The last 7 years are an argument against inflation targeting

The big controversy since the Great Recession began has been about fiscal policy: government spending, taxes and the budget deficit. In contrast monetary policy has not hit the headlines so much. This is understandable: while fiscal policy has oscillated from fiscal stimulus in 2009 to fiscal austerity in 2010, once the recession became clear (to some earlier than others) monetary policy in the UK, US and Japan appears to have been unambiguously expansionary, with interest rates staying at historical lows. The ECB is the exception, raising rates just before a second Eurozone recession.

Look a little closer however and we find something rather more worrying. Most people who base their view on economics rather than politics would regard the recovery from the Great Recession as disappointing. We have got particularly good reasons to be disappointed in the UK, but many economists think the US and Japan could also have done better at reducing unemployment more rapidly. More worrying still, the recession and the slow recovery may have caused permanent damage. (See Antonio Fatás here on his work with Larry Summers.) In the UK in particular we appear to have permanently lost a massive 15% of income during the recession. That kind of loss over a 7 year period is totally unprecedented in peacetime.

There are well known mechanisms by which short term output losses could lead to a permanent reduction in output capacity, known collectively by economists as hysteresis mechanisms. They include deskilling of the unemployed, less capital and less capital embodied technical progress. Just how permanent they are varies by type, but they all involve real costs in terms of lost output. One that worries me a lot is how expectations about trend output get downgraded, which can become self-fulfilling for quite some time.

The people whose job it is to make sure recessions are short-lived and these kinds of mechanisms do not take hold are in central banks. Yet if you ask monetary policy makers what they think about the last 7 years, they will not hang their heads in shame. They will not say it has been a disaster, but what more could we do? They will not say that, with interest rates near zero, they were powerless to do much, because unconventional policies like Quantitative Easing were poor instruments and government fiscal policy was moving in the wrong direction. Instead they will probably say that overall the last 7 years have not been too bad. This very different view seems both odd and worrying.

The reason however is straightforward. Monetary policy makers either regard their primary target as inflation, or are explicitly told that inflation should be their primary target. While below target now, inflation was above target in 2011 and 2012, so on balance maybe the record is not too bad. So looking at what they were asked to do, monetary policy makers feel little remorse.

In the UK we can put this in a rather startling way. Imagine someone in 2011 discovered a magical new policy instrument that was guaranteed to stimulate the economy, and gifted it to the Bank of England. In all probability they would not have used it. For four months in 2011 three members of the MPC voted to raise rates. We were just two MPC members away from following the ECB’s disastrous course. Just because we avoided that calamity by a whisker does not mean we should pretend it didn’t happen.

This all comes down to what economists have called the divine coincidence. This is the idea that you do not need to target both output and inflation. Ensuring that inflation is on target in a considered way (by for example looking at inflation two years ahead) will stabilise output as well. While the US central bank has a dual mandate (essentially both inflation and output), central banks that were made independent later (like the Bank of England) have inflation as their primary target. One of the main reasons for this was a growing belief before the Great Recession that the divine coincidence would hold. Target forecast inflation and output will look after itself.

The idea of the divine coincidence has not had a good recession! As I explained in one of my better posts, if the divine coincidence worked a central bank in a parallel universe that targeted the output gap rather than inflation should feel exactly the same way about the last 7 years as our inflation targeters. Yet as I explained there and above they would instead feel ashamed and frustrated. We know there are good empirical reasons why the divine coincidence might break down when inflation is low: resistance to nominal wage cuts will mean that monetary policy makers targeting inflation in a recession will overreact to positive inflation shocks like oil price increases and underreact to below target inflation. Add hysteresis, and you can get lasting damage.

So one lesson of the last 7 years must be that relying on the divine coincidence is a mistake. A primary goal of the central bank is to end recessions quickly, and giving it a single primary target of inflation can detract from that. One obvious improvement is to give the central bank a dual mandate, although the best way to specify that is not clear. Another possibility is to combine output and inflation into a single target, and yet another is to raise the inflation target to a level where the divine coincidence might still hold. Luckily for me I have thought quite a bit about these questions already, but in the next few months I may need to come off any fences that remain.

UK Growth has been even worse than we thought

That is one headline on the Office for National Statistics (ONS) latest data revisions. Output in the UK economy is now estimated to be currently almost 4% below its previous peak, compared to previous estimates of 2.5% below. Or alternatively, the headline could be that the UK never had a double dip recession: at the beginning of 2012 growth was flat rather than falling by 0.1% (not annualised), a 0.1% that has been reallocated to the subsequent quarter. The chart below shows the old and new data for GDP growth, quarter on quarter. So GDP went fall, flat, fall, which technically is not a recession. I’ll leave you to decide which the more informative headline is.*

As you can see the big revision is in how much GDP fell in the recession. GDP is now thought to have decreased by a little over 5% in 2009 as a whole, compared to the previous estimate of -4%. At this point I cannot resist telling a small story about this number, but for those who are fed up with my personal anecdotes there is a serious point about inflation to follow. I make a weak attempt to connect the two at the end.

