A New Macropolicy Assignment

With central bankers rightly pessimistic about fighting recessions, maybe it is time to give that responsibility to politicians, while keeping central banks in charge of keeping inflation at target.

At the recent Jackson Hole conference of central bankers there seemed to be a general acceptance that central bankers just do not have the tools to effectively fight a new recession. I discussed some of the reasons here. The most familiar is the lower bound for nominal interest rates, but Anna Stansbury and Larry Summers argue that even before we get to the lower bound interest rates may be an ineffective stabilisation tool when they are very low. [1]

This is not a problem specific to this period of time. Most people agree that the natural real interest rate (the real rate at which inflation is stable) has fallen with little sign that this fall will be reversed. That means nominal interest rates are likely to remain low for decades. So its not just this recession where monetary policy is impotent, but every recession in the foreseeable future.

One response is that, as I argued in my earlier piece, central bankers should aim to develop new tools that are effective in recessions. This includes differential interest rates for borrowers and savers, and helicopter money. But for whatever reason central bankers are in no hurry to do this. Instead their current view is that fiscal policy needs to take some of the burden of fighting recessions.

Unfortunately for a variety of reasons many politicians in government have not got the message. In the Eurozone they are stuck with primitive fiscal rules that assume monetary policy can always control demand. In the US and perhaps the UK they think a fiscal stimulus is giving the rich tax breaks, which is perhaps the most ineffective way of stimulating demand.

More generally we have had decades were central banks were responsible for controlling inflation and avoiding downturns, and both politicians and the media (and to some extent economists) will require something more than one Jackson hole conference to shift this expectation. Maybe another recession might do it, but the largest recession since WWII failed to do the job. Part of the problem is that central bankers will try to fight the next recession with ineffective measures like Quantitative Easing, and this appearance of activity will fool too many into thinking they have the problem in hand.

As we saw in the last recession, the danger is not just that politicians will fail to fight a recession, but they may actually do the wrong thing. In their minds and also the minds of most media commentators, the central bank is responsible for controlling demand (and therefore fighting a recession) but politicians are responsible for controlling the deficit. This leads to a perverse response in an economic downturn if monetary policy is ineffective.

Macroeconomists call a simple division of labour between monetary and fiscal policy an assignment. What I call the conventional assignment is that interest rates control demand (and therefore inflation) and politicians control the deficit. I called this assignment conventional because it had become ingrained in the minds of economists, the media and politicians. Right now the conventional assignment is not working in terms of fighting recessions.

If central banks remain conservative in developing new tools, what we need to do is give back to politicians the responsibility for fighting economic downturns. One way of doing that is to take monetary policy away from independent central banks, and give it back to politicians. This would make politicians responsible for avoiding recessions as well as controlling inflation, and they will realise that a fiscal stimulus is a more effective means of doing this than any kind of monetary policy stimulus.

I do not want to rehearse the arguments for or against central bank independence (CBI), but simply note that the popularity of CBI comes from a suspicion that politicians are unreliable when it comes to fighting inflation. And unlike supporters of MMT I see no reason to believe that interest rates chosen by independent central bankers are not effective at moderating periods of excessive inflation.

My suggestion is instead a modified assignment. Central bankers remain responsible for controlling inflation, but politicians become responsible for fighting recessions. That is two different bodies managing the same variable - aggregate demand - but at different parts of the business cycle. Think of it like a car, with independent central bankers as the brake and politicians as the accelerator.

Cars are designed so it is difficult to push the accelerator and brake at the same time. We need something similar for this assignment: some way of coordinating between politicians and central banks so they don’t try to manage demand at the same time. The obvious coordination device is the adoption of a common belief about what the NAIRU is (or something similar to the NAIRU) and a common forecast (as actions will depend on expectations of future states of the economy).

The advantage of this asymmetric assignment is that it makes politicians responsible for tackling recessions, which in turn avoids a mistaken view that in a recession they should be controlling the deficit. In other words it is an assignment that rules out austerity. Any assignment that prevents austerity has to be worth considering.

[1] I will wait to see the paper before commenting on this idea, but there is no theoretical reason why the IS curve should be linear. What we need is some empirical evidence, but unfortunately the microfoundations hegemony means that is thin on the ground.

Political economy assignments

Suppose you have two objectives for monetary policy: financial sector stability and real economy stability. You have two main instruments: interest rates and macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). Should you assign one instrument to one objective (often called an assignment), or try and achieve both goals with both instruments?

As Tony Yates points out, assignments are rarely optimal from a purely macro point of view. Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective. An exception is when one instrument completely dominates the other: then assignment is optimal. An example of this exception in a certain class of model is monetary over fiscal policy as means to achieve real stabilisation, as discussed here and here (less technical discussion here). But this type of result is unusual, and even when you get a result like this for a certain class of models it is not hard to add real world complications that remove the result.

