UK monetary policy is too complacent

Economists at the Bank of England and members of the Monetary Policy Committee spend a huge amount of time poring over the details of our current macroeconomic position. There is a danger in all this. The danger is a version of not ‘seeing the wood for the trees’. By focusing in great detail about what you see as the most likely scenario for the UK economy, you begin to think that something similar is the only possible future, and therefore give too little weight to the risks that this scenario is seriously wrong. That is the only way I can explain to myself why the MPC have not yet cut interest rates below 0.5%

The Bank’s central projection is that current deflation is a temporary phenomenon. We all know about oil prices, but this projection also involves a view that core inflation will rise from its current level of 0.8%. Today’s low core inflation may have a lot to do with an appreciation of sterling, which should be temporary. In addition actual deflation means that real wages have begun to rise, which should provide a boost to consumption. This could be enough to offset the impact of any renewed austerity, the impact of sterling’s recent appreciation on the demand for UK produced goods, and any delays in investment caused by the possibility of the UK leaving the EU. I could be convinced that this is the most likely outcome, and that inflation will be back at 2% within two years.

But good policy is not about just focusing on the most likely outcome. It is also about allowing for risks. So step back from the trees and just look at the wood. The most basic thing we know about the UK economy is that output is now something like 15% below where it should be if pre-recession trends had continued. For the UK that pre-recession trend had been remarkably stable. There may be reasons why the last recession should be so different from all other pre-war recessions, but we all know the dangers of convincing ourselves that this time is different. So it is possible that the scope for additional expansion is large. This is real uncertainty, but it is also one sided uncertainty. No one is seriously suggesting the economy is running at 5% above trend, let alone 15%!

Of course we get a rather different picture if we look at employment or unemployment. That is because productivity has stalled since the recession. Again quite unprecedented, and somewhat unbelievable if we are thinking about technical progress - have firms collectively thought of no ways that their production processes could be improved since 2009? Productivity growth in other countries has not been great, but are UK firms (some of which are multinational) incapable of learning from the improvements that have been made by others? We have yet to find a convincing explanation for this ‘productivity puzzle’. There is a serious possibility that, due to falling real wages, firms have simply put off making labour productivity improvements for the moment, but such improvements would come quickly if demand picked up enough (and labour became scarce). Again the risks here seem one-sided.

So there are perfectly sensible reasons to believe that the negative output gap might be much larger than currently estimated. There is no offsetting reasons to believe the output gap is large and positive. If the negative output gap is much larger than currently estimated, the social losses being currently made are huge, even if we forget about the deflation dangers ahead.

One final point. Andy Haldane has published some Bank model simulations which suggest that cutting interest rates now would be optimal, assuming that the Bank’s central projection is correct. So even if we ignore everything above about one sided risks, there is a clear case for cutting rates now. [1]

In these circumstances, the obvious thing to do, as well as the cautious and prudent thing to do, is to cut rates now to cover for the possibility that the output gap is actually much larger than estimated and inflation will therefore not return to target as hoped. The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2% target. If it is not done, there is a non-trivial probability that in 3 years time we will all be asking why on earth the MPC were so complacent. 

[1] I’m not sure if this optimisation exercise takes account of the point made here by Brad DeLong, which is that the existence of the lower bound means that you want to skew policy to avoid hitting that lower bound in the future. This is a rather different asymmetry to the one I explore in this post, but it also points to cutting UK rates now.

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? 

The race to raise interest rates

If you do not like the sporting metaphors in the post below, you can blame new MPC member Andy Haldane whose speech I have just read. Or maybe the World Cup.

When it comes to monetary policy, in recent years the UK has consistently followed the US. The US Fed started reducing interest rates in September 2007, and hit the Zero Lower Bound (ZLB) at the end of 2008. The UK’s MPC started reducing interest rates in October 2008, and hit the ZLB in March 2009. The lag between the two shortened considerably with Quantitative Easing, which the UK started just two months after the US. The MPC also followed the Fed with forward guidance, using a very similar formula.

The big question today for monetary policy in both the US and UK is when interest rates will start to increase. Until very recently this looked like a race that neither central bank was keen to enter, at least for a while. But that all changed last week following a speech by UK Governor Mark Carney. That led Gavyn Davies to ask what implications UK hawkishness might have on the US. It is very easy with such things to get lost in the immediacy of each new data release. In this post I’ll try and focus on the fundamentals.

Both central banks prioritise price inflation. UK inflation remains comfortably below target at 1.5%. US inflation had been in similar territory. The CPI rose by slightly more than 2% in May, but that is more volatile than the measure the Fed targets, so it is too soon to know whether this represents the beginning of a return of inflation to target. The FOMC committee’s latest forecasts indicate that inflation will remain below target for some time.

If the May CPI figure in the US turns out to be a blip, then there appears to be no immediate pressure to raise rates. However interest rate changes take time to feed through to inflation. As a result both central banks would like to start raising rates before rather than after the underlying level of inflation starts to exceed its target. Whether this is a sensible strategy I will discuss later, but it means the focus in both countries is on what determines future price inflation.

