Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 8 May 2014

Hawkery, or is the Bank biased

An interesting contrast in my evening reading yesterday. In the US, Matt O’Brien in the Washington Post’s Wonkblog making fun of reporting that inflation is just around the corner. There is one particularly nice line: “Well, there's always demand for pieces about why we need to raise rates — mostly from 60-year-olds who think it's always 1979 …” The contrast is with the Financial Times’s Chris Giles, who in yesterdays FT accuses the Bank of England of ‘institutional dovishness’, which he compares to institutional racism. The Bank is “institutionally biased against higher interest rates.”

Now, lest I be misunderstood, let me say three things before addressing Chris Giles’s charge. First, I’m pretty sure Chris is well short of 60. Second, Chris is no fool who blindly follows some party line: this piece on the Treasury’s exercise in dynamic scoring is as good as economic journalism gets. Third, central banks can suffer from what I and others prefer to describe as ‘groupthink’. Laurance Ball argued that this happened at the Fed when it came to not trying what I call forward commitment (promising higher inflation and a positive output gap in the future to combat the zero lower bound).

Having said that, Chris can occasionally pursue a line that, while popular in some quarters, makes little macroeconomic sense. The idea that UK austerity did not matter much had him clash with not just the usual suspects (including me), but also US academics Alan Taylor and Oscar Jorda. (I discussed an earlier version of their paper here: their latest version is here). In a similar way, over the last few months Chris has relentlessly pursued the idea that UK interest rates should rise very soon.

Chris’s charge against the Bank is that they keep moving the goalposts. For example, they say they will think about raising interest rates when unemployment dips below 7%, but when unemployment does go below 7% they decide that there is no reason to raise rates, and so on. But for the Bank the goalposts are the inflation target, and inflation is below target.

In the past I have made the point that, given uncertainties about the size of the output gap, it is best to err on the side of expansionary policy. This is because the Bank can easily deal with inflation if it does begin to rise, but because of the lower bound the opposite is not true. Chris responds that “no one should expect that an overheating economy will quickly set prices and wages on the climb”. “As the pre-crisis period showed, economies can overheat and develop dangerous imbalances without displaying the usual warning sign of inflation.” He is of course talking about house prices. But raising rates is a very inefficient way of dealing with a housing boom, which is why we now have the Financial Policy Committee at the Bank with its macroprudential tools. It is also very inefficient for the Bank to be trying to undo effects caused by the Chancellor’s policies (Help to Buy).

To see what can happen in this situation, we just need to look at Sweden. Sweden raised interest rates from almost zero to 2% beginning in 2010, because they were worried about overheating in the housing market. They now have deflation: inflation was -0.6% in March. As a result, the central bank has had to bring interest rates back down again. Lars Svensson, one of the world’s leading macroeconomists who resigned from their equivalent of the MPC while this happened, can only say I told you so.

While we are on the subject of premature interest rate increases, let us not forget the ECB raising rates just before the second Eurozone recession. And let us not also forget that the MPC almost followed their lead - not much evidence of institutional dovishness there.


I suspect and hope that the Bank and MPC have their eyes on the big picture. UK GDP per capita is currently around 15% below the level we might have expected it to be at if it had followed pre-recession trends. At no time since WWII has the economy not come back to this trend. We have no even half decent theories about why this trend should have dramatically changed. In these circumstances, starting to put on the brakes when we have only just begun to catch up lost ground, and when inflation is below target, just seems dumb and dangerous

17 comments:

  1. Some interesting things in this post but I think the professor is neglecting the strongest reason why Chris Giles is wrong. Chris asserts that “no one should expect that an overheating economy will quickly set prices and wages on the climb." citing the years before the crisis. His fault is in mixing up economic imbalances with an overheating economy. The economy was most definitely becoming imbalanced (house prices!) during the years before the crisis but it doesn't look like it was overheating. Growth was at a level in line with the long term trend which should've been sustainable, inflation was low and wages were only rising slowly. Nothing in here to suggest an overheating economy.

    Of course, overheating calls for action by the central bank while economic imbalances require an entirely different response.

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    1. gastro george8 May 2014 at 05:32

      Nice point, clearly put.

