Expectations driven liquidity traps

For macroeconomists

This is my own take on the idea of expectations driven liquidity traps (as opposed to liquidity traps where the natural real interest rate is low and unobtainable). I note some of the literature that has promoted these thoughts at the end, but I am not trying to summarise what these papers actually say, but rather to give my own thinking on how such a trap could arise. The usual health warning on such occasions applies: if you think I have got something wrong, or missed something important from the literature, please let me know.

Consider the diagram below, which represents the simplest possible model. Real interest rates are always constant, which is the 45 degree line. Monetary policy follows the Taylor principle, but nominal rates cannot go below zero, so the bold monetary policy line kinks. There is one ‘locally stable’ equilibrium at the inflation target (let us call that the ‘intended’ equilibrium), and one ‘indeterminate’ equilibrium when we are at the ZLB (which involves negative inflation).

It is often said that the intended equilibrium is ‘globally unstable’. (Michael Woodford in Interest and Prices  - page 123 onwards - talks about global ‘multiplicity of equilibria’.) By this is meant that, in the absence of imposing an endpoint constraint that has to be met, there are infinitely many rational expectations solutions to the model, many of which involve inflation exploding. I trace one: if we start at A, the monetary authority raises nominal interest rates, but for constant real rates that must mean that expected inflation next period is even higher etc etc.

John Cochrane says: “Transversality conditions can rule out real explosions, but not nominal explosions.” As a result, he suggests, we cannot rule out travelling along this unstable path. After all, hyperinflations do occur. I am less worried about this. Hyperinflations occur when monetary policy makes no attempt to stabilise inflation. Here we have a model where everyone understands it does, so it makes sense to impose an endpoint on any dynamic path. 

For example, what happens when interest rates and inflation go up when we are at A. Do agents say to themselves ‘hyperinflation here we come’. Of course not. This is inconsistent with the model, which involves an inflation target. They say instead ‘that was unexpected - we must have got something wrong’. We only travel along the unstable path for as long as agents do not revise their ‘beliefs’ (in this case, expectations about the inflation target and the real interest rate). Once they revise their beliefs, whether it is their belief about the inflation target or the real interest rate, inflation is likely to fall towards the intended steady state. [1]

Note that we cannot just say - suppose we start at A, as if history put us there. History does not put us there: in this forward looking model history is irrelevant. Given the Taylor principle, there are only two reasons we could be at A within the context of this model: agents get the real interest rate wrong, or the inflation target wrong. Once we allow beliefs to be revised, it seems inconceivable that hyperinflations would occur within the context of this model.

In looking at how beliefs change we are applying a simple notion of learning. The fact that learning helps stabilise inflation around the intended steady state should not be surprising, because what we are in effect doing is adding some backward dynamics into the model. A locally stable steady state with forward looking dynamics will tend to flip to a stable steady state with backward dynamics. This property is helpful, because we probably do not know the mixture of backward and forward looking dynamics we have in the real world, so it is good that policies should be robust to this.

A consumer has to eventually get on to their stable saddlepath because it is stupid for them to accumulate infinite wealth and stupid for others to carry on lending them more and more (no Ponzi games). But things in this model are not so very different - all we are saying here is that we are working with a model in which we rule out hyperinflation because that is a stupid thing for central banks to allow. But unlike the consumer case, it is not impossible that central banks could allow it, which is why we sometimes see hyperinflation. [2]

If we start off with inflation below the inflation target, then we can apply a symmetrical argument. Nominal interest rates will fall. This is inconsistent with agents’ beliefs, so if they revise these beliefs it seems likely that inflation will rise rather than carry on falling. But suppose they do not revise their beliefs. In that case we do not shoot off to hyper negative inflation. This path will converge on the ZLB steady state. This steady state is not ‘locally stable’, but ‘indeterminate’.

