An interesting contrast in my evening reading yesterday. In the
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
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
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
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.