Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 21 June 2017

UK monetary policy: you cannot be serious?

Nothing shocks me in the area of fiscal policy anymore, but I do have some faith that monetary policy makers know what they are doing. While fiscal policy makers in the US, UK and the EZ did precisely the wrong thing consistently from 2010, monetary policy makers rightly pulled out all the stops, and my main quarrel was that in the UK and EZ they pretended QE was an instrument with the same order of reliability as interest rates. Instead they should have told fiscal policy makers that they could no longer do their jobs efficiently because interest rates had hit their lower bound.

However, there are occasional aberrations. EZ interest rates went up in 2011 rather than down and the MPC almost did the same. (Let’s not mention Sweden.) And then, last month, three members of the MPC voted to raise interest rates. After I had had my John McEnroe moment, I quickly realised that these three members were making exactly the same mistake as a different three made in 2011. Only this time they had less excuse.

Back in 2011, inflation was between 4% and 5% but the UK was still in deep recession. Inflation was high because of austerity (an increase in VAT), higher energy prices and maybe the lagged effects of an earlier depreciation. In 2017 inflation is high because of the Brexit depreciation, yet the real economy looks very weak as consumers start to pull back spending. In essence the situation is identical: inflation is high because of one-off factors, and because the real economy is weak inflation will come back down of its own accord. There is no point making the real economy even weaker by raising interest rates.

The only thing you might worry about in these circumstances is that inflation might be more persistent than you thought because nominal wages start to rise as workers try and avoid falls in real wages. That didn’t happen in 2011 even though inflation reached 5%, and inflation did come quickly back to near target within a year. An increase in interest rates would have achieved nothing except make the recession worse.

Exactly the same applies now, with the only difference being inflation is still less than 3%. We can be sure of this by looking at what is happening to nominal wages. UK nominal wages have increased in the four months of 2017 by less than 2% compared to a year earlier, which represents a distinctly lower rate of growth than in the second half of 2016. A relative price change, like a depreciation, can only shift inflation permanently higher if wage inflation starts rising. Right now it is falling.

When I recently wrote about increasing the inflation target, I knew I would get at least one comment saying wouldn’t this reduce real wages even further. As I always do, I explained that raising the inflation target should raise the rate of increase of all nominal quantities by the same amount, which is what economists mean by inflation. But it seems the same basic point has to be made to these three members of the MPC too: inflation is not just the rate of change of the consumer price index.

The weakness of real wages in the face of rising inflation (and remember this increase in inflation was predictable the moment Brexit happened) also tells us something important about the UK labour market. Here is the Resolution Foundation’s underemployment measure, based on work by Bell and Blanchflower. It shows the index still above its level in the first half of the 2000s. 


But perhaps more importantly, the weakness of nominal wages suggests that the NAIRU may have decreased since then. A good rule for monetary policymakers right now is to only think about raising interest rates when nominal wage inflation starts rising by more than 2% above underlying labour productivity growth. 

Postscript 22/6/17

The day this post was published a speech from MPC member Andy Haldane was also published. Haldane did not vote for higher interest rates in May. It is a speech of two halves. The first presents a detailed and analytical discussion of the changing nature of the UK labour market, and his conclusion is that the NAIRU may well have declined as a result. He therefore provides solid evidence for the conjecture in my last paragraph. 

However the second half of the speech is in complete contrast. It involves a kind of unstructured shopping list of pros and cons for raising rates, full of references to things like 'political uncertainty' and equity markets and 'inflation narratives'. As a result of that, he favours raising rates earlier than markets expect. Sterling rose on publication of the speech. (If nothing else, sterling's reaction to first Carney's speech and then this has been a nice vindication of uncovered interest parity (UIP) theory.)

I think there is another way of describing this speech of two halves. The first involves a careful analysis of a key driver of the inflationary process (and finds a strong explanation of why wage inflation is currently weak). The second is unstructured list making, with a decision based on some unexplained intuitive process. I may be a little harsh, but it looks to me like the best and worst of monetary policy making.       

19 comments:

  1. The situation in 2011 was quite different. Commodity prices generally were at multi year highs with obvious implications for food prices.

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  2. Yes well said.

    I'm not really surprised that Ian McAfferty and Michael Saunders voted for increases. These two are essentially financial industry lobbyists.