Indeterminacy means that the model does nothing to tie down the initial point. We could start anywhere below the intended steady state, and a solution of the model would get us to the indeterminate steady state. While this may sound desirable, it is not, because we normally want the model to give us a unique dynamic path. With a forward looking model where history does not matter we need something to give us our starting point. Often indeterminate steady states flip to unstable points if we change from forward looking to backward looking dynamics.

This is where the desirability of the Taylor principle comes from. If we replace the Taylor rule plus the Taylor principle by a constant nominal interest rate that passes through the intended steady state, then the fact that this steady state would be indeterminate is conventionally seen as a very strong argument against constant nominal interest rate policies. The ZLB is just a particular constant interest rate policy.

To put this point another way, recall that in this purely forward looking model history is irrelevant. We cannot say ‘history means we start somewhere, and then we converge to the indeterminate steady state’. Now incorrect beliefs could start us anywhere, but beliefs are not completely independent of the model and subsequent dynamic paths. All along the approach to the ZLB equilibrium, events are contradicting those initial beliefs.

However, it may be as unrealistic to assume beliefs are continually revised as it is to assume they are never revised. Suppose beliefs are not revised for some time, and the initial belief involves an inflation target which is below the actual target. Inflation is below target, which leads to interest rates falling, which if real rates are constant implies still lower inflation next period. If beliefs do not get revised, we do not go to hyper disinflation, but to the ZLB steady state. Suppose agents only revise their beliefs once they get close to the ZLB steady state. What will happen then?

Recall that originally agents thought that the inflation target was a bit below the actual target (1% rather than 2%, say). Inflation has now fallen much further (to -3%, say). Is it possible that they might conclude that they originally overestimated the true inflation target? If they ignored the fact that the ZLB is a constraint, they might decide that current stability implied that the inflation target was -3%. The central bank cannot demonstrate that this is incorrect by lowering nominal rates, because of the ZLB. This is why this situation is very different from the hyperinflation case.

In a model this simple, we have stretched credibility a bit to get us to a point where we stay at the ZLB steady state. Agents ignore all the observations on the path towards that position, each of which was inconsistent with a -3% inflation target. But if you add in additional uncertainty, allowing the real interest rate to temporarily change for example, things get more complicated. Agents could interpret falling nominal rates when inflation was 1% as being due to temporarily lower real interest rates.

So for a time, at least, we could stay at the ZLB steady state because of ‘self-fulfilling’ but mistaken expectations. If we allow real interest rates to change, then at some point real interest rates will rise and agents will recognise this. Instead of nominal rates rising (as they should if the inflation target was -3%), they will stay at zero, which should make agents revise their belief about the inflation target. So the ZLB steady state remains transitory. But we could stay stuck in the ZLB steady state because of mistaken beliefs for some time: for as long as beliefs remain unchanged or no information arrives that makes them change.

Does this story of an expectation driven liquidity trap fit the evidence better than stories based on an unobtainable negative natural real rate? Or is it instead just a cute (‘liberating’) theoretical construct with zero application. I think it is difficult to argue that something like this applies today to countries like the US or UK. Expectations of inflation are still positive, and central bank inflation targets are clearly positive and pretty credible. (The concept of pessimistic beliefs, or animal spirits, might well be more applicable in the context of other models with different unobservable variables.)

However, if we take the idea seriously at all, it does suggest that one-sided inflation targets are dangerous. Central banks that have a target of 2% or less invite speculation that they would settle for zero inflation if that came around, which would make falling into an expectations driven liquidity trap that much easier. Perhaps the major economy where the central bank’s intentions towards inflation have been least clear, and therefore the potential for an expectations driven liquidity trap greatest, has been (until very recently) Japan.

Some literature:

Benhabib, J, and Farmer, R (2000) ‘Indeterminacy and Sunspots in Macroeconomics’ , in John

Taylor and Michael Woodford (eds.): Handbook of Macroeconomics, North Holland.