Here the UK seems to be in the lead, with stronger GDP growth than in the US. However economies often grow very rapidly when emerging from a deep recession. US growth was strong in 2010, but the Fed did not start raising rates then. The US has been growing at a moderate pace ever since, while the UK economy stagnated in 2011 and 2012. With this perspective, the US has not raised rates even after 5 years of recovery, so it seems odd that the UK should raise rates after just two years.

Economists would normally say that the more relevant measure for inflation is the output gap: an estimate of how much actual GDP is below the level at which inflation would be stable. Here most estimates suggest the UK is ‘winning’: the latest OECD Economic Outlook estimates for 2014 are UK -1% and US -3.1%. Now output gap estimates should normally be taken with a pinch of salt, but for the UK in recent years this pinch has become a spoonful. Most UK estimates assume that the marked decline in UK productivity growth since the recession (the UK ‘productivity puzzle’) is largely permanent. But as no one has any idea about why this decline has happened (hence puzzle), there is no compelling reason to assume it is permanent rather than reversible.

We can make the same point in a very simple way. UK output is currently around the same level as it was in January 2008, while US output is over 6% above its pre-recession peak. This would normally imply that the UK should be following well behind the US in raising rates.

      

What about the labour market? Here is a chart comparing unemployment in both countries.

I have taken the OECD’s latest Economic Outlook forecast for the US, but I have used much more optimistic numbers for the UK: 6.4% for 2014, and 5.7% for 2015. (Unemployment in May was 6.6%.) It is true that for unemployment, the lag between the UK recovery and the US recovery is shorter than for GDP growth. However they seem to be in similar territory at the moment, with unemployment unlikely to return to 2000-2007 numbers by 2015. In addition, there may be more labour market slack than is implied by these numbers, although for different reasons in each country. One final point worth noting is that, with free movement of labour within the EU, any labour market pressure in the UK can be offset by inward migration as long as Eurozone unemployment remains high.

There is no indication of any tightening in the labour market in either economy from data on wages. In the US real wages are stagnant, and wage growth in the UK continues to be below price inflation. In the UK, there is even some doubt whether rising real wages would put that much upward pressure on price inflation. Some part of the UK productivity puzzle must be the result of factor substitution: using labour rather than machines because real wages are low relative to the cost of capital. If that is the case, there is scope to reverse this if real wages start to rise, meaning that wage increases are not fully passed on into prices.   

One area which is often talked about where the UK is well ahead is the housing market, with UK prices rising rapidly. House prices are not part of the consumer prices index, but some argue that they should be. This is problematic conceptually - rents are the price of housing services, and house prices are the price of an asset. As I pointed out here, what we have in the UK at the moment is a rise in house prices relative to rents, which may in turn reflect the combination of falling interest rates and static supply, plus perhaps a bit of froth on top. According to the ONS data, rents have not been rising rapidly since the recession.

As John Williams among many others have emphasised, using interest rates to calm the housing market when inflation is below target has proved disastrous for Sweden and Norway. A housing boom is not a reliable indicator of incipient inflation. The UK should certainly not follow the Scandinavian example in this particular respect. 

Taking all this together, who will be the first to raise rates? My feeling is that US monetary policy makers are on reasonably solid ground, and are not even in their starting blocks. The output gap in the US is sufficiently large that there is little need to start raising rates now. UK monetary policy makers are in a much more difficult place, because of the UK productivity puzzle. The Carney speech has in effect tightened monetary policy by appreciating the exchange rate, as he must have known it would. Before this I had hoped that they would at least wait until real wages started rising significantly, but now I’m less sure. I fear after the Carney speech that they have entered the starting blocks, and any noise might trigger a false start.

The problem for the UK is that the strategy of wanting to start raising rates before inflation exceeds the target is inappropriate given the extreme uncertainties implied by the productivity puzzle. As Mark Thoma explains, and I have argued before, the risks are not symmetric. It would be unfortunate if inflation started rising before interest rates started increasing, but the costs of a few years of excess inflation would not be that great. The MPC has after all been there recently, and the world did not come to an end. The costs of prematurely choking off a recovery are much greater when recent productivity and output losses might be recoverable (as they were in the early 1980s and 1990s). These are very strong grounds for the Bank of England to continue to follow the US Fed, and not jump the gun.  

Postscript: Tony Yates elaborates on this last point, and also has more on the Haldane speech.

Forward Guidance is not Forward Commitment

Some recent discussions I have had with those who follow monetary policy in the UK and US, and indeed some who actually make that policy, suggest deep confusion between forward guidance and forward commitment. By forward commitment I mean a policy of committing to a future stimulus that would raise future output and inflation, in order to assist the current recovery. This is the policy that was first suggested by Paul Krugman for Japan and championed by Michael Woodford in particular. For more background, I discussed a recent paper exploring this policy here.

