there will be low inflation before they stop building expectations of high inflation into their decisions. The authorities have to demonstrate that they will not allow inflation to rise that they will act to ensure demand does not rise too much ahead of output. The ultimate cause of inflation can really be said to be central banks, like the Bank of England. Their behaviour and actions determine whether inflation is allowed to rise or is kept low in other words, whether they allow prices to rise unchecked by monetary policy, or whether the central bank seeks to influence the amount of money in the economy. To keep inflation low, we want to ensure that the growth in demand does not get ahead of the growth in what the economy can produce. We want output to rise, but at a steady rate across the economy as a whole and not so fast that the resulting demand for resources generates upward pressure on costs and prices. Section B What causes inflation? 24

What is monetary policy for? Price stability The aim of monetary policy is to achieve stable prices. Price stability means that changes in the general level of prices across the economy are relatively small and gradual in other words, prices do not rise by much from month to month and from year to year. In practice, price stability equates to low and stable inflation. The broad aim of monetary policy is to achieve price stability A quote from Alan Greenspan, a former Chairman of the US Federal Reserve the central bank of the United States is one of the most apt. "For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household decisions." The goal of price stability has become widely accepted as the appropriate objective of monetary policy, and is now one of the primary considerations of central banks around the world. This consensus reflects an understanding of how the economy works and a practical experience of the ineffectiveness of using monetary policy to achieve other economic objectives. Monetary policy, prices and output The effects of monetary policy are ultimately seen in prices. A change in interest rates feeds through the economy, influencing demand, costs and then prices. This process is explained on pages 28 29. Boosting demand, by lowering interest rates, may cause output to rise at a faster rate for a time. But monetary policy does not have a lasting impact on output. Suppose the Bank of England printed double the amount of money in the economy and left it on street corners for people to help themselves. People would go out and spend more. But the economy cannot simply produce twice as much. Firms would try to increase output to meet the extra demand and imports might rise. But the extra demand for resources would force costs and prices higher. In the same way, changing interest rates will result in changes in demand in the economy. But, overall, it cannot affect what the economy is able to produce, other than in the short term as output responds to fluctuations in demand. Some of the mistakes in economic policy in the past resulted from a belief that it was possible to raise output and employment permanently by accepting a degree of inflation there was an assumed trade-off between inflation and unemployment. But efforts to exploit it, by trying to boost demand through higher government spending or lower interest rates, led to increasing rates of inflation they revealed that, in the long run, there was no such trade-off. There is no general, lasting trade-off between output and inflation There is, however, a recognised trade-off between output and inflation in the short term, ie. a few years. This is very important to the workings and conduct of monetary policy. In the short term, if demand and output are growing too quickly, increasing interest rates can reduce output growth back to a level which does not result in inflationary pressure. Conversely, reducing interest rates can increase output growth. But, in the longer run, there is no lasting trade-off between output and inflation. Changes in interest rates affect prices only. The effects of monetary policy are ultimately seen in prices The role of monetary policy is restricted to influencing the level of demand in the economy in order to control inflation. Changes in monetary policy do affect output and employment in the short term. But these influences do not last. Section B What is monetary policy for? 25

