Home > Bank of England, Monetary Policy > “Money remains at the heart of the transmission mechanism”

“Money remains at the heart of the transmission mechanism”

That great quote is from a footnote in Mervyn King’s 2005 Mais Lecture, via FT Money Supply; in full:

For many years there was a debate about whether policy was better seen as setting short-term interest rates or determining the monetary base. That is no longer an issue. For some time, the demand for money has been purely demand-determined. As a result, central banks can set the short-term interest rate either to influence real interest rates or to determine the path of the monetary base or a broader monetary aggregate. Money remains at the heart of the transmission mechanism but since its velocity is unstable most central banks use interest rates as their instrument rather than a monetary aggregate

King explains in this speech his “Maradona Theory” of interest rates; apologies for the long quote but the whole passage is worth reading:

The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.

Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those expectations were sufficient – at times – to stabilise private spending while official interest rates in fact moved very little.

That pattern is sometimes described as “the market doing the work for us”. I prefer a different description. It is the framework of monetary policy doing the work for us.  Because inflation expectations matter to the behaviour of households and firms, the critical aspect of monetary policy is how the decisions of the central bank influence those expectations. As Michael Woodford has put it, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. Indeed, one can argue that the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations. The precise “rule” which central banks follow is less important than their ability to condition expectations. That is a fundamental point on which my later argument will rest.

How did King go from such an enthusiastic endorsement of the “expectations channel” to talking incessantly about uncertainty?  King’s 2005 view of monetary policy seems so close to the modern-day market monetarists, if you merely (and it really does seem “merely”) shift the focus from the short term interest rate onto the size of the monetary base, and target level of nominal GDP as the nominal anchor in place of the inflation rate.

From the October MPC meeting minutes published today, we get this:

31.  There were, as ever, limits to what monetary policy could be expected to achieve. The
Committee discussed the likely effectiveness of further asset purchases, should they be required. Some members felt that there was still considerable scope for asset purchases to provide further stimulus. Other members, while acknowledging that asset purchases had the scope to lower long-term yields further, questioned the magnitude of the impact that lower long-term yields on corporate debt and equity would have on the broader economy at the present juncture.

How depressing.  What happened to the spirit of March 2009:

Given the Bank’s role as monopoly supplier of sterling central bank money, the Committee had previously chosen to influence the amount of nominal spending in the economy by varying the price at which it supplied central bank money in exchange for assets held by the private sector. Under the operations now under consideration, the Committee would instead be focusing more directly on the quantity of money it supplied in exchange for assets held by the private sector.

Can’t we get back to that?

  1. Bill le Breton
    October 19, 2012 at 15:19

    And your views on this? http://www2.lse.ac.uk/publicEvents/pdf/2012_MT/20121009-Mervyn-King.pdf

    I have left a revolver in the library.

    • October 23, 2012 at 12:30

      Hi Bill. I hope to do a post on that speech as soon as time permits!

  2. W. Peden
    October 24, 2012 at 02:48

    “For some time, the demand for money has been purely demand-determined.”

    That’s one of the dumbest sentences I’ve read in a while. I usually have to read Hegel or Marx to get such rot.

    The point he is trying to make- that the Bank of England doesn’t target monetary aggregates- is accurate. The last vestiges of targets for broad and narrow money were removed in 1997, and thankfully bona fide monetary base control was fought off in the early 1980s.

    • October 24, 2012 at 08:43

      Hi. Yes, that is a very strangely worded sentence.

  3. W. Peden
    October 24, 2012 at 15:23

    He might have meant “the supply of money has been purely demand-determined”, but that’s similarly stupid. Would one say that the supply of cheese is demand-determined or supply-determined?

    The most charitable way I can interpret it is to say that “the BoE has a monopoly over new base money and targets the price of new base money rather than the quantity”. Even that’s false under QE which is closer to monetary base targeting than interest rate targeting.

    It’s not even true that the Bank of England targets the price of broad money i.e. the price level, because no-one measures or targets the entire price level, just relatively narrow indexes like the CPI or the RPI, whereas the price measure that is the price of broad money would measure everything that could be exchanged in return for something that comes under a particular definition of broad money. Furthermore, it’s not the case that the BoE is a monopolist of broad money in a fractional reserve banking system.

    Milton Friedman described British civil servants and central bankers in 1980 as “Rip Van Winkles”. Unfortunately, today, most people are in this position: unused to thinking in terms of money rather than credit and interest rates, the analytical tools required to deal with a ZIRP aren’t present anymore. Even Mervyn King can’t avoid monstrosities like the above sentence.

  1. October 24, 2012 at 03:26

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