Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 2 June 2012

Is monetary policy taking Euro uncertainty seriously?

                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.


  1. Very interesting post thank you.

    Why hasn't the MPC emphasized how they will offset shocks from the Eurozone?

    Surely if the monetary policy response to shocks from the Eurozone is expected to be sufficient, there would be little danger of deflation in the UK.

    Deflation can only occur if there is a large shock from the Eurozone and the Bank of England's monetary policy response is insufficient.

    Despite this, the OBR* argue in the March Economic and Fiscal Outlook, that if the Eurozone crisis deteriorates, the change in CPI would be -0.6% in 2013-14, 0.0% 2014-15, 0.7% in 2015-16 and 0.8% in 2016-17. How could the CPI fall if the MPC's policy response was sufficiently aggressive? Is the OBR expecting that given a major shock from the Eurozone, the MPC's response will be inadequate? How else could CPI below target over four years?

    Wouldn't it help if the Bank of England was explicit about how monetary policy will respond to shocks from the Eurozone?

    For instance, they could state "if medium term inflation expectations in the gilt market fall below 2.75%, we will expand QE".

    As I commented on Britmouse's blog, short term implied inflation expectations have fallen considerably in the last month. Expectations of RPI in 3.5 years was 1.87% on Thursday. This has fallen from 2.5% mid-march, and compares to a daily average of 2.75% from Jan 2003 to Oct 2008. At no point between 2003-2008 were 3.5 year inflation expectations lower than 1.92%.

    Furthermore, on average inflation expectations from Oct 2008 to June 2012 have been 2.37%. So the Bank of England, since the October 2008, has actually kept market expectations of inflation lower than in the previous five years. This is despite a number of tax rises which have increased the price level.

    As Britmouse has pointed out, doesn't this suggest that the MPC is failing to maintain inflation expectations, and expectations of future monetary policy responses is extremely uncertain?

    For example, Sentance was arguing in favour of increases in interest rates as recently as the 21st of April. Surely the Bank of England could mitigate some of this policy uncertainty by announcing it will hold interest rates at 0.5% until at least the end of 2014 as the Fed has done?

    Or they could change the damn inflation target!

    * Table 5.5 page 177.

    Expected inflation figures from:

  2. I watched a documentary 97% Owned on I would say that this is first documentary highlighting this issue. Fabulous documentary

  3. The bit about ignoring the downside risk from the Euro is very worrying. Maybe, just maybe, the need to draw those fancharts is the problem. "We would have chosen a more expansionary monetary policy, to allow for the downside risk from the Euro. But that would have meant quantifying those downside risks, and putting them in the damn' fanchart. And we decided that was too hard. So we decided to ignore the Euro risks altogether."

    Sometimes, the insistence on measuring everything means that you ignore things that are hard to measure.

  4. Simon, sorry to be nitpick, but this is a request for spacing between your paragraphs to make your posts more readable in the future.

  5. You should watch this video posted by Ed Butowsky. He discussed there how Stock Market Suffers On European Debt Crisis.


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