bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

THE EVOLUTION OF MONETARY POLICY IN THE UK 343
DM:£ exchange rate slumped repeatedly to 2.85 while the real economy
showed increasing signs of being in very serious recession. By the summer of
1992, non-oil output had fallen for six consecutive quarters — to nearly 5 per
cent below its peak in 1990(2). Amongst the novelties of this particular slowdown
was the sharp fall in output from services as well as manufacturing. The
rise in unemployment (from 5.6 per cent in spring 1990 to 10.1 by autumn
1992) was thus spread geographically more evenly so that London and the
South East were badly affected. It was in this region that the highest levels of
personal sector floating-rate indebtedness had developed during the property
boom of the mid-1980s and it was here, therefore, that the more dramatic
cases of personal sector gearing and indebtedness were to be found. By the
middle of the year the concern with falling house prices had crystallized in the
problem of ‘negative equity’, preventing people from moving house and
threatening banks and building societies with insolvency if they repossessed
property from defaulting borrowers.
By the summer, opinion was widespread that, faced with a choice of even
higher interest rates or abandoning the exchange rate, the government would
have to choose the latter. The UK was not alone with this problem. The lira,
the Irish punt, the peseta and escudo were all subject to speculative pressure
as their weak economies suggested the need for interest rate reductions. The
only way of avoiding widespread realignments within or defections from the
ERM seemed to lie with a cut in German interest rates. The Bundesbank,
however, was concerned about rapid monetary growth, domestic inflationary
pressures and the costs of reunification and used the occasion to enhance even
further its own credibility, by demonstrating its total independence of the general
clamour. The crisis came in September 1992 when doubts about the willingness
of some countries to ratify the Maastricht treaty called into question
the durability of the ERM itself. Sterling, which had been very weak throughout
August, came under heavy selling pressure in the middle of the month.
The Bank used its powers to announce an MLR of 12 per cent (in effect raising
base rates from 10 per cent) on the 16th September, accompanying it with
a statement of intent to raise it to 15 per cent from the following day. This,
plus large-scale intervention buying, failed to stop the pressure and sterling
was withdrawn from the ERM on the evening of the 16th September. On the
18th, interest rates were reduced to 10 per cent, beginning a steady decline
that continued through the first half of 1993.
Leaving the ERM in 1992 left UK monetary policy with the same problem
that it had in 1985: how to find a target which would enable agents to judge
the policy stance. The new monetary policy framework announced in
October 1992 contained two features. The first was the adoption of an explic-