As a 54-year-old, Mr Fisher jokes he is old enough to recall when inflation was a far bigger problem — hitting 25 PER CENT in the Seventies.“What people have experienced over the last year or so shows why inflation is such a bad thing — and why the bank’s Monetary Policy Committee was set up with dedicated powers to keep it closer to target.”
Their emphasis. Inflation is “such a bad thing”! Get the message?
OK, it is more than likely the Sun have mangled Mr Fisher’s original words beyond recognition. So over to MPC member Paul Tucker, speaking to Euroweek:
A provision in our mandate that we have used actively is that we aim to achieve 2% inflation in the medium term, but if inflation gets pushed away from target by, say, oil price movements, we don’t have to get inflation back to target immediately because that would risk undesirable volatility in output and unemployment. We don’t have to create recessions to get inflation back to target quickly in the event of an oil price hike.
EUROWEEK: How much fuel is there left in the QE tank?
Tucker: Technically we could do more. It’s just a question of what we think the risk to inflation would be.
Some significant GDP revisions to quarterly rates in the Q2 Quarterly National Accounts this morning, though the levels remain roughly the same.
The ONS seem to have moved a chunk of nominal GDP previously counted towards Q1 forward to Q2. Annualized quarterly growth rates here, showing both GDP at market prices and Gross Value Added at basic prices so as to “look through” the effect of VAT changes in 2011 as usual (market prices include VAT, basic prices do not):
The implied deflator on GVA at basic prices has been revised from very very bad to utterly horrendous in Q2. More revisions likely?
That said, if we use nominal GVA as the best proxy for aggregate demand, a +4.7% annualized growth rate is actually the best quarter for demand growth since 2008 Q1. Headlines you won’t read today: “UK aggregate demand soars in Q2″.
I should probably steer clear of this well-trodden path, but it’s hard to resist. The fiscal deficit dominates UK politics and economics. Yet I find the economics becomes murkier as time passes.
I can understand a world in which monetary policy determines
the size of the sun the level of nominal GDP. I can understand a world in which fiscal policy affects lots of things, including the velocity of money. I struggle to understand a world in which fiscal policy determines the level of nominal GDP. And nominal GDP is what we really care about in terms of demand management. Everybody is signed up to that, right? But let’s pretend we can ignore monetary policy for the moment.
The defining narrative of our times was that the Coalition government is cutting the deficit “too far, too fast”. The implication is that running deficits is “good”, and contributes positively to aggregate demand (NGDP). Running smaller deficits will “hurt growth”. We can interpret those claims in terms of the effect on the level, or growth rate, of nominal GDP.
(Economists do themselves no favours by talking exclusively about real not nominal aggregates when discussing demand management. It’s a shoddy trick, because supply-side changes get mixed in with demand-side changes.)
But this is the Guardian in November 2011:
Britain will borrow a “staggering” £158bn more than the government planned a year ago, Ed Balls claimed on Tuesday as he accused George Osborne of presiding over a “truly colossal failure” in his economic plans.
And here the narrative shifts, or at least becomes murky. Can it still be that deficits are “good” per se? Ed Balls thinks that running large(r) deficits is a sign of failure!
For almost the entire period since March 2007, and particularly since March 2010, the US has run a looser overall fiscal stance – a more stimulative fiscal policy – than the UK, even taking the full operation of the larger automatic stabilizers in the UK into account. Cumulatively, since 2007Q1, the difference has amounted to 3% of GDP.
This is from a paragraph talking about deficits, measured as a percentage of GDP. So here is more support for use of the deficit (% of GDP) as a “measure” of how fiscal stance affects aggregate demand.
Even if the deficit did tell us the “correct” measure of the fiscal stance… which deficit? The ONS inconveniently give us two for the UK: one including the effects of financial interventions, one which doesn’t. Similarly, US deficits are “flattered” (reduced) by the regular return of coupons paid on Treasury bonds held by the Federal Reserve – a reasonably chunky number due to the large purchase of bonds under QE. The Bank of England is not doing the same. (Simon Ward has suggested the BoE return the accumulated profits from QE to HM Treasury as a one-off improvement to the deficit. I wonder if this idea might be revisited this year in light of gloomy projections for the fiscal position?)
Then we can head over to Brad DeLong on “self-financing fiscal expansion“, or Simon Wren-Lewis for a discussion of the “Balanced Budget Multiplier”. The latter is the idea that an increase in fiscal spending and taxation by £x will increase aggregate demand by £m*x but hold the deficit fixed. If the deficit is held constant in nominal terms, but nominal GDP is rising, that means the deficit is falling as a percentage of GDP. So… we can have “fiscal stimulus” and “falling deficits”? Now I’m really confused.
Should we instead talk about the level of fiscal spending as the measure of the fiscal stance? OK, but then Mr Posen’s comparison of deficits is totally meaningless. And we need a more nuanced take on the fiscal policy of “Slasher Osborne”, who has always planned to increase the level of total fiscal spending (Total Managed Expenditure rising from £696.8bn in 2010-11 to £757.5bn 2015-16, in the June 2010 Budget). That’s a slightly slower rate of increase than planned under Labour, but it’s still an increase. Yes, we could add in the multiplier fairy, and say that increases in current spending will not offset cuts to capital spending. But it all requires some pretty heroic assumptions.
And if Osborne is increasing spending, and increasing taxes (in 2011 at least), how exactly does that differ from a “self-financing fiscal expansion”?
