There is a wonderful scene is the film Being There, where the innocent gardener played by Peter Sellers is asked by the President whether he should stimulate the economy. I thought of this while wondering why central banks seem to be gripped by inactivity as the global economy looks more perilous by the day (see R.A. here). I remembered being equally puzzled by the actions of the UK’s Monetary Policy Committee at a similar time last year, when they almost voted to raise interest rates, and by the ECB that did raise rates. On both occasions spring was in the air, and when much of the natural world is coming back to life, perhaps central bankers are filled with undue optimism about economic growth. This led me to think of Being There.
I doubt, however, if this hypothesis would survive econometric testing. A better hypothesis, which I talked about here, is that central banks take inflation targeting rather more literally than economists thought they did. Actually, we probably suspected this of the ECB, but I really did believe that both the Fed and MPC saw themselves as pursuing ‘flexible inflation targeting’, which meant also being strongly influenced by the output gap. Perhaps I was naive, but in the case of the MPC I know these people, and they are all really good economists who know what optimal policy is all about.
Perhaps my naivety partly comes from underestimating the influence of public accountability. With an explicit inflation target, the performance of the MPC is judged by most of the media as success in meeting that target. Very few non-economists blame the continuing recession on monetary policy, but the MPC has had a really hard time as a result of underestimating inflation. As I said here, forecast errors are generally down to bad luck rather than incompetence, but that is not widely recognised.
It is true that knowing what the output gap is at the moment is very difficult, but that should not mean that you ignore it. As I argued here, at the Zero Lower Bound (ZLB) output gap uncertainty should make you more inclined to pursue an expansionary policy. Another factor I suspect is having to rely on Quantitative Easing to stimulate the economy. The impact of QE is very uncertain, the numbers involved are very large, and we should not discount the influence of those who look at these numbers and say hyperinflation is nigh. Other possible factors were mentioned in that earlier post.
But these are explanations, not excuses. In that earlier post I talked about central projections. However the MPC prides itself (and quite rightly) on stressing the uncertainty of forecasts by using its famous fan charts. It was therefore with some surprise to read, via Britmouse, that one member of the MPC thought that “The forecasts in May were consistent, two years out, with roughly balanced risks on either side of the (inflation) target.” To which I immediately thought: balanced risks, what about the Euro?
So I went to the Inflation Report, and sure enough the fan chart shows the forecasts for inflation pretty evenly distributed around 2%. I then read the section on uncertainty. I’ll be honest here – this is normally part of the report where I tend to skip. It is full of platitudes like ‘Inflation depends on X, and X could be higher, but then again it might be lower’. I found “..the biggest risks stem from developments in the Euro area..” which is consistent with Mervyn King's recent remarks. But then I read this “As was the case in past Reports, the MPC sees no meaningful way to quantify the size and likelihood of the most extreme outcomes associated with developments in the euro area and they are therefore excluded from the fan charts.”
This is something I should have picked up before, but as I said that is my fault. As a principle it strikes me as a little odd – we try and quantify uncertainty, unless it’s really important! But it also raises an immediate question. If the forecast probabilities are evenly distributed around 2% without allowing for a really bad Euro outcome, what allowance was the MPC making for this bad outcome when deciding not to undertake further QE? I would have thought that, as the Inflation Report says that a bad Euro outcome would reduce output, the MPC also believes this bad outcome would reduce inflation. So, making some allowance for this would reduce expected inflation below the 2% target. So what happened to this downside risk?
I cannot think of an answer. Perhaps there is some equally large but imponderable uncertainty on the positive side, which can be set against a bad Euro outcome. If there is, I think we should know about it, if only to cheer everyone up. But maybe it’s just that spring air.