Benhabib, J, Schmitt-Grohe, S and Uribe, M (2002) ‘Avoiding Liquidity Traps’, Journal

of Political Economy 110(3), pp. 535–563. (pdf)

Cochrane, John, 2011, “Determinacy and Identification with Taylor Rules”, Journal of Political Economy 119(3), pp. 565–615. (pdf)

Farmer, R (2012a) “Confidence, Crashes and Animal Spirits,” Economic Journal, Vol. 122, No. 559, Pages, 155-172

Mertens, K and Ravn, M (2012) ‘Fiscal Policy in an expectations driven liquidity trap’ (pdf)

[1] With asset market bubbles, we can get the rather interesting possibility that we continue to travel along the explosive path, not because expectations of the fundamentals are wrong, but because agents think they can make money along that path but get out before the bubble bursts. However, this does not seem to apply to inflation and monetary policy.

[2] Of course it is not completely impossible that some people are misers or get away with Ponzi schemes, which illustrates the point that the difference in rationale for imposing end point conditions in each case is not that great.

Cameron, austerity and what other people did not say

The Prime Minister said this on BBC Breakfast yesterday about forward guidance:

"But I think what is good about what Mark Carney is saying is that he is effectively saying look, the Government is doing the right thing by taking difficult decisions to get the deficit down and therefore we can have an aggressive monetary policy until unemployment falls even further."

Now perhaps I have missed something, but I can find no instance where Mark Carney either said or implied that “the Government is doing the right thing by taking difficult decisions to get the deficit down”. All I did see was his strenuous efforts to avoid saying anything about fiscal policy, in line with his previous practice (ignore the headline, just read the quotes).

Was there something in the Inflation Report? You will find on page 22 this

“The IFS estimates that the additional fiscal tightening each year is equivalent to around 1% of nominal GDP on average from 2008/09 to 2017/18, and the pace of consolidation is planned to be broadly similar in 2013/14 to that in 2012/13. Although it is difficult to know what would have happened in its absence, the consolidation is likely to have weighed on output growth over the past three years and will continue to do so.”

Carefully chosen words, but no hint of “the Government is doing the right thing”. Now if the UK was in the same position as the US, with inflation below target, then this ‘weight on output growth’ could well prompt the Governor to say that fiscal policy was making the MPC’s life more difficult. In the UK, however, it appears that it is inflation rather than (maybe?) the (perceived?) inadequacy of monetary policy instruments which is restraining further monetary stimulus.

However, in the February 2013 report you will find an interesting analysis of the impact of government decisions on inflation. In a box on page 36, there is a discussion of the impact of administered and regulated prices (prices either directly or indirectly set as a result of government or regulatory decisions). To quote: “The likely contribution of administered and regulated prices to CPI inflation in 2013 and 2014, at around 1 percentage point, is about ½ percentage point higher than its average between 1997 and 2006.” Over half of this ½ percentage point is due to higher student tuition fees brought in by this government. Not helpful when you are trying to target 2% inflation.

On the basis of this, maybe I could just about get away with claiming that the Bank is ‘effectively’ saying the government’s fiscal decisions are making it more difficult for the MPC to do its job. There is just no way that I could get away with claiming that the Bank, or this Governor, said “the Government is doing the right thing by taking difficult decisions to get the deficit down”.

You may remember that the Prime Minister has form when it comes to putting words into other people’s mouths. Both he and Osborne were fond of claiming that the OBR in some way supported the government’s austerity programme, and that austerity was not harming growth, until it became too much for the OBR to stomach, and Robert Chote wrote the Prime Minister a rebuke (see my before and after posts, and a forecast of mine that was - happily - immediately proved wrong). That episode clearly has not led the Prime Minister to kick the habit, perhaps because he is sure he can get away with it this time. But it says something about the confidence the government has in its policy, when it has to make up the support for it.  

Bringing economics back into fiscal policymaking

Today around the world the dominant framework for making fiscal policy decisions is personal finance for the overextended household. The state is like an individual who has borrowed too much, and so it must cut back on its borrowing. It is as if the basic insights of macroeconomics (let alone the more sophisticated analysis of the last 20 years) never took place. To take just one example: John Quiggin describes the success story of how Australia dealt with the Great Recession, which included a large fiscal stimulus, yet the politicians that helped achieve that success are now on the defensive because the budget is not in surplus.

