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Thursday 21 March 2013

The 2013 Budget and UK Monetary Policy

The Budget yesterday included an important update to the remit of the Bank of England’s Monetary Policy Committee (MPC). Depending on who you listen to, this is either an important change that could offer a considerable additional stimulus to the UK economy, or a major disappointment. So which is it?

The document reaffirms flexible inflation targeting, and rejects alternatives such as nominal GDP targets. However the Treasury wants to make it clear to the MPC just how flexible it can be. It can, for example, ‘see through’ (i.e. ignore) any short term increase in inflation for a lot longer than the two years that has so far been part of the MPC’s mantra. It can create ‘intermediate thresholds’ as part of forward guidance. In short, it believes flexible inflation targeting is quite compatible with the MPC doing what the US Fed is currently doing. [1]

I think Britmouse has it exactly right when he writes:

“I see nothing at all in the new remit text which compels the MPC to do anything different to current policy.  It is all about judgement.  Neither did the old remit prevent the MPC from giving forward guidance if they so desired.”

To see why this is important, read the minutes just released of the last MPC meeting, where the committee voted 6 to 3 not to undertake any further Quantitative Easing. In para 27 it sets out the arguments for providing more stimulus, which include:

“inflation expectations were relatively stable; wage growth remained weak; there remained a degree of slack in the economy; and the potentially positive response of supply capacity to increased demand meant that higher output growth would not necessarily lead to any material increase in inflationary pressure”

Which all sounds pretty compelling. But then the next paragraph sets out the reasons for doing nothing, which basically boil down to

“Inflation was above the 2% target and was likely to stay above it for an extended period, and there was a risk that could lead to inflation expectations drifting upwards with adverse consequences for wage and price setting behaviour. Further monetary stimulus might increase that risk. It might also lead to an unwarranted depreciation of sterling if it were misinterpreted as a lack of commitment to maintaining low inflation in the medium term”

In other words, any attempt to use the very flexibility that the Treasury emphasises the MPC has risks a loss in the credibility of the medium term inflation target. So 6 of the 9 member committee decided it was best not take take that risk. I cannot see anything in the new guidance issued by the Treasury yesterday that would have influenced any of the 6 who voted to do nothing to change their minds.
Now I guess the Treasury is hoping that the new governor will persuade some on the committee to vote the other way (although note that the current governor was one of the minority who voted for additional stimulus). But surely the key question is why they need persuading in the first place. Why are possible risks to the credibility of the medium term inflation target allowed to outweigh the current almost 100% certainty that we have chronic demand deficiency which no one else is going to do anything to change. Perhaps a remit that places medium term inflation stability at its core, and says nothing about eliminating demand deficiency, might just have something to do with it. 

[1] In addition, it also believes that flexible inflation targeting allows the MPC to consider deviating from the inflation target if there is a “development of imbalances that the FPC may judge to represent a potential risk to financial stability”.


  1. How much good can monetary stimulus do at this point, isn't it likely that this kind of inflation will erode real wages? and therefore decrease consumer spending?

    1. On your first question, I do not know how much good it will do, but in the current situation it is best to try anything that might help. We do not have to choose between monetary and fiscal stimulus - we can do both.
      On your second question, the way monetary stimulus should work is by raising spending, and therefore output, which is more likely to raise rather than reduce real wages.

  2. The answer is "Because the 1970s happened", right?

    The MPC really do not think (absurd as it might seem) there is an "almost 100% certainty" that we have an AD problem. Many MPC members might well place a non-zero certainty on that, but five years of high inflation after "historically unprecedented monetary stimulus" is telling them we *might* just have a supply-side problem.

    And therein lies the "risks". They think there is a non-zero probability that pumping up AD now, when we might just have AS problems, is simply a return to the 1970s, and that inflation expectations will get "de-anchored".

    King, Dale and Bean have all made that point very very forcefully. And HM Treasury seems to agree with them. It is low-inflation targeting... or the 1970s.

