Monetary policy in extraordinary times

David Miles interviewed by Viv Davies, 25 February 2011

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<p><em>Viv Davies interviews David Miles for Vox</em></p>
<p><em>February 2011</em></p>
<p><em>Transcription of a VoxEU audio interview []</em><b><br />
<p><b>Viv Davies</b>: &nbsp;Hello and welcome to Vox Talks. I'm Viv Davies from the Centre for Economic Policy Research. It's the 23rd of February 2011 and I'm talking to Professor David Miles, member of the Bank of England's monetary policy committee, on the subject of a talk he is giving this evening titled &quot;Monetary Policy and Financial Stability in Extraordinary Times&quot;. The event is being hosted jointly by the Centre for Economic Policy Research and the London Business School. I began by asking Professor Miles to explain the principal factors that have given rise to what he refers to as &ldquo;the extraordinary times in which we live.&rdquo;</p>
<p><b>Professor David Miles</b>: &nbsp;Yes, well people use that phrase very frequently, they say, &quot;We're living in extraordinary times&quot; and of course by definition most of the time it's not true. I think in terms of what's happened in the economy right across the Western world, certainly here in the UK, it really is true at the moment. I mean, just in the last few years we've seen a series of really extraordinary events that I think few people could have predicted.</p>
<p>Toward the end of 2008 the banking system in the UK came pretty close to almost complete gridlock and if the banking system had stopped working, and I think it came close to stopping working, it would have been about as serious as the supply of electricity being cut off. And I think in the aftermath of that crisis there was a period when confidence declined and the level of economic activity declined certainly in the UK, and not just in the UK, but certainly in the UK, declined for a period of three or four quarters which was comparable to the decline in output in the first six to twelve months of the Great Depression.</p>
<p>We've also seen an extraordinary roller coaster ride really for commodity prices between maybe the middle of 2008 and the middle of 2009. That is the period just before the near collapse of the banking system, the worst part of the financial crises at the end of 2008, between a few months before that and a few months after that, commodity prices, roughly speaking, halved, and in some cases, in oil prices, more than halved.</p>
<p>Now since then, since the middle of 2009 to now, prices more or less doubled. So they first of all halved and then they doubled so we've had something that has been close to a Great Depression-like trajectory for output in the UK. We've had a situation with the banking sector came pretty close to complete meltdown, and we've had a degree of volatility in commodity prices which is pretty extraordinary. We've also had a huge increase in the scale of the fiscal deficit, and again this is absolutely not unique to the UK, but it's been very serious in the UK, and an increase in the stock of government debt on a scale that's unprecedented outside of world wars.</p>
<p>We also on top of all that had a period in the first few months of 2009 where world trade declined in a way that we've never seen, outside of the outbreak of world wars. So I think this adds up to a truly extraordinary period and it's generated a situation where economic policy, monetary policy and fiscal policy is pretty difficult to set but we've got to try and get through it.</p>
<p><b>Viv</b>: &nbsp;The current rate of inflation in the UK is around 4% which is twice the Bank of England's official 2% target and according to the bank's quarterly inflation report, inflation is also likely to rise further in the coming months to 4.5% or even higher perhaps. There's also a widespread expectation that interest rates will go up as soon as May. Does this mean that we can expect rapid interest rate increases through 2011? And, if so, is there a danger that such increases could perhaps harm the economy given that it's still relatively fragile and facing further tax increases and public spending cuts, et cetera?</p>
<p><b>Professor David</b>: &nbsp;Well, I think it helps to sit back and try and understand as best as one can why inflation is as high as it is and in some ways it is a very unusual situation. We've had a very deep recession, unemployment has gone up a great deal. Other things equal you would expect that more likely than not that would take inflation lower and inflation might be sitting underneath the Bank of England's 2% target rather than rather uncomfortably above it. I think the reasons inflation is as high as it is are largely to do with the big exchange rate depreciation in 2007, 2008. Probably more important right now has been the enormous increase in commodity prices over the last year or so. Just in the last couple of weeks commodity prices have moved higher again. Over the last year in sterling terms on average commodity prices are up not far off 40%.</p>
<p><b>Viv</b>: &nbsp;So they are not where they were two years ago or 2008?</p>
<p><b>Professor David</b>: &nbsp;That's right. So commodity prices halved and then doubled and that's caused a great deal of variability in inflation. We've had an increase in VAT, in fact we've had two, one at the beginning of 2010 and another at the beginning of this year 2011. I think it's almost inevitable that when you have such big changes in the level of commodity prices and other imported goods prices and an increase in VAT, it's highly likely that's going to drive measured inflation up for a period after those increases in prices. I think the key thing for us in the monetary policy committee is to try and look through the temporary effects of those price changes and think about where the underlying inflation pressures in the UK are. I think if one focuses on the, what you might call the domestically-generated inflation pressures, you actually get a very different picture for the degree of inflation pressure than simply looking at the headline inflation rate right now. One of the, probably most important indicators of domestically-generated inflation pressure is what's happening to wages and the story there has been an unusual one.</p>