As I argued in a recent post, what we have here is a combination of two things. First a strong political force that wants deficit reduction to be the focus of policy because it sees this as a useful way of reducing the size of the state. Second, public perceptions that try and understand events in terms of what they know: their own borrowing and spending decisions. So the need for immediate austerity becomes the dominant policy almost everywhere. I get frustrated sometimes that some colleagues, naturally concerned about the details of academic debate, cannot see the bigger picture here. The bigger picture is the marginalisation of our discipline - used when it suits a particular political purpose, but ignored otherwise. If policymakers and the pundits just pick up economic ideas when its suits them, and when the analysis or facts do not suit them just make stuff up (examples from US and UK), economic analysis just becomes fodder for speech writers. That reduces the discipline to an academic game, and soon those same people will ask: why are we paying people just to play games?

So how do we get macroeconomics back into fiscal policy making? First, we need to sort between politicians and political parties that are quite happy with the current state of affairs, and those who are not. Those who are not need to fight fire with fire, replacing one bit of homespun thinking with another which gets us closer to how policy should be made. One way of doing that is to replace the ‘state as an overextended household’ idea with the ‘state as an innovative firm’.

In terms of the sorting, in many cases that is pretty easy. Let’s take the example of the coalition partners in the current UK government: the Liberal Democrats. Now some might simply use guilt by association, but I prefer to be charitable. Perhaps they were bounced into supporting austerity by events in 2010 and advice they received from certain quarters. As the 2015 election comes nearer, the LibDems are trying to differentiate themselves from the Conservatives on many issues, and they do have a reputation for progressive thinking.

So have a look (pdf, page 37) at the key motion on the economy to be discussed at their September conference. It has Nick Clegg’s name on it, so we can assume it reflects the leadership’s thinking. It starts thus:

“Conference welcomes recent improvements in the UK economy, specifically that: 

I. Faced with the highest budget deficit in post-war history in 2010 as a consequence of the banking crisis and Labour’s mismanagement, the Government has managed to reduce the structural deficit by a third since it came to power.”

Point number two then talks about recent GDP growth figures. So the best thing that has happened to the UK economy recently has been that the deficit has come down. The message seems clear: reduction of the budget deficit is the number one priority and all else has to be subsumed to that.

Now you might in Clegg’s defense say that he has to put it this way, as he has been part of a government which has made deficit reduction the overriding priority. I think that is simply wrong. He could say instead that the focus on deficit reduction was appropriate given all the uncertainty as the Eurozone crisis broke. However now it is clear that this was a crisis specific to the Eurozone, and with interest rates on UK borrowing really low and likely to stay there, the UK can make reducing unemployment the priority, while still of course operating a prudent fiscal policy in the longer term. In other words, he could begin to de-prioritise deficit reduction. The fact that he chooses to do the complete opposite suggests he is content to see fiscal policy as an extension of household financial management. We will see in September whether the Party as a whole is happy to follow its leader in ignoring 80 years of macroeconomic analysis.

So how do politicians that do want to bring macroeconomics back into fiscal policymaking start to change the public debate? Knowing that the intellectual case for austerity is crumbling is reassuring, but it is not enough to make these politicians feel confident in challenging the dominant narrative. They need an alternative narrative, and a good one is the idea of investing when borrowing is cheap. In the UK the argument that there are plenty of useful infrastructure projects for the public sector to undertake has already been conceded by the government, and as Uwe Reinhardt points out here, it is also an easy argument to make in the US. So all that is needed is to see the state like a firm that decides to undertake these investments by borrowing when borrowing is cheap and there is plenty of spare labour to complete them.

