What is the only option for a central bank up against the ‘zero lower bound’ (i.e. the policy interest rate has been set to zero) and whose asset purchases (‘quantitative easing’) have little traction? Answer: inflation expectations. The whole point is that, for better or worse (largely for worse), monetary policy has been given the job of revitalising the economy. This is true across the OECD and especially so in the United Kingdom, where the government has instructed the central bank to do whatever necessary to deliver growth. How can the central bank prod the economy into growth? Answer: through a meaningful reduction in the real interest rate. Since the nominal component of that rate is already at zero, the only thing left is to push up inflation expectations. As a refresher: the real interest rate is approximately the nominal rate minus expected inflation.
What has the Bank of England done today? The opposite! Instead of saying, ‘We commit to keeping rates at zero come hell or high water, so long as unemployment is above X’ (where X is 7% in this case), it has said, ‘We commit to keeping rates at zero, so long as unemployment is above X — unless “medium-term inflation expectations no longer remain sufficiently well anchored” (pdf). What? You’ve just told the market that you won’t tolerate a rise in inflation expectations! It’s actually worse. There are three escape clauses attached to the interest-rate commitment: the aforementioned inflation-expectations; signs of frothiness in asset prices; and signs that inflation might rise to 2.5% over the coming 18-24 months.
I have been sceptical about the traction any central bank can attain in conditions such as faced in the OECD today. Far from worrying that central banks (like the Fed, the Bank of England, BoJ, ECB etc) are doing too much through their QE, I’ve been much more sceptical of them achieving much at all. Too much is attributed to QE which doesn’t follow from the actual mechanics of the thing. My view for some time has been that central banks will come round to nudging up inflation expectations precisely in order to get some traction. But, along with many others, I’ve been sceptical that they can do so. This is because most central banks have worked for decades precisely to prove that they will never allow such a thing, i.e. a rise in inflation expectations. In essence, they have a reverse-credibility problem. And the Bank of England just proved this point in spades.
It is for this reason that Nick Crafts suggests governments themselves regain control of monetary policy — they have the credibility to deliver on higher inflation — it’s in their self-interest as net debtors. That wouldn’t be the first time central banks lost their independence.
I am reminded of a passage in Eichengreen’s Golden Fetters about monetary policy mindsets in the midst of the Great Depression: “There is no little irony in the fact that inflation was the dominant fear in the depths of the Great Depression, when deflation was the real and present danger.” (Golden Fetters, 24).