Why am I so confident that central banks are not undertaking this policy? First, because this policy only works through its influence on expectations. So those undertaking forward commitment have to be completely clear about what they are doing. The more opaque they are about the policy, the less effective it will be, particularly as the policy is time inconsistent. (The central bank has an incentive to change its mind once the recession is over)

Second, there is a defining characteristic of a forward commitment policy that no central bank has so far committed to, and that is to raise output above its natural rate (or equivalently to reduce unemployment below its natural rate) in the future. In short, to create a future boom. So, if that is a defining characteristic of the policy, yet no central bank has committed to do this, then as the policy has to be clear to be effective it must follow that central banks are not following the policy.

So why the confusion? First, I think there is a presumption that central bank communication will always be obscure, and that money can be made from trying to decipher their true intentions. Sometimes that may be true. In those circumstances, statements by certain policymakers that talked positively about a Woodford type policy might be relevant. However for this particular policy clarity is central. To pursue forward commitment yet to be mysterious about doing so is like announcing that you are targeting inflation but not announcing what your inflation target is.

The second source of confusion comes from focusing on inflation. A second feature of the forward commitment policy is that inflation will be above target during the boom (and perhaps before). So some have taken the part of forward guidance that says the central bank will be relaxed about inflation up to 2.5%, when their target is 2%, as indicating forward commitment. Yet that same forward guidance also features unemployment thresholds, which are above the estimated natural rate. [1] That would be a perverse thing to announce as part of forward commitment, because the whole idea is to get future unemployment below its natural rate.

A much more plausible explanation of forward guidance in the UK and US is that it is clarifying the short term trade-off the central bank will allow between inflation and unemployment. That could simply be informing the public about existing policy at a time when shocks might push inflation above target without also pushing output above the natural rate. Alternatively it could be indicating a change in that trade-off - a change in policy. In either case, the framework of that policy is entirely traditional. There is no commitment to engineer a future boom.

If I am right about this, it raises the interesting question of why no central banks during this recession have tried forward commitment. A closely related question is why no central banks have established price level or nominal GDP targets. In the case of the former this is the puzzle addressed in a recent paper by Steve Amber. To quote from the introduction: “Price-level targeting has convincing advantages, especially as a tool for avoiding the worst consequences of economic downturns. Then why haven’t central banks experimented with the regime?” He suggests that central banks are too fond of their current discretion to make this kind of commitment. If I have something interesting to say about this it will be for a future post.

[1] Here is the Fed's discussion of forward guidance. It suggests that it will be "appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent". But at no point does it say it intends to reduce unemployment below the natural rate (between 5% and 6%) in order to raise inflation above target in the future. 

Will the MPC raise UK interest rates in 2014?

Chris Giles of the FT thinks they will. His reason is straightforward: economic growth will continue to outstrip productivity growth, implying unemployment will fall below the MPC’s 7% threshold, and the MPC will worry that inflation will start rising.

While I try an avoid making forecasts (see my first answer to the FT questionnaire here), I would agree that strong growth in 2014 is more than possible. The savings ratio could continue to fall, net trade could pick up and non-residential investment may begin to recover. It would be bad news if this was accompanied by continuing near zero productivity growth, but as we do not know why UK productivity growth has stalled, we cannot rule this out.

Yet if interest rates did rise as a result, it would be extraordinary. To see why, just compare the UK with the US. US GDP began growing strongly at the end of 2009. So the UK is a full three years behind. Yet the US still has interest rates at their zero lower bound, four years after their recovery began, and has only just begun to scale back increases in its quantitative easing programme. (The MPC stopped increasing their programme some time ago.) So if we followed the US, there would be no question of raising rates this year.

The UK has been unusual in the past because of inflation. While US inflation has been at or below target for the past year and a half, it has been above target in the UK for 4 years. Yet the UK inflation rate is now down to 2.1%, despite the recovery in output. So it increasingly looks like high UK inflation in the past was down to a number of temporary factors, which the MPC rightly ignored. This is consistent with other measures of UK inflation, which have been lower throughout.

Now of course if inflation really does look like taking off in 2014, the MPC will raise rates. But what would ‘taking off’ mean precisely. As the MPC focuses on inflation two or so years down the line, I think it would have to mean a sudden tightening in the labour market. Given that unemployment is currently around 7.4%, and averaged 5.25% between 2000 and 2008, and earnings growth is currently running at 0.9% in nominal terms (!), we seem to have a long way to go before anyone could argue the labour market is about to initiate a wage price spiral.

Think of it another way. UK GDP is currently between 15% and 20% below where it would have been if it had followed past trends and there had been no recession. Past trends involved average growth rates of at least 2%. With that historically unprecedented gap, if two years of GDP growth one or two per cent above that past average meant monetary policy had to be tightened, it would mean accepting that something catastrophic and irredeemable had happened to the UK economy. That is why a rate rise this year would be extraordinary.

Now you might say a small increase in UK short term interest rates would still mean that monetary policy was easy, but just a little less so, and so a modest rate rise would be no big deal. The Resolution Foundation would strongly disagree. In a recent report they looked at the impact that various different scenarios for interest rates would have on households. The following chart indicates the key point.