As Martin Wolf wrote over a year ago: “Not only the economy, but the government itself is virtually certain to be better off if it undertook such investments and if it were to do its accounting in a rational way. No sane institution analyses its decisions on the basis of cash flows, annual borrowings and its debt stock. Yet government is the longest-lived agent in the economy. This does not even deserve the label primitive. It is simply ridiculous.” I think ‘borrowing to invest when borrowing is cheap’ is a message that can resonate with the public, which is why I suspect David Cameron described those pushing the idea as ‘dangerous voices’.

The MPC’s Forward Guidance

So, as expected, the MPC (pdf) is catching-up with the Fed, in introducing forward guidance that looks very similar. There are two notable differences: the unemployment threshold is 7%, rather than 6.5%, and there is a caveat (which the MPC calls a ‘knockout’) about financial stability as well as a caveat about inflation expectations. The MPC has also committed to not cut back on its QE purchases as well as not raise interest rates until unemployment falls below 7%, provided expectations of inflation do not exceed 2.5% and these caveats/knockouts do not apply.

We should be grateful for small mercies. This does clearly show that the MPC is not targeting 2% inflation two years ahead regardless, which I have argued it seems to have been doing recently. It focuses on unemployment, which does at least marginalise the idea that there is currently no spare capacity in the economy. In addition, by saying they do not currently expect unemployment to fall below 7% before mid-2016, they have provided a forecast of interest rates of sorts. The 7% unemployment figure is not a guess at the NAIRU, but just an upper threshold, and there is no commitment to raise rates if unemployment goes below 7%. To those in the Bank, where the regime has hardly changed since 1997, all this will seem like a big deal, even if to outsiders it seems less radical.

Yet this remains a very weak recovery, as the new Governor concedes. Although the Bank has raised its forecast for future growth, it is still a fairly pathetic 2.4% in two years time. The choice of 7% for the unemployment threshold is very conservative: UK unemployment did not go above 6% from 2000 to 2008. A ‘knockout‘ of 2.5% for expected inflation may copy the Fed, but given how high UK inflation has been recently, it is arguably more conservative - and anyway pretty low. I am not surprised by any of these things, because Carney had to get every member of the MPC to sign up to this, and so the numbers were always going to reflect the position of its more conservative members.

One additional thing has become clearer. By saying that, even with this new guidance, they do not expect unemployment to fall below 7% until 2016, the MPC has made it more transparent how prolonged this recession is going to be. Only two conclusions can follow: either high inflation is preventing the MPC from doing something about this, or they do not think they have any effective instruments left. If the first is true, that should focus discussion on whether consumer price inflation should be allowed to be such a tight constraint on growth. If the second, then why not turn to a proven instrument for stimulating demand?  

Is it possible to raise the inflation target?

This post is not about whether raising the inflation target is a good idea or not. Instead I want you to imagine that, after much analysis, a clear majority of the macroeconomics profession decided that it was a good idea. This post is about imperfections in representative democracy and what policy design can do about it, so I need you to go along with me in this thought experiment. You should be able to, for whatever your views on the optimal inflation target, you must be able to imagine the possibility that - for example - the frequency of ZLB episodes and their costs meant that a higher inflation target became optimal. [1]

Like many economics seminars these days, before I get a chance to talk about this you could raise another objection. Has Japan not shown that it is possible to raise the inflation target? Of course it has, but think about the circumstances. Japan moved from a high growth economy to near stagnation in 1990. It has taken nearly 25 years for the political process to realise that maybe this might have something to do with having a monetary policy that seemed content with zero inflation. As Paul Krugman would be the first to remind you, it is not as if no one told them what the problem might be. So it seems to me Japan shows why my question is a very good one: despite what would appear to be a macroeconomic disaster, it took two decades before the political process tried a fairly obvious remedy (moving the inflation target to the same level as the US and UK!). [2]

