Does high M4 money growth trigger large increases in UK inflation? Evidence from a regime-switching model

March 2007 saw an increase of 3.1 percent in the Consumer Price Index (CPI) annual inflation rate and triggered the first explanatory letter from the Governor of the Bank of England to the Chancellor of the Exchequer since the Bank of England was granted operational independence in May 1997. The letter gave rise to a lively debate on whether policymakers should pay attention to the link between inflation and M4 money growth. Using UK data since the introduction of inflation targeting in October 1992, we show that: (i) the relationship between inflation and M4 growth is not stable over time, and (ii) the tendency of M4 to exert inflationary pressures is conditional on annual M4 growth exceeding 10%. Above this threshold, a 1 percentage point increase in the annual growth rate of M4 increases annual inflation by only 0.09 percentage points, whereas a 1 percentage point increase in the disequilibrium between money and its long-run determinants increases annual inflation by only 0.07 percentage points. Since the money effects are very small, the implication is that the Monetary Policy Committee should not be particularly worried for not paying close attention to M4 money movements when setting interest rates.Monetary Policy Committee (MPC), M4, inflation targeting, regimeswitching model.

Financial Stability and Monetary Policy

We argue that although UK monetary policy can be described using a Taylor rule in 1992-2007, this rule fails during the recent financial crisis. We interpret this as reflecting a change in policymakers’ preferences to give priority to stabilising the financial system. Developing a model of optimal monetary policy with preference shifts, we show this provides a superior empirical model over crisis and pre-crisis periods. We find no response of interest rates to inflation during the financial crisis, possibly implying that the UK abandoned inflation targeting during the financial crisis.monetary policy, financial crisis

Causes of the Financial Crisis : An Assessment using UK Data

We present empirical evidence that the marked rise in liquidity in 2001-2007 was due to large and persistent current account deficits and loose monetary policy. If this increase in liquidity was a pre-condition for the financial crisis that began in July 2007, we can conclude that loose monetary and the deterioration in current account balances were causes of the financial crisis.liquidity; monetary policy; financial crisis; global imbalances

Monetary Policy and the Hybrid Phillips Curve

This paper argues that existing empirical models of interest rate rules are too simplistic. The hybrid Phillips curve implies that policymakers should respond to both current and expected future inflation rates, in contrast to existing models. We provide evidence that UK policymakers do this.optimal monetary policy; inflation persistence; Phillips curve

Modelling Monetary Policy: Inflation Targeting in Practice

This paper estimates a simple structural model of monetary policy in the UK for 1963-2000, focusing on the policy of inflation targeting introduced in 1992. Our main findings are: i) the adoption of inflation targets led to significant changes in monetary policy giving greater weight to inflation; (ii) monetary policy post-1992 is asymmetric as policy makers respond more to upward deviation of inflation away from the target; (iii) in the post-1992 period policymakers may be attempting to keep inflation within the range of 1.4%-2.6% rather than pursuing a point target of 2.5%; (iv) monetary policy is more responsive to inflation when it is further from the target.

The Sub-Prime Crisis and UK Monetary Policy

The “sub-prime” crisis, which led to major turbulence in global financial markets beginning in mid-2007, has posed major challenges for monetary policymakers. We analyse the impact on monetary policy of the widening differential between policy rates and the 3-month Libor rate, the benchmark for private sector interest rates. We show that the optimal monetary policy rule should include the determinants of this differential, adding an extra layer of complexity to the problems facing policymakers. Our estimates reveal significant effects of risk and liquidity measures, suggesting the widening differential between base rates and Libor was largely driven by a sharp increase in unsecured lending risk. We calculate that the crisis increased libor by up to 60 basis points; in response base rates fell further and quicker than would otherwise have happened as policymakers sought to offset some of the contractionary effects of the sub-prime crisis.optimal monetary policy; sub-prime crisis

Non-linear real exchange rate effects in the UK labour market

Using data over the 1973q1-2004q1 period, this paper identifies an important role for the real exchange rate in affecting UK labour market conditions. When the real exchange rate is undervalued, short-run unemployment falls as firms respond to an improvement in domestic competitiveness by increasing their demand for labour. The unemployment response to the real exchange rate deviations occurs outside a narrow interval band. To the extent that the real exchange rate equation reflects monetary policy considerations, our results imply that unemployment can be targeted by economic policy. Our results also suggest that when the real exchange rate is undervalued, workers respond to an improvement in domestic competitiveness by demanding and getting higher wages. Again, this effect is non-linear.Real exchange rate; unemployment; monetary policy; Smooth Transition Vector Error Correction Model.

Modelling official and parallel exchange rates in Colombia under alternative regimes: a non-linear approach (Corrected version)

We examine the long-run relationship between the parallel and the official exchange rate in Colombia over two regimes; a crawling peg period and a more flexible crawling band one. The short-run adjustment process of the parallel rate is examined both in a linear and a non-linear context. We find that the change from the crawling peg to the crawling band regime did not affect the long-run relationship between the official and parallel exchange rates, but altered the short-run dynamics. Non-linear adjustment seems appropriate for the first period, mainly due to strict foreign controls that cause distortions in the transition back to equilibrium once disequilibrium occurs. ********************************************************************** En este documento se analiza la relación a largo plazo entre la tasa de cambio oficial y paralela de Colombia, bajo dos régimenes distintos, un periódo de crawling-peg y un periódo más flexible de banda cambiaria. Se analiza el proceo de ajuste a corto plazo de la tasa paralela bajo contextos lineal y no lineal. Como conclusión se detectó que el cambio de régimen de tasa de cambio no afectó la relación a largo plazo entre la tasa de cambio oficial y la paralela, pero sí modificó la relación a corto plazo. Un método de ajuste no lineal parece ser apropiado para formalizar el comportamiento en el primer periodo, principalmente debido a los estrictos controles externos que generan distorsiones en el proceso de retorno al equilibrio, cuando un desequilibrio ha ocurrido.Parallel market, cointegration, non-linear error correction models, Colombia

Multivariate STAR Unemployment Rate Forecasts

In this paper we use smooth transition vector error-correction models (STVECMs) in a simulated out-of-sample forecasting experiment for the unemployment rates of the four non-Euro G-7 countries, the U.S., U.K., Canada, and Japan. For the U.S., pooled forecasts constructed by taking the median value across the point forecasts generated by the STVECMs perform better than the linear VECM benchmark more so during business cycle expansions. Pooling across the linear and nonlinear forecasts tends to lead to statistically signißcant forecast improvement for business cycle expansions for Canada, while the opposite is the case for the U.K.

Financial Market Conditions, Real Time, Nonlinearity and European Central Bank Monetary Policy: In-Sample and Out-of-Sample Assessment

We explore how the ECB sets interest rates in the context of policy reaction functions. Using both real-time and revised information, we consider linear and nonlinear policy functions in inflation, output and a measure of financial conditions. We find that amongst Taylor rule models, linear and nonlinear models are empirically indistinguishable within sample and that model specifications with real-time data provide the best description of in-sample ECB interest rate setting behavior. The 2007-2009 financial crisis witnesses a shift from inflation targeting to output stabilisation and a shift, from an asymmetric policy response to financial conditions at high inflation rates, to a more symmetric response irrespectively of the state of inflation. Finally, without imposing an a priori choice of parametric functional form, semiparametric models forecast out-of-sample better than linear and nonlinear Taylor rule models.monetary policy, nonlinearity, real time data, financial conditions