Saturday, 5 April 2014

MPC: Success or Stalemate?

By Shivani Maru

Mark Carney with prominent members of the UK's Monetary Policy Committee.
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The MPC is short for the Monetary Policy Committee; a committee in the Bank of England that controls the base interest rate in the UK. They meet every month in order to discuss what they believe the interest rate should be.
The main aim of the MPC is to alter the rate of interest in order to meet the inflation target. In the UK, the inflation target is 2% CPI, which has been set by the government.  Although this may seem like a simple task, it actually is quite daunting.

Many factors are taken into consideration by the MPC such as the size of the output gap, economic growth etc. which guide their decision to alter the interest rate.

We can assess the success of the MPC by looking at its use of monetary policy as well as considering how well it has achieved the inflation target.

Monetary policy is when the level of interest rates and/or the money supply is altered in order to change the level of total demand within the economy. Therefore, the MPC is able to respond to changes in the economy via monetary policy.

It seems that the MPC has been successful through its implementation of monetary policy, as it has made some sensible reactions to changes in the economy. For example, during the 08/09 recession, the MPC reduced interest rates from 6% to around 0.5%. The recessions was caused by a significant fall in consumption and investment, thus it would only seem logical to reduce interest rates in order to stimulate demand again.

As shown in the UK Consumption graph below, consumption fell at the start of 2008. This correlates with the interest rates graph, which illustrates that when interest rates fell to 0.5% at a similar time to when consumption fell, consumption began to rise slowly. Thus, the MPC can be considered successful as it’s execution of monetary policy appears to have achieved its aim of stimulating demand when the economy was weak.

 In general, it appears that consumer spending and interest rates appear to have a strong correlation, however pre-08, the changes in the interest rates don’t appear to have had too much of an effect on consumption as it continued to rise.

Nevertheless, the interest rates have remained at 0.5% for the last 5 years. This raises questions as to how successful the MPC is because the MPC can only go so low with the policy. This is known as the ‘liquidity trap.’  The liquidity trap occurs when interest rates are close to 0, like the UK. The problem with this trap is that it begins to prove that monetary policy is becoming ineffective. Interest rates can’t go negative because that would be impractical, therefore other polices such as fiscal policy need to be used because it’s clear that the MPC can’t reduce interest rates any further to stimulate demand further. This suggests that in the long term, the MPC haven’t been successful with executing monetary policy as it has lead to a dead end. Perhaps, quantitive easing could be used, but the effectiveness of this part of the monetary policy is still unproven. Thus, it can be concluded that the MPC haven’t been as successful in the long run.

Another reason to back this up is the idea that the UK government appears to be looking at other methods of stimulating demand, as interest rates and quantitive easing don’t seem to be working. One of these methods is the pension reform. It was announced recently that pensioners would now be able to take out as much as money from their pension as they want without having to pay an annuity cost. Hopefully, this will be effective in boosting demand as the marginal propensity to consume will increase for pensioners.

Now, let’s look at the MPC in terms of inflation. As mentioned before, the MPC’s aim is to achieve a 2% CPI inflation target. Before going any further, here are some limitations of the inflation target.

     Your inflation is different to my inflation
Inflation is simply a number. Some of the goods that Consumer A may spend on are different to that of Consumer B. Therefore, a change in inflation may not affect Consumer A, yet inflation reaching 2% was a big deal.

     What happens when the inflation target is reached?
      Reaching 2% is a great success for the MPC, however it’s unlikely the inflation rate will continue to be 2% over the next few months, so what’s the point?

Although the MPC have only hit the 2% CPI inflation target twice within the last two years, another way of measuring their success is through the number of open letters that have been written by the government. If the level of inflation is 1% lower or 1% higher than the 2% target, then the government has to write an open letter highlighting the reasons for its occurrence as well as what the MPC propose to do about it. This occurred a few times, but mostly after the recession. Therefore, it can be said that the MPC have been successful in keeping inflation stable because even though they haven’t hit the target many times, they have managed to control its range. Furthermore, there are many factors that can affect consumption other than interest rates; the recession and the recovery of the recession are incidences, which are out of the control of the MPC.

All in all, it can be said that with regards to monetary policy the MPC haven’t been very successful in the long run. However, there is a chance that interest rates may rise if unemployment reaches 7%. Furthermore, the MPC’s role in targeting inflation has been successful but it’s hard to really measure the success of their role, as there are various limitations to the inflation target and many factors that affect inflation other than interest rates.

Thanks for reading!


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