So what are the barriers here? Why would politicians not just say: ‘economists are the experts, and if that is what the clear majority recommend, so be it’. I can think of two reasons why this would not happen. The first is that this policy, like most macroeconomic policies, would not be a Pareto improvement: even if the majority gain, some would lose. If - and this is an important if - those who lose out have political power, then they would contest this ‘recommendation by experts’. [3] The second is that public debate operates a discourse on macroeconomics that does not necessarily reflect how macroeconomists view the world, and which also contains some fairly basic misunderstandings. In this discourse, inflation is always and everywhere a ‘bad thing’, because it means people can buy less with their money. Many people think inflation by definition means falling real wages (see this study by Robert Shiller for example). [4]

Now we could argue about which is the more important of these two factors, but I think it is the combination that is critical. Simple misconceptions could be overcome by politicians if their attempts to do so were uncontested. Equally, the political process is all about a contest between different groups in society, so if this were all there was then at least we should see a debate, as long as each side had its advocates. However, putting the two factors together can kill debate. We get argument by ridicule: ‘How can anyone seriously suggest raising inflation is a good idea, when everyone knows it makes us all worse off.’ A retort that most macroeconomists think it is a good idea just does not cut it in these circumstances, for reasons I have discussed before. As a result, even politicians who might favour the idea conclude that it is far too risky to champion.

These thoughts occurred to me when I was writing about the monetary policy regime set up by the UK Labour government in 1997. As I listed some of its virtues, I remembered that I have previously included in that list having the finance minister set the inflation target. This time I did not, and this post explains why.

Inflation targets are not the only macroeconomic example of where this problem arises. Government borrowing has, at least in the UK, become something that is perceived by the public to be so obviously bad that no political party thinks it can be seen to advocate additional borrowing (see here and here). So while the intellectual case for austerity crumbles, its political hold becomes stronger.

If you buy this reasoning, then it can be used as a justification for delegation, as argued here. However in this post I want to make a different point. Economists should take this kind of problem into account when they think about policy design. In the case of inflation, the popular misperception in part comes from, and is encouraged by, the identification in public discussion of inflation with consumer prices. So inflation targets are (always?) defined in terms of consumer prices. There is no compelling reason for this that comes from the macroeconomics literature, and there are plenty of proposals that involve focusing on either output prices or wages. [5] Given this, why not have an inflation targeting regime that involves a composite index: for example one that gave a third weight to the CPI, GDP deflator and average earnings.

The advantage of a composite target that involved wage inflation as well as price inflation is that it would help make the real meaning of inflation clearer in the public mind. [6] This in turn would make it easier for politicians to raise the inflation target if and when the economic case for doing so became clear. 

 

[1] There is a very nice study by Coibion, Gorodnichenko and Wieland (earlier pdf) which does this kind of exercise. Although it concludes that something like 1.3% is optimal, it all depends on the numbers, and you should note their assumption about how long a typical ZLB episode would last.

[2] There may be other examples of countries that have explicitly raised their inflation target, but I know of only one other case, and that is New Zealand (the pioneer of inflation targeting). There I believe the target is designed to be revisited in periodic ‘negotiations’ between the government and central bank. In 1996, the target inflation range was raised from 0-2% to 0-3%.   

[3] What seems fairly clear is that in most representative democracies in the last 30 plus years the unemployed have very little political power. So policies that increase unemployment meet very little resistance. Any natural sympathy from the employed is countered with talk of the ‘workshy’.

[4] This misapprehension may be partly based on real experience, due to nominal wage rigidity. With nominal wage rigidity, unexpected increases in inflation will reduce living standards. However that association is inappropriate to any discussion of a long run inflation target.

[5] Of course nominal GDP targets would involve output prices rather than consumer prices. I have suggested, in the specific context of current UK policy, a nominal wage growth target, and a champion of nominal GDP targets also prefers these.

[6] I wonder if there is a similar trick that could make fiscal stimulus more acceptable, particularly following a boom and bust where the boom involved excessive private sector borrowing. Perhaps by establishing a ‘borrowing reserve’, which was in effect just an amount that could be borrowed on condition - say - interest rates were at the ZLB. Any borrowing would have to be paid back at some pace when the economy was not at the ZLB.  

