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The Limits of UK Monetary Policy

It didn’t take long for the hand-wringing about the limits of monetary policy to resurface.  Chris Dillow wonders whether we are “approaching the limit of what QE can do“, and concludes that QE is “not enough” to raise real GDP.

If you ask the wrong question, you get the wrong answer.  The MPC already explained that they don’t believe the real GDP numbers, and repeatedly state that they think demand growth is about right.

Let’s consider the question of QE.

The Bank of England has a legal mandate to operate monetary policy such as to hit a 2% CPI rate.  Have they been unable to hit it?  In a sense.  They have overshot it for the best part of seven years, three of those with interest rates firmly at the “zero bound”, one (and a half?) of those where fiscal policy was tightened – apparently – “too far, too fast”.   So is monetary policy itself approaching a “limit”?

Did we suffer below-2% CPI inflation after hitting the zero bound?  Yes, briefly during 2009, but the CPI rebounded after that.

Did we enter a deflationary slump after fiscal policy was tightened?  Not obviously;  the level of CPI grew 3.3% in 2010 as a whole, and 4.4% in 2011.

The only limit I see is on the number of different excuses the MPC can conjure up for the “temporarily” high CPI rate.

Various counterarguments to the above are often thrown around: the main one being that the VAT rate change “artificially” boosted the CPI rate in 2011, so that somehow “doesn’t count”.  But the CPI rate is the Bank of England’s target, not CPI-CT or any other price index which ignores indirect tax changes.  You could just as well blame them for failing to stabilize the price paid for Premier League footballers.  They weren’t trying to do that, so don’t pretend that their behaviour would be exactly the same in a counterfactual where they had a different mandate.

The empirical evidence hardly falsifies the claim that QE is “enough” to keep CPI growing at around 2%, meeting the Bank’s legal mandate – even at the zero bound and in the face of fiscal tightening.  Quite the opposite; doesn’t CPI growth of 4.4% in 2011 suggest the Bank were doing “too much”?

The real question is whether a 2% CPI target is sufficient to get the desirable rate of demand growth.   To that we can say: no, evidently not.  It is not QE which is providing deeply unsatisfactory macro outcomes, it is the inflation target itself – combined with a healthy dose of supply shocks.

Chris Giles writes that the Bank “must unleash more QE“.  That is all very well, but expecting to get good outcomes from monetary policy like this surely requires a huge leap of faith.  We are asking the Bank to do one thing (target 2% CPI inflation) and hoping they’ll do something completely different (ignore inflation and provide “enough” demand growth) – if we ask them loudly enough.  What if they don’t listen to Mr Giles, and instead, say, the shrill voices of the liquidationists?

If we want really really really want faster nominal demand growth, then why do we not simply change the Bank of England mandate to target the desired path of nominal demand?  And empower them to use whatever tools they see fit to hit the level: interest rates, QE, currency devaluation, whatever.

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Categories: Monetary Policy
  1. asdasdasd
    April 26, 2012 at 22:02 | #1

    I agree, the UK has reached the end of what targeting headline inflation can accomplish, but not the limits of monetary policy.

    The argument about CPI-CT is clearest in 2010, when CPI-CT was below 2% for the entire year. Therefore, it was only contractionary fiscal policy, taxes increases, that caused inflation to rise above the 2% headline inflation target. Does it make sense for monetary policy to tighten in response to tighter fiscal policy? The UK does not follow a strict inflation target, surely the MPC should have allowed headline CPI to rise above target in 2010 rather than attempting to force all other prices relatively lower to compensate for a increases in taxes. This is what they did in 2011, but high headline inflation has given them quite a lot of bad press.

    It’s been pretty well established that if a central bank wants to stabilize output, then it should target sticky prices, not volatile prices and prices set on international markets. Mankiw has a number of papers investigating the best measure of inflation for the central banks to target. Sentance in particular seems to completely ignore this literature and focuses exclusively on headline CPI.

    I suspect, that if you repeated Mankiw’s analysis on changes in consumption taxes, you’d find that output volatility is lower when the central bank targets CPI-CT rather than headline CPI.

    Note that the Federal reserve places much greater emphasis on core measures of inflation. This could explain why output in the UK has been so volatile and unpredictable.

    So at the very least the BoE should explicitly target CPI-CT, better yet a core (or domestic?) measure of inflation, (nominal wages?).

    Also surely a higher inflation target could be effective?

    At present, by targeting headline inflation at 2% we have the worst of all worlds. In the short term we have inflation overshoots. Monetary policy was “too easy” in the past, but in the future investors expect the central bank to tighten monetary policy to bring inflation back down to 2%. This suggests there is may be insufficient demand in the future because a -1.5% short term real interest rate may be insufficient to keep the economy at full employment. The uncertainty about how monetary policy (and aggregate demand) will evolve could be extremely damaging.

    So investment is remains low, and there has been little increase in the UK aggregate supply.

    Part of the problem is the secular fall in real interest rates over the last 25 years you’ve identified. Almost nobody has noticed this. People complaining about low interest rates really need to see that graph to comprehend that real interest rates have been falling way before QE was started.

    So inflation targeting headline CPI could be perfectly effective when (Wicksellian?) real yields on long term debt is 2%. But if real yields fall to 0%, then the natural short term real rate of interest in equilibrium could be lower than -1.5%. In which case the central bank can use QE, but there is a lot of uncertainty about the effects of QE policy on output and inflation.

    It’s a toxic combination. Either way, I’m surprised there’s been so little discussion of alternative inflation targets.

    The only defense I’ve heard is that the public wouldn’t understand nominal GDP targeting. But given the public’s understanding of inflation targeting, (and frankly Sentance’s) this seems pretty weak.

  2. April 26, 2012 at 23:18 | #2

    Great comment. I agree on CPI-CT, though the inverse of the 2010 situation occurred in 2009, when the CPI-CT rate never dipped below 2%. You could argue that the VAT cut was effective in forcing the MPC to do more QE in 2009.

    I don’t think I’ve posted a graph of long-term real interest rates – I think that might have been on Sumner’s blog!

    I also agree it is unsurprising that we see low levels of capital spending when the Bank act to deliberately suppress expectations of future nominal income. And what will they say about export demand following the 5%+ appreciation of Sterling this year? I’m sure it has nothing to do with the monetary policy stance.

  1. May 17, 2012 at 18:09 | #1

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