Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 20 February 2012

2010 and Monetary Policy in the UK

                I have argued that the decision to reduce the UK budget deficit more rapidly in 2010 was a major policy error. (I looked at figures on cyclically corrected budget deficits in the UK, US and Eurozone here.) One argument against this view is that without such a tightening, the UK would have been at greater risk of a loss of confidence in UK government debt. I think many believed that at the time, because they thought what was happening in the Eurozone could happen to the UK. As interest rates on government debt continue to fall around the world, this fear looks increasingly groundless. As the IMF has recently noted, growth as well as debt levels are important influences on market perceptions.
                A rather better argument (see the first comment on this post) is that if fiscal policy had not tightened in 2010, the Monetary Policy Committee (MPC) of the Bank of England would have raised interest rates in 2011. In the Spring of that year, 3 of the 9 members voted for an interest rate rise from the zero bound floor level of 0.5%. If the economy had been stronger because of less austerity, would two or more committee members have switched sides, leading to an increase in UK interest rates?
                A think it is far from clear that they would. Inflation was high in part because of the result of those austerity measures. VAT was increased from 17.5% to 20% at the beginning of 2011, which probably added around 1% to inflation in 2011. You could argue that as this was always going to be a temporary influence, it was neither here nor there as far as MPC decisions were concerned. I think this would be a little naive. One of the major concerns of MPC members around that time was the loss of reputation that the MPC might suffer if inflation got too high, and here I think the actual numbers mattered.
                But supposing the Bank had raised rates. Would that have been the right thing to do? In hindsight clearly not. The ECB did raise rates at this time, and that now looks like a very foolish decision, but it looked pretty foolish at the time. (See this from Rebecca Wilder.) I also argued strongly against raising UK interest rates in early 2011. My note was called ‘Ten reasons not to raise interest rates’, but the main argument was very simple. The costs of inflation exceeding its target were much lower than the costs of a persistently high output gap.
                At the time it was possible to try and calculate these costs based on what the Bank itself was thinking, because it published output and inflation numbers under two alternative scenarios: one where interest rates were kept flat and another where they increased through the year (based on market expectations at the time).  Here is the table I put together.

Calculating social welfare

   Rising rates

   Flat rates
Output growth
   Rising rates

   Flat rates

Output gap
   Rising rates

   Flat rates
Numbers are estimated using the Bank of England’s February 2011 Inflation report. Output gap numbers assume a 4% gap in 2011 (consistent with the latest OECD Economic Outlook), and that potential grows by 2% p.a. 2013 numbers are guesses based on extrapolating the Q1 forecast. 

            Raising rates through 2011 had virtually no impact on 2011 numbers, so these are ignored. Higher interest rates leave inflation is a little lower in 2012, and inflation then comes back to target in 2013. In contrast, keeping rates flat would leave inflation half a percent above target in 2013. Raising rates would reduce output growth by a quarter of a percent in 2012 and by half a percent in 2013, leaving the output gap 0.7% higher in 2013. Now suppose we take the difference between the forecast number and the target for inflation each year, square this figure and sum. We do the same for the output gap. That gives a very crude measure of the social loss implied by each policy, and this is shown in the column headed loss. Take the difference between the two policies in the final column. Raising rates clearly does better on inflation, but worse on the output gap. However the output gap losses are much larger, because inflation is near its target, but the output gap is not.
                This puts into numbers a very simple idea, which is that missing the inflation target by half a percent is no big deal, but raising the output gap by over half a percent when it is already high is much more costly. Now we can argue forever about the size of the output gap, but we need to remember that in these calculations it is mainly a proxy for the costs of higher unemployment, and we have real data on unemployment.
                We can put the same point another way. Although 5% inflation in 2011 sounded bad, it was the result of a temporary cost push shock, caused by higher VAT and energy prices. Inflation was bound to come down again, because unemployment was high. (I think some in the Bank began to doubt this basic macroeconomic truth because they kept on underestimating inflation.) There was never any sign of higher price inflation leading to higher wage inflation. In contrast, the recovery from the recession was slow, so this was the problem to focus on.
                Crucial in this analysis is the view embodied in the Bank’s forecast that it takes some time before higher interest rates influence output and inflation. What this means is that to prevent inflation rising in 2011, we really needed higher interest rates at the end of 2009. A year in which GDP fell by 5%! Those who argue that the MPC ‘failed’ because inflation reached 5% in 2011 are really arguing that the MPC should have made the recession deeper.
                So, if the MPC had raised interest rates in 2011, they would have been wrong to do so. That is obviously true in hindsight, but it was also true based on the more optimistic projections made at the time. It would also have been true even if the economy had been stronger because of less austerity.
                One final point on this policy error. It is just possible that, without the Eurozone crisis, the LibDems might not have been persuaded to adopt the Conservatives’ fiscal plans as part of the coalition agreement. But the real source of the error is to be found much earlier, when the Conservatives opposed the government’s fiscal stimulus measures in 2008/9. From that point on, their macroeconomic policy was all about austerity, and they denied that this would have harmful effects on the economy. I’m afraid I have no knowledge about why they decided to adopt this line, but it has proved to be a very costly mistake. 


  1. RE: Your last comment "I'm afraid I have no knowledge about why they decided to adopt this line" - I put forward a suggestion here...

    1. I agree about the politics. But I'd like to know who advised them on the economics, because I'm interested in how bad macroeconomics gets to become policy.