    The way the MPC is constructed - with approximately equal numbers of City "Economists" and academics - means that you will get occasional aberrations once you recognize the incentives of the former group.

    I was more surprised that Kristin Forbes voted for the increase. It may be just as well that she is being replaced.

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  3. We're in a post-forward guidance era where influence needs to be covert but communicated widely. The BoE simply want to stabilise the pound during the current instability and don't want to see further devaluation at the present time otherwise inflation will become a persistent problem. Aren't they simply playing a confidence game?

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  4. Interesting. From a macro theory point of view, also sounds like some members of the MPC have forgotten where inflation concerns even come from. As you say, what matters is clearly output (i.e. real factors), so just because there is generally a 1:1 relationship between output and inflation, doesn't mean it's always the case, especially when there have been plausible "exogenous" shocks to inflation recently.

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  5. I don't foresee nominal wage inflation rising any time soon for the fact that companies are now looking at automation and robots to replace the workforce. In the words of Schaeuble today "The Longer The Period Of Expansive Monetary Policy Lasts The Greater The Danger Of Risks"... 10 years on in this low interest environment will give them no room for manoeuvre when the next crisis hits... the Sovereign Debt Crisis... I have marked 2018 as the start of this crisis in Europe as the Greek problem rears its ugly head again.

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  6. Andy Haldane, BofE deputy governor, in his 20.6 Bradford speech, offered his tentative support for a 0.25 % rate increase later in the year on the back of business and consumer survey evidence that indicated future 'about-trend' growth, notwithstanding that he acknowledged continuing post GE2017 and brexit uncertainty. http://www.bankofengland.co.uk/publications/Documents/speeches/2017/speech984.pdf

    Such an incremental increase, in his words, would by reversing the incremental August 2016 loosening demonstrate confidence 'in the resilience of the economy and the sustainability of the 2% target'.

    Think on this that Carney with his more cautionary approach, is correct.

    With respect to moving to a 4% inflation target to escape the zero low bound constraint, the impact on the housing market of any consequent increase in interest rates, would almost certainly be deflationary, with prices falling as mortgage repayments rose (although with possible attendant spin-off benefits for affordability) given the institutional relationship between housing and the the UK economy: what I call, the housing double bind.

    That would tend to add further to brexit uncertainty. The political opposition would also further discourage the MPC from following that course.

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  7. Attention: there are THREE types of inflation
    Comment on Simon Wren-Lewis on ‘UK monetary policy: you cannot be serious?’

    Simon Wren-Lewis clarifies: “When I recently wrote about increasing the inflation target, I knew I would get at least one comment saying wouldn’t this reduce real wages even further. As I always do, I explained that raising the inflation target should raise the rate of increase of all nominal quantities by the same amount, which is what economists mean by inflation. But it seems the same basic point has to be made to these three members of the MPC too: inflation is not just the rate of change of the consumer price index.”

    What economists mean by inflation is false and this is relevant for the relationship between inflation and employment.

    From the correct employment equation* follows that employment L depends (i) on aggregate demand, which is here given with the expenditure ratio rhoE and investment expenditures I, and (ii), on the price mechanism, which is formally embodied in the macro-ratio rhoF=W/PR with W = average wage rate, P = average price, and R = average productivity.

    Let rhoE and I be fixed and the rate of change of productivity R for simplicity be zero, i.e. r=0, then there are THREE logical cases:
    (i) The rate of change of the wage rate W is equal to the rate of change of the price P, i.e. w=p, then employment does NOT change NO MATTER how big or small the rates of change are.
    (ii) The rate of change of the wage rate is greater than the rate of change of the price then employment INCREASES.
    (iii) The rate of change of the wage rate is smaller than the rate of change of the price then employment DECREASES.

    So, it is DIFFERENCES in the rates of change of wage rate and price and NOT the absolute magnitude of change. Every PERFECTLY SYNCHRONOUS inflation/deflation is employment-neutral, that is, employment sticks indefinitely where it actually is.

    Perfectly synchronous inflation/deflation is, according to Simon Wren-Lewis, “what economists mean by inflation”. Synchronous=employment neutral inflation, though, is a LIMITING case that occurs with a probability CLOSE TO ZERO.

