Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 20 August 2014

The symmetry test

Two members of the Bank of England’s Monetary Policy Committee (MPC), Ian McCafferty and Martin Weale, voted to raise interest rates this month. This was the first time any member has voted for a rate rise since July 2011, when Martin Weale also voted for a rate increase. A key factor for those arguing to raise rates now is lags: “Since monetary policy …. operate[s] only with a lag, it was desirable to anticipate labour market pressures by raising bank rate in advance of them.”

The Bank of England’s latest forecast assumes interest rates rising gradually from 2015. It also shows inflation below target throughout. The implication would seem to be that the MPC members who voted for the rate increase do not believe the forecast. But it could also be that they are more worried about risks that inflation will go above target than risks that it will stay below, much as the ECB always appears to be.

I like to apply a symmetry test in these situations. Imagine the economy is just coming out of a sustained boom. Interest rates, as a result, are high. Growth has slowed down, but the output gap is still positive. Unemployment is rising, but is still low (say 4%) and below estimates of the natural rate. Wage inflation is high as a result, and real wages had been increasing quite rapidly for a number of years. Consumer price inflation is above target, and the forecast for inflation in two years time is that it will still be above target.

In these circumstances, would you expect some MPC members to argue that now is the time to start reducing interest rates? Would you expect them to ignore the fact that price inflation is above target, wage inflation is high, the output gap is positive and unemployment is below the natural rate, and discount the forecast that inflation will still be above target in two years time? There is always a chance that they might be right to do so, but can you imagine it happening?

You could? Now can you also imagine large numbers of financial sector economists and financial journalists cheering them on? 

32 comments:

  1. For a distubingly large number of people, inflation is always and everywhere...just around the corner. Why?

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    1. if you are a rentier, any inflation is bad, even if it is expected.

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  2. Aye, and there's the rub...

    At some point, the path of an economy in a democracy seems destined to be decided by the will of the more and more ignorant as the news disseminates further and further down the knowledge spectrum until it reaches the tabloids. Unless you have brave politicians without an ideology that prescribes how to act.

    In the UK though, the disconnect seems to be between the housing economy and the real economy; just as those who argue the one size fits all Euro cannot succeed, how can a one size fits all interest rate policy succeed, with or without taking the lag into account?

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  3. There's also a curious asymmetry over fears of wage inflation. Carney suggested this week that interest rates might have to rise in anticipation of wages increases rather than in reaction to wage increases. McCafferty and Weale seem to be thinking similarly. Yet wages are static or falling. And there is a recognition by some economists that wage suppression is contributing to the slump. The idea that anybody should be considering interest rate rises at the moment seem somewhat insane. Didn't Sweden raise their rates only to reverse the rises within a few months?

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  4. Is there a point, an accumulation of evidence, at which the dogmatic (rather than informed and balanced) viewpoint expressed by Very Serious People can be ignored with impunity? I'm not suggesting a blanket ban on their utterances, that would be illiberal, but surely there must come a point when we can suffer no criticism for just pointing and laughing at their knee-jerk outpourings before moving on to spend our time sifting real content from the information deluge? Would anyone care to suggest how close McCafferty and Weale are to that point?

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  5. The BBC for six years now has said how savers are being hurt by low interest rates.

    Krugman blog Jul 8 2014 'Class and Monetary Policy' looked at who in the US "benefits from low inflation or deflation, and from higher interest rates. And the answer, basically, is rich old men."

    Maybe like the BBC directors and the chocolate fireguard that is the BBC Trust.

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  6. I think this is partly a consequence of the orthodoxy pushing for independent central banking whose mission is the pursuit of price stability, "credibility" and the crushing of price expectations (the dominance of expectations theory allowing them to crush inflation even before we have any inflation - this I think is a crucial link between austerity and the REH revolution) - even when the problem for most of the country is not inflation.

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    1. I think this is nonsense. There is nothing wrong with wanting low inflation - the key issue is how low. Anchoring inflation expectations at this level is beneficial. The problem is with central bankers who are much more worried about inflation above than below target, and who ignore the other job of the central bank, which is to stabilise the real economy.

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  7. There is nothing wrong with wanting low inflation - the key issue is how low.

