Should we worry about temporarily raising government debt? - Blanchard’s AEA Address

This post not about the main part of this address, although as its my area and interesting I may write about it later. Instead I’m going to talk in a non-technical way about its premise, because that alone has implications that may be well known among economists but not elsewhere. The following is based on his presentation.

Should governments worry about temporarily paying for things by borrowing? One standard answer is yes, because although nothing obliges government to pay off this extra debt (it can be rolled over), it has to pay interest on that debt which requires higher taxes. If the government didn’t raise taxes to pay the interest on the debt, but instead just borrowed more to pay the interest, you would enter what is sometimes called a debt interest spiral, where debt goes up and up and eventually explodes.

But does a slow explosion in debt matter if the economy is also growing? A government (like a firm of individual) should look at debt as a ratio to its ability to pay, and the easiest way to do that is to look at the debt to GDP ratio. A company would not worry about increasing debt if its profits were rising even faster. For a given stock of debt, its growth rate is given by the rate of interest on the debt. So GDP rises faster than debt if its nominal growth rate (real growth plus inflation) is greater than the rate of interest on that debt. In shorthand, g > r.

Typically economists like me tend to assume that this is not true, and instead r > g. But the starting point for Blanchard’s lecture is that currently, and on average in the past, g > r. There has been only one decade since the 1950s when this hasn’t been true, and that is the 1980s when governments were pushing up interest rates to bring inflation down. Most of the time g > r. So the fact that g > r today may be the rule and not an exception.

Why do economists typically assume r > g when the opposite has generally been true? One answer is called financial repression, which is a label given to attempts by governments in the past to keep interest rates ‘artificially low’ in conjunction with various credit controls. The idea was that in a financially liberalised world where interest rates are used by central banks to target inflation there will be no financial repression, and real interest rates will be higher. So it made sense, the argument went, to assume r > g from now on even though g > r in the past. However what economists call secular stagnation suggests that the average interest rate required to keep inflation constant has actually been steadily falling, so Blanchard’s findings become relevant again. There is plenty of scope here for more research and debate.

So if normally g > r, does this mean we do not need to worry about debt? Not quite. What it means is that one of the standard objections to raising debt, which is that taxes will have to rise to pay the interest, no longer holds if g > r. If g > r the government can borrow to pay the interest, and yet the debt to GDP ratio will still gradually decline, because the economy is growing faster than debt. The objection to raising debt that taxes will have to rise in the future to pay for it disappears. Indeed the whole ‘burden on future generations’ objection to raising debt falls away, because the debt to GDP ratio declines by itself: there is no future burden.

An important proviso, however, is that we are talking about one-off increases in debt. Such one off increases would include, for example, increases in debt to build new public infrastructure or increases in debt caused by fiscal expansions to fight a recession. g>r does not mean we do not need to worry about persistent primary deficits (by which I mean spending permanently higher than taxes). A persistent primary deficit will add to the growth in debt, so the debt to GDP ratio will rise despite g > r.

This is just the starting point for Blanchard’s lecture, and if you are an economist I recommend watching it as it is very easy to follow. In policy terms I think it is the last nail in the coffin of what Paul Krugman calls the deficit scolds. Those who argued for austerity because of the burden on future generation, although on weak ground even if r > g, find their argument collapses if g > r. [1]

[1] Blanchard shows this remains true even if there are periodic shocks where r > g, as long as on average g > r.

How China beat the Global Financial Crisis

If you were hoping for something on yesterday’s interest rate rise, I can only direct you to the leader in the FT today which says: “There is no compelling reason to increase the cost of borrowing in the UK, but there is definitely good cause to wait.” On why nine intelligent people could all make the same mistake, you have to question their mandate, and move to something that focuses on having the right environment for growth, as I do here.

I recently finished reading the latest book by Adam Tooze (of which much more in a subsequent post), and it reminded me of a story that was not told enough in the early days of austerity. Everyone knows about how quickly the Chinese economy has grown over the last few decades, and how strong exports have been an important part of that. In dollar terms the value of Chinese exports more than quadrupled between 2000 and 2007. By 2007 Chinese exports represented 35% of GDP.