<p>Wage settlements in the UK now, certainly in the private sector, have been running at somewhere around 1.5 ‑ 2% for much of the last few years. In fact for many companies there has been a wage freeze for most of the last couple of years. Now wage settlements are picking up a little bit, but it's plausible that they remain, at least in the near term, at a level far beneath the actual rate of inflation and probably beneath a level consistent with domestically-generated inflation pressures being above the target.</p>
<p>So once we get through, I think, the aftermath of a big increase in commodity prices and a substantial increase in VAT, I think it's more likely than not, I wouldn't put it any stronger than that, but more likely than not, that inflation will move back down toward the target level. Now who knows how things will play out, there's plenty of risks that inflation maybe stays above the target level a bit longer then our best guess, an educated best guess that the monetary policy committee makes, but I think there's plenty of chances that actually inflation moves back to the target level even more quickly than the central forecast that the monetary policy committee came up with just a few weeks ago.</p>
<p><b>Viv</b>: &nbsp;This is the 14th month in a row that inflation has exceeded the bank's 2% target. In light of this do you think that criticism of the bank in failing to meet its target is justified and more broadly do you think it has implications for the effectiveness of inflation targeting as a monetary policy framework?</p>
<p><b>Professor David</b>: &nbsp;I mean it's certainly true that inflation has been above the target level for an uncomfortably long period of time and indeed for longer than the monetary policy committee had thought likely. I think some of the reasons for that are the very sharp further increases in commodity prices over the last six to twelve months. And we've had increases in the VAT rate that almost inevitably would keep the inflation rate high for a period, maybe not permanently, I don't think permanently, but for a period. Some of those things are easy to see in retrospect but if you go back a year or two it wasn't at all clear that one's best guess 18 months ago would have been that commodity prices would have risen as fast as they actually have risen.</p>
<p>Now, that&rsquo;s an explanation for why the MPC's own past forecasts have been lower than what's actually happened to inflation. I don't think it's an excuse. I hope it doesn't come across as an excuse. I think it is just the inevitable consequence of things happening that are easy to see in retrospect but difficult to forecast in advance.</p>
<p>The key policy question for the Monetary Policy Committee is, given where we are now, given that inflation has been and for a few more months is likely to stay rather significantly above the target level, what's the best policy to bring it back down to the target level? I don't think it makes a great deal of sense to take the 2% target level and say, we must try by any means possible to bring inflation back to that target over the course of three or four months, because in order to do that, one would need to tighten monetary policy on such a scale as to make it likely that you'd push the economy back into a recession.</p>
<p>So the question, I think, is, what's the right way of balancing the risks of inflation staying above the target for sufficiently long that people get used to it and think that's the new normal against, balance that against the risks of tightening monetary policy so rapidly to bring inflation down very quickly, but that causing the rather fragile recovery we've seen already being essentially knocked on the head and the economy going back into a recession.</p>
<p>I think that's a tricky judgment. It's a judgment that it&rsquo;s my job as being a member of the Monetary Policy Committee to make, and it's a judgment that I wouldn't want to try and forecast in advance what the best thing to do is. The reason we meet every month rather than meet every six months or 12 months is precisely because you get a lot of information from one month to the next which is relevant to judging what the right setting in monetary policy is.</p>
<p><b>Viv</b>: &nbsp;Given the UK government's policy of fiscal tightening, do you anticipate any potential tensions between undertaking that whilst at the same time implementing a tighter monetary policy? Could the two together perhaps serve to hinder an economic recovery?</p>
<p><b>Professor David</b>: &nbsp;I think, given what had happened to the size of the deficit and the trajectory of the debt result, it's absolutely essential that there be a period of fiscal consolidation. What we do at Monetary Policy Committee is take the fiscal stance that the government has decided on as a given, we'll assume that that's how fiscal policy will be set, and we set monetary policy in the light of that to bring inflation back toward the target level and try and keep it there. I wouldn't say that there was a tension with those things or that was problematic, it's just the natural, if you like, division of labor, if you will, between a government that sets fiscal policy and an independent Monetary Policy Committee that uses monetary policy to hedge an inflation target. I think there are lots of advantages in doing things that way, and I wouldn't say that that caused enormous tensions or difficulties.</p>
<p><b>Viv</b>: &nbsp;OK. The second part of your talk deals more directly with banking and regulation. You say that one way to make the banking sector more robust is to have banks use more equity and less debt to finance their activities. Could you expand on this perhaps?</p>
