The advantage of a central bank not being ‘ahead of the curve’

Imagine the following economy. Growth has been strong for a number of years: 2.7% 2014, 3.8% 2015, 3.1% 2016 and is expected to be above 3% again in 2017. The OECD also think the output gap is positive i.e. output is above the sustainable rate. Inflation was bobbing around zero for a few years, but since 2016 has gradually crept up to the target of 2%. It was just over 2% in the summer, but dipped just below target in the last two months. Fiscal policy is broadly neutral, and is expected to remain so. The unemployment rate is still slightly above 6%, but the average rate since the crisis in the early 1990s is over 7%.

We are talking about the very healthy Swedish economy. An economy where inflation is at target and some experts think the economy is running hot. What level do you think the Riksbank, Sweden’s independent central bank, has set its interest rate at? The answer is -0.5%. What is more the general expectation (the Riksbank publishes its interest rate forecast) is that rates will not start rising above -0.5% before min-2018. In addition, the Riksbank is undertaking its form of QE.

What can explain this dovish behaviour? Central banks are supposed to be inflation averse, and elsewhere they talk about the need to ‘normalise’ rates the moment the economy starts recovering, so that they are ‘ahead of the curve’. Part of the answer lies in the past. I have told the story in real time (here, then here, then here), so just a short synopsis this time. The Riksbank started raising interest rates from its then lower bound of 0.25% towards the end of 2010, because they were worried about a potential housing bubble. Rates continued to rise to 2%, but inflation began to fall, and did not stop until it hit zero at the end of 2012. There was no growth in GDP in 2012. The eminent macroeconomist Lars Svensson resigned from the Riksbank in protest at this departure from inflation targeting.

Sweden: Consumer Price Inflation and Short Interest Rates, plus forecast (from OECD Economic Outlook)

In 2012 the Riksbank admitted their mistake, and started lowering rates to the new lower bound of -0.5%, where they have been since the beginning of 2016. Having made the error of prematurely raising rates once, they are in no hurry to risk doing so again.

The Swedish experience I think illustrates a number of points that could also be applied to other central banks.

1. Macroprudential policy is the way to deal with financial instability like housing bubbles. Using the interest rate instead can be very costly. Controlling inflation should be the only thing short term interest rates are used for.
   
   
2. Low, below target, inflation can be very sticky. Swedish interest rates went below zero at the beginning of 2015, but inflation only went above 1% just under 2 years later, and this despite growth in GDP of 3.8% in 2015.
   
   
3. Inflation went above target in July, August and September of this year. But the central bank, looking at the basic determinants of inflation like wage growth relative to productivity growth, held their nerve and kept rates at -0.5%. Inflation fell back to 1.7% in October, and has stayed below 2% in November.
   
   
4. The argument that interest rates must be raised above their floor so that central banks are ‘ahead of the curve’ has not been as influential in Sweden as it has been elsewhere.

It could still go wrong for Sweden, but if it does not then the Riksbank's 2010/11 mistake may have a silver lining. By making the central bank extremely dovish, they have allowed the Swedish economy to grow strongly and unemployment to fall substantially. Perhaps the mantra adopted by other central banks of needing to be ahead of the curve in terms of early ‘normalisation’ is not such a clever idea.

In praise of macroeconomists (or at least one of them)

This is a title that is sure to spur some angry comments. Didn’t the financial crisis prove that mainstream macroeconomics was hopelessly flawed, that the ‘Great Moderation’ (fifteen or so years of relatively stable inflation and output) that preceded the crisis was a sham, or worse still a cause of the crisis, and basing policy on lots of maths and rational expectations has been totally discredited?

One of the architects of that macroeconomic mainstream is Lars Svensson. He wrote a number of key papers on inflation targeting using lots of maths and rational expectations. Probably for that reason, he was a member of Sweden’s equivalent of the Monetary Policy Committee from 2007 to 2013. By the middle of 2009 Swedish short term interest rates were, like most other places, close to their ‘zero lower bound’ - in this case 0.25%. But in mid 2010 they began to rise again, reaching 2% at the end of 2011. The primary motivation for this continuing rise in rates was a concern that Swedish consumers were taking on too much debt.

Svensson fiercely and publicly opposed these increases, and eventually left the central bank in frustration. He argued that there was still plenty of slack in the economy, and raising rates would be deflationary, so that inflation would fall well below the central bank’s target of 2%. By the end of 2012 inflation had indeed fallen to zero, and since then monthly inflation has more often been negative than positive. It was -0.4% in September. This week the Swedish central bank lowered their interest rate to zero.