An important characteristic of the Global Financial Crisis (GFC) was how quickly world trade collapsed. If we compare the beginnings of Great Recession after the GFC with the start of the Great Depression, while world industrial production moved in a similar fashion, world trade collapsed by much more in the Great Recession than the Great Depression. Here is a chart from Barry Eichengreen and Kevin O'Rourke’s ‘A Tale of Two Depressions Redux’ VoxEU article.

Trade collapsed in the winter of 2008 around the globe, without exception. This was very bad news for China. Whereas exports had been around 35% of GDP in 2007, they fell to around 25% of GDP in 2009. That is a big hole to fill, and if it wasn’t filled, there was a chance that Chinese growth would collapse completely with damaging knock on (multiplier) effects to the rest of the economy. Above all else, China feared the political consequences of the unrest widespread unemployment would bring.

As Tooze recounts, China’s reaction was swift and bold. In November 2008 it announced a stimulus package of public spending worth 12.5% of GDP. (The Obama stimulus package, by comparison, was around 5% of GDP.) “Over the days that followed [the announcement], across China, provincial party meetings were hurriedly convened …” Within a year 50% of the stimulus projects were underway. Some of this stimulus paid for what Tooze describes as “perhaps the most spectacular infrastructure project of the last generation anywhere in the world”, the Chinese high speed rail network. Monetary policy was also relaxed.

In 2008 as a whole, before the stimulus and hardly touched by the collapse in world trade, Chinese GDP grew by 9.6%. In 2009, when GDP in the advanced countries fell by 3.4%, Chinese growth was 9.1%. The stimulus package had filled the whole left by collapsing Chinese exports. (Source)

Basic macroeconomic theory says that a negative shock to GDP, caused for example by falling exports, can be completely offset by a monetary and fiscal stimulus. China is a good example of that idea in action. What about all the naysayers who predicted financial disaster if this was done? Well there was a mini-crisis in China half a dozen years later, but it is hard to connect it back to stimulus spending and it had little impact on Chinese growth. What about the huge burden on future generations that such stimulus spending would create? Thanks to that programme, China now has a high speed rail network and is a global leader in railway construction.

Now of course people will say that China is not like an advanced democracy, and it was not part of the global banking network that caused the GFC. But the US and UK stimulus programmes could and should have been larger. Those close to the action tell me that the UK was running out of things to spend more money on in 2008/9, but I cannot help think this amounts to a failure of imagination: it is not as if UK infrastructure is great, there are no flood defence projects left to do etc. Above all else China’s example tells you what a huge mistake 2010 austerity was.

A short guide to why we should not raise UK interest rates

Everyone expects the MPC to raise rates on Thursday. This would be a mistake. Discussion about interest rate changes in the press normally involve large amounts of data and charts about the state of the economy. Here I want to do the opposite: to present the minimum you need to know to understand that raising UK rates right now is the wrong thing to do.

Everyone should know that UK inflation is currently around 3% because of the Brexit depreciation. But because the impact of a deprecation on price inflation is temporary if wage inflation remains flat, the Bank said they would ignore this temporary rise. The key is to look at whether average earnings inflation is responding to higher consumer price inflation. The answer is they are not: average earnings growth has been slightly above 2% all this year, which is a little lower than the average for 2016.

But what about unemployment being at a 42 year low? Surely that means earnings growth is just waiting to kick off. The first point is that unemployment is not currently a good measure of labour market slack. A better measure is the Resolution Foundation’s underemployment index, which is still above levels before the global financial crisis. And before you say but that was a boom period, it wasn’t. UK core inflation was below 2% throughout, and earnings growth was consistent with this.

The other thing to say is that it is quite wrong to assume that we know what the level of labour market slack is that would lead to increases in earnings growth (what economists call the NAIRU). The NAIRU moves over time. As just one example of why it might move, a labour force that rents is likely to be more mobile than one that owns a house, and so the trend towards renting should reduce the NAIRU.

