Monetary policy and the sterling exchange rate*

By :

• David Cobham¹¹Heriot-Watt University

· ¹Heriot-Watt University

*I am grateful for comments on earlier drafts to Chris Allsopp and Simon Wren-Lewis.

Abstract

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This article introduces the three contributions to the Feature, which address issues raised by the sterling appreciation of 1996–97 and the subsequent prolonged overvaluation. Cobham discusses the MPC's understanding of exchange rate changes and examines policy makers' responses to the proposal that policy should respond to exchange rate misalignments. Kirsanova, Leith and Wren-Lewis construct a 'new open economy macroeconomics' model with international risk sharing shocks, in which the welfare function derived includes a term in the 'terms of trade gap'. Allsopp, Kara and Nelson investigate the exchange rate-prices pass-through and how imports should be modelled, and draw out the policy implications.

There is widespread agreement that UK monetary policy has been pursued with greater competence and success since the Monetary Policy Committee (MPC) was given control of interest rates in 1997. Policy now has a clear target and a transparent set of operating practices, the MPC's reaction function is relatively well understood, and inflation has not so far strayed far enough from the target for the Governor of the Bank of England to have to write and explain the MPC's behaviour and thinking to the Chancellor of the Exchequer. However, the period from 1997 has been characterised by a persistent overvaluation of sterling brought about by a 20% appreciation in the second half of 1996 and the first half of 1997, and there have been recurring concerns about the resulting 'imbalances' between the tradable and non-tradable sectors of the UK economy. Such concerns have raised the question of whether the policy makers could have taken some action to forestall or correct the development of exchange rate misalignments, and the broader question of whether the open economy element in the current monetary framework is satisfactory.

The three articles in this Feature explore the issues involved in the appreciation and overvaluation of sterling in different ways. The first provides a background narrative, discusses the thinking and actions of the policy makers (the Chancellor before May 1997 and the MPC since), and shows that they were indeed aware of and concerned with the sectoral imbalances created by the overvaluation, but felt there was little they could do about them. Part of the problem was that the MPC found it very hard to explain past changes in the sterling exchange rate, or to forecast future changes (which it did mainly by using interest rate differentials in an inversion of uncovered interest parity (UIP)). Cobham also examines why the policy makers did not take some other actions which might have prevented or moderated the overvaluation: in particular he examines Wadhwani's (2000) proposal that the policy makers should take account of asset price misalignments (notably exchange rate misalignments) as well as the inflation forecast in setting interest rates. He identifies the arguments deployed by other members of the MPC against this proposal, documents its lack of influence on MPC decisions, and discusses what the policy makers would have had to have done differently and when if they were following the proposal. The counter-arguments included the difficulty of identifying misalignments and the risk that such actions would confuse the markets and undermine the MPC's credibility, while the conjunctures in which action would have had to be taken were often ones of strong domestic demand growth. However, Cobham also stresses the counter-argument that the response of the exchange rate to such actions was intrinsically unpredictable. As he points out, if this is because the exchange rate is typically erratic, then the Wadhwani proposal is difficult to defend but, more importantly, there is a case for a reconsideration of the whole monetary framework, including a more open examination of the case for adopting the euro.

In the second article Kirsanova, Leith and Wren-Lewis (hereafter KLW) focus on the theoretical arguments put forward by authors such as Clarida et al. (2001), who have concluded that 'the monetary policy design problem for the closed economy is isomorphic to the problem of the closed economy' (p. 248) and, in particular, that policy should target the same price index, domestic output price inflation, rather than consumer price inflation (which includes imported goods). Such arguments differ sharply from earlier articles which had argued that optimal policy in an open economy should take explicit account of the exchange rate, e.g. Ball (1999) and Svensson (2000); but see also Taylor (2001) and Galí and Monacelli (2002). KLW generalise the small open economy model of these authors by incorporating preference shocks and international risk sharing (IRS) shocks, and they use Woodford's (2003) method to derive a welfare function from individual representative agent utility functions. They find that optimal policy should still target output price inflation, but, in the presence of IRS shocks, they find a role for policy to respond systematically not just to the output gap but also to the 'terms of trade gap', that is the difference between the actual level of the terms of trade and the level that would exist in the absence of IRS shocks and nominal inertia. They argue that this terms of trade gap is close to the deviation of the real exchange rate from John Williamson's Fundamental Equilibrium Exchange Rate (FEER). Moreover, the results from their calibrated model suggest that the use of a closed economy model in an open economy could produce significant policy errors. KLW also discuss the stability argument for targeting output rather than consumer price inflation. They show that in their model the latter strategy could generate instability, through the feedback from interest rates to consumer price inflation via the exchange rate, particularly in a highly open economy with a full pass-through from the exchange rate to prices.