    1. I agree, but the main point of my post was that the inflation targeting remit encourages that view. With a dual mandate, the MPC would surely be under much more pressure to try and increase demand, and I think that would have some influence on its members. Do you disagree?

    2. I agree on the broad point, for sure, the remit encourages the emphasis on inflation above all else. But the Fed is similarly conservative about inflation even with their dual mandate and goal independence; the Fed has been "failing" on both sides of its dual mandate far "worse" than the BoE, US inflation has been generally below target, and unemployment very high.

      So I'm very sceptical a dual mandate would compel the MPC to do more right now, do you think that would help? They would say they are doing enough and the output gap is probably really small, and employment is OK, etc.

      The MPC are imitating the BoJ in all the ways Bernanke (et al) attacked them for in a decade plus ago, even down to the choice of words, it scares me a lot. "Historically unprecedented stimulus.. oh and we're expecting the CPI to stay really low... if we did more it would be really dangerous... doing more probably wouldn't help anyway... our real problems are structural/supply-side." It's all there.

  3. Just heard Ed Balls on Bloomberg saying that we are in a liquidity trap, but that new remit won't lead to higher inflation because BoE will "do its job" and meet 2% inflation target(!). Frankly, I don't see any prospect of necessary change to the policy rule from the left that would even accommodate their own plans for fiscal stimulus. Seems to me best hope is that Carney persuades rest of MPC to get on board with a Bernanke/Evans style rule, however remote that hope is.

  4. Generation stagflation seems to have quite the grip on the economics profession, and it is worth remembering that when the Germans got their central bank back from the US after WW2, Enoch Powell loved their inflation-only remit.

    That's the sad thing about the Coalition: the Eurocrat Liberals are inflationistas because the Germans are (the Germans have dealt culturally with what they did in WW2 but not WW1, whence 1923 originated, which has stopped them assessing 1930-3 austerity = Hitler), and the Liberals must be anti-Keynesian to want to join the Euro and ignore sticky prices and wages.

    The Thatcherites (Powell-Joseph-Thatcher) are equally anti-Keynesian due to their political myths of the 1970s, and are anti-Euro for political not intellectual reasons, as the ERM crisis showed.

    Is Ed Balls, son of Larry Summers, capable of riding to the rescue?

    Too soon to tell.

    1. I don't know about that. The ERM crisis showed that trying to share a currency with Germany without having your economy converge on Germany's first, leads to disaster sooner or later. I'd call that intellectual, not political.

      What we discovered in the ERM affair is what the periphery is discovering today. Any currency shared by Germany will be run to suit Germany, not to suit you.

  5. Neither. It's a meh (a tweaking of the current stance whereby monetary policy is supposed to do the heavy lifting while the "books get balanced").

    Based on my recent experience of BoE bods the FLS has already had a bigger impact on the BoE's remit/objectivity as they're very (and I mean VERY) keen to prove its working.

  6. If the motive of more stimulus was to increase demand, that would be benign given that currently demand is below long-term supply.

    However, once demand reaches long-term supply, we'll get demand-pull inflation, and if that gets transmitted form sector to sector, we could then get cost-push inflation, which is usually pretty difficult to stop.

    We keep judging the Coalition on how much growth they are creating - or not - today, when I think it's pretty clear that they have other criteria in mind. They want growth, but not the boom and bust type of growth.

    1. You're right Jon - we have a sizable output gap at the moment (estimates of anywhere between 2-10%!)so a demand stimulus is in order and won't risk demand pull inflation. Even without the output gap, we'd only risk demand-pull inflation if AD was growing at a faster rate than the growth of the supply-side of the economy - so perhaps this is what they should be wary of, not simply a demand stimulus of any magnitude.

  7. Someone mentioned Thatcher above, but I think that story is more complicated than generally recognized.

    Thatcher did introduce some austerity measures, and got roundly lambasted for them, not least by the Economics profession, and yet here we are in Maggie's reformed economy, a whole lot better off than we would have been without her.

    Therefore - insert some lazy thinking - "austerity works".

