Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 13 December 2012

Monetary Policy Innovations

It is always interesting to compare the Fed, ECB and Bank of England. For both the Fed and ECB it has been quite a year for innovation. At the Fed the most recent announcements in terms of forward guidance can be seen as just a development of how it began the year, by publishing its own forecasts for interest rates. Once you tell others how you expect policy to develop given one (central) projection of how the economy will go, it is natural to say how it might develop in other circumstances. Just as it seemed to me the first development was eminently sensible (but others disagreed), so I think recent moves are as well.

Do they mark a substantial shift in policy? Brad DeLong thinks so, but Paul Krugman is more downbeat. I think the answer depends on the timespan you are looking at. In terms of the very recent developments, they are perhaps not a huge shift, although I agree with Mark Thoma that raising the inflation target from an ‘apparent 2%’ to a ‘definitely at least 2.5%’ is significant. Seen over the year as a whole, and including the idea of continuing QE, I think it is an important change.

The ECB has also had an innovative year, but from a different starting point. OMT was a big deal not in terms of central bank practice - it just allows the ECB to do what others are doing already, but with a much more limited remit and under conditionality - but it was a big deal in terms of the mindset of the ECB. However, whereas I think the Fed has been consistently building one innovation on top of another, it seems as if OMT was such an effort for the ECB that they want a rest for at least a year or so. But the Eurozone is starting a new recession, while the US is at least growing. So in terms of what is needed, the ECB is looking at least as out of touch with reality as they did a year ago.

Which brings us to the UK. Now it was only a Christmas Party, but Stephanie Flanders’ account of Bank reactions to the Fed moves sound depressingly plausible. I remember hearing similar reactions to Fed policy as the financial crisis began (‘they will regret cutting rates so quickly’), and to their publication of interest rate forecasts (‘a rod for their backs’). Now if everything was hunky dory in the UK such conservatism might be forgiven, but its not. So it seems that if you want innovation at the Bank, it needs to be imposed from outside.

Which is why this recent speech from Mark Carney has attracted a lot of interest. It has been interpreted by some as arguing for NGDP targets, but I think it is more nuanced than that. Carney clearly argues that forward guidance is useful, but it is much more useful for a country like the US which does not have an overriding inflation mandate than it could ever be for the UK which does. The Bank of England, whoever is Governor, will never say that they will not think about raising interest rates until inflation goes beyond 2.5% because they would be clearly going outside their remit.

On NGDP targets, Carney is quite equivocal about their use in normal times, but sees clear advantages as a device for dealing with the Zero Lower Bound (ZLB). So one interpretation of his remarks is that, yes, they might have been useful back in 2008/9, but they are less useful today. However I think its also possible to take a more optimistic view. As long as we do not treat the survey evidence too seriously, acknowledging that there is a significant output gap (x% say) implies that any NGDP path has to start at a point x% above current NGDP. So even if the long term desired NGDP growth rate is 4% (2% real + 2% nominal), the target for NGDP growth for the year the policy begins will be 4%+x%, which implies a much more aggressive monetary expansion than we have at present.

To get this aggressive monetary stimulus for the UK, I still prefer my suggestion of moving temporarily to a 4% earnings growth target. (Latest number 1.3%.) There are two reasons. First, this puts no upper limit on GDP growth. If in fact the output gap is y% rather than x%, where y is much higher than x, a 4% earnings path will not stop us closing that gap quickly, whereas a NGDP path based on x% might. Second, I take a pessimistic view that x% will be chosen very conservatively, as a price for what will be seen by the indigenous Bank as a radical move. I can also see it taking time to come, because the new Governor will want to persuade, rather than impose his views. If, indeed, these are his views, which as I suggest above the speech leaves open.

I want to end by returning to the general theme of central bank innovation, and the lack of it in the UK. In the reaction on the Carney speech, one report suggested that the Chancellor was open to new ideas that might come from the new Governor. I think this tells you a lot about the current Chancellor. Even though he is in charge of the monetary policy framework and the target itself, he still waits for any suggestion of change to come from the Bank. I cannot imagine Gordon Brown, or indeed Alistair Darling or Nigel Lawson, waiting to hear from the Bank before thinking about changing macroeconomic policy. Perhaps the curtains of No.11 are closed while others do all the hard work?