So looking at the labour market, there is no sign that we are close to a level where earnings inflation might pick up. And that is pretty well a precondition for inflation to exceed its target of 2% over the medium term. That is all you really need to know. If you want to know why the MPC probably will raise rates, read on.

What I suspect the Bank are worrying about is that Brexit has created what economists call a negative supply shock. In particular, both investment and productivity growth are much lower than the Bank were expecting before Brexit. They will point to various survey measures which show firms do not have any spare capacity. But this reasoning I think indicates a conceptual weakness.

Firms have two responses to lack of capacity: raising prices or investment. By choking off demand and raising rates when firms run out of capacity the Bank will discourage investment, and right now what the economy desperately needs is more investment and the productivity improvements that brings with it. The Bank shouldn’t worry about a bit of inflation that might come with higher investment, because 2% earnings growth is an anchor that will prevent inflation deviating from target for any length of time.

That should be enough, but there are two other reasons why the Bank should not raise rates. First, right now the downside risk on the demand side from Brexit surely exceeds the upside risk. Second, as the OBR chart here shows (look at orange bars), after a pause in 2017 austerity is planned to return in 2018 and 2019. Combining fiscal and monetary tightening in a boom would make sense, but we are currently in an economic downturn, with GDP per head growing this year at a third of its average pace since the recession of 2009. [1]

Finally, it is always important to consider risks. Suppose earnings growth does pick up sharply just after the MPC’s monthly meeting. The Bank always says it wants to be ‘ahead of the curve’, to avoid too rapid an increase in rates. This is the mentality that has led inflation to undershoot in the US and Eurozone since the recession, and if you take out the impact of depreciations by looking at the GDP deflator the same is true for the UK. The problem for the UK economy since the recession has not been too much inflation, but far too little demand.

[1] Specifically, average growth in 2017 is 0.1% per quarter, and averaging quarterly growth rates from 2010 Q1 to 2016 Q4 gives 0.3% per quarter          

A Labour run on Sterling?

The news that John McDonnell was looking at a scenario where the election of a Labour government was met with a run on Sterling was all over the news yesterday. The Conservatives, who of course know all about runs on Sterling having created one just a year ago with the Brexit vote, immediately grasped the political gift they had been given.

Paranoia on the left meets prejudice on the right. But what would really happen to Sterling if Labour were to win the next election? Given announced policies, the answer is quite clear: Sterling would appreciate. The main reason is that under Labour there would be a large fiscal expansion: for certain in term of public investment and to a lesser extent with current spending. (I assume by then interest rates will be above their ZLB: if they are not, the fiscal expansion could be even larger.) There would also be a balanced budget fiscal expansion: even if government spending increases are financed by tax increases, this is likely to be expansionary to some extent because some of the tax will come out of savings.

This fiscal expansion, together perhaps with other labour market measures, would put upward pressure on inflation, prompting higher interest rates from the Monetary Policy Committee of the Bank of England. It is the prospect of those higher interest rates that would make Sterling appreciate. How much inflation rather than output would rise depends on how pessimistic you are about the supply side. If the MPC were doing their job properly, that increase in interest rates plus the appreciation would stop inflation rising very much. We will finally get the rebalancing between monetary and fiscal policy that we should have had for the last decade.

If we are also in a transition period for Brexit, with the final destination unclear, then Labour being elected would also lead to an appreciation because Labour are softer on Brexit than the Conservatives.

So where does the run on Sterling idea come from? The idea that all those traders in currency will get together and engineer one because they do not like a Labour government is nonsense. They may not like a Labour government, but they dislike losing money even more. Capital flight? You might see the share price of power or rail companies fall, but that is not going to be enough to move a currency like sterling. Any depreciation in sterling would be the equivalent of pound notes waiting to be picked up in the City and Wall Street: with higher expected interest rates and a likely future appreciation, who wouldn’t buy sterling?

The only way I can see that you could get a run on Sterling is if enough traders in the markets came to believe that Labour was going to abolish BoE independence because it wanted to keep interest rates low. In that case you could get significantly higher inflation under Labour, which would justify a nominal Sterling depreciation.