Confusing levels and rates of growth

It was entirely predictable. Once growth returned to the UK economy, those with a political axe to grind, but also some who do not, and even some who should know better (uneconomical has a good detailed response), will start saying that any aggregate demand problems have gone away. The simplest argument suggesting otherwise is NIESR’s well known chart, the latest version of which is reproduced below.

Of course this does not prove that the UK still has an aggregate demand problem. Perhaps something unprecedented has happened to UK supply over the last five years. After all, consumer price inflation (CPI) is still above target. Well, as I pointed out here, CPI was above target in 2008, and 2009, and 2010 ….. so unless you want to suggest that the UK never had an aggregate demand problem, the behaviour of the CPI today is not very reliable evidence.

The main point, however, is that aggregate demand problems are about the level of GDP, not its rate of growth. In a demand induced recession, aggregate demand will fall: consumers start saving more; firms reduce the level of investment etc. As a result, resources are underutilised, the clearest indication of which is an increase in unemployment. We start a recovery when aggregate demand starts rising again at a rate that exceeds the rate of growth of underlying supply (labour force growth and technical progress). That might have just started in the UK.  GDP growth in the last quarter was 2.4% at an annual rate, which if you were pessimistic might be above trend. The chart shows the recovery started in 2010 but then stopped, but better late than never.

However that is just the start of a recovery. As the chart again shows, we should really be looking for rates of GDP growth of 4% or more if we are going to start utilising those resources which are currently being wasted (i.e. if we want to reduce unemployment). The aggregate demand problem only disappears when those resources are utilised again, and unemployment goes back to its non-inflationary rate (NAIRU). (And no, CPI inflation does not tell us that has already happened - average earnings are increasing at rates well below CPI inflation, which strongly suggests unemployment is well above the NAIRU.) As yet, falls in UK unemployment have been tiny relative to the increase that occurred during the recession.

UK Unemployment

If this all sounds too ‘Old Keynesian’, we can retell the story in New Keynesian terms. In a recession the natural real rate of interest falls below the level the actual rate can reach. Whatever shock caused the fall in the natural real interest rate (initially a need to adjust balance sheets, later compounded by fiscal austerity and a Euro recession), that shock can gradually dissipate, allowing the economy to grow. However, the aggregate demand problem only disappears when the natural real interest rate rises to equal the actual real interest rate. We should know when that happens because unemployment will fall to the NAIRU. Recessions do not just last as long ‘as it takes prices to adjust’, because we are at the zero lower bound.

The reason why this is so important is that it may be too easy to settle into a political equilibrium, where the economy is growing roughly at trend, but unemployment is not falling. It is a political equilibrium because the unemployed have very little political voice, and sections of the media encourage politicians (I’m being as polite as I can here) to label the unemployed as workshy. This may not have happened in the US since the war, but with fiscal policy being tightened as a result of Tea Party fundamentalism it could well do this time. In the UK there are some similarities with the 1980s, when unemployment stayed above 10% until near the end of that decade. Luckily no one in the UK has started arguing that current levels of unemployment are ‘structural’, but given the rhetoric about strivers vs skivers it will not be long before they do, and of course if you wait long enough to reduce unemployment you are in great danger of creating a structural problem.

So we will stop having an aggregate demand problem when unemployment falls to near pre-recession levels, and (assuming rational monetary policy) nominal interest rates start rising significantly. It would be great if that happened very quickly because of rapid growth, and while I can think of reasons why that might be unlikely, I know enough about forecasting to know it is also quite possible. However that will have no impact on the costs of austerity that have already been incurred, which is why I wrote my ‘final verdict’ on the current Chancellor six months ago.

Even earlier, over a year ago, I wrote this: “come 2015, the spin “we have done the hard work and the strategy has worked” will accord with (relatively) strong growth, while talk of output gaps and lost capacity will have less resonance. True, unemployment will still be high, but not many of the unemployed are Conservative voters, and the immunising spin about lack of willingness to work can be quite effective.” Paul Krugman described this post as ‘remarkably cynical’. I fear it will be one of my better forecasts.  