<p><b>Professor David</b>: &nbsp;Yes. One of the unusual things, it certainly looks exceptional and extraordinary, and unusual , in retrospect, of the unusual things about the position major banks have got themselves into before we ran into the financial crisis that began in 2007 and got very bad in 2008, was the degree to which they had very high leverage. In other words, many banks were in a situation where they had a huge balance sheet, a very large stock of assets, a very large amount of debt financing that and very little equity. What that means is that, if people become nervous for whatever reason, good reasons or bad reasons, about the value of the assets, since there's very little equity capital in the institution, it doesn't take much of a fall in the value of the assets or, indeed, a perception that there's a risk of a fall in the value of the assets, for the institution to simply run out of capital and to become insolvent. We had let banks get into that situation.</p>
<p>I think in retrospect that was a mistake. Had banks had far more equity, had their leverage been lower, they would have been far more robust institutions and, even if people had become much more nervous about the true value of assets, if the equity buffer had been very much larger, it wouldn't have led people to believe there was a risk about them not getting their money back if they lent money to a bank.</p>
<p>So I think the primary way, to my mind, of having the banks become much more robust so we don't get in a situation again, is that they have a lot more equity. The reason I think that's the natural response is that having banks hold a lot more equity is probably not really that costly a thing to have them do.</p>
<p><b>Viv</b>: &nbsp;It's been suggested that extra equity financing and increased capital requirements means that there's actually less money available for lending, but you maintain that the opposite is, in fact, the case.</p>
<p><b>Professor David</b>: &nbsp;Yeah, I think there's a bit of confusion here. There's a view that some people have which is that if you have banks use more equity, have higher capital, that somehow this reduces their ability to lend. I don't think that makes much economic sense, to be honest with you. If a bank goes out and raises more equity capital, and it could do that by issuing some new shares or maybe paying out slightly less of its profits in the form of dividends and retaining it, that would be a form of equity financing, if a bank does that, it's got more money to lend, not less money to lend. That's why I think there's a degree of confusion in the vocabulary people sometimes use here, where they give the impression that having banks hold more capital is somehow tying the money up and there's less money available to lend. Actually, I think that pretty much the opposite to the truth.</p>
<p><b>Viv</b>: &nbsp;Finally returning to the theme of extraordinary times, you refer several times in your talk to the idea that what we are currently experiencing is clearly not a standard textbook economic cycle. In your view, does this mean that micro‑economic textbooks probably need to be rewritten?</p>
<p><b>Professor David</b>: &nbsp;That's a good question, because with my co‑author, Andrew Scott, I'm actually rewriting a micro‑economics textbook that we wrote a few years ago. I think my point there about this being not a standard economic cycle is merely a way of making the following point: That there are occasions where economies go through a natural downswing and growth is a little bit less than average for a while, and then there's an upswing and there's a period where growth is a bit above average, and it sort of evens out. You could call that a textbook economic cycle. There are plenty of occasions in history where that is a perfectly reasonable description of what economies have gone through.</p>
<p>I do not think it is in any way a good description of what we're going through at the moment. Just to come back to the prototypical example of the UK, output fell by around about 6%, GDP fell 6%, in 2009. The level of output is probably now in the UK about 10% below where you might have expected it to be at the beginning of 2007 if you just thought the next three or four years would be typical, average years of growth. So in some sense we've lost 10% of our growth.</p>
<p>I don't think it's particularly likely, I don't think it's likely at all, to be honest with you, that we over the next three or four years have a period of such strong growth that we get back onto the same trajectory where we were on. And if that's right, then you wouldn't be able to describe what we've gone through as a textbook economic cycle. Now, I'm not saying that there aren't such things as textbook economic cycles, my point is merely the simple one that this isn't one of those things.</p>
<p><b>Viv</b>: &nbsp;So we've experienced more than just a blip on the landscape?</p>
<p><b>Professor David</b>: &nbsp;I think we have experienced more than a blip on the landscape and I think that if you just look at a picture showing the trajectory of GDP, not just in the UKbut for many economies, this doesn't look like just a blip.</p>
<p><b>Viv</b>: &nbsp;David Miles, thanks very much for talking to us today.</p>
<p><b>Professor David</b>: &nbsp;Thank you very much.&nbsp;</p>

Topics:  Global crisis Macroeconomic policy Monetary policy

Tags:  interest rates, inflation targeting, monetary policy, financial regulation, capital requirements, financial reform

Related Publications:

David Miles’ speech Monetary Policy in Extraordinary Times and accompanying slides

Optimal Bank Capital”, by David Miles, Jing Yang and Gilberto Marcheggiano, External MPC Unit Discussion paper no 31, January 2011. 


Professor of Financial Economics, Imperial College Business School


CEPR Policy Research