Which, of course, is why McDonnell committed to keeping Bank of England independence as one of the first things he did. And which is also why he was very foolish to say what he said, because it might lead some to speculate that he might renege on that commitment. Something tells me he is missing his Economic Advisory Council.

Productivity and monetary policy

The Bank are warning of imminent rises in interest rates. As Chris Giles points out, we have been here before, and before that, but that shouldn’t mean we should dismiss this talk, because one day it will happen. [1] They (the MPC) certainly sound serious. But why when current growth is so slow are they even contemplating it? Here is a clue from Mark Carney’s latest speech (my italics).

“On the supply side, the process of leaving the EU is beginning to be felt. Brexit-related uncertainties are causing some companies to delay decisions about building capacity and entering new markets. Prolonged low investment will restrain growth in the capital stock and increases in productivity. Indeed, if the MPC’s current forecast comes to pass, the level of investment in 2020 is expected to be 20% below the level which the MPC had projected just before the referendum. Net migration has also fallen by 25% since the Referendum.

As a result of these factors and the general weakness in UK productivity growth since the global financial crisis, the supply capacity of the UK economy is likely to expand at only modest rates in coming years.”

When people, like me, say how can the Bank be thinking of raising rates when demand is so weak, the response from the Bank would be that supply has been at least as weak.

This pessimism about the supply side comes straight from the data. If I hear people talking about the UK being a ‘strong economy’, I know they either have not seen this chart or are just lying.

UK Output per hour, whole economy (ONS)

The red line is a trend that pretty well matches the trend in the data until the end of 2007, with the amount you can produce with an hours worth of labour increasing by 2.2% a year. Since the global financial crisis (GFC) there has been almost no growth at all. If you want to know the main reason real wages have stopped increasing, this is it. [2]

I hear some people say this is just oil and financial services. It is not, as this table from a recent Andy Haldane speech shows.

Start at the bottom: total average growth has been non-existent since the crisis. The rest of the table looks at the contribution of each sector to that total. To see what productivity growth would be excluding financial services, just add that figure to the total: 1.8% 1998-2008, 0.4% 2009-2016. That table makes it clear that the productivity crisis is economy wide.

It is worth looking at aggregate productivity since the GFC period in more detail (same data). I often hear people say the productivity slowdown started before the GFC. From the chart below, it clearly did not. (We have just seen the tenth anniversary of Northern Rock going bust, and the UK productivity slowdown started shortly after that event.)

We could describe this data as five phases. 1) Productivity in the recession fell, as it often does in a recession for various reasons. 2) As the economy begins to grow again, so did productivity growth. 3) As it becomes clear, in 2011, that the ‘recovery’ is going to be very weak because of austerity, productivity growth stops growing. 4) By the end of 2013, with stronger growth under way (although still no catch up to previous trends, so not a true recovery) productivity starts growing again, although rather slowly. 5) Since the 2015 election, with the prospect and then the reality of Brexit, even that modest growth disappears. (My data does not include 2017Q2, which saw a very slight fall.) I could shorten the description as follows: recession, modest optimism, pessimism, even more modest optimism, uncertainty.

That is my gloss on the numbers, but I’ve done it to make a point. Productivity growth invariably requires an investment of some kind. It may not be physical investment, but just training someone up to be able to use some new software. Whether a firm incurs that cost will depend, in part, on their expectations about the future. There is a regrettable tendency in macro (I blame RBC theory) to treat productivity growth as manna from heaven. But the idea that potential improvements in technology stopped after the GFC, and just in the UK, is simply ridiculous. The problem is that firms are not investing in new technology. What I call the ‘innovations gap’ has emerged in the UK because of weak growth and the consequent pessimistic expectations of most firms. [3]

The idea that the economy could get itself in a low growth expectations trap is increasingly being put forward by economists: here is George Evans, for example. The UK has got itself into that trap because on the two occasions that a recovery of sorts appeared to be under way, the economy has been hit with terrible policy errors (austerity and Brexit). But the idea that UK firms are incapable of upgrading their production techniques is nonsense. They will do so initially if they can be confident that the demand for their products will increase, or subsequently when the innovation pays for itself even though demand is flat.