The left hand panel gives the proportion of households paying over 25% of their disposable income in debt repayments (light pink), and over 50% (dark pink). The key point is this. The 2011 proportions are not very different from the average over the previous two decades, despite interest rates being much lower. In other words, we have not seen a wave of defaults and repossessions following the recession because the MPC cut interest rates to the bone. If interest rates rise but real wages do not (because productivity growth continues to stall), then that wave may happen after all. (See the right hand panel.)

As a result, even a small increase in interest rates is likely to have a large impact on at least some parts of the UK economy. The Bank is well aware of this (pdf, HT Pieria), so members of the MPC should not take this action lightly. As I have argued before, given the risks and uncertainties associated with the economy’s current position, it makes much more sense to take risks with inflation than to risk stalling the recovery. But I also thought that in 2011, when GDP growth was flat, and a third of the MPC disagreed, so nothing is for sure.

We can at least be thankful that interest rate decisions are not made by the so called ‘Shadow MPC’, a group set up by the Institute of Economic Affairs. They have been voting since February 2013 to raise interest rates! How can you vote for higher rates before a recovery starts, when it is obvious that there is large scale involuntary unemployment and underemployment? Well back in the 1940s Michal Kalecki had a theory, but then he was a Polish immigrant!

NGDP targets and UK Monetary Policy: Criticism and Reaction

In my presentation to the Bank of England advocating the adoption of NGDP as an intermediate target, I added at the last moment the following slide near the beginning of the talk:

Context

•     UK macroeconomic performance since 2010 has been disastrous, both in comparison to previous recoveries and to the US.
•     I have not seen any remotely persuasive ‘structural’ reasons why this has to be so, but there are some fairly obvious policy related explanations. (Austerity + ZLB + a string of cost-push shocks.)
•     For a policy mistake of this magnitude, it seems unlikely that either fiscal or monetary policy bears sole responsibility. It also seems sensible to ask to what extent the macropolicy regime caused or enabled this mistake.

Understandably this was just a little provocative to an audience of Bank of England economists and some MPC members.

Is this an example of the Rogoff-Krugman dilemma in how to confront policymakers? I suppose I could have said instead that it was mostly fiscal policy’s fault, and that the Bank had done a reasonable job in difficult circumstances, but I just thought they might tweak things a little bit. But if I had done so, this would have been an argument for something like forward guidance, not a more radical change like NGDP targets.

However Bank economists were right to be provoked, because the slide conflates two things: the weak recovery everywhere, and how the UK has performed relative to the US. I should have ignored the latter. As I have previously noted, the difference in productivity growth between the UK and US is substantial, and unlikely to be down to just labour hoarding. Although that post and others have speculated about what is behind that difference (see also below), in truth no one really knows. As a result, using relative UK/US GDP growth performance in a simplistic way to criticise policy is too easy.

That said, I do think that macropolicy has been better in the US than the UK. In terms of monetary policy, I would note the following:

1.        The US was quicker to recognise the severity of the crisis and reduce interest rates
2.        In spring 2011 the UK came close to raising interest rates, while the US did not.
3.        The US introduced forward guidance that countenanced exceeding the inflation target, whereas the UK has yet to do so. (The fact that actual UK inflation has generally exceeded 2% misses the point, because the idea should be to raise inflation expectations as long as unemployment remains high.)
4.        Bernanke has recently been explicit that US austerity means that monetary policy may not be able to meet its goals. Either UK policymakers do not believe that to be true, or they are keeping very quiet about it.

None of these are huge differences. I have argued that the lack of a dual mandate in the UK has been an important contributory factor behind the first three points above, which was the idea behind my last bullet point on the slide, but which rather got lost in debating the second. But perhaps the more basic point, which I should have focused on, is that in both countries the intended output inflation trade-off in this recovery has been wrong. In terms of decisions within the context of their respective mandates, I’m not sure either committee has done better than the other.

So that is one example where the Bank’s criticism would lead me to improve my argument. Another point that I perhaps should have tackled head on is the idea that the UK’s problems start and end with its banks (rather than the Bank).  The story goes something like this. UK banks, unlike US banks, remain undercapitalised, and undercapitalised banks are very reluctant to lend. In additional small and medium sized firms are more reliant on bank finance in the UK than in the US. This might help explain the UK’s poor productivity performance. So far this is believable, although the survey evidence on why firms fail to invest is not that supportive. The argument then goes that if banks are the problem, then changing bank behaviour (rather than raising inflation expectations) is also the solution, and policies like the UK’s FLS are unconventional but appropriate. To put the same point another way, it is the effective interest differential between short rates and bank lending rates that is the problem, and not the zero lower bound.

Unfortunately changing bank behaviour has proved rather difficult. In that situation, it is not the case that the only remedy is to tackle the cause. For example, although fiscal expansion is second best to lower nominal interest rates, when we are at the ZLB it can largely eliminate the impact of incorrect real rates on output with relatively low costs in terms of distortions. Equally expanding demand could offset the impact of risk averse banks on the economy as a whole. Indeed it might even encourage these banks to think rather more optimistically about their loan book.

