The future effectiveness of Monetary Policy lies in the Credibility of the Banking System

In the wake of the 2008/09 Financial Crisis, we saw sectors of the economy racing to withdraw cash from commercial banks, causing a banking panic. The frequent bank runs saw institutions’ liquidity drop and with now few deposits, many were unwilling to lend despite many wishing to borrow - enter the Credit Crunch. The deregulation had backfired as banks held too few deposits and the Austerity that beset the UK due to the fault of banks has caused a sharp decline in the trust of the banking system. We now sit with the base rate’s lowest ever point of 0.1pc. Monetary stimuli seem to be ineffective in comparison to earlier years. Why is that? And how have we gotten to this state?  The frequent use of monetary tools has brought the UK to a tipping point where the Bank of England is discussing the concept of implementing negative rates. The use of negative rates requires long and thorough research as the transmission mechanism may react differently to the discussed avant-garde rates. For these monetary tools to work however, sectors of the economy must listen to and believe in the Central Bank, but many understandably have little faith in the banking system after the near collapse just over a decade ago. And so, before the system can throw around stimuli to mend what they please, they must first fix the long-time broken issue – trust and credibility.

At the core, monetary policies rely on the trust and expectations of Central Banks by households and firms. Central Banks aim to achieve monetary and financial stability and they can do so by targeting inflation, unemployment and output. But they usually only have explicit targets for inflation. The CBs choice level of inflation is dictated by what firms and households expect but firms’ and workers’ expectations depend on what the Banks do. Suppose a CB wishes to considerably reduce inflation. With the implementation of monetary policies, inflation falls slightly. Wages have been negotiated for the original level of inflation, meaning real wages experience a slight increase and push an economy to a rate of unemployment higher than before. The unexpected change in inflation is adjusted for by the economy and expected inflation falls. 

If in the best case scenario where people trust the Central Bank and believe that they are committed to reducing inflation to the explicit target, their adjustments of expected inflation will quickly match the Bank’s target rate of considerably lower inflation and hence the economy would operate at that equilibrium of inflation, unemployment and therefore output. The trust and transparency allow for monetary policy to be effective and hence, it is used minimally rather than frequently and consecutively.

On the other hand, if people do not trust the Central Bank to commit to their target, expectations for inflation will remain high and the economy moves to a point of inflation at the slightly lower level and unemployment will be at a slightly higher rate than it began. For the Bank to reach their target, this implementation of policies will have to be repeated multiple times simply due to the fact that there is little trust in the CB. Overall this process would span over many years and the longer the length of time, the more vulnerable the economy is to shocks that can undo progress made, for example with COVID-19. In the first two quarters we’ve seen Central Banks enter the economic boxing ring fiercely with further rate slashes, open market operations on an unprecedented scale and even direct funding to the government in the UK’s case. The co-ordinated attacks show the severity of the current climate, but they also serve as a reminder that Monetary Policies are on the ropes. The reliance has left little wriggle room for rate changes in the future because we were unable to increase rates to a comfortable position in the last ten years.

Another critical event – the Financial Crisis. In 2008, the Bank of England reduced their rates five times between 2008 and 09 from 5.5 to 0.5pc. Having witnessed the big banks flail in their market failures, consumer and investor confidence took a hit with investment confidence falling by ~33pc. The loss of faith in the banking system and the state of the economy led to households’ inflation expectations drifting away from the Central Bank’s target. With bank runs, some people had cash to spend but didn’t due to their lower expectations. The Bank, attempting to stimulate the economy, changed the base rates but to little effect. Their following consecutive and drastic base rate changes in the year period may represent how the breach of trust between households and banks has led to the unresponsiveness to and therefore ineffectiveness of monetary stimuli. 

This issue of credibility and trust is still prevalent in the UK: A YouGov poll of 2,250 adults in 2018 concluded that “66 percent of adults do not trust banks to work in the best interests of society”. In 2019, Bank of America Merrill Lynch reported that the Bank of England’s forecasts are losing credibility with the public and markets. Up until 2016, one-year expectations of inflation from the Bank and households were similar in pattern and with pundits like Sir Paul Marshall openly criticising the Central Bank, trust is most likely to further fall. Now is not the time for the lack of trust in the banking system, however.  Over 40,000 lives have been lost to the virus, we’ve faced our worst quarter of GDP in UK history and jobs are starting to disappear. As we rescued the big banks from going bust, we should be offered help in these drastic times.

Not only is aid from the banking sector arguably deserved, it can help rebuild its once respected credibility. Commercial banks have already implemented initiatives like mortgage, credit-card and loan holidays but this is temporary and once we have gotten back to a decent position, these will be removed quickly. To improve the trust of banks, the central bank and therefore the effectiveness of monetary policies, we need a long-term solution aimed at dispersing the fog between the banking sector and the public.

I believe the best solution to increase transparency between the sector and the public, is to improve financial literacy. Many individuals are unfamiliar or weak with their finances and spiral into deep debt and sometimes harsh bankruptcies. As banks understand the risks in finance and many consumers do not, asymmetric information pollutes the market and externalities arise. An uninformed individual taking out a loan receives the private benefit of the increased cash but as they are not so knowledgeable, they may take out more than necessary or at a rate they are unable to pay back. In the case that they default, the loan is written off from the bank’s assets and this has to be paid for using funds that could’ve otherwise been used to provide loans to more financially capable people. The marginal social costs become greater than the marginal private benefits as funds were misallocated and now others miss out. It would therefore be in everyone’s best interests to reduce the externalities by improving financial literacy from young ages. A few hours a month from the ages where we understand basic mathematics would go a long way in the future. When we don’t understand things, we are unable to be risk averse and in the context of finance, situations can deteriorate faster than we even realise that something is happening. It doesn’t have to be informing people of the components of aggregate demand or the derivation of the IS-LM model. Simple explanations for example; how to save money and what interest rates on your bank account mean, are what I believe will increase the trust and credibility of financial institutions. The increased understanding of how money works and moves can lead us to trust institutions like the Bank of England and we can therefore be more responsive to monetary policy changes since we would now know the opportunity costs of financial decisions. 

In conclusion, the banking sector and the Bank of England in the eyes of the public seem to be untrustworthy and non-credible. The poor confidence is arguably reflected in the unresponsiveness to monetary stimuli as expectations are different to the Bank’s, especially since 2016. The way I recommend repairing the broken bridge is to increase the understanding of financial institutions’ operations and therefore increase transparency between the public and the sector. With this knowledge, we can hope that we are more informed and therefore more comfortable of our finances. It is hoped that it will thereby increase our trust of the banking system and therefore the effectiveness of monetary stimuli. 

By Hamzat Ken Isah - Bank of England Scholar

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