With regard to the recent policy experience in the UK, KLW argue that in the context of the model they use the 1996–7 appreciation involved a large terms of trade gap as the result of an IRS shock. On their analysis policy should not have responded only to inflation and output, and for inflation it should have focused on output rather than consumer price inflation. However, their calibration implies that on optimal policy interest rates would not necessarily have been lower.

In the third article Allsopp, Kara and Nelson (hereafter AKN) provide an empirical analysis of the exchange rate-prices pass-through and draw out its implications for policy. They update and supplement earlier empirical work (Kara and Nelson, 2003) to show that the pass-through, which is typically strong from the exchange rate to import prices but weak from import to retail prices, is best modelled via the McCallum and Nelson (2000) approach in which imports are treated as intermediate inputs. In that case the appropriate index for policy makers to target is indeed retail or consumer prices (rather than domestic output prices): the appropriate target should include those prices which are sticky but exclude those which are perfectly flexible, but in this case all (final) goods and services have sticky prices.

There are a number of implications in AKN's analysis for the recent policy experience. First, they raise questions about the standard estimates of domestically generated inflation (DGI) which are derived on the basis of a misplaced assumption about the pass-through. According to the published data import prices fell and DGI rose in the late 1990s, but if the pass-through to retail prices is low as AKN argue then there would have been no such rise in DGI (and the concept of DGI needs to be rethought). Second, their analysis implies that the tendency for the MPC to keep interest rates high on the grounds that sterling was expected (on the basis of the UIP forecasts) to fall was misplaced: given a low first round pass-through to retail prices and given that monetary policy seems to be capable of controlling second round effects of exchange rate changes, the committee could have waited for the exchange rate to depreciate before taking any action. Third, they suggest that the new forecasting model being introduced by the Bank should treat imports differently (from the previous model, with its high pass-through), which would have obvious implications for both forecasts and interest rate decisions. Fourth, their analysis implies that the impact on output of exchange rate misalignments (if that concept is still useful) needs to be rethought. The treatment of imports as inputs involves a smaller pass-through to prices, but not necessarily a smaller effect than in the standard view on firms that participate in international trade: an appreciation, for example, cheapens inputs and raises potential supply while at the same time it reduces demand (insofar as other inputs are domestic their prices do not fall, so that costs fall by less than the appreciation and relative prices rise), thus having a larger effect on the output gap. Moreover, the AKN treatment indicates that what matters is not just whether firms compete, on domestic or export markets, with foreign goods but also the extent to which they use imported inputs.

Overall, the articles strongly suggest that the open economy element in the current monetary framework is unsatisfactory, and that more research is needed – on the modelling of trade relationships, on the determination of exchange rates and on the appropriate policy responses to external shocks of different kinds.

References

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Clarida, R., Galí, J., and Gertler, M. (2001). 'Optimal monetary policy in open versus closed economies: an integrated approach', American Economic Review, vol. 91(May), pp. 248–52.

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Galí, J., and Monacelli, T. (2002). 'Monetary policy and exchange rate volatility in a small open economy', National Bureau of Economic Research working paper 8905.

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Kara, A., and Nelson, E. (2003). 'The exchange rate and inflation in the UK', Scottish Journal of Political Economy, vol. 50 (November), pp. 585–608.

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McCallum, B., and Nelson, E. (2000). 'Monetary policy for an open economy: an alternative framework with optimizing agents and sticky prices', Oxford Review of Economic Policy, vol. 16 (Winter), pp. 74–91

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Svensson, L. (2000). 'Open economy inflation targeting', Journal of International Economics, vol. 50 (February), pp. 155–83.

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Wadhwani, S. (2000). 'The exchange rate and the MPC: what can we do?', Bank of England Quarterly Bulletin, vol. 40 (August), pp. 297–306.

•Woodford, M. (2003). Interest and Prices, Princeton: Princeton University Press.