Those are two specific issues. What about the general reaction to my proposal for establishing a path for NGDP as an intermediate target for policy? On the idea of raising inflation to raise output, this visit reinforced my impression that once you spend a lot of time in central banks, you become infected with the strange belief that while it is quite easy to get inflation expectations to increase, subsequently reducing these higher expectations is much more difficult. I would love to see the evidence or model on which that idea is based. But more generally I think the Bank’s reaction to NGDP targets goes back to where this post started.

My impression from this and other evidence is that the Bank has a form of what I have called ZLB denial: it thinks it can still do its job with unconventional monetary policy.  That in turn must imply that it bears responsibility for intended outcomes, and here I get mixed messages about the output inflation trade-off it is aiming for: maybe it is optimal because the UK output gap is pretty small (but what about all those unemployed and underemployed?), or maybe it is because the inflation target is primary. But either way I get the impression that the Bank thinks that it has done reasonably well in difficult circumstances. With these beliefs, the case for radical change seems underwhelming. 

The UK economy in three charts

It is a measure of the state we are in that the latest quarterly growth number for the UK, at 0.3% (1.2% annual rate) for 2013Q1, should be regarded as a political plus for the Chancellor. [See postscript at end.] So here is the first chart:

This extremely weak growth from a starting point of a deep recession should spell disaster for employment. But it has not, as this second chart from the Bank of England’s February Inflation report shows.

The upside of this incredibly poor productivity performance is that employment has been much more buoyant than the GDP numbers would normally imply. However a moment's thought reveals that this could be really bad news, because it might imply that the recession has led to a permanent reduction in what the UK economy can produce. I say ‘could’ and ‘might’ advisedly, because the reasons for this productivity disaster are almost totally mysterious, as I discuss here. Yet it helps explain why inflation has remained above target, and gives us a reason (although not in my view a justifiable one) why monetary policy has not been more expansionary.

Is this a reason for thinking that in fact policy in the UK has not been too bad, and that really we are suffering from some unexplained malady that the usual medicine (continuous monetary expansion and fiscal stimulus) could do nothing to cure?  So we come to my third chart, which is UK unemployment (source ONS).

Despite strong growth in private sector employment, which with stagnant GDP gives us our second chart, unemployment remains high. Low earnings growth suggests that this level of unemployment is keeping real wages low, so there is no suggestion that this increase since the recession is in any way structural. (The wages Phillips curve in the UK continues to work as normal, with a natural rate way below 8%.) It reflects in part a significant increase in labour force participation (again quite different from the US), but that is no excuse to allow it to remain high.

So policy clearly has not and is not doing enough to expand demand. If it did do much more, with any luck productivity would start growing again and catch up some of the ground it has lost, but even if it does not this third chart shows us that expansion is the right policy. What has been happening instead is that fiscal policy has been working in the opposite direction, contracting demand, and monetary policy has been unwilling or unable to offset this. It is indeed one of the major UK macroeconomic policy errors since the second world war.

Postscript

As an illustration of this sad state, the normally excellent Stephanie Flanders describes 0.3% as "good news". A better description would be pathetic. How can an annualised growth rate of 1.2%, in an economy that pre-crisis had a trend growth rate above 2%, and at the bottom of a deep depression, be described as good news! If you think I'm biased, read John Van Reenen.

The 2013 Budget and UK Monetary Policy

The Budget yesterday included an important update to the remit of the Bank of England’s Monetary Policy Committee (MPC). Depending on who you listen to, this is either an important change that could offer a considerable additional stimulus to the UK economy, or a major disappointment. So which is it?

The document reaffirms flexible inflation targeting, and rejects alternatives such as nominal GDP targets. However the Treasury wants to make it clear to the MPC just how flexible it can be. It can, for example, ‘see through’ (i.e. ignore) any short term increase in inflation for a lot longer than the two years that has so far been part of the MPC’s mantra. It can create ‘intermediate thresholds’ as part of forward guidance. In short, it believes flexible inflation targeting is quite compatible with the MPC doing what the US Fed is currently doing. [1]

I think Britmouse has it exactly right when he writes:

“I see nothing at all in the new remit text which compels the MPC to do anything different to current policy.  It is all about judgement.  Neither did the old remit prevent the MPC from giving forward guidance if they so desired.”

To see why this is important, read the minutes just released of the last MPC meeting, where the committee voted 6 to 3 not to undertake any further Quantitative Easing. In para 27 it sets out the arguments for providing more stimulus, which include:

“inflation expectations were relatively stable; wage growth remained weak; there remained a degree of slack in the economy; and the potentially positive response of supply capacity to increased demand meant that higher output growth would not necessarily lead to any material increase in inflationary pressure”

Which all sounds pretty compelling. But then the next paragraph sets out the reasons for doing nothing, which basically boil down to

“Inflation was above the 2% target and was likely to stay above it for an extended period, and there was a risk that could lead to inflation expectations drifting upwards with adverse consequences for wage and price setting behaviour. Further monetary stimulus might increase that risk. It might also lead to an unwarranted depreciation of sterling if it were misinterpreted as a lack of commitment to maintaining low inflation in the medium term”

In other words, any attempt to use the very flexibility that the Treasury emphasises the MPC has risks a loss in the credibility of the medium term inflation target. So 6 of the 9 member committee decided it was best not take take that risk. I cannot see anything in the new guidance issued by the Treasury yesterday that would have influenced any of the 6 who voted to do nothing to change their minds.