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    2. Hugo - actually I couldn't agree more, but I'm trying to make my posts shorter! I really should do one on this idea that just because house prices rose in the 00's we must have had a boom. But there are a few issues here, so not for this post. But thanks for making the point.

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    3. I remember Shiller writing about the word 'overheating'; his view was that it is a word many economists use without the term having a purposeful meaning.

      I wonder if it is more of an emotional marker?

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    4. That makes sense. Regular readers of your and/or Krugmans blog are no doubt already aware of what I'm pointing out out so there is no need for you to mention it in every blog post that talks about the pre-crisis years.

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  2. Thanks for this Simon. I thought the Giles article very odd. Raising rates that effect the whole economy to puncture a housing bubble which is being inflated in part by government policy, seems crackpot to me. But what do I know?

    Two questions:

    Could you update the graph which shows UK per capita GDP against the post war trend? The one you have posted a couple of times only goes up to the end of 2012.

    What is this trend in percent per year? Sorry if it should be clear from the graph!



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  3. Simon, could you possibly write a post about the long term "plan" of capitalism as we know it? There seems to me to be a complete dearth in public discourse about how the world economy is supposed to grow exponentially... forever? For that is what needs to happen if we want to avoid a collapse in the international monetary system, is it not? Is there any talk about moving towards a 'steady-state' global economy in the academic world, or do economists really believe that in 150 years time the world economy will still be growing?

    I know this is irrelevant to this post but I couldn't find your email address on this page.

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    1. This is a question of very large interest to many non-economists.

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  4. The imminent rate rise seems to be turning into (what Krugman would call) one of those things that everybody knows, which is true because everybody knows it. Commentators seem to listen to other commentators, markets (which obviously can never be wrong), politicians... anyone except the BoE governor when it comes to rates. Looking at the basics of the UK situation: falling inflation, stagnant (and much depreciated compared to 2007) wages, elevated unemployment, GDP massively under trend, cash hoarding high and investment low... how could raising rates possibly be the answer to any serious question?

    By the chancellor's own logic, if a specific program like help to buy can stimulate demand for housing, then modifying it, cancelling it or even implementing a new policy to dampen the London house price boom must be possible. Decoupling the London housing market from national interest rate decisions is surely the key; otherwise the rest of the country will suffer.

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  5. «UK GDP per capita is currently around 15% below the level we might have expected it to be at if it had followed pre-recession trends. At no time since WWII has the economy not come back to this trend. We have no even half decent theories about why this trend should have dramatically changed.»

    Dramatic worsening of the terms of terms due to massive swing from exporting oil to importing oil?

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  6. «Raising rates that effect the whole economy to puncture a housing bubble which is being inflated in part by government policy, seems crackpot to me.»

    Raising rate hard and long to puncture low and middle real wages when they stop going down, by creating recessions and unemployment to keep them going down, as they have for 30-40 years, is a policy of which central banks boast loudly and frequently; they call it "anchoring [wage] inflation expectations".

    But using the same means to stop the massive redistribution of income and wealth caused by government-boosted property capital gains and rents from low and middle wage earners to higher income property rentiers is "crackpot"?

    When that massive upward redistribution depresses demand by reducing the spending of a large number of consumers? And the recipient of that redistribution, if they consume it they spend it on holidays abroad and luxuries imported from other countries, or else they invest it or moved it to foreign countries...

    And besides even with low interest rates who is so stupid to borrow to invest in risky low profit business, by spending borrowed money on capital and employees, when highly leveraged government-sponsored profits from property speculation are around 60% gross and 30% net?

    The story of the past 30-40 years has been that despite repeated massive government-induced low interest rates and debt booms, low to middle income wages (especially in the North) have declined, and property capital gains and rents (especially in the South-East) have ballooned, along with employment and wages (at a 10-15% a year gallop) in the countries from which imports come (China, India etc.).

    Because given easy money, government policy has ensures that the best returns have come from property speculation in the South East and offshoring manufacturing and services away from the North.

    To me that looks crackpot... But it is very popular with middle aged and older landladies of South East marginal seats, and financial spivs in London.