Which is why an increase in interest rates right now would be very bad news. It would confirm the pessimistic expectations of most firms that demand is not going to grow fast enough to make innovation worthwhile. Formally, the job of the MPC is not to worry about productivity but to control inflation. But elsewhere, where the same process may be happening to a lesser extent (the productivity slowdown is worldwide, just most acute in the UK), central banks are puzzled at why inflation just refuses to rise. 

The concept of an innovations gap is one solution to that puzzle. Expanding demand allows firms to invest in more productive techniques, and so there is less incentive to choke of demand by raising prices. I suspect in an alternative world where Brexit had not happened the Bank of England would also be puzzling over why prices were not rising. As a result, if the MPC do finally raise interest rates this year, it would be one more mistake to add to the growing list under the heading Brexit.

[1] On each occasion I also wrote a post saying that they should not raise rates, starting I think at the beginning of 2014.

[2] I discussed in earlier posts why real wages are falling by even more than output per head.

[3] Or perhaps the pessimism of the bank manager lending money to those firms. The Haldane speech shows that productivity growth has remained strong among the top, frontier companies. Why? Because these companies, given their position, will be seeing growth relative to the average, and have got to the frontier through a culture of innovation.

Two related confusions about helicopter money

Confusions about helicopter money is something of a generic title (although Martin Sandbu is thankfully not confused). Because a discussion of helicopter money (HM) cannot normally be found in the textbooks (which have only just caught up with central bank independence), the scope for misunderstanding is huge. Here I want to talk about two related confusions. The first is about whether HM would lead to an increase or decrease in nominal interest rates, as discussed in a recent interchange between Tony Yates and Paul Krugman. The second is whether HM is in competition with the use of fiscal policy to get us out of recessions.  

On HM money and nominal interest rates, there is of course the standard and very basic point that in a market you cannot control both quantity and price, still less move them in opposing directions. So if we want to think about a market for money, you cannot raise the supply of money and raise its price - the nominal interest rate - at the same time.

But this observation ignores what else is going on when you have HM. HM is a large fiscal expansion. Please none of this ‘but if Ricardian Equivalence (RE) holds’: we are talking real world policy here not doing thought experiments, and we have all the evidence we need that RE does not hold (for reasons that are not difficult to understand). Let's also not fall into the trap of doing IS-LM. We are in a world of inflation targeting, and anything that raises demand (as a fiscal expansion will) will tend to raise inflation, and so the monetary authorities will tend to raise nominal interest rates. Any temptation to say ‘yes but in the short run’ becomes dubious because of expectations effects. 

So it is really quite simple. Either the nominal interest rate lower bound constraint continues to bite, which means helicopter money will leave nominal interest rates unchanged (but the economy better off), or there is no constraint (or that constraint is removed), in which case rates will rise (sooner) with HM.

The second confusion is that helicopter money in some way precludes undertaking countercyclical fiscal policy. It does not. Right now, for example, governments could and should announce large increases in public sector investment (where I am using investment in the economist’s sense to include investment in human capital, rather than in a national accounts sense). This would negate any immediate need for HM. Monetary policy adapts to fiscal policy.

When people ask me which we should have, helicopters or fiscal expansion, I'm tempted to say I would love to have the choice! If I did have that choice, right now I would take additional public investment over a helicopter drop, because the micro case for investment is in many cases (and countries) very strong, interest rates are low and investment improves the supply as well as the demand side. In any future severe recession where the interest rate lower bound was likely to be hit [1] I would also advise bringing forward public investment. However I do not see this as a competition (countercyclical fiscal action vs HM) for two reasons.

First, one lesson of the Great Recession is that we cannot rely on governments to do the right thing with fiscal actions, so HM is an insurance policy in that sense. If governments do spend more or tax less as we approach the ZLB, that insurance policy may not be needed. [2] Second, even if governments do the right thing, either lack of good projects [3] or information delays may mean they do not do enough, and so the very quick action that central banks could take with HM could be a useful complement. To put it another way, helicopter money is best seen as an alternative to QE rather than as an alternative to fiscal action.