Quarter on quarter changes to UK GDP (not annualised): ONS

At the beginning of 2009, I was asked to attend a breakfast meeting with the then Chancellor, Alistair Darling, along with some non-academic economists. I had never attended one of these before, so I did not know what to expect. I had not met Darling, but all the other economists invited appeared much more comfortable with the format and surroundings, so to be honest I was rather nervous. Academics in particular can appear out of touch because they do not have all the latest data at their fingertips.

Sure enough, one of the first questions Darling asked was just how bad we each thought things could get. I cannot remember what each person said, but the general view was that GDP could fall by as much as 3% in 2009. I was the last to give my opinion. I could have ducked out, but instead I remembered one thing from my earlier days as a forecaster. This was that forecasts typically underestimate the extent of large swings in GDP, particularly if they are globally synchronised. So I said that I thought things could be worse than that, and GDP could fall by 5%.

Impossible! was the immediate retort of one of the other economists: someone who is very well known and very sensible, although I will not say who it was here. This person then used their detailed knowledge of the data to say why it was inconceivable that GDP could fall by so much. One by one everyone else agreed that although things were bad, they could not get that bad, and 5% was an outlandish number. Just as I wished I had kept my mouth shut, or better still just not come, the senior economist from the Treasury who was there came to my defence: a fall that large could happen, and they described how it might happen. I of course take no pleasure in the fact that my forecast has been vindicated, and it was little more than luck, but it is one of those moments I will not forget.

Now for something more consequential. The chart below compares two different measures of UK inflation: the CPI (green) and the GDP deflator (blue). CPI inflation has been significantly above the 2% target since 2010. In contrast over the last year growth in the GDP deflator has been well below 2%. This is the deflator at market prices, so it includes indirect taxes. The dashed line is the GDP deflator at basic prices, which excludes these. The press release only includes numbers going back to 2010 for this series, but you can see that growth has been below 2% for the last three years. The dotted line is growth in the US GDP deflator - this moved in a more immediately understandable way after the recession, but over the last two years the UK and US measures have not been that different.

Alternative measures of inflation

The fact that output price inflation (which is what the GDP deflator measures) has been below CPI inflation is neither surprising, nor unique to the UK. What is less appreciated is that there is no reason from an economic point of view to focus on one series (the CPI) rather than the other (the GDP deflator) when setting monetary policy. At an intuitive level looking at the output price measure makes more sense, because policy has more control over things produced in the same country. At a deeper level, inflation matters because some prices are sticky, and the GDP deflator generally excludes volatile commodity prices. It should be less influenced by volatility in the exchange rate, so it may be better for that reason too.

I cannot help but reflect on how different UK monetary policy might have been if it had focused on output prices rather than consumer prices. In 2011 interest rates were almost raised (3 out of 9 MPC members voted for doing so), despite the lack of a recovery. Would this have happened if the target inflation measure had been below 2%, as growth in GDP at basic prices was? Since then Quantitative Easing has largely stalled, which would have been very hard to justify if the focus had been on output prices.

One of the reasons often given for focusing on the CPI (which has come up again in discussion of nominal GDP targets) is that this data is available quickly and is not revised. [1] Which brings me back to the beginning, because the GDP deflator numbers for the first quarter of 2013 and earlier have been significantly revised (and are smoother as a result). I have never understood this argument. We should start with why inflation is costly, and then think about how best to measure these costs. If measurements change because information gets better, policy should respond to that. If that causes problems, improve the measurement. Perhaps policy needs to obsess a bit less about this bit of data or that, and think more about the fundamentals of what it is trying to do. 

* I changed the text here from the original version to make the nature of the adjustment clearer. As one economic journalist put it, reallocating 0.1% of GDP between quarters makes no difference in terms of the economics, but revising away the double dip recession will play well for George Osborne politically. I think that says a lot about the quality of political debate.

[1] Another argument is that the CPI is easily understood by the non-economist. If this impresses, why not use wages rather than the CPI, as I suggested here. As wages are clearly sticky, there are good theoretical reasons to focus on this as a measure of inflation.

2010 and Monetary Policy in the UK

                I have argued that the decision to reduce the UK budget deficit more rapidly in 2010 was a major policy error. (I looked at figures on cyclically corrected budget deficits in the UK, US and Eurozone here.) One argument against this view is that without such a tightening, the UK would have been at greater risk of a loss of confidence in UK government debt. I think many believed that at the time, because they thought what was happening in the Eurozone could happen to the UK. As interest rates on government debt continue to fall around the world, this fear looks increasingly groundless. As the IMF has recently noted, growth as well as debt levels are important influences on market perceptions.