    In general terms, the neutrality condition reads w=p+r+pr. Therefore, it is a matter of indifference whether the wage rate falls or rises or whether wages are sticky or not. ALL depends on relative changes. Employment increases if w is greater than p+r+pr and decreases in the opposite case.

    So, what is needed in the present situation is an asynchronous inflation, more specifically, w greater than r and p=0. This increases also the multiplier effect of expansive fiscal policy. The wage increase has to take the lead.

    Egmont Kakarot-Handtke

    * The elementary version of the correct (objective, systemic, behavior-free, macrofounded) employment equation reads
    https://commons.wikimedia.org/wiki/File:AXEC62.png
    For details see ‘Keynes saw the problems but did not solve them’
    http://axecorg.blogspot.de/2017/04/keynes-saw-problems-but-did-not-solve.html

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  8. “The funny thing is: they haven’t. In fact, among the more than 10,000 research articles produced by the major central banks in the two decades prior to the 2008 crisis, none explored the correlation or causation between nominal interest rates and nominal GDP growth. Fortunately, this task is not very demanding, and once we conduct such an examination, we conclude that, in actual fact, there is no evidence to back these assertions whatsoever. To the contrary, empirical evidence shows that the central banking narrative on interest rates is diametrically opposed to the observable facts in two dimensions: instead of the proclaimed negative correlation, interest rates and economic growth are positively correlated. Secondly, the timing shows that interest rates do not move ahead of growth, but instead are either coincidental or even follow it.”

    https://professorwerner.org/shifting-from-central-planning-to-a-decentralised-economy-do-we-need-central-banks/

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  9. Very good and interesting post. I also find strange that some rate setters are voting for higher interest rates because of current inflation which seems very likely to be temporary. Playing devil's advocate: there might be an argument to remove the "extraordinary" brexit change (the fundamentals don't seem much different than before the referendum), to create a bit of slack for the next recession (which the planet is due anyway).

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  10. Krugman blog 'Rate Rage' SEPTEMBER 19, 2015

    "Commercial bankers really dislike a very low interest rate environment, because it’s hard for them to make profits: there’s a lower bound on the interest rates they can offer, and if lending rates are low that compresses their spread. So bankers keep demanding higher rates, and inventing stories about why that would make sense despite low inflation...nobody has ever accused bankers of being especially clear about macroeconomics, and in any case what matters for today’s bank executives is not the long run but the next few years, during which they either will or won’t be getting big bonuses; in the long run they are all full-time golfers...Like everyone, the bankers no doubt are able to persuade themselves that what’s good for them is good for America and the world; more alarmingly, they may be able to persuade officials who should know better. Does this explain the puzzling divergence between the views of Fed officials and those of outsiders like Larry Summers (and yours truly) who have a similar model of how the world works, but are horrified by the eagerness to raise rates while inflation is still below target?
    I don’t know about you, but I feel that I’m having an Aha! moment here."

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  11. Doctor Lewis
    Do you think maybe in the US (not in the UK) the unemployment rate is really below NAIRU?
    like I wrote in my last post: https://losinterest.wordpress.com/
    Nevertheless, there is still a need for more stimulus in my opinion

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  12. What a load of complete drivel that reflects everything that is wrong with modern economic thinking. The stupidity of this is monumental. When the Western world is drowning in debt and the UK is running a massive CAD and totally dependent on selling London property to foreigners, to an extent that out democratic and social institutions are about to come under severe strain the economic profession keeps peddling this ''debt doesn’t matter' or even 'we NEED more debt' rubbish.
    Equally this promotion of lower interest rates so we can all consume more of our world even faster is just so far beyond stupidity that it beggars the imagination. I’d guess that at the same time the writer is some sort of hero in the conservation/anti carbon dioxide brigade. Doesn't this stuff clash in anyone's head?????

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    1. «When the Western world is drowning in debt»

      It is what happens when asset stripping is the strategy. Sometimes I have the impression that the clever people in finance apply the BCG matrix to regions of countries and whole countries, not just to companies, and they have decided that the UK has a "dog" economy and that loading it with debt and asset strip it is the most profitable option.