[1] Because of implementation lags, a fiscal response to an impending deep recession should not wait until nominal interest rates actually hit their lower bound. If that fiscal response involves investment, used in an economists rather than national accounts sense, then there is no great loss if the deep recession does not happen, because it is wise to invest when real interest rates and wages are relatively low.

[2] In the proposals put forward in Portes and Wren-Lewis (2015), the central bank would directly tell the government the probability of the lower bound being hit.

[3] I think the argument that the amount of public investment cannot be adjusted to match macro conditions is often overstated. We are not talking HS2 here (the proposal to build a high speed train line between London and Birmingham and beyond), but improving flood defences, repairing roads and schools etc.

More on UK interest and exchange rates

A lot of stuff written on UK interest rates reasons as follows. Many estimates of the UK’s output gap - the difference between actual output and the level of output that is consistent with steady (domestically generated) inflation - suggest it is almost zero. That cannot be consistent with nominal short term interest rates as low as 0.5%. Therefore a rise in interest rates is long overdue.

This ignores the rest of the world. Although the OECD estimate that the UK output gap in 2015 is zero, they also estimate it is nearly -2% for the OECD as a whole and nearly 3% for the Euro area. That means the UK is selling less goods abroad. For the UK output gap to be zero, we therefore need some other element of UK aggregate demand to take up the slack created by low exports. It is not government spending, which is going in the opposite direction. So it is consumers and firms that have to be encouraged to borrow more and save less. To put it another way, they need to be encouraged to shift spending from the future to the present. That means lower than normal UK real interest rates.

It is still true that monetary policy should be easier in the Eurozone than in the UK, but with active QE it already is. The fact that markets expect UK interest rates to rise well before those in the Eurozone intensifies the exports problem, because it means that exports are being hit not just by low demand but also by becoming less competitive as sterling appreciates against the Euro. [1]

The problem of low demand for UK exports would be made worse still if, as I suspect, sterling is overvalued even after you allow for differences in expected interest rates. Philip Lane, soon to become governor of the Irish central bank, has produced an interesting analysis of the recent deterioration in the UK current account. He concludes that “financial engineering may have played some role”. I suspect he is right, mainly because he is a renowned expert on these matters. However I wanted to stress that my arguments about overvaluation owed nothing to this recent deterioration.

The UK’s trade balance deficit has remained large and fairly constant for many years, despite the depreciation around 2008. That was not offset by investment income, even before the recent deterioration, which is why we have been running current account deficits for over 15 years. There may be good reasons why some countries run deficits for a long period of time, but it is not obvious whether any of these reasons apply to the UK, and those deficits in themselves mean that the equilibrium exchange rate will be depreciating alongside those deficits.

So we should not expect UK real interest rates to return to their ‘normal’ level until output gaps are closed in the rest of the world. We should also note that the Bank thinks that the normal or natural level of real interest rates is much less than it has been in the past (secular stagnation). Finally with inflation currently low, low real interest rates imply low nominal rates. All this would be true even if you were certain that the current UK output gap was zero, which I am not.

[1] Using UIP, the current real exchange rate is determined by the medium term equilibrium rate (calculated at zero output gaps everywhere) plus expected real interest rate differentials.

More (dark) thoughts on interest rates

The following has numbers for the UK, but the logic if not the numbers also apply to the US: see Mark Thoma here.

Imagine the following lottery. If you win, you receive a total of £5000 over the next few years. The cost of a ticket? The risk that inflation will be 0.5% higher than it would otherwise have been for a couple of years, where inflation includes the rate that wages increase.

To enter the lottery in the UK you need to cut interest rates. This lottery is just another way of describing the key argument I made in Monday’s Independent article (now complete with chart).

Of course you want to know the odds of getting the prize. The odds come in the form of a puzzle. What are the chances that the economy has, over the last ten years, permanently lost 15% of its normal ability to produce goods and services. Something that has probably never happened to the UK before. [1] Those are the chances of you NOT winning.