OK, so one eminent macroeconomist got a forecast right. Plenty of others get their forecasts wrong. Why the big deal? Suppose you took the statement in my first paragraph seriously. The Great Moderation was about central banks having an explicit forward looking target for inflation, and varying interest rates with the aim of trying to achieve it. So if the success of that policy was a sham or worse, and had been exposed by the financial crisis, a central bank should not worry too much if they abandon it. They should certainly not worry if they deviate from it because of concerns about the financial health of the economy. Which is exactly what the Swedish central bank did.

Now Sweden has negative inflation, and interest rates have come right back to zero. Deviating from what mainstream macroeconomists in general advocate (and what one in particular recommended) has proved a costly mistake. (Svensson estimates it has cost 60,000 jobs.) So maybe the story with the financial crisis is a little more nuanced. Perhaps good monetary policy, aided by the analysis of mainstream New-Keynesian theory, did help bring about the pre-crisis moderation in inflation and output variability. The Achilles heel was that monetary policy lost traction when nominal rates hit zero, but a number of mainstream macroeconomists had discussed the implications of that possibility before it happened in 2009. In the UK at least (and also elsewhere), it was politicians and central bank governors that did not take the consequences of this possibility seriously enough. The financial crisis suggests that what was missing was better financial regulation (including macroprudential monetary policy tools), rather than a need to rewrite how we set interest rates.

I am certainly not claiming that mainstream macroeconomics is without fault, as regular readers will know (e.g.) However it is important to recognise the achievements of macroeconomics as well as its faults. If we fail to do that, then central banks can start doing foolish things, with large costs in terms of the welfare of its country’s citizens. And while it might appear unseemly to occasionally blow one’s own profession’s trumpet, I suspect no one else is going to. 

Why macroeconomists, not bankers, should set interest rates

More thoughts on the idea that interest rates ought to rise because of the possibility that the financial sector is taking excessive risks: what I called in this earlier post the BIS case, after the Bank of International Settlements, the international club for central bankers. I know Paul Krugman, Brad DeLong, Mark Thoma, Tony Yates and many others have already weighed in here, but - being macroeconomists - they were perhaps too modest to draw this lesson.

To most macroeconomists, the theory of monetary policy is pretty straightforward. Interest rates should be set at a level which closes the output gap, which can be defined as the level of output and unemployment that will keep underlying inflation constant. We can call this real interest rate the Wicksellian natural rate. The difficulty is not in the concept, but in the practice of putting numbers to this concept when inflation is noisy, the output gap is hard to estimate, there are lags in the system etc etc.

But, respond those putting the BIS case, wasn’t that what monetary policymakers thought they were doing in 2007, and look what happened next. Monetary policy cannot afford to ignore the financial sector, and the risk of excessive lending and bubbles that subsequently blow up the economy. There are signs, they say, that what happened in 2007/8 may be happening again now, so we need to raise rates to prevent another crash, even though there is still a negative output gap and inflation is below target.

Which might seem plausible, until you notice what is going on here. The implication is that a financial crisis only happens because interest rates are set at the wrong level. The Great Recession was all the fault of the Fed, who kept interest rates too low after the 2001 recession. The gradual deregulation of the financial sector in the decades before? - not an issue. The widespread misselling of subprime mortgages? - these things happen. All the other examples of misselling and fraud? - boys will be boys. An industry that profits from a massive implicit public subsidy? - we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s? - all the result of keeping interest rates too low.

When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low. There is no evidence for that proposition, and a lot of history that says otherwise. We do not have to accept a deregulated financial sector which has the power at any moment to derail the real economy. But of course most working in the financial sector hate regulation. They have an interest in perpetuating different stories about the Great Recession. If you spend too much time around bankers, there is a danger that you come to believe these self-serving stories.

But, you might say, what harm would a modest increase in interest rates do? Again, basic macroeconomics, which I have not seen anyone putting the BIS case address. Raising rates implies in current circumstances a larger negative output gap, which will reduce inflation further below its target. As happened in Sweden, and accurately predicted by macroeconomist Lars Svensson. Two things could then happen. First, interest rates come back down again (in Sweden’s case by outvoting the governor for the first time since it gained its independence in 1999), but the cost of lost resources and higher unemployment created in the meantime can never be redeemed. Second, interest rates stay high for long enough that the public will conclude that the inflation target has in reality been revised down, and we risk converging to a deflationary steady state (technical discussion here), or in non-technical terms a Japan-like lost decade or more of low output and deflation.

To see clearly why this makes no sense, consider the symmetric case. Suppose someone argued, when inflation was above target, that we should not raise rates, but instead allow the output gap to be positive. I suspect those currently making the BIS case would scream disaster – it is the 1970s all over again. So why is that wrong but doing the same thing in reverse OK? In fact it is worse than that. If long run expected inflation rises, a central bank can always signal its true inflation target by sharply raising rates. In the opposite case it may not be able to, because of the Zero Lower Bound.