Why do we want stable prices? The value of money Ensuring that prices are fairly stable amounts to trying to maintain the value of money, ie. ensuring that what 1 buys today will be roughly the same as what it will buy tomorrow or next month. If people expect the value of their money to fall, this undermines the role of money as a measuring rod for the value of goods and services in the economy. It no longer acts as a standard and stable measure of value, because its own value is falling and uncertain. At worst, when confidence in a currency deteriorates completely, money can stop being used as a means of exchange. When prices were rising rapidly in Germany in the 1920s, people had so little confidence in their currency that they demanded to be paid several times a day, so they could quickly spend their wages before they fell in value. In the United Kingdom in the 1970s, the annual rate of inflation was more than 20% for a time what 1 would buy was reduced by over a fifth in one year. In response, people sought wage increases to compensate them for this decline in the value of money. This placed further upward pressure on prices creating what is known as a wage-price spiral. The role of prices Uncertainty about the value of money the future prices of goods and services can be damaging to the proper functioning of the economy. Prices are at the core of a market-based economic system. They help to determine what goods and services are demanded and what is supplied. When prices across the economy are fairly stable, specific changes in the prices of individual goods and services allow firms and individuals to make decisions about how much to consume, how much to produce and invest, and how much to save or borrow. These price changes are reasonably clear to see; they are not obscured by a general rise in prices. But when the prices of most goods and services are rising, it is more difficult to know which items are rising in price relative to others. For example, if the demand for organic vegetables is high and prices are rising, this should be a signal to other companies to increase supply to this market. But if prices in general are rising, it might not be clear whether the higher price is part of this general increase or specific to an individual product. Economic stability When inflation is high, it also tends to be more variable and uncertain. Many of the costs of inflation are associated with its uncertainty. Price stability is important because high and volatile inflation creates economic instability Savers and lenders might want some insurance against the uncertainty of the future value of their money, ie. a higher rate of interest for lending their money. This will mean higher borrowing costs for individuals and firms. And uncertainty about prices and the value of money might discourage firms from making long-term investments. One of the main consequences of high inflation has been greater instability in economic conditions as a whole periods when demand and output have been growing strongly but then fallen sharply. These episodes are commonly referred to as boom and bust cycles. In the past, when demand rose much faster than output and inflation increased, sharp increases in interest rates were necessary to bring demand back into line. This often resulted in large falls in output ie. a recession as the imbalance in the economy was abruptly corrected. One of the costs of unsustainably high output growth an economic boom and the resultant upward pressure on costs and prices, has been large falls in output and employment. These falls were probably greater than would have been the case had demand and output grown in a steadier and more balanced way. Section B Why do we want stable prices? 26

One such episode in the United Kingdom was during the late 1980s and early 1990s. Inflation rose to over 10% as demand increased strongly. Interest rates were increased to as high as 15%. With consumers and companies burdened by high levels of debt, higher interest rates led to a large contraction in demand and resulted in falling output and employment in the early 1990s. The boom was followed by the bust. These episodes inevitably affect individuals and firms behaviour. Firms find it more difficult to plan ahead when there is uncertainty about demand, prices and interest rates. Until the first quarter of 2008, output had grown for the longest continuous period since the mid-1950s when current statistical records began and inflation had been relatively low over the previous decade. But the sharp rise in energy and food prices pushed CPI inflation well above target to a peak of 5.2% in September 2008. Following this accelerated pick up in inflation, output growth quickly fell to -2.3% in 2008 Q3, the largest fall since 1974 Q1. More recently, a sharp drop in energy prices in the second half of 2014 drove a fall in the inflation rate. This, combined with falls in the prices of other goods, particularly food, contributed to the inflation rate turning negative in April 2015, the first time this has occurred since 1960. Further falls in the prices of food and commodities, particularly oil, kept the inflation rate around zero for the remainder of 2015 and the start of 2016. Over the same period, output growth remained low but positive. Monetary policy is aimed at achieving price stability. But the goal of price stability is not an end in itself. Stable prices are a necessary condition for the economy to grow in a stable and sustainable way, and for the effective functioning of prices and money in the economy. Section B Why do we want stable prices? 27

How do interest rates affect inflation? Monetary policy aims to influence the overall level of monetary demand in the economy so that it grows broadly in line with the economy s ability to produce goods and services. This stops output rising too quickly or slowly. Interest rates are increased to moderate demand and inflation and they are reduced to stimulate demand. If rates are set too low, this may encourage the build-up of inflationary pressure; if they are set too high, demand will be lower than necessary to control inflation. How does this work? Bank Rate Monetary policy operates by influencing the price of money, ie. the cost of borrowing and the income from saving. The MPC sets the interest rate for the Bank of England s financial market transactions In the United Kingdom, the Monetary Policy Committee (MPC) sets the interest rate that is paid on deposits held at the Bank of England by commercial banks and building societies. This interest rate is known as Bank Rate. From Bank Rate to inflation Changes in Bank Rate affect the whole range of interest rates set by commercial banks, building societies and other financial institutions for their own savers and borrowers. It will influence interest rates charged for overdrafts and mortgages, as well as savings accounts. A change in Bank Rate will also tend to affect the price of financial assets such as bonds and shares, and the exchange rate. These changes in financial markets affect consumer and business demand and, in turn, output. Changes in demand and output then impact on the labour market employment levels and wage costs which in turn influence producer and consumer prices. The effects on demand When Bank Rate is changed, demand can be affected in various ways. Spending and saving decisions A change in the cost of borrowing affects spending decisions. Interest rates will affect the attractiveness of spending today relative to spending tomorrow. An increase in interest rates will make saving more attractive and borrowing less so. This will tend to reduce current spending, by both consumers and firms. That includes spending by consumers in the shops and spending by firms on new equipment, ie. investment. Conversely, a reduction in interest rates will tend to increase spending by consumers and firms. Cash flow A change in interest rates will affect consumers and firms cash flow, ie. the amount of cash they have available. For savers, a rise in interest rates will increase the money received from interest-bearing bank and building society deposits. But it will also mean higher interest payments for people and firms with loans debtors who are being charged variable interest rates (as opposed to fixed rates which do not change). These include many households with mortgages on their homes. These fluctuations in cash flow are likely to affect spending. Lower interest rates will have the opposite effects on savers and borrowers. Asset prices A change in interest rates affects the value of certain assets, such as house and share prices. Higher interest rates increase the return on savings in banks and building societies. This might encourage savers to invest Section B How do interest rates affect inflation? 28

