How the ECB could be radical by being old fashioned

In a recent post I wondered whether, in 20 years time, we might look back on this period with the same bewilderment that we now look back on monetary policy in the early 1930s or 1970s. After the 1929 crash the Federal Reserve was relatively slow to cut interest rates, and Milton Friedman argued the Fed was largely to blame for the subsequent depression. In the 1970s central banks failed to raise interest rates in response to rising inflation. As my previous post was ‘for economists’, let me spell out what central banks may be missing this time.

As we all know, short term nominal interest rates in the US, UK, Eurozone and Japan are as low as they can go, so it appears as if there is nothing more central banks can do with conventional interest rate policy. However that is not the case. What they can do is promise to keep future interest rates lower than they would otherwise be. This policy, first suggested by Paul Krugman for Japan and championed by the highly influential Michael Woodford, I will call ‘forward commitment’. It is not the same as ‘forward guidance’, which central banks are implementing.

The form of forward guidance that the US and UK operate involves giving the public some information about when interest rates might begin to rise. For example, if unemployment falls below some figure, each central bank may think about raising rates, but there is no commitment to do so. I believe the best way to understand this policy is that it is entirely conventional, targeting a combination of expected inflation and the output gap, but that it gives the public a bit more information about the trade off between these two goals.

The forward commitment policy is radically different. It promises to allow both inflation and the output gap to be above target in the future, so as to increase demand today. How does this work? Perhaps the easiest way to think about this is by considering long term interest rates. Long term (say 5 year) interest rates are mainly a combination of expected short rates from now until 5 years ahead. If you promise to have above target inflation tomorrow, the central bank must allow future short term interest rates to be lower tomorrow, which reduces long term rates today. Lower long term interest rates encourage additional consumption and investment today.

I call this the forward commitment policy because the central bank has to make the private sector believe it will carry it out. The problem is that the policy has a built in temptation for the central bank to cheat. They increase demand today by making the promise to allow inflation to be above target tomorrow, but once tomorrow comes they can change their mind - because who likes above target inflation? Yet if the private sector believes they will change their mind, the policy will not work today. So the central bank has to commit to allow inflation to be above target in the future, and get the private sector to believe in that commitment.

There are various ways it could do this. One is to have a target path for the level of nominal income (nominal GDP). The recession reduces nominal income, so nominal income has to grow more rapidly to catch up with its target path. That may well involve inflation rising above 2% for a prolonged period.

You might wonder whether this policy just helps one problem (lack of demand in the recession) by creating another - above target inflation after the recession is over. That is true, but if the recession is deep enough the net result is still positive on balance. However what is also true is that the policy is best implemented at the beginning of the recession. Once the recovery is underway, and the period at which nominal interest rates would normally be stuck at zero decreases, the net benefits of implementing the forward commitment policy decline.

Some people have interpreted forward guidance as forward commitment, because forward guidance in the UK and US allows inflation to go slightly above target if unemployment remains high. I think that is a mistake. Traditional inflation targeting allows inflation to go above target if unemployment is high (as we have seen in the UK and US). The distinctive feature of forward commitment is a promise to allow inflation to be above target when unemployment is low (or equivalently the output gap is positive, rather than negative as it is at present). No central bank has made this promise.

So what we may ask in 20 years time is why central banks did not try this forward commitment policy. In simple toy models, as my previous post showed (where conventional policy is called ‘discretionary’), it can lead to much better outcomes. Is it too late? In the US, with the recovery well under way, I suspect it is. In the UK, where we seem to have got very excited by the economy actually growing again, the same is probably (if regretfully) true. However the story might be very different in the Eurozone.

The Eurozone experienced a real double dip recession. Although positive growth has recently resumed, the OECD still expect the output gap to be -3.5% in 2015: much higher than they forecast for the US or UK. Inflation is currently below 1%, and my colleague Andrea Ferrero argues that there is a real risk of deflation. So the case for a forward commitment policy in the Eurozone remains strong. Furthermore, the ECB feels it cannot implement a Quantitative Easing programme of the type followed by the UK and US, so it may be more inclined to try forward commitment.

But, you may rightly say, isn’t the ECB also notoriously conservative? In particular, German central bankers and their allies would never allow a promise of above target inflation. I suspect this is right, but let me offer a glimmer of hope. Forward commitment could be sold not as a radical new policy, but a return to a very old one: money targeting. The one major central bank that did maintain a money targeting policy for more than a few years was the Bundesbank.

Why is money targeting like a forward commitment policy? Because the level of the money stock is closely related to the level of nominal income. So having a target path for the stock of money is like having a target path for nominal income. And as I suggested above, having a target for nominal income is one way of implementing a forward commitment policy.

So if I was ever in the position of advising the ECB (!) I would sell forward commitment this way. I suspect it would not work, partly because the Bundesbank in practice never rigidly targeted the level of the money supply. However I could reasonably argue that the inflation performance of the German economy in the 1970s was better than in the UK or US partly because expectations were anchored through money supply targeting. It would be worth a try.