    There are three problems with this.

    One, we are reducing the deficit, not actually running a surplus, so calling today's measures "austerity" is a misnomer.

    Two, Maggie's reductions in the rate of increase in spending were smaller than Osborne's.

    Three, Labour and its supporters are labouring under a self-imposed false narrative according to which Maggie cut spending, not the rate of spending.

    So the whole Maggie narrative is up for grabs. Anyone can use it to "prove" anything they like.

    1. "yet here we are in Maggie's reformed economy, a whole lot better off than we would have been without her."

      Whilst this is off topic from the austerity debate,doesn't your comment make the big presumption that all other possible policy choices were inferior, and that Thatcher's were optimal? I'm not sure how its possible to claim this. Particularly given that her policies have resulted in ever growing income inequality, social disclocation and the culture of greed and a 'quick buck' thanks to hasty (some misguided) privatisation, deregulation and the liberalisation of the financial sector - putting the banking sector onto a pedestal (and similarly in the USA thanks to Reagonomics). All of which is at the heart of the current economic crisis, with unrestricted capital flows, shadow banking, corporate tax avoidance and a deregulated banking sector having proved to be massively destabilising for domestic and global economies,increasing the likelihood of major banking/economic crises in the future.
      The foundations were, unfortunately, laid by Thatcher, but built on by Major, Blair, Brown and now Cameron/Osborne.

      Secondly, and most importantly, millions of people particularly in the North-East, Midlands, Scotland and South Wales valleys would very much struggle to agree that they are "a whole lot better off than...without her", after she so rapidly and callously destroyed so many livelihoods and entire communities without a thought for what opportunities/occupations might replace those taken away. And it is still very much felt today in these regions, but they are of course a long way from Westminster and the Square Mile.
      In Maggie's reformed economy, some people are undoubtedly better off, as is the economy in aggregate;but many,many more people are not, since the aggregate improvement masks the gross inequalities which exist today that were accelerated by Thatcher's policies. Falling living standards in general, worsening public services and decreasing median incomes for the population as a whole are stark reminders, and are part of her legacy.

    2. We all have our biases, and mine are partly informed by living in the UK before Maggie and partly from living in the USSR in the Seventies.

      The goals of social equality sound virtuous when stated, but there isn't much merit in pursuing social equality if it leads to harming the whole economy. Cutting up a smaller and smaller pie in more equal sized slices doesn't really help anyone.

      Both the UK and Russia have gone through radical changes. The UK has gone from 60% of German GDP/head in the seventies to about 90% today ($36.5k v. $39.5k) which is a big recovery. The Economist had an editorial back in 1979 in which they said it would take about 40 years to recover the ground lost to Germany, given Maggie's proposed reforms, and they got it about right.

      It seems to me that today a lot of people on the vague intellectual left want to "bank" Maggie's reforms as a given, enjoy their increased living standards, but go on talking about Maggie as if she was the worst thing that ever happened to the country anyway. They strike me as similar to the folk who boast about WWII but damn Churchill.

      Now Russia. When I lived there it was the epitome of socialist equality. That is, all wage earners earned very roughly the same, maybe the equivalent of $200 a month in Dollar terms, and they all shared the same social facilities - censored libraries, hospitals that achieved a life expectancy of 40-50 plus huge infant mortality, planes that crashed regularly, Spartan living conditions, drab clothes and monotonous food. (Meanwhile party members lived almost Western lives).

      Today, after great upheaval, Russia has become a place of wide inequality. It has organized crime, deep poverty, great wealth, communities dying that communism subsidised into existence, a ruling kleptocracy.

      But which Britain do you want, and which Russia? Do you want a Russia that stagnates for another 70 years the way it stagnated for the past 70? Do you want the Britain of the Seventies, when it took 18 months to get a telephone line from the Post Office, and you had to make an application to the Bank to take fifty Pounds of your own money on holiday?