    Obviously that is the issue. Clearly they think inflation is too high (or in other words, it is above target - or they expect to be). The point being made above is that most people (outside London anyway) do not think that inflation is the problem now. Jobs and wages are. However, an independent central bank can pursue this anyway outside the democratic process. It obeys technical rules based on targets that can appear to be able to override the democratic process. The issue is firstly where do you think these targets come from and secondly why do you think these argets must be steadfastly pursued in such an environment?

    Clearly the orthodoxy puts a premium on price stability.

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    1. In the UK it is clear. The targets are set by the Chancellor. So while I might complain in this post that these two MPC members are making poor judgments that would not survive the symmetry test, I do not think its fair to suggest they are overriding any democratic process. If you want to complain that the inflation target is too low and that it is given undue priority, complain to George Osborne.

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    2. To have these decisions taken by a panel of 'experts' who are not democratically accountable is, of course, anti-democratic. How could it not be?

      The problem that all who favour these kinds of panels making decisions eventually confront (Philosopher Kings naturally enough preferring decisions being made by Philosopher Kings like them) is that often the people on them are not very good (eg Weale and McCafferty).

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    3. "In the UK it is clear. The targets are set by the Chancellor.|

      I did assume that the central bank set the targets, my apologies for the oversight.

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    4. Spinning Hugo,

      Are you equally opposed to the design of nuclear power stations being determined by a “panel of experts” who are not “democratically” elected? I think the vast majority of the population are quite happy, and rightly so, with technical decisions being taken by committees of technically qualified experts, while of course democratically elected politicians inevitably have the power to overrule those committees if they really want.

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    5. re: Experts - It depends on their track record. For a while in the 1970s, it seemed our nuclear plants were being designed and run by clown college graduates. There have been five years of inflation warnings, but no real inflation. At a certain point it's time to change the channel.

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  8. Excellent post and the same point holds for the U.S. The FOMC didn't lower rates preemptively before the little depression/great cluster@#$%. Minutes from 2007 show they weren't considering the lag of easing, but rather worrying that inflation wouldn't moderate!

    "Anonymous" is always wrong, but another way to to look at what's he saying is that he suggest the whole system allows it to fail. No it's just that they're missing the target they've set themselves. An NGDP path level target is being pushed in part because it would make this failure more apparent and harder to deny. Even though it's hard for them to deny that they're missing their inflation target at the moment.

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  9. You seem to be assuming sincere voting, but perhaps there is something 'exotic' going on here. If I wanted to send out just a slither of a message that interest rates will go up at some point in the future, but didn't want to actually raise rates today, and furthermore anticipate (or even know with certainty) that my colleagues are all going to vote against a rate rise, then perhaps I would vote for an increase.

    I realise that's a bit convoluted (though no less so than half of Mark Carney's statements), but voting on committees with small numbers can often involve weird behaviour.

    Do you know if the voting is sequential or simultaneous? Do they all raise their hands at the same microsecond, or do they look around the room first? In general I suspect that these details affect the vote.

    Admittedly if I had an eye on a potential juicy financial services sector consultancy then perhaps my vote could also be influenced by this, though I am a lesser mortal than the MPC members.

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    1. From the many conversations I have had with MPC members, I think I'm right to assume sincere voting. Furthermore one advantage of having external MPC members is that their reputations are to some extent on the line here. So I'll go for the more straightforward explanation, which is that they are making poor judgments.

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  10. The explanation for this asymmetry seems straightforward. An extra point of inflation transfers tens or hundreds of billions of dollars a year in real buying power from (a relatively small group of) creditors to (a much larger group of) debtors. (With nary an account transfer to be seen.) The magnitude of this basic economic/arithmetic effect utterly overwhelms any of the "menu cost" type effects that economists love to obsess over.

    And central banks are run by creditors.

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  11. In a sovereign floating fiat currency economy, the natural rate of interest, on overnight money, is ZERO. Quantitative Easing, has unbalanced the supply and demand for "reserves", and would have resulted in loss of control over LIBOR rates, had banks been required to continue to set and meet "reserve" targets. Since March 2009, Banks have not been required to set targets for their reserves accounts and all reserves balances are paid interest at BoE Bank Rate. With £300 billion in reserves, there is no incentive for banks to borrow from or lend to each other for settlement, other than at Base Rate.