Playing catch-up at the Bank of England

On Wednesday (7th August) the Bank of England will announce what it intends to do on forward guidance. Many seem to expect it to follow the Fed, and indicate a combination of (expected) unemployment and inflation that would not result in monetary tightening. Expectations may turn out to be wrong, however, because there is a quite wide divergence of views on the MPC about these things.

I think it is pretty clear that they should announce something like this, for two main reasons. First, it would help clarify what the overall objective of UK monetary policy is. As I argued here, a quite plausible interpretation of recent MPC’s behaviour is that they are simply targeting inflation two years or so ahead, and ignoring the expected output gap. Such a strategy is not consistent with how most academics think monetary policy should work, and it would not be compatible with Fed style forward guidance. So by adopting the latter, they could signal that they are in fact following a more orthodox, and appropriate, monetary policy. Second, forward guidance of this type gives us an indication of how they currently view the trade-off between the objective of achieving the inflation target and the objective of achieving a zero output gap. (My reading of the Treasury paper in March is that it makes clear, which it was not before, that having such a trade-off is compatible with the UK’s inflation targeting regime.) I cannot see how revealing that information can be a bad thing.

There are two other areas where the Bank could usefully receive forward guidance from the Fed. The first is to end the nonsense of not revealing what it expects future interest rates to be. I have always found the arguments for not publishing its own forecasts for interest rates particularly weak - they often amounted to the view that the public was too stupid to understand the difference between a forecast and an unconditional commitment. However, as long as only a few ‘minor’ central banks did publish this information (New Zealand, Sweden, Norway), the Bank of England could get away with this. Once the Fed starting publishing this information, the case for the Bank not to do so collapses. (See more here.)

The second is to be honest about fiscal policy and Quantitative Easing. This does not mean the Bank should say that the current government’s austerity programme is wrong (even though it is), but that it should say that it makes it much more difficult for monetary policy to achieve its objectives. As I have argued before, this statement is almost undeniably true, so why not go on the public record as Bernanke has done? It is in the Bank’s own interest to do this.

When the Bank was given independence in 1997, the regime the Labour government then established was arguably ‘state of the art’. Within the context of inflation targeting, it was very sensible to establish a symmetrical range where getting inflation too low was considered as bad as allowing inflation to be too high. Having an MPC that included some academics was a good idea, obviously (and debate within the MPC has clearly been much better as a result). However the Bank has largely stood still since then, in terms of practice and transparency, in part because the Bank itself is an inherently conservative institution that instinctively avoids public discussion. (A recent example, now rectified, is here.) So now it is behind best practice, and needs to catch up. Anyone who still thinks the Bank is transparent enough should read this recent post from Tony Yates.

Playing catch-up is all the more important because ‘best practice’ (what the Fed currently does) is still probably a long way behind what is optimal. This is not a criticism of central bankers so much as an acknowledgement that the game today is much more difficult than we thought it was just ten years ago. Miles Kimball has a very nice little piece on the major challenges that future monetary policy faces. Even if the recovery gathers pace and unemployment falls back to more normal levels and central banks can safely raise interest rates above the floor, the lessons of the Great Recession need to be learnt. To do better next time (because there will be a next time), is there a role for explicit policy commitment to mitigate the impact of the ZLB, and would level nominal GDP targets be a means of achieving that? Are there more inventive ways of removing the ZLB constraint, or if not, should we think about raising the inflation target? Is there a permanent role for unconventional monetary policy, and how does macroprudential regulation coordinate with conventional policy? Do we really have to keep discussion of using inflation to help reduce debt a taboo? All that, even before we start thinking about the financial sector and banks.

So there are huge challenges ahead, and it would be great if the Bank of England could be at the forefront in addressing these. The Bank should be given substantial credit for undertaking Quantitative Easing, and innovative programmes like Funding for Lending. However it would be even better if it could be at the innovative frontier across the whole range of monetary policy practice, as I think it was fifteen years ago.