Now I guess the Treasury is hoping that the new governor will persuade some on the committee to vote the other way (although note that the current governor was one of the minority who voted for additional stimulus). But surely the key question is why they need persuading in the first place. Why are possible risks to the credibility of the medium term inflation target allowed to outweigh the current almost 100% certainty that we have chronic demand deficiency which no one else is going to do anything to change. Perhaps a remit that places medium term inflation stability at its core, and says nothing about eliminating demand deficiency, might just have something to do with it. 

[1] In addition, it also believes that flexible inflation targeting allows the MPC to consider deviating from the inflation target if there is a “development of imbalances that the FPC may judge to represent a potential risk to financial stability”.

Bean on Nominal GDP targets

This is the third in a series of posts on NGDP targets. Links to the earlier two are given at the appropriate points in the text.

At last we are getting a Bank of England led debate on alternatives to UK inflation targeting. Charlie Bean gave a speech on Wednesday on nominal GDP (NGDP) targeting which is well worth reading, not just because he is Deputy Governor for Monetary Policy at the Bank (and of course on the MPC), or because he is one of the UK’s top macroeconomists (he was at the LSE before going to the Bank), but also because he is something of a veteran on this issue, having written a chapter of his PhD on the topic.[1]

Charlie quite rightly distinguishes between NGDP growth and NGDP levels targets. On the former, he argues that their superiority over inflation targets in the face of cost-push shocks (shocks to inflation, like increases in VAT) [2] is something of a red herring, because in practice inflation targets are flexible, and central banks have the discretion not to come down too hard on such shocks. That is the party line, which I called into question here.

What is interesting is that he goes on to say that one advantage of NGDP growth targets is that “it might lead to fewer instances where we have to resort to the use of our ‘constrained discretion’ to justify a temporary acceptance of inflation away from the target”. I think that may be a subtle way of saying that the MPC has felt inhibited from exercising this discretion in the recent past, and as a result it has not pushed stimulus measures as hard as it might over the last few years, and indeed on one occasion came close to raising interest rates. I’m also glad to see that the MPC are now forecasting inflation above 2% in two years time, yet they are also moving towards more QE, which suggests their appetite for discretion has returned. Perhaps what Charlie is saying here is that he did not vote in favour of more QE last month because he still felt constrained by the inflation target.


On NGDP levels targets, Charlie shows some simulations of a toy New Keynesian model which illustrate the advantages of NGDP level targets when interest rates hit the zero lower bound (ZLB). The model assumes that there are no alternative monetary policy instruments. Similar pictures can be found in Eggertsson and Woodford.[3] Here I cannot help repeating a point I have made before. While NGDP targets get close to the optimal monetary policy, they still mean any demand shock has a significant negative impact on output and inflation while interest rates are at the ZLB. Expansionary fiscal policy still has an important role to play, and austerity will make things much worse.

I want to make one final point, which I do not think is mentioned often enough. Levels targets (for prices, or NGDP) are not just advantageous when we hit the ZLB. In the lectures I have just finished to second year undergraduates, I go through a little numerical example of how monetary policy might deal with a one-off cost-push shock (perhaps an increase in VAT), assuming for simplicity that monetary policy has perfect control over the output gap. Crucially inflation is forward looking (the Phillips curve is New Keynesian), and current inflation depends on inflation expected next period. If policy can only act in the same period as the cost-push shock (the ‘first period’), it reduces the output gap to get the best trade-off between higher inflation and lower output. However, I show the students that if monetary policymakers can also change output in the next period (the second period), they will lower output in that period as well. This will generate negative inflation in that second period, but bad though this is in itself, the anticipation of it reduces inflation further when the cost-push shock hits in the first period. If policy does it right, and expectations anticipate policy and its impact, by reducing output  in both periods it can improve welfare compared to the case when it only acts in the first period.

Now I present this as an example of the problem of time inconsistency. By promising to reduce output in the second period, we get a better outcome. But once we get to that second period, the policymaker or the public may ask why do we need to actually go through with the plan? It was beneficial to promise to reduce future output and inflation when the shock hit, but now the shock is over it would be better still to do nothing. If the policymaker changes their policy as a result, then of course a rational public will anticipate this, and we will not get the benefits in the first period, because these benefits come through expectations effects. So to overcome this time inconsistency problem, we need some device to commit the policymaker to stick to the plan.

Although that is the main point, I also ask the students to note what happens to the price level in either policy. With the time inconsistent policy where output and inflation is reduced in the second period, the price level we end up with is a lot closer to its original level than the case where policy only acted in the first period. But why stop in period 1? Policy could also promise to reduce output a little bit in the third period as well, and so on, and that would indeed be the optimal thing to do (although it remains time inconsistent). If we were to compute that fully optimal policy, we would find that the price level would end up where it started. (The proof is not that difficult - maybe I’ll put it in the lectures next year.)