    So, with QE having taken lots of interest bearing Gilts out of the private sector and swapped them for cash; effectively a tax on the private sector, the banks; pension and insurance funds are set to get some of it back if Base Rate is increased. This negates what QE was trying to do in the first place, force those funds to go and invest in new enterprises with better ways of making stuff and paying dividends from the success of such enterprises!

    Discuss; marks will be given for initiative. All the best Acorn.

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    1. BTW. QE has done nothing for the UK economy, but our zombie banks love it. That's the banks we should have nationalized in the first hours of the Great Financial Crisis of 2008. (you only have to keep the payment and clearing bit of the bank going to prevent chaos).

      The best way to get households to go out and spend today, is to tell them there is inflation coming in the near future. That washing machine will cost more next year; go get it now. Keep that credit card maxed out; your country needs you to spend. ATB Acorn.

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  12. I only have anecdote to offer.

    I had to re-mortgage today, my very large two year fixed mortgage having come to an end. I was on what I considered to be a good deal, 3.29 fixed. (I have a high debt to income ratio). I don't follow mortgage rates very closely, and assumed that I would not be able to get as good a deal as I got two years,ago, what with the recent belief that a rate rise was in the offing either late this year or early next.

    I was offered a lower two year fixed rate (2.15) than I was then.

    So, it looks to me that the market expectation of rises is lower than it was two years ago, and that of course is what practically determines the levels at which it is possible to borrow.

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  13. Excellent post. One remark though ... How is it possible to have a positive output gap? I thought that the output gap measures the difference between actual output and maximum potential output. The output gap can not be positive in my opinion.

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    1. It's economics jargon. Having a positive output gap means that growth is unsustainably high which will lead to increased inflation and, eventually, crisis. In other words, a positive output gap = an overheating economy. If you're at potential output, economic growth is at a level that is sustainable over the long term. In the short term you can be at above potential output however this will have the effects mentioned above.

      In a similar vein, full employment does not signify that everyone is working; full employment is when the unemployment rate is sustainable in the long term.

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  14. What about using real data to test for symmetry? Has inflation been equal to the target on average?

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  15. While I think that there are many Central Bankers that would fail your symmetry test, I think that the Federal Reserve (as a whole) has passed it. They cut rates "preemptively" in terms of the flow of macro data in 1995, 2001 and 2007. Raising rates from zero at this juncture by the Fed or BOE to 1 percent also would pass this test as as policy would still be very lax from an historical standpoint. I don't think that raising rates off the ZLB is tight policy it is still loose policy and it might be the appropriate amount of looseness. I would not doubt that some members forecast for the economy are different than that of the Central tendency and so there should be some dissent.

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  17. Can I ask whether you in principle might support a policy of purposefully raising the public's inflation expectations in order to drive down the real interest rate? i.e. if fiscal policy is neutral over the cycle, and you're at the zero lower bound

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  18. I think these people regard inflation as very volatile, i.e. you'd rather want to have it under control. It's better to have it too low and stable than to have it at the right level but unstable. I guess the fear is that we want inflation to increase but the process of rising inflation can't be stopped easily, and suddenly we have too high inflation and a destruction of nominal wealth.

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    1. I remember the inflationary 1970s, and back then everyone loved inflation. Your expenses rose, but your wages rose too, and usually more than enough to compensate. People had rising incomes. Most working people have never seen one, at least not in the last 30 years. Even better, if you borrowed money, you could pay it back with your rapidly increasing income. You didn't have to be genius to do the math.

      Of course, this didn't sit well with the economic deadweight that rules our society.

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  19. What really happened at the BoE: http://www.newsbiscuit.com/2014/08/20/bank-of-englands-governor-feeds-interest-rate-dissenters-to-piranhas/

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    1. Very happy to see this sort of satire as it might be the start of a wider recognition that there have become no consequences for irrationality and poor decision-making in our business leadership. Pointing and laughing may be the only weapon we have left; use it wisely and often.

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