I like to praise the current UK government when I can. In setting up a Financial Policy Committee that is separate from the Monetary Policy Committee they did exactly the right thing. This formalises an assignment: macro prudential policy to control financial sector excess, and interest rates to control demand and inflation. Most macroeconomists know this makes sense. But the financial sector has a pecuniary interest in pretending otherwise. Those that get too close to that sector should be kept well away from setting interest rates. 

Should fears of financial instability raise interest rates?

Inflation is significantly below 2% almost everywhere. In the US, Japan and the UK (even though in the UK inflation is still just above 2%) central banks are doing a great deal to get inflation back to 2%. Maybe not enough, but their goal is clear. The ECB is belatedly following the same path (although it remains somewhat behind), but this has caused a very public split in its ranks. One reason given by those who have opposed the ECB’s latest rate cut is a risk to financial stability, and house price increases in certain Eurozone cities. [1] In the US some have raised concerns that continuing QE might generate financial instability. In the UK one of the three ‘knockouts’ to forward guidance, that could allow interest rates to rise even if unemployment remained above 7%, concerns financial stability.

And in one country, Sweden, the independent central bank has kept interest rates above the ZLB, even though prices have been literally falling. While the central bank cut short rates to 0.25 in 2009, during 2010 they were increased to 1%, and during 2011 to 2%. They have since been cut to 1%, but the central bank does not want to cut any further despite prices being flat or falling throughout 2013. Yet the central bank has a clear target for inflation of 2%.

The reason the Swedish central bank - the Riksbank - is overriding its inflation target were clearly set out in a speech given by Kerstin af Jochnick, First Deputy Governor of the Sveriges Riksbank, in January 2013. The Riksbank is concerned that low interest rates will exacerbate a housing bubble. The discussion is interesting for at least two reasons. The first is that the Riksbank is not primarily concerned about the impact of any bursting bubble on the financial sector itself. It is not worried about a second financial crisis. Instead it is worried about the impact a bursting bubble might have on households (creating another balance sheet recession) and overseas confidence.

The second is that the Governor is explicit that higher interest rates are a second best solution to this problem. The first best solution is macroprudential regulation. But, to quote the speech: “One reason why monetary policy in Sweden has needed to give consideration to financial imbalances is because there has been no framework for macroprudential policy.” The speech discusses the progress that the central bank has made in developing a framework for macroprudential regulation.

In passing I would want to add that interest rate policy is probably the third best solution to housing market concerns. The potential for using particular fiscal policy instruments is often overlooked. For example, just as the UK government has tried (somewhat opportunistically) to stimulate the housing market through fiscal means (Help to Buy), these means can also be used to dampen that market. Indeed Goodhart and Baker have argued that Help to Buy can be seen as a macroprudential instrument.

My more substantive point is that a monetary policy of the Swedish kind risks undermining the legitimacy of independent central banks. As regular readers will know, I believe strongly that there are areas of macroeconomics where delegation can be highly beneficial. You only need to look at the influence that misguided, and sometimes crazy, macroeconomic ideas can sometimes have among politicians to see why. On the other hand, delegation potentially undermines the democratic process. There is nothing which says that central bankers, or experts who sit on monetary policy committees, have any particular right to take decisions which can have a substantial impact on people’s lives.

That is one reason why Alesina and Tabellini [2], among others, stress that successful delegation happens when there is a broad consensus on what constitutes sound policy. I think one reason that delegation of monetary policy to central banks has been largely uncontested so far is that this consensus existed for monetary policy. Essentially the task of central banks was to keep inflation low. Of course there is plenty of scope to discuss the details of how this is done, which macroeconomists spend a great of time doing. But the primary task, and the proximate means by which it should be achieved, were clear and commanded near universal support.

For some time the only potentially competing goal was keeping unemployment low: hence the dual mandate in the US. However there was near universal agreement amongst economists that the only sustainable level of unemployment or output that monetary policy should try to achieve was precisely the level that kept inflation stable. If that level of unemployment was too high, then means other than monetary policy should be used to address that problem. Again there are disputes at the margins, particularly when supply or cost-push shocks hit, but little dispute about the basic idea.

The moment central banks start allowing inflation to be persistently below target (with the loss in output that this implies) because of concerns about housing bubbles, this consensus will evaporate. Again Sweden provides a clear example. Lars Svensson, a highly respected academic and a former Deputy Governor of the central bank, has strongly disputed that this policy will achieve the goals it is designed to achieve, and instead suggests that the central bank is violating its mandate. (A good summary is here.) On the more general issue of how much monetary policy should take account of financial risk or housing bubbles there is a wide spectrum of views among economists.   