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  7. «government policy has ensures that the best returns have come from property speculation in the South East»

    As to this I can't resist quoting an indisputable authority, our future prime minister Boris Johnson:

    http://www.telegraph.co.uk/finance/personalfinance/pensions/10717846/Budget-2014-the-Lamborghini-ride-that-says-power-to-the-people.html

    «I think the vast majority will want to put their pots into the market with the greatest yield over the past 40 years – and that is property;»

    This is a top politician essentially *boasting* that purely redistributive, unproductive, property speculation (in the South East of course) having been far more profitable than value-adding, productive, business investment for 40 years, and advising pensioners to just pile into this great mechanism to squeeze harder low and middle income workers (in particular unemployed ones from the North when they move to the South East).

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  8. "in particular unemployed ones from the North when they move to the South East"

    These people have had to also compete against some 2 million Eastern Europeans. Earn 7 pounds an hour and pay rent of 1000 pounds for a one-bedroom flat.

    The elite say, if Eastern Europeans can do that work, so can you?

    (But course the political elite, often with inherited wealth so they do not have to worry about getting mortgages, do not have to do this work).

    Any wonder why UKIP is on to something?

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  9. BTW when I wrote:

    «Raising rate hard and long to puncture low and middle real wages when they stop going down, by creating recessions and unemployment to keep them going down, as they have for 30-40 years, is a policy of which central banks boast loudly and frequently; they call it "anchoring [wage] inflation expectations".

    But using the same means to stop the massive redistribution of income and wealth caused by government-boosted property capital gains and rents from low and middle wage earners to higher income property rentiers is "crackpot"?»

    I had in mind also the previous "New Keynesian" exchange:

    «wages were only rising slowly. Nothing in here to suggest an overheating economy.
    Of course, overheating calls for action by the central bank while economic imbalances require an entirely different response.»
    «actually I couldn't agree more»

    Because stagnating or rising wages are class-war driven "inflation" while massive redistribution from poor low and income workers to boost the incomes of wealthy rentiers with capital gains is... Ah nice weather coming this weekend. It was a bit windy last weekend though.-).

    "New Keynesians" old and new are the renewed heralds of "fine tuning": that unregulated markets deliver the optimal resource allocations and thus income distribution and it is a sacrilege to interfere with the Real Business Cycle, but because of frictions sometimes business profits are depressed by oversaving by consumers, and central banks must boost demand via welath effects induced by abundant credit at low interest rates, and if that means that property speculators make enormous capital gains and rents and City spivs get gigantic bonuses by creaming off the top of the flow of debt, all at the expense of low and middle income workers, .... It's been rather nice weather most of the week, hasn't it?

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  10. Blissex. Thanks for your comment. It is refreshing to see people talk about the resource allocation effects of expansionary government credit policies. Lord Glasman describes a lot of these policies as "viagra economics"

    http://www.theguardian.com/commentisfree/2012/jul/08/talk-about-keynes-labour-roots

    Perhaps if we are going to have huge injections of government capital, they need to channelled to the right areas. That means not bankers, but to worker apprenticeships and capital investment in the regions. This will hopefully be an investment that, unlike the miserable experience under New Labour, when the world economy does pick up it translates to demand for output produced by workers in depressed regions.

    This though calls for an active state in credit allocation, rather like you see in Germany, Japan and China. Not sure it bids well for Anglo Saxon countries, and especially Anglo Saxon economists.

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  11. Eventually we will need some higher interest rates on the money supply which may cause some short term pain regarding inflation. It has to happen some day or we will print our currency into meaningless pieces of paper, which is causing inflation too. JMHO.

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  12. Mechanically low rates increase the value of assets such as housing and stocks, which generate future cash flows and so by a simple arbitrage become more valuable today. Since those who own assets are wealthier people, low rates increases inequality.

    Now I understand the idea that economists shouldn't concern themselves with politics. But if, as is the case both in the UK and the US, one can't, as a practical matter, tax adequately the wealthy to reduce this inequality, low rates means, as a practical matter, greater inequality. Sure, low rates decreases unemployment, but the asset-effect swamps by a large margin the job effect.

    Low rates has increased inequality. Well done.

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