If assignment in the case of real and financial stabilisation is not optimal, does this imply that those setting interest rates should take financial stability into account? It is important to understand what we are talking about here. We are not talking about how financial conditions might influence what interest rates need to be to achieve real stabilisation, which is the kind of issue discussed in this post by Bianca De Paoli for example. Nor is it talking about allowing for risk as I discussed here. Instead it would be saying that institutions like the US Fed should have a triple mandate when setting interest rates, where the third mandate was financial stability. Interest rates could be changed if financial stability was a concern, even if this had no implications for inflation or output. Equivalently, interest rates could move to help financial stability even if this took output and inflation away from target.

However we already have assignments that are clearly suboptimal from a purely macro perspective. Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy. Yet the mainstream consensus is that monetary policy should not be used to reduce debt.

The reason for this suboptimal assignment is most probably because of political economy concerns. Or to put it another way policy is mainly concerned about knowingly sub-optimal decisions. Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.

Can such political economy concerns be applied to financial stability and monetary policy, particularly as the same actor - an independent central bank - is in charge of both? My instinct is that it can, because central bankers are heavily influenced by pressures from the financial sector. As a result, there is a danger that if interest rates are set with both objectives in mind, central bankers will depart from optimal policy and, for example, needlessly raise interest rates before the real economy requires them to rise. The recent experience of Sweden is a clear example where this happened. For this reason I rather like the UK institutional set-up, with a separate MPC and FPC and a clear assignment for each.

Does Monetary Policy make Austerity Irrelevant?

                There are three variations of this question that I have come across in recent posts and comments.

1) If monetary policy had targeted nominal GDP, it could have been successful whatever fiscal policy had been.

2) Even within the context of inflation targeting, Quantitative Easing (QE) allows monetary policy to overcome the problem of the zero lower bound (ZLB) for nominal interest rates. So inadequate demand can be put down to not enough QE.

3) Less austerity would have led to higher inflation, which given the recent behaviour of monetary policy makers  would have led to higher interest rates, leading demand back to where it now is.

On (1), I have said that the possibility of moving to a different monetary target has a lot to commend it, and that this should be discussed much more actively in the UK right now. However I do not think targeting nominal GDP means that the monetary authorities can achieve that target at all points in time. The main way I think it overcomes the zero lower bound (ZLB) for nominal interest rates is by promising to create higher inflation in the future, which is itself a cost. The more austerity reduces current demand, the more inflation we will have in the future to counteract it.

                Argument (2) in effect says that the ZLB does not matter: monetary policy just switches from one instrument to another. I think this is seriously wrong. Although recent studies suggest QE has some effect, everyone I talk to who is involved with monetary policy thinks the uncertainties and limitations of QE are of an order above those of conventional policy. If I had to choose between QE and fiscal policy as a way of regulating demand, I would choose fiscal policy.

                Argument (3) suggests that if we had not had austerity, inflation would have been higher, and monetary policymakers would have raised interest rates. There are two uncertainties here. First, we cannot be sure that if there had been less austerity, inflation would have been significantly higher. In the UK there is a very simple reason for this – part of the additional austerity was to raise VAT. But more generally, what we may be seeing today is that inflation is much less sensitive to the output gap when inflation is low.

Second, we cannot be sure how monetary policy makers would have reacted. As I have argued before, sensible monetary policy targets both inflation and the output gap, so when the latter is large and negative, you should be very tolerant of moderate and temporary excess inflation. You certainly do not appear to ignore the output gap. Unfortunately that is exactly what monetary policy makers did do in the Eurozone in 2011, and I really hope this decision is now regretted by the ECB. In the UK they nearly did the same, and I have discussed this episode at length. So I know what monetary policy should have done if we had had less austerity (not raise interest rates), but I do not know what they would have done.

                So I agree that, if demand was stronger because we had had less austerity and more fiscal stimulus, inflation might have been higher, and interest rates might have increased as a result. However not only am I uncertain about this, but the monetary policy response would have been a policy choice. In this situation, should I say that austerity does not matter? Should I instead blame the monetary authorities for something they might have done, had austerity not happened? This seems a bit odd to me.

                I’m also a bit concerned that all three arguments hark back to a place too many were at before (and even during) the recession, which was to believe macroeconomic stabilisation was only about monetary policy.  Now my own writing and research has been quite supportive of what I call the conventional assignment, under the right conditions. But those conditions do not apply at the ZLB, and they obviously do not apply to members of a currency union. There are also other circumstances where fiscal policy could in principle assist monetary policy in its stabilisation role. This tendency to discount the short term macroeconomic effects of fiscal policy is part of the reason we are in our current situation.