Normal monetary policy

Most economists expect Bank Rate to stay at 0.5 per cent until at least 2014 and that there will be more quantitative easing soon. It seems, therefore, that monetary policy will stay exceptionally loose. But, in one sense, there's nothing exceptional about this at all. The Bank of England is setting monetary policy in much the same way it always has. What's extraordinary is not monetary policy, but the depressed state of the economy.

To see what I mean, start with the question: what should monetary policy be? Back in the early 1990s, John B Taylor of Stanford University proposed a simple equation to answer this. He said that the official interest rate should be equal to the inflation rate multiplied by 1.5, plus the output gap multiplied by 0.5, plus a constant term. The logic here is simple. When inflation rises, interest rates should rise by more, so that the real interest rate rises to cool off the economy and so reduce inflation. And when the economy is weak - and the output gap negative - interest rates should be cut to revive growth.

Now, CPI inflation is 2.6 per cent and the OBR estimates that GDP is around 3 per cent below its potential level. The Taylor rule therefore predicts that Bank Rate should be a little over 3 per cent*. It seems, then, that monetary policy is too loose.

However, it is not too loose by historic standards. Since it was made independent in 1997, the Bank has not followed the Taylor rule very closely. A different version of the rule fits the path of Bank Rate between 1997 and 2007 better. It is: the output gap multiplied by 1.3, plus 0.5 times the inflation rate, plus 4.3. In other words, even in the good economic times, the Bank put more weight upon the output gap and less upon inflation than the Taylor rule predicted. Looking at the numbers, you'd think the Bank had been targeting output rather than inflation.

For example, in 2001-02 the Bank cut Bank Rate by more than the conventional Taylor rule implied, which was consistent with it worrying about the weak economy more than inflation. And in the mid-2000s it didn't raise rates as much as the Taylor rule advised, which was consistent with it putting less weight upon rising inflation and more upon the fact that output was around its trend level.

In this context, monetary policy now isn't remarkably loose. This equation predicts that Bank Rate should be 1.7 per cent, which means that interest rates now are well within two standard errors of where you'd expect, given the Bank's monetary policy setting in normal times. And you can easily justify such low rates as insurance against a possible worsening of the euro crisis, or because the constant term should now be lower, to reflect the fact that the crisis has reduced the economy's long-term growth rate.

In other words, monetary policy is not exceptionally loose. What's exceptional is the state of the economy, not the Bank's reaction to it. The Bank is setting monetary policy in much the same way it always has done.

This has three implications.

First, it means those people who want the Bank to target nominal GDP rather than inflation are missing the point. The Bank has never really targeted inflation that closely anyway. If it had been, inflation would not have averaged a percentage point more than its target rate over the last four years. Instead, the Bank has tried to target output.

Secondly, this implies that the future of monetary policy depends more upon output than inflation. If the economy recovers quickly and the output gap closes, interest rates could rise surprisingly quickly. And if - as seems more likely - it does not, then we're stuck with a low Bank Rate for some time.

Thirdly, all this should caution investors against moving greatly out of cash. There are two sorts of loose monetary policy - the sort that's justified by the state of the economy and the sort that isn't. The latter is a reason to get out of cash, because easy money will either increase inflation or the price of real economy assets such as equities. However, the loose monetary policy that is a product of a weak economy is no reason to switch from cash to equities, because the things that cause interest rates to be low - slow growth and the threat of worse - are bad for shares. And, sadly for investors, our current loose monetary policy is justified.

*This assumes a constant term of 0.8, chosen so that the real interest rate is 2.3 per cent when inflation is on target and GDP at its potential rate - which is equal to the OBR's estimate of trend growth.

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