The implication is interesting. If the central bank had a price level target, and it had discretion about how quickly to achieve it, then it could implement the optimal, time inconsistent policy. The central bank would be committed to that policy, because it had to bring the price level back to its original level. A levels target can act as a commitment device. (The is an example of a general point I made here.) It uses the same principles as the ZLB case, but it applies even when interest rates are in no danger of hitting that ZLB. (A good paper to read on this is by David Vestin, but the point will also be familiar to students of Michael Woodford.)

So the case for levels targets (often called history dependent targets) is stronger than the particular issue of hitting the ZLB. However it depends crucially on the idea that agents are forward looking. Replace this New Keynesian Phillips curve with something more old fashioned and ‘backward looking’ in this particular example, and price level targets would just involve additional costs with no benefits. Other models would give different results (see, for example, a well known paper by Svensson [4].) However I think it is reasonable to make the following generalisation: this particular attraction of levels targets (of which NGDP levels targets are an example) depends crucially on how forward looking we think agents really are.


 
[1] Bean, C.R. (1983). ‘Targeting nominal income: an appraisal.’ Economic Journal, vol. 93, (December), pp. 806-19.
[2] In the face of such shocks, the central bank can only reduce their impact on inflation by reducing output. A strict inflation target means you ignore the output costs of reducing inflation, whereas a nominal income target will mean you have a chance at getting nearer the optimal trade-off between lower output and inflation.
[3] Gauti B. Eggertsson & Michael Woodford, 2003. "Optimal Monetary Policy in a Liquidity Trap," NBER Working Papers 9968
[4] Svensson, Lars E.O. (1999) “Price-Level Targeting versus Inflation Targeting: A Free Lunch?” Journal of Money, Credit, and Banking, vol. 31, no. 3, pp. 277-95.

Carney and the Treasury Select Committee: Episode One Preview

The new Governor of the Bank of England, Mark Carney, will appear before the Treasury Select Committee for the first time tomorrow. The Committee asked for evidence that could help them with their questioning, and I obliged with the short note reproduced below, which also provides a useful summary of my current views on UK monetary policy which have otherwise been scattered around various posts. However the new Governor’s first appearance might also be an appropriate point to say something about central bank communication in the era of the Zero Lower Bound (ZLB).

Consider the following alternative things Dr Carney might say:

1) At the ZLB there is really nothing more we can do. We have tried QE, which may have helped at the margins, but decreasing returns have clearly set in, and basically monetary policy is now a spent force.

2) The ZLB means we have to do things differently, but we are still able to achieve the goals set for us using a variety of unconventional policies. The instruments have changed, and everything is more uncertain, but otherwise its business as usual.

I’m sure the first statement will never be made, but I think there is a clear danger that something like the second message will be the one conveyed. I know there are some who think, perhaps with the right choice of target, that the second statement is true, but I do not think it is. The following would I believe be the right thing to say:

3) At the ZLB there are still actions that the monetary authorities can take to try and stimulate demand. However there may be limits to this ability, which means that monetary policy can no longer ensure that the output gap falls to zero and that we hit our inflation target. This needs to be understood when other policy decisions are taken.

It is the right thing to say not only because it is nearer the truth, but also because it is the best way to protect central bank independence in the long run.

I was also going to say something on helicopter money, prompted by the following from a leader in the FT today:

“Demand stimulus by helicopter money need not be more inflationary than other types. It could be less so, since by definition it does not come with a built-in expectation of future reversal through tax rises (unlike public borrowing) or monetary tightening (unlike quantitative easing).”

However I realise it requires a whole post to cover all the reasons why this makes no sense, so here is my piece for the select committee, in which no helicopters appear.

1. Monetary policy has two objectives: to stabilise inflation at an acceptable level, and to try to eliminate any output gaps. As a result, academic work on monetary policy has two ultimate goals for monetary policy: to minimise excess inflation and to minimise the output gap. Views about the relative importance of these two objectives vary, and our knowledge here is very partial, but both objectives matter.

2. The current UK monetary policy regime places one of these objectives - targeting inflation - above the output stabilisation objective. This is in contrast to the regime in the United States, which has a ‘dual mandate’, which essentially corresponds to the two objectives outlined above. So why have in the past most macroeconomists, including myself, been relatively content with focusing on inflation as the primary policy objective?

3.  The most important reason was that these inflation targets were interpreted in a flexible manner. (The regime is often called flexible inflation targeting.) Specifically the Bank of England has interpreted this flexibility as trying to hit the inflation target in two years time. The general view was that over this kind of time frame, hitting the inflation target would be consistent with closing the output gap. So although minimising the output gap was not a primary policy objective, that objective would be fulfilled under flexible inflation targeting. The theory behind this view is that inflation is ultimately determined by a Phillips curve, which implies inflation will only be stable in the long run if the output gap is zero.