      «and the UK is running a massive CAD and totally dependent on selling London property to foreigners,»

      Academic Colin Crouch has called this the "privatised keynesianism" strategy, where governments instead of borrowing to spend, "encourages" the private sector to borrow and spend.
      All that our blogger is arguing is for a return to direct government spending.

      «the economic profession keeps peddling this ''debt doesn’t matter'»

      Well, that is not quite right: the "mainstream" believes that government debt is bad, because it leads to higher taxes or higher inflation later, while private debt does not matter because all private debt is owed to other private persons, so it nets out to zero. That's ridiculous because a lot of private debt is endogenously created, and anyhow it tends to become government debt when it comes due "because financial stability!".

      «or even 'we NEED more debt' rubbish.»

      SimonWL could be arguing that we need more government spending, but he is specifically arguing that the UK needs bigger government deficits (which can be achieved also by lower taxes).
      Obviously the “a massive CAD and totally dependent on selling London property to foreigners” aspect does not bother him and other Economists, because politically the valuation of the pound is no longer important, and perhaps because the lower the pound is the lower real wages become, making the UK more "competitive".

      Delete
  13. Haldane has been a huge frustration for many years.

    Technically brilliant, insightful and able to direct and co-ordinate sharp and apposite research findings into cogent briefings and speeches. Rarely shies away from 'difficult' issues to dig for evidence and consistently reveals a truer picture of our economy and the factors affecting it over the medium and longer term than anyone else I'm aware of outside academic departments. A real treasure, in other words, someone insightful, compassionate and well-placed to do something about it all.

    However, as in his latest speech, he plays a game of two halves. What he does with this cornucopia of compelling evidence is just as consistently to fail in providing policy details. He and his employers plus their political bed-fellows would argue that he tries to be pragmatic within the Overton window which strictly polices his role and output but I'd suggest that he continually bottles it. Failing to gain any traction at all for policies to counteract underemployment, inequality, financialisation, real wage stagnation, productivity declines or low inflation conditions.

    After a couple of decades of urging him on to actually DO something it eventually becomes impossible to think he'll ever feel he's in a position to do so. Shame.

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    1. «he tries to be pragmatic within the Overton window which strictly polices his role and output but I'd suggest that he continually bottles it.»

      This is utterly unfair to him: he works for a government department, he is a top civil servant, a spokesperson for the "establishment", his role is not to lead the opposition to the policies of a democratically elected government. Those government policies of upward redistribution from workers to business and property owners have been consistently endorsed by the electorate, of which many more are property and/or business owners (indirectly if not directly) than in the past.

      SimonWL would like the BoE to lead the political opposition to the government “loudly and publicly” but that really is for the opposition parties to do. Of course New Labour or their Liberal clones would not do it, but fortunately today Labour is doing effective opposition.

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    2. «“he tries to be pragmatic within the Overton window which strictly polices his role and output”
      he works for a government department, he is a top civil servant»

      And specifically for a part of government whose main role is to represent and protect the interests of the City, currently under the "because financial stability!" excuse, and the City benefits hugely from policies of upward redistribution from workers to business and property owners.

      Delete
  14. David Nowakowski23 June 2017 at 01:50

    Carney described the situation clearly to me. Brexit is a decision by voters and Parliament to make themselves poorer. Monetary policy cannot change this much, but has an impact on distribution: higher rates and less inflation, but more unemployment... OR... Lower rates and more inflation and employment but decreased real wages. This ignores second-order impact of the external sector and debt service, though these are not isolated but channels through which the above are made to happen.

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    1. «Brexit is a decision by voters and Parliament to make themselves poorer.»

      And it has been also a decision to become even less independent from the USA, a decision to give even more control and sovereignty to the USA over UK policy.

      «Monetary policy cannot change this much, but has an impact on distribution: higher rates and less inflation, but more unemployment... OR... Lower rates and more inflation and employment but decreased real wages.»

      Attributing that to Brexit is a poor excuse, as those policy choices have been advocate by the tories and whigs for a long time. The “Lower rates and more inflation and employment but decreased real wages” option has been advocated by the whigs of "Britannia Unchained" well before Brexit, and indeed they largely supported Brexit because it would make that option easier to push through.

      Delete
  15. Finally. An article about tennis's 'bad boy'. But it was all about economics! How dare you call yourself Mainly McEnroe ?

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