  1. ah, yes. Monetary policy innovations. Let me quote Alan Greenspan in 2000:
    "I believe that the general growth in large [financial] institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically -- I should say, fully -- hedged."

  2. My guess is that Mark Carney would not have taken the BoE job unless he had some sort of commitment from the Chancellor to give him carte blanche to do what he needed to do. It might have been a specific commitment to move to NGDPLPT. And Carney was in a strong bargaining position to get that commitment. It seems he didn't really want the job, especially if taking the job would mean he would switch from being seen as a success (at the BoC) to being seen as a failure (after 5 years at the BoE).

    1. I do not think the Chancellor will dismiss a recommendation from Carney for such a change, for the reasons you give. It still does not make sense that he has waited for a new Governor: the Chancellor has the power to make this change, and the political capital that Mervyn King has is not large enough for that to worry him.

      But the Carney speech does not sound like it comes from someone who can see nothing wrong with NGDP path targets. You will know him and the context in which he talks better than I: could it be that his remarks about normal times can be read as 'Canada today', while his remarks about the ZLB case can be read as 'UK today'? In other words, why has he not pushed more for NGDP targets in Canada?

    2. Simon: "...could it be that his remarks about normal times can be read as 'Canada today', while his remarks about the ZLB case can be read as 'UK today'?"

      That is how I read them. Not with certainty, but it did seem the most plausible reading.

      There's a very strong sense in Canada of "It (IT) ain't broke; don't fix it". A rather complacent/smug attitude. Because maybe we just got lucky (or even if it was partly good bank regulation/supervision, the BoC was still lucky that bank regulation/supervision was good). And because we still had a recession (though not a bad one), even though the BoC kept inflation roughly on target.

  3. If Osborne has already decided (w/Carney) to switch to NGDPLPT sometime next year his comments are roughly what you'd expect him to say, no? His actions (headhunting Carney) speak much louder than his words. Picking Turner would have been the action of a timid Chancellor who is happy with the status quo. Darling re-appointed King after King presided over the worst UK demand crisis in generations - what does that say about Darling?

    1. But the monetary framework in the UK is decided by the Chancellor, not the Governor. Yet Osborne is acting as if its the other way around.

    2. My guess is that it's never that clear cut. Especially in the current UK situation, where expectations/guidance/pre-commitment are so important. The Government would like to have the central bank fully onside, rather than making (and being seen to make) a half-hearted Sir Humphrey attempt to pretend to play along.

      (It's not really clear cut in Canada either, after the Coyne affair, and the more minor non-renewal of John Crow. They have ducked the question, by saying 2% IT is a joint agreement between BoC and the govt.)

  4. We discussed in previous posts about the risk inherent in raising inflation expectations when private households are indebted and busy deleveraging. I argued that indebted household might anticipate the wage squeeze to worsen because wages do not adjust for higher inflation due to weak bargaining power for employees worried about hanging on to their job. In response to an uncertain employment outlook deleveraging HH would thus reducing their consumption further, which would depress aggregate demand, further weaken the employment outlook which would feed a vicious cycle with further belt tightening. The adoption of the NGDP target would institutionalise this vicious cycle by introducing an automatism into it. Wouldn't the new target command an increase in expected inflation in response to lower aggregate demand due to lower private consumption? And what would be the response of indebted private households when the NGDP target is credible? Further belt tightening? In the meantime, corporate investment might fail to materialise due to expected sluggish private consumption.

  5. I came back to read this post again as I thought about what is (not) being done.
    However, my question arises from another concern. May it not be the case for an earnings growth target that the problem is partially the same as with CPI inflation? I mean, if today we miss the target, tomorrow will not have to "make up for it", so we are left the same with future expectations. Isn't this right somehow?

    Thank you in advance.


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