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?