Commentary – Monetary Policy

In the UK Central Bank Policy Rates as low as 0.5 are unprecedented in the post-1945 period.

Furthermore, such low interest rates mean that rates they cannot be lowered much further. (Negative nominal interest rates are clearly not impossible but significantly negative rates are unlikely to persist – they imply that the lender not the borrower is paying interest, and the lender can always hold cash – and so pay no interest – rather than make such a loan.)

With the interest rate route blocked, Central Banks have tried to stimulate the economy using an alternative instrument: Quantitative Easing. This involves the Central Bank buying government bonds and certain other financial assets from (mainly) commercial banks, and in payment crediting the commercial banks’ reserve accounts held at the Central Bank. The hope is that these extra reserves will encourage the commercial banks to increases their own lending. This type of operation inevitably increases what is known as the monetary base – the sum of cash in the hands of the public and the reserves which the commercial banks hold with the Central Bank.

In March 2009 the Bank of England initiated such a policy of Quantitative Easing. The effect on the UK Monetary Base has been dramatic and unprecedented in peacetime.

Other Central Banks have resorted to the same policy and experienced the same dramatic and unprecedented movements in their Monetary Bases.

Ordinarily, such increases in the Monetary Base would lead to similarly-sized increases in the broader concept of the money supply itself – cash held by the public and bank deposits – as banks used their reserves to buy bonds or make loans to their customers. Fears that this would happen and – given the usual link between money supply growth and inflation – consequent fears that inflation would explode were raised in all the countries which experienced these Base Money increases. In the event these fears have appeared groundless. In fact if anything the Base Money increases have failed to increase the money supply – and so failed to stimulate the economy – as much as was hoped, though they have had some effect. The commercial banks appear to have been unwilling or, more likely, unable to lend out their reserves because of a lack of demand for loans.