‘OPPORTUNISTIC MONETARY POLICY’:

WHY UK INTEREST RATES ARE OFTEN CONSTANT FOR LONG PERIODS – AND WHY THEY ARE LIKELY TO RISE SOON

Monetary policy-makers do not make minor adjustments to interest rates when inflation is close to the inflation target – but they do respond vigorously when inflation begins to move further from the target. That is the central argument of new research by Professors Christopher Martin and Costas Milas, presented to the Royal Economic Society's 2007 annual conference at the University of Warwick.

UK interest rates were increased in January 2007 in response to an unexpectedly high jump in inflation, to 3%. The immediate danger of higher interest rates may have passed as inflation fell below 3% in February. But the Monetary Policy Committee is known to be concerned that oil and gas prices will lead to increased wage demands; and the Governor of the Bank of England has signalled willingness to act to avoid this.

This has led many commentators to expect higher interest rates this spring. The analysis of Martin and Milas suggests that this response could be stronger than many think: further, even small, rises in inflation are likely to trigger higher interest rates.

Interest rates are often constant for long periods of time. The Bank of England base rate did not change in 2002 or between the summer of 2004 and autumn 2005. This is puzzling. The Monetary Policy Committee of the Bank of England adjusts interest rates in order to keep inflation close to the target. In these periods, inflation changed, so why where interest rates kept constant?

The argument of this research builds on the ‘opportunistic approach to monetary policy’, an analysis of the behaviour of the Federal Reserve by the Fed’s own economists. The opportunistic approach suggests that interest rates remain constant so long as inflation remains within a ‘zone of discretion’ around the inflation target but are adjusted when inflation moves outside the zone (the United States does not have an official inflation target, but most observers feel the Fed aims at an inflation rate of around 2%).

This approach implies that more traditional models of monetary policy, which assume that interest rates respond proportionately to all movements in the inflation rate are wrong; they over-predict interest rate changes when inflation is close to the target and under-estimate changes when inflation is further away.

Martin and Milas estimate various statistical models of interest rates and conclude that policy-makers in the United States do indeed follow the opportunistic approach and that the traditional model is wrong. They argue that the width of the zone of discretion is 2%, so inflation is allowed to fluctuate within 1% either side of the inflation target without triggering an interest rate response. Once the zone is breached, however, the response of interest rates is stronger than previously thought.

What are the implications for the UK? The UK economy is similar to that of the United States and the UK has a similar policy-making structure. Therefore the opportunistic approach is likely to be equally applicable to the UK (other statistical analysis by Martin and Milas confirms this).

This is the likely explanation of the long periods of static interest rates in recent years. This can also explain the large rapid changes in interest rate that have occurred in recent years, for example the fall of nearly 2.5 percentage points in 9 months in the late 1990s and the fall of 2 percentage points in 2001.

But there is one important difference between the UK and the United States, which is that UK policy-makers must write an open letter of explanation if inflation deviates from the target by more than 1%. The desire to avoid this suggests that the zone of discretion in the UK is narrower, less than the 2% zone estimated for the United States.

ENDS

Notes for editors: ‘Testing the Opportunistic Approach to Monetary Policy’ by Christopher Martin and Costas Milas was presented at the Royal Economic Society’s 2007 annual conference at the University of Warwick, 11-13 April.

Christopher Martin is at Brunel University. Costas Milas is at Keele University.

For further information: contact Chris Martin on 01895-266644 (email: ); Costas Milas on 01782-583090 (email: ) or Romesh Vaitilingam on 07768-661095 (email: ).

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