It is also not difficult to see how reasoned debate could easily escalate into attacks on central bank independence itself. If the central bank begins to be perceived as protecting the interests of the financial sector rather than the public at large, then demands for the government to take back the control of interest rate setting could become difficult to resist (even if the government wanted to resist). I would have no difficulty writing the slogan myself. First the banks created the recession, and now (through the central bank) they want to take away the recovery.

One response to this argument might be that the public would not forgive a central bank that allowed a second financial crisis to develop. I would agree that in the absence of any other remedy interest rate policy should be influenced by the possibility of a financial crisis, as Michael Woodford has demonstrated formally (see this post). So how do you exercise this option of last resort, but still ensure the legitimacy of independent central banks by focusing on the control of inflation? I quite like the arrangement in the UK, where there is a separate Financial Policy Committee (FPC) that works with but is independent of the Monetary Policy Committee (MPC). The FPC, not the MPC, is in charge of macroprudential policy. The knockout to forward guidance that I mentioned above involving financial instability is called by the FPC, and the MPC can then decide whether to act on that call.

Such an arrangement works best if both committees are populated by experts from outside the central bank, and in the case of the FPC those experts are not just current or past bankers. It has the advantage that before the MPC can even begin to consider allowing fears of financial instability to influence its interest rate judgement, the FPC has to in effect say we have exhausted all the other means at our disposal. It would be also good if the FPC was explicit about any micro fiscal issues that might also be involved, just as Bernanke has been explicit about the problems macro fiscal policy has caused him in the last year or so. This institutional arrangement makes it clear that it is for others, and not those who set interest rates, to protect mortgage borrowers from their own potential folly.

[1] See this article by Hans-Werner Sinn for example. To be fair housing is only briefly mentioned there, and the main point seems to involve something else, although what exactly is less clear to me.

[2] Alesina, A. and Tabellini, G. (2007) “Bureaucrats or politicians? Part 1: A single policy task.” American Economic Review 97: 169–179.

      

Leading Macroeconomist Leaves Central Bank

Maybe not the most compelling title for a post, but the news that Lars Svensson is not renewing his term as Deputy Governor of Sweden’s central bank (HT Saroj Bhattarai) will be of great interest to academic macroeconomists. What I want to suggest here is that it should also be of wider interest.

Apart from making major contributions to the discipline, Svensson has also been extremely influential among policymakers, and is often associated with the idea of flexible inflation targeting. (Here is just one example.) It is interesting news because of why he is leaving. He says: "I have failed to find support for a monetary policy that I believe would lead to better performance, with both a higher inflation rate closer to the target of two percent and a lower unemployment rate." He has for some time been fighting a losing battle to persuade his colleagues that current Swedish monetary policy is too deflationary (see for example Britmouse), and he has decided to give up the fight.

Interest rates in Sweden are low, at 1%, but according to Svensson they should have got there faster and should now be even lower. Here is a plot of inflation (blue, left hand scale) and unemployment.

Inflation is currently zero, so well below the 2% target. GDP growth was 1.2% last year. Unemployment rose in the recession, came down a bit, but has begun to rise again. The case for lower interest rates over the last two or more years looks pretty clear.

So why have most of Svensson’s colleagues not been following his advice? Their concern is that low interest rates are encouraging Swedes to borrow too much. Now of course one of the ways monetary stimulus is supposed to work is that it encourages more borrowing, but the worry is that borrowing in Sweden is dangerously high, and could threaten financial stability. There are echoes here of doubts expressed by some members of the Fed (see here and here) and international organisations (Tim Taylor here). However so far these have been just concerns, which do not seem to have had a major impact in preventing expansionary policy. Except in Sweden.

Svensson’s arguments against such concerns are persuasive (pdf), and I find the argument that there are better financial instruments available to deal with these problems particularly strong. However I want to draw a slightly different parallel, with policy at the ECB. At first sight similarities appear slight: although both central banks are resisting a cut in interest rates from low to very low levels, in the Eurozone growth is negative rather than just slow, and inflation is currently only a little below target rather than zero (although the ECB itself expects it to fall to nearly 1%). In addition, the ECB has not focused on financial stability as a reason for not cutting rates. Yet the parallel is this. In both cases we have central banks making decisions that appear to contradict the wisdom of mainstream macroeconomics. So what, you may say, but in both cases the cost is being measured in unnecessary unemployment, and below target inflation. Compute the cost in terms of lost output, and they are the kind of losses that could cost a politician their job. The cost in terms of human misery is greater still. You may be pretty skeptical of the wisdom of macroeconomists, but do you really think that these central bankers know better?