We can of course discuss those numbers. But in the UK that discussion appears largely absent. Instead all the talk is about interest rate increases. We seem to have collectively written off 15% of national GDP with just a shrug. ‘Oh that must be supply and there is nothing conventional macro policy can do’ is the general view. That view may be right, but it is important enough that this should be the centre of the national debate. Instead we talk about the need to normalise interest rates, as if the real economy was doing just fine.

Time for a DeLong type lament. If you had told me ten years ago that a decade hence UK output per head would be 15% below the 1955-2008 trend, inflation was zero and yet people would be talking about raising interest rates I would have said you were mad. If you had said that at a time when interest rates and real wages are at record lows the government was proposing to not invest for the future because that was the best way to prepare for the next crisis I would have said you knew nothing about business and economics. If you had said that just years after a huge financial crisis, followed by a host of financial scandals, the City regulator would be sacked because the Chancellor wanted less tough regulation I would have said you were thinking about some corrupt state and not the UK. If this is all a bad dream, what will it take to wake people up?

[1] Economies do appear to suffer some permanent loss to potential output after financial crises: there is a handy summary of studies here (table 4.1) - HT Andrew Goodwin   

The UK as a test case for NGDP targets

In an article in the Independent today, I argue that it is about time the Bank of England changed UK interest rates. But they should go down, not up. The essence of the argument is there remains a significant risk that we have substantial deficient demand. Even if the probability of this is below 50%, if it is true the costs of it persisting far outweigh the costs of some mild inflation overshooting.

One point I do not consider in the article are the implications for nominal GDP (NGDP) targeting. Here is the picture.

I use nominal GDP per head, because that is robust to changes in migration flows, which for the UK have been important and variable. The serious arguments are for a levels target, so I’ve drawn in a reference path for 4.25% growth. That is a combination of 2% output price inflation and 2.25% real growth per head, the latter being the 1955-2008 average rate.

If the Bank of England had adopted a NGDP target, as many have recommended, the MPC would be tearing their collective hair out right now trying to stimulate the economy. There would be zero talk of interest rate increases. So there seem to be just two possibilities. Either NGDP targeting is nuts, or monetary policy has slowly gone off the rails by focusing on CPI inflation alone.

Time will tell. But if the possibility that the UK could really grow quite fast right now without inflation getting out of control turns out to be true (and the argument I make in the Independent is just that there is a non-trivial possibility that it might be true), what will history say? I suspect they will talk about Goodhart’s law, which says “when a measure becomes a target, it ceases to be a good measure”. Targeting inflation and ignoring output seemed like a good idea, because of what is called the divine coincidence. I talked about this in what I think is one of my better posts. Goodhart’s law applied to this case says CPI inflation ceases to be a good indicator of both the state of the economy and maybe also the costs of inflation when you try using it as a target.

Sticky wages both sides of the Atlantic

At the beginning of last year, there were many who were predicting a rise in UK interest rates in 2014. By then UK unemployment had been falling for many months, and we had had four quarters of solid growth. However I said that if rates did rise in 2014 it would be extraordinary. One of the reasons I gave was that there was absolutely no sign of any increase in nominal wage inflation. I thought it would be particularly odd if UK rates rose before US rates, given that the UK’s recovery was lagging a few years.

Unemployment continued to fall rapidly. By June 2014 even the Bank’s governor, Mark Carney, was giving indications that rates might rise sooner than some were expecting. US monetary policymakers showed no signs that they were about to raise rates, and I still thought they should be the first to move, but I was worried that the MPC was sounding too itchy. Sure enough in August two MPC members voted to raise rates. But wage inflation showed no signs of increasing.

Move forward to March 2015, and the prospect of rate increases seem to be receding on both sides of the Atlantic. On Wednesday the FOMC revised down their forecasts for inflation, and also revised down their estimate for the natural rate of unemployment. The reason is straightforward: despite continuing falls in unemployment, wage inflation refuses to budge. John Komlos argues that this state of affairs is unlikely to change anytime soon.

Much the same seems to be true in the UK, as this excellent account from Andy Haldane makes clear. In the UK there is an additional twist. To quote Haldane: “Back in 2009, the MPC’s judgement was that the benefits of cutting rates below 0.5% were probably outweighed by their costs, in terms of the negative impact on financial sector resilience and lending. With the financial sector now stronger, the MPC judges there may be greater scope to cut rates below 0.5%.” It now looks like the Zero Lower Bound (ZLB) may actually be zero.