4. Recent UK experience has unfortunately shown that view to be seriously incomplete. Inflation has been persistently above target, yet output is well below its sustainable level.[1] The MPC has currently set policy to achieve the inflation target in two years time, but it does not expect the output gap to come near to being closed in two years time. So the inflation objective is overriding the output gap objective.

5. There are probably two reasons why we now have a conflict between hitting the inflation target and closing the output gap. The first could be called bad luck. The UK economy has been hit by a series of positive inflation shocks: a large depreciation with lagged effects, increasing commodity prices, and increases in certain government charges and taxes. The second is more fundamental and also more a matter of conjecture. When inflation is low, high unemployment appears to have a smaller downward influence than when inflation is higher. One obvious reason for this is that workers are particularly resistant to nominal wage cuts.

6. Whatever the causes, there is now a clear conflict between what a sensible UK monetary policy would be doing and what is actually happening. Monetary policy is not providing enough stimulus to the UK economy, because it is focusing on the inflation target, and not the output gap. Inflation targeting in the UK is not working, and something needs to change.

7. Some commentators suggest that a change in personalities may be sufficient to deal with this problem. I think this is quite wrong. It is clear to me that the MPC takes the Bank’s interpretation of inflation targeting very seriously. It was put very well by Adam Posen in his recent (22nd Jan 2013) evidence to this Committee: “anyone who was on the [MPC] basically took the equivalent, in my opinion, of an oath of office. They were serving on the committee under the terms of the given inflation target.” Posen was generally a ‘dove’, not because he wanted inflation above the target, but because he thought inflation would come down more quickly than others.

8. For this reason, I do not think the MPC would be able to do what the US Fed is currently doing with monetary policy. The Fed has said that they are willing to see inflation go (a little) above their 2% target in order to get unemployment down. I believe the MPC would regard that as violating their remit. It would be useful if the Committee could see if the new Governor takes a different view.

9. If I am right, some change (or official reinterpretation) in the UK monetary regime has to take place. There appear to be three types of change that could be explored: moving to a dual mandate, looking at other measures of inflation, or getting rid of the inflation target completely.

10. Perhaps the most straightforward change would be to make monetary policy in the UK more like policy in the US, by adding an output gap or unemployment objective alongside the inflation target. It would not be necessary, and given current uncertainties it would not be desirable, to specify a particular number for unemployment or output. Instead the MPC could be charged with ensuring output was at a level consistent with long run inflation stability, or some similar phrase. The risk that this change would lead us back to the 1970s is zero. What this change would enable the MPC to do is allow inflation to be above target in 2 years time if they expected the output gap to persist.

11. Another possibility would be to stay with an inflation target, but to broaden the range of inflation measures that were looked at. There is no reason from economic theory why consumer price inflation is the ‘right’ inflation measure to target, and other measures (like output prices, or wage inflation) may be at least as relevant. Unfortunately the series of positive inflation shocks the UK has recently experienced have their maximum impact on consumer prices. Monetary policy in the UK would now be very different if the inflation target was for earnings growth - and there is no reason in terms of the macroeconomics why it should not be.

12. Both these suggestions have one apparent disadvantage: we lose the simplicity and clarity of a single target. By specifying more than one target, and not specifying the trade-off the MPC should use when the targets conflict, we are leaving more to the discretion of the MPC. However, such a regime would still give less discretion to the MPC than monetary policymakers in the US or Eurozone currently have. The targets would still be set by the Chancellor.

13. The third alternative is to replace a single inflation target by a single target for something else. Targets for nominal GDP have been widely canvassed. It is absolutely vital that here a clear distinction is made between targets for nominal GDP growth, and targets for the level or path of nominal GDP. It is the latter that many economists have recently suggested might offer some clear advantages over inflation targets, and which were discussed in a recent speech by the new Governor.

14. As some eminent macroeconomists, like Michael Woodford, have been arguing for the advantages of such ‘history dependent’ targets for some time (well before the recession), a debate on their merits is overdue. Although this issue is widely discussed in the US, we have very little discussion in the UK. This may be because the natural host for such a discussion would be the Bank, but the Bank has felt that it would be inappropriate for it to question its own remit. I hope the new Governor does not take that view, and it would be useful for the Committee to ask him about this. If the Bank, under its new Governor, still felt it inappropriate for it to lead a discussion on the merits or otherwise of NGDP targets, then the Committee itself should think about undertaking this role.

15. While I would welcome an extensive discussion of this type, it would be unfortunate if that debate put on hold any change in UK monetary policy. As I have argued above, policy is providing insufficient stimulus to the UK economy now, because of the form of the current monetary policy regime. Changes could and should be made to that regime now, without in any way prejudicing the results of a more extensive debate on NGDP targets. That is why I think it is important to address the possibility of moving to a dual mandate, or looking at alternative inflation measures.  

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[1] Macroeconomists use almost as many names for this sustainable level as there are estimates for its magnitude (natural rate, NAIRU, natural level, output potential...), but unless anyone wants to suggest that none of those currently unemployed are capable of working, there can be no doubt that UK output is currently below this level.