  2. "So, if the MPC had raised interest rates in 2011, they would have been wrong to do so"

    This is purely an appeal to the discretion of the MPC. The median CPI target was above target all the way out in the second quarter of 2011. It was quite reasonable for them to tighten policy on that basis.

    There is a broader issue. If you want the MPC to exercise discretion rather than follow rules, we must hold them accountable for past failings. Yet you only find blame for Tory politicians?

    Were the MPC not failing in 2008 on any reasonable metric? Rates were above 5% all the way to September.

    Here's my post.

  3. I'm happy to criticise Labour politicians when appropriate. Deficits were too high before the recession, for example. I'll do the same for the MPC - they were too slow in cutting interest rates in 2007/8. But the MPC were absolutely right to ignore increases in inflation after the recession. Surely you must acknowledge that, given lags, higher interest rates in 2008 would have just made the recession worse.

  4. "higher interest rates in 2008 would have just made the recession worse"

    Yes, absolutely, and also post-'09. We should judge the success of monetary policy under inflation targeting NOT by current headline CPI, but by its ability to stabilize the forecast for CPI inflation... "over the medium term", as the MPC always say.

    (Is there another metric by which you think we should hold them accountable, if not the CPI forecast? That is what they concentrate on, though "medium term" is always left ill-defined.)

    The MPC failed on this basis in 2008 because they allowed the forecast for CPI to fall off a cliff by keeping rates too high for too long. They were behind the curve by Q3, and by Q4 were staring deflation in the face. This is a monetary policy failure of the greatest order. Rates were above 0% all the way through 2008. Who will call them on it?

    You can say this is a practical failure: they weren't doing it right. But then you insist they would use their discretion in 2011. They did exactly that in 2008, and they blew up the economy by focusing too much on current CPI.

    We need monetary policy to follow rules, not discretion. A target path for the level of nominal GDP will get us away from all this vague estimation of the output gap, and it will get away from discretionary policy.

  5. Simon, George Osborne's main economic advisers appear to be Rupert Harrison, formerly of the IFS, and Matthew Hancock.

    Do you know anything about their views on stimulus/austerity? Are they regarded as credible macro-economists?

  6. Perhaps I am hopelessly naive, but I thought the Bank of England was made independent in order to control inflation. It is supposed to set interest rates so as to deliver inflation of 2% on the CPI measure. The main reason for delegating this task to an independent body is that there is always the possibility of reducing unemployment in the short term by accepting higher inflation, so in the long run we get permanently higher inflation but unemployment returns to the natural rate. By tasking the Bank with keeping inflation close to 2%, we can overcome this inflationary bias.

    Thus, the Bank is not responsible for preventing recessions or for unemployment. It is not the Bank's responsibility to weigh up the costs and benefits to society of its actions, but rather to keep inflation close to 2% at all times. If it does so, it has succeeded. If it is forced to write letters to the Chancellor explaining why inflation is way above target, it has failed. So, if we accept the premise that it takes over a year for an increase in interest rates to reduce inflation, then yes, the Bank should have raised rates in 2009 regardless of the recession.

    Of course the Bank is supposed to promote growth and employment, but only subject to the primary task of controlling inflation. It's a bit like a soldier who has the opportunity to use his initiative to kill the enemy or help civilians: this should only be done subject to him completing his mission.

    Since most recessions are caused by inadequate demand (which tends to reduce inflation) the Bank's objectives are usually consistent with stabilizing output, stimulating the economy in a recession. But if there are supply shocks (as in the 1970s) the Bank should be raising interest rates even in the face of high unemployment and recession. This is the price we pay for low and predictable inflation, which was a rarity in the UK before the 1990s, when the government first started using monetary policy to target inflation and then delegated this task to the Bank of England.

    1. Inflation Bias happens when the CB tries to push employment above the natural level. If it is currently below it, pushing it back up won't cause inflation bias.

    2. True, but we don't know what the natural rate of employment is, and there's a clear tendency to overestimate it. Inflation tends to occur when the monetary authorities dismiss observed inflation as temporary and claim employment is consistent with the natural rate even when it is higher (say because the natural rate is less than its historical level).

      In any case, the Bank of England is tasked with ensuring inflation is close to 2%, not with keeping employment at the natural rate. In many situations the two goals will be consistent, but where there is a conflict the Bank should prioritize inflation.

      Of course, there's a debate to be had about what the best form of monetary policy would be, and the Fed's mandate seems closer to what Simon has in mind. But I think there is a good case for focusing on stable inflation and that is what the Bank of England is supposed to be doing. I think they are stretching their mandate to the limit already, if inflation went any higher than last year they would either have to tighten or lose all credibility.

    3. "The Bank has "to maintain price stability, and, subject to that, to support the economic policy of HM Government including its objectives for growth and employment" (Bank of England Act 1998).

  7. "I’m afraid I have no knowledge about why they decided to adopt this line, . . . "

    Barro/Ricardo equivalence?

  8. Sorry to post so late on this topic.

    It seems to me clear that it should have been the role of the Liberal Democrats in post-election negotiations to get the Conservatives off the austerity ‘hook’ (as they did on a number of other election-based or party-pleasing positions).

    In fact if Laws in his book 22 Days in May is to be believed, it was the Lib Dem negotiators – and especially Chris Huhne – who encouraged them. Huhne would have considered himself an economist who didn’t need advice on the subject. Reading the book one can sense each side in turn raising the hysteria of the other over the assumed reaction to a hung parliament in the ‘bond markets’ and the spectre of Greece – that close cousin of the UK economy.

    And of course King ‘stood ready to brief us’ wrote Laws – pp108-09


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.