A comment on Kocherlakota's suggestions for clarifying monetary policy objectives

In a recent speech (HT MT), Narayana Kocherlakota (who helps set US interest rates) makes two suggestions to clarify what US monetary policy is trying to do. The first I completely agree with. The Fed should make clear that the 2% inflation target is symmetrical. Inflation at 1% is just as much of a problem as inflation at 3%. We only need to look at the Eurozone to see the dangers of asymmetry (which in their case is explicit).

His second suggestion is that the Fed should articulate a “benchmark two-year time horizon for returning inflation to the 2 percent goal.” You can see why Kocherlakota is suggesting this change, particularly in the current context. A target which is only going to be achieved in the indefinite long term may cease to have value. However applying the two year benchmark to just the inflation target may create inappropriate pressures in different circumstances.

The UK’s Monetary Policy Committee operated until quite recently what appeared to be exactly this two year benchmark. As evidence for this, here is a chart of the Bank’s own forecast for inflation two years ahead. (The dates refer to when the forecast was made.) The inflation target was 2.5% until 2003, and 2% thereafter.

Until the Great Recession, the forecast was generally pretty close to the target. Since then, the dates on which inflation two years ahead was expected to be below target roughly correspond to dates on which the Quantitative Easing (QE) programme was expanded. (More details in this post.)

The problem with this strategy emerged in 2011. As a result of the delayed impact of the 2008 depreciation in Sterling, increases in sales taxes (VAT) and higher commodity prices, actual inflation briefly exceeded 5% in 2011. As a result, in 2011 the MPC came pretty close to following the Eurozone in increasing interest rates. (For a number of months, 3 MPC members voted to raise rates, and the remaining 6 voted for no change.) A major concern of those who voted for higher rates was that inflation would not fall back to 2% within 2 years, and that as a result the credibility of the inflation target would be damaged.

So the 2 year time horizon came close to having a very damaging impact in the UK. (Arguably it did cause some damage, because it inhibited additional QE.) Now it is of course true that the combination of cost-push shocks experienced by the UK during that period was unusual, but even if rules allow for opt-outs in exceptional circumstances, they can nevertheless exert inappropriate pressure in those circumstances. Arguably the 2013 paper issued by the UK Treasury on monetary policy was at heart a message to the Bank to no longer apply the two year ahead rule.

Luckily there is a simple way of avoiding this danger, by making a small addition to Kocherlakota's suggestion. This is to apply the two year time horizon to both the inflation target and the output gap. I can see no convincing argument why the two year horizon should not be applied to both elements of the dual mandate. The problem in the UK arose partly because the UK does not have a dual mandate. If it had had this dual mandate, and the two year horizon had applied to both elements of the mandate, then the pressure to raise interest rates in 2011 would have been much less. (Few expected the UK output gap to close by 2013, even without interest rate increases.)

There is a more general argument that is completely independent of what happened in the UK. Whatever the intention, if the two year horizon is applied to only one element of the dual mandate, there is a danger that it appears to give priority to that element over the other. So my own opinion, for what it is worth, is that Kocherlakota's suggestions are a good idea, as long as the two year time horizon benchmark is applied to both parts of the dual mandate.    

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”.