      You can have anything you want, but you can't have both. You can have a Russia of equality or you can have today's unequal Russia with a routine 5% annual growth rate. Similarly, you can have an Old Labour Britain, poor and parochial, or you can have a Britain which is now a mainstream European economy, and no longer the perennial "sick man".

      Once again, you can't have both. We can't legislate equality in Britain or Russia. We can, however, liberate markets and capital to do the job - sometimes unpleasant to look at - that markets and capital do. Then we have to something difficult and real, which is to reform our useless "fairness based" education system.

      Oh, and you mentioned the North-East, which is where I grew up. At the beginning of the C20th my Paternal grandfather was fatally injured in a foundry accident, and sent home to die at lunch-time, which cost my grandmother half a day's pay. I have relatives who worked in deep coal-mining, and most of them ended up with emphysema or black lung disease. Tyne-side was visibly dying when I was growing up, not because of anything Maggie would do decades later, but because British wage rates made ship-building uneconomical.

      Certainly Britain and Russia are less attractive countries today than they were, and people are less protected from economic reality, but it's important not to remember Golden Ages that never happened, and it's a mistake to try to pin individual politicians with the blame for things that were going to happen anyway.

    3. Hi Jon
      Some good and interesting points which I agree with, but overall I would question framing the argument using polar extremes:
      - the economy with Thatcher's policies or no Thatcher policies
      - the UK economy c.1970s or the modern, major economy we are today
      As in my original reply, my main point was that we can't presume Thatcher's policies were optimal, which is particularly true with the benefit of hindsight, and that other, alternative policies wouldn't have been more economically beneficial in so much as they could have avoided/reduced some of the more damaging consequences of Thatcher's policies.
      The question is not necessarily Thatcher or no Thatcher, regulation or no regulation, privatization or no privatization; rather the extent/degrees that these policies were implemented can be questioned. Eg.'Light-touch regulation' has since proved for both business and banking to largely be a disaster - particularly in the financial sector, creating via successive governments the economic problems we have today. De-regulation was needed, but to the extent that Thatcher desired? Likewise, privatization may be a good policy, but again, to what extent and why so hastily, at often greatly undervalued prices, and whether it is always totally appropriate for certain industries (eg.seeking profit at the terrible cost of safety on the railways, or currently market forces introduced into hospitals with private cleaning contracts - so the need to cut costs at the expense of hygiene).
      So rather than presenting a polarised choice of wanting the UK economy c1970s or the economy we have today - its not an 'either/or' choice. Other, more considered,less extreme policies (such as less financial deregulation, but not stifling regulation!) are likely to have produced a healthier, more balanced economy without the massive over-reliance on financial services and the near destruction of UK industry/manufacturing (though these would have decreased for the reasons you state as with other European countries). Similarly, it is not 'inequality' per se, or wanting to eliminate inequality to the point that it harms the economy, rather it is the extent of the inequality we have which can be brought into question, which as Joseph Stiglitz argues is actually harmful for the economy at the levels it currently is here and in the US.
      I would also question the notion of 'golden ages which never happened': For those many communities and families who had jobs and reliable incomes before, compared to their lives subsequently it was a 'golden age'. Similarly, I would also question the inevitability you describe - as we can't categorically say that "things were going to happen anyway" for the simple reason that other similar economies, whilst sharing some of our economic experiences over the last 30 years, have certainly not changed to the same extent we have - notably the decline in the manufacturing and industrial base). Mistaken government policies and politicians surely have to shoulder a lot of the blame, especially so with regard to financial deregulation/lax banking regulation, which as I originally stated began with Thatcher, but the final results have now become only too apparent, and appear to be an extremely high price to pay for all but the top 1% who remain insulated from the subsequent austerity policies being currently implemented.

  8. If people haven't seen it already, there is an interesting speech in growth and inflation by Spencer Dale that seems to represent the BoE's thinking.

    "Inflation targeting is not a sham: the discipline of the inflation target is paramount. But it can be operated in a manner that also supports output and employment as long as – and only as long as – our credibility is maintained. Without credibility there can be no discretion."


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