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

	2012	2013	Loss	Diff
Inflation
Rising rates	2.4%	2%	0.16
Flat rates	2.6%	2.5%*	0.61	0.45
Output growth
Rising rates	2.7%	2.6%
Flat rates	3.0%	3.0%
Output gap
Rising rates	3.3%	2.7%*	18.18
Flat rates	3.0%	2.0%	13.00	-5.18

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.