less of their money in alternatives, such as property and company shares. Any fall in demand for these assets is likely to reduce their prices. This reduces the wealth of individuals holding these assets, which, in turn, might influence their willingness to spend. Again, lower interest rates have the opposite effect, ie. they tend to increase asset prices. Exchange rates A particular influence on prices comes through the exchange rate. A rise in interest rates relative to those in other countries will tend to result in an increase in the amount of funds flowing into the United Kingdom, as investors are attracted to the higher sterling rates of interest. This will tend to result in an appreciation of the exchange rate against other currencies. In practice, the exchange rate will be influenced both by expectations about future interest rates and any unexpected changes in interest rates. That is because if investors expect interest rates to rise, they may increase the amount they invest in a currency before interest rates actually rise. So there is never a simple relationship between changes in interest rates and exchange rates. Other things being equal, an increase in the value of the pound will reduce the price of imports and, because many imported goods are included in the CPI, this will have a direct influence on inflation. In addition, a higher pound will tend to reduce the demand abroad for UK goods and services. Any fall in export demand will, in turn, reduce output, as will any shift of domestic spending to imported goods. A reduction in interest rates will tend to have the opposite effect. How long do these effects take to work? Changes in the official Bank Rate take time to have their full impact on the economy and inflation. All the factors we have described have an impact on demand and, in turn, prices. Some influences, such as those on the exchange rate, work very quickly. A change in the official Bank Rate takes around two years to have its full impact on inflation But it often takes time for changes in the official Bank Rate to affect the interest payments made by consumers or firms such as mortgage payments or the income from savings accounts. It is likely to take a further period of time before changes in mortgage payments or income from savings lead to changes in spending in the shops, and longer still for this spending to work its way up through the supply chain to producers. Changes in production, in turn, can lead to changes in employment and wages and eventually to changes in prices. We cannot know with any certainty the precise size or timing of these influences. And the effects might vary depending on factors such as the stage of the economic cycle for example, the impact of higher consumer demand on inflation just after a recession will be different than that after several years of growth. This is because after a recession, when output has been falling, there will be plenty of spare capacity in the economy output will be able to rise quite strongly without generating inflationary pressure. Interest rates have to be set based on what inflation might be over the coming two years or so A change in the official Bank Rate may have some instant effects for example on consumers confidence which may influence spending straight away. But, more generally, a change in the official Bank Rate will take time to influence consumers and firms behaviour and decisions. Overall, a change in interest rates today will tend to have its full effect on output over a period of about one year, and on inflation over a period of about two years. This is of course a very approximate guide. In this sense, monetary policy has to look ahead. Interest rates have to be set based on what inflation might be over the coming two years or so, not what it is today though that is a relevant consideration. Policymakers have to judge what the likely economic developments will be over that period, in particular what the rate of growth in demand will be relative to the growth in supply (output). This is why the Monetary Policy Committee uses forecasts of growth and inflation to help it decide on the right level for interest rates. We don t expect you to produce forecasts but we explain more about their role on page 37 and on pages 54 55. This section has provided a thumb-nail sketch of what is referred to as the transmission mechanism the economic route-map between changing interest rates and inflation. We tell you more about the transmission mechanism on pages 71 72. We also describe the different parts of the economy in Section F. The data you will need to look at to assess demand, output and price pressures in the economy will be available on the website. Section B How do interest rates affect inflation? 29