                A rather better argument (see the first comment on this post) is that if fiscal policy had not tightened in 2010, the Monetary Policy Committee (MPC) of the Bank of England would have raised interest rates in 2011. In the Spring of that year, 3 of the 9 members voted for an interest rate rise from the zero bound floor level of 0.5%. If the economy had been stronger because of less austerity, would two or more committee members have switched sides, leading to an increase in UK interest rates?

                A think it is far from clear that they would. Inflation was high in part because of the result of those austerity measures. VAT was increased from 17.5% to 20% at the beginning of 2011, which probably added around 1% to inflation in 2011. You could argue that as this was always going to be a temporary influence, it was neither here nor there as far as MPC decisions were concerned. I think this would be a little naive. One of the major concerns of MPC members around that time was the loss of reputation that the MPC might suffer if inflation got too high, and here I think the actual numbers mattered.

                But supposing the Bank had raised rates. Would that have been the right thing to do? In hindsight clearly not. The ECB did raise rates at this time, and that now looks like a very foolish decision, but it looked pretty foolish at the time. (See this from Rebecca Wilder.) I also argued strongly against raising UK interest rates in early 2011. My note was called ‘Ten reasons not to raise interest rates’, but the main argument was very simple. The costs of inflation exceeding its target were much lower than the costs of a persistently high output gap.

                At the time it was possible to try and calculate these costs based on what the Bank itself was thinking, because it published output and inflation numbers under two alternative scenarios: one where interest rates were kept flat and another where they increased through the year (based on market expectations at the time).  Here is the table I put together.

Calculating social welfare

	2012	2013	Loss	Diff
Inflation
Rising rates	2.4%	2%	0.16
Flat rates	2.6%	2.5%*	0.61	0.45
Output growth
Rising rates	2.7%	2.6%
Flat rates	3.0%	3.0%
Output gap
Rising rates	3.3%	2.7%*	18.18
Flat rates	3.0%	2.0%	13.00	-5.18

Numbers are estimated using the Bank of England’s February 2011 Inflation report. Output gap numbers assume a 4% gap in 2011 (consistent with the latest OECD Economic Outlook), and that potential grows by 2% p.a. 2013 numbers are guesses based on extrapolating the Q1 forecast. 

            Raising rates through 2011 had virtually no impact on 2011 numbers, so these are ignored. Higher interest rates leave inflation is a little lower in 2012, and inflation then comes back to target in 2013. In contrast, keeping rates flat would leave inflation half a percent above target in 2013. Raising rates would reduce output growth by a quarter of a percent in 2012 and by half a percent in 2013, leaving the output gap 0.7% higher in 2013. Now suppose we take the difference between the forecast number and the target for inflation each year, square this figure and sum. We do the same for the output gap. That gives a very crude measure of the social loss implied by each policy, and this is shown in the column headed loss. Take the difference between the two policies in the final column. Raising rates clearly does better on inflation, but worse on the output gap. However the output gap losses are much larger, because inflation is near its target, but the output gap is not.

                This puts into numbers a very simple idea, which is that missing the inflation target by half a percent is no big deal, but raising the output gap by over half a percent when it is already high is much more costly. Now we can argue forever about the size of the output gap, but we need to remember that in these calculations it is mainly a proxy for the costs of higher unemployment, and we have real data on unemployment.

                We can put the same point another way. Although 5% inflation in 2011 sounded bad, it was the result of a temporary cost push shock, caused by higher VAT and energy prices. Inflation was bound to come down again, because unemployment was high. (I think some in the Bank began to doubt this basic macroeconomic truth because they kept on underestimating inflation.) There was never any sign of higher price inflation leading to higher wage inflation. In contrast, the recovery from the recession was slow, so this was the problem to focus on.

                Crucial in this analysis is the view embodied in the Bank’s forecast that it takes some time before higher interest rates influence output and inflation. What this means is that to prevent inflation rising in 2011, we really needed higher interest rates at the end of 2009. A year in which GDP fell by 5%! Those who argue that the MPC ‘failed’ because inflation reached 5% in 2011 are really arguing that the MPC should have made the recession deeper.

                So, if the MPC had raised interest rates in 2011, they would have been wrong to do so. That is obviously true in hindsight, but it was also true based on the more optimistic projections made at the time. It would also have been true even if the economy had been stronger because of less austerity.

                One final point on this policy error. It is just possible that, without the Eurozone crisis, the LibDems might not have been persuaded to adopt the Conservatives’ fiscal plans as part of the coalition agreement. But the real source of the error is to be found much earlier, when the Conservatives opposed the government’s fiscal stimulus measures in 2008/9. From that point on, their macroeconomic policy was all about austerity, and they denied that this would have harmful effects on the economy. I’m afraid I have no knowledge about why they decided to adopt this line, but it has proved to be a very costly mistake.