Haldane goes through in great detail the possible reasons why wage inflation seems so sticky. Moving to the monetary policy implications, he talks about asymmetries, and many of the issues that I raised here he also raises. However he ends with something that I think is even more telling. The chart below shows an optimal interest rate path, using the Bank’s COMPASS model, and assuming a ZLB of zero.

What it does is confirm a suspicion that both Tony Yates and I had about the MPC’s current stance. The policy of doing nothing, and waiting for the inflation rate to gradually converge towards 2%, does not look optimal even if the Bank’s forecast is completely correct. 

Monetary policymakers as boyfriends

An MP who is a member of the Treasury Select Committee has described the Bank of England as an unreliable boyfriend: “one day hot, one day cold". City economists make similar complaints. The same is frequently said in the US about supposed Fed communication failures. Are these complaints justified?

In judging whether a central bank is really ‘blowing hot and cold’, we need to distinguish between public information about the economy on the one hand, and how policymakers will behave given new information on the other (in technical terms, their ‘reactions functions’). If you start flirting with your boyfriend’s best mate, you should not be surprised if he starts going a little cold. If, on the other hand, he had been attentive and considerate until the World Cup started, since when you have been completely ignored, you have probably learnt something about him that you did not know before.

The problem is that we cannot know for sure how each MPC or FOMC member will react to new bits of data as they emerge. So when Mark Carney in his Mansion House speech said “There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced.” he could have just been reflecting the fact that recent data had been surprisingly strong. As everyone had seen this data, there was no useful additional information in that statement.

However he went on to say “It could happen sooner than markets currently expect.” The intent of that statement is clear. For some reason markets had not reacted to this recent data (and therefore advanced their expectations about when the first rate increase would occur) in the way Mark Carney or the MPC as a whole had done. So they had got the Bank’s reaction function wrong, and Carney was telling them so.

This is why the market reacted strongly to Carney’s speech, and Carney intended them to do so. The trick was to reference something tangible - the market’s forecast for when interest rates were likely to rise. But this raises an obvious question. If part of the Bank’s communications strategy is to make comments about market forecasts of interest rates, wouldn’t it be both clearer and more efficient to have the Bank’s own forecast about interest rates. This is a point that ex-Bank economist Tony Yates makes here.

I have argued for this for some time (e.g. here, para 105), and was therefore enthusiastic when the Fed started to publish rate forecasts just after I started this blog. The idea is obviously not to commit the central bank to some path: a forecast is a forecast. Nor is the idea that the central bank somehow knows more about the data than the market, or that its ability to forecast is better. What publishing a forecast allows the market to do is get a better idea of character of their ‘boyfriend’. (It also allows the public to check that their boyfriend is not being time inconsistent, as I also explain here.)

It is only a matter of time before the Bank of England does this, and continues in its tradition of following the Fed. One interesting question of detail remains, however. Should the Bank publish a single forecast, or follow the Fed and publish the forecasts of each MPC member? (I give an example of the FOMC ‘blue dots’ in this post.) There are arguments for both. The Bank publishes a forecast for inflation and other aspects of the economy, but only on the basis of market guesses of future rates. It would be much more efficient and informative to publish forecasts based on the Bank’s best guess about the future path of interest rates.

The problem with having just one forecast is illustrated by the Carney speech. Was Carney at the time giving his view, or the view of the MPC? If the latter, how unanimous was that view? If subsequently a member of the MPC says something different, is that consistent with the majority view or a change? This problem becomes particularly acute when new MPC members replace old. Questions such as these can only be answered if individual MPC members give their own personal forecasts, as FOMC members currently do but with, in addition, their names attached.

When it comes to monetary policy, we have not one but many ‘boyfriends’. Now boyfriends can get annoyed if you keep asking them ‘what are you thinking’, but in this case we do rely on them (and pay them) rather a lot, so I think we are entitled to know.