I’m left more confused than enlighted by the whole debate.
This is FT Economics Editor Chris Giles on “The real lesson from Japan’s lost decade“:
Were the UK Treasury to set the BoE a target to hit a path for nominal GDP – the value of spending on goods and services – that rose at 5 per cent a year, many of the problems could be minimised. No one would have to pretend they knew how much slack there was in the economy or the precise supply capacity over the next two years. If supply was growing strongly, inflation would be lower and, if not, it would be higher. But it would be contained in both cases.
and here is Martin Wolf banging the drum again:
Finally, the country needs an ambitious macroeconomic target, but one that also caps inflation. As my colleague Chris Giles notes, the obvious one – in an environment of such uncertainty – is for nominal GDP. In the second quarter of this year, nominal GDP was more than 10 per cent below its pre-crisis trend, despite the big inflation overshoots. If the Bank were told to make up some of the lost ground, together with subsequent growth at up to 5 per cent a year, inflation might overshoot. But there might also be a surprising buoyancy of output and a recovery of at least some of the lost ground on productivity. It would surely be better to try and fail than to be sure of failing, by not trying.
The UK’s fiscal debt and deficit targets are again in question. The well-worn story goes that there can be no deficit reduction without growth, and growth is zero-to-negative, so there can be no deficit reduction. Well, OK, but it is nominal GDP growth which we care about. Tax revenues follow nominal GDP, and it is nominal GDP which is the denominator in the debt/GDP ratio. David Beckworth has illustrated how clearly this plays out in the Eurozone.
Real GDP growth is almost irrelevant in this context. A few years of 1980s-style 8-10% nominal GDP would (given continued moderation in public spending growth) eradicate the deficit in just a few years, even if there was no associated real GDP growth. So economists who only ever talk about the real GDP numbers, and draw conclusions about the deficit or public sector debt/GDP, miss the elephant in the room.
On this subject I am fascinated by the game theory of fiscal vs monetary policy, and loved this 1996 paper by Simon Power and Nick Rowe on policy coordination, courtesy of Lars Christensen. It seems remarkably prescient. We clearly do not have well coordinated policy at the moment; the Treasury is “trying” to run smaller deficits, but the Bank of England keeps suppressing NGDP growth so as to avoid overshooting its inflation target too much. And because the Bank “moves” (sets policy) every month, the Bank wins, and the Treasury loses – to oversimplify a bit.
Here’s a graph showing how badly the Bank has performed against the OBR‘s forecasts for NGDP growth used in the fiscal plans. The OBR keep revising their forecasts down, and are currently expecting 3.3% NGDP growth for calendar year 2012. To hit this starting from the sub-2% annualized growth rates seen in Q1 and Q2, a sharp jump will be required in Q3 and Q4.
A scary prospect here is the negative feedback loop. The OBR become more pessimistic about the supply-side over time as their growth forecasts are missed, and lower their estimate of potential output. This requires the Treasury to consider more of the deficit “structural” and less “cyclical”, and tighten the fiscal stance. When this is done by raising indirect taxes it pushes up inflation, as happened in 2011 with VAT and numerous smaller duty changes. The Bank of England then see higher inflation, downgrade their own estimate of potential supply capacity, and presume we don’t need more demand stimulus.
Inflation targeting done badly is really, really bad.
The September MPC minutes are out. The Guardian saw “raised hopes” of more QE. I thought the minutes are rather hawkish. There are three references to risks that the CPI rate “would fall more slowly than the Committee had previously anticipated”. Maybe the MPC really are trying to get the headline CPI rate down to 2%? Who’d have guessed?
Five mentions of uncertainty. The Funding for Lending scheme is a new source of confusion for our poor MPC members: they are not sure whether people actually want more credit.
24. Turning to inflation, the Committee continued to judge that there was a substantial margin of spare capacity in the economy, particularly in the labour market. This would continue to bear down on domestic inflationary pressures for some time. But oil prices had risen again and continuing tensions in the Middle East meant they could possibly increase further.
Are the MPC concerned primarily with domestic inflationary pressures in the Middle East? I think we should be told. How else do we make sense of that? (Maybe the MPC really are targeting… oh, I give up.)
With the untimely exit of Adam Posen, we can presume that David Miles is the MPC’s remaining “dove”:
For one member, the decision this month was more finely balanced, since it was not clear that the uncertainties about the medium-term outlook would be resolved to any great extent in the coming months and, given the weakness in demand, a good case could be made at this meeting for announcing more asset purchases.
But even Mr Miles is stuck on the fence. So long, Adam, and thanks for all the QE.
The usual responses I hear to the suggestion of currency devaluation in a depressed economy are split equally between:
a) “If we devalued, that would hurt our trading partners by making our exports too cheap!”
b) “If we devalued, that would damage our terms-of-trade and hurt domestic consumers!”
Both of these really miss the point, but it is always seems particularly obtuse to think we can “hurt” foreigners by selling them cheap(er) stuff. And people generally only switch to (b) after insisting that monetary policy is “impotent” at the ZLB. Impotent, that is, except in that it can obviously “create inflation”.
With monetary easing from the Fed last week, and the Bank of Japan this week, concerns about “competitive devaluation” have resurfaced. Lars Svensson demolished the argument in his papers on the “Foolproof Way“, so I can do little better than quote him verbatim:
The second issue is whether escaping a liquidity trap via a currency depreciation has negative consequences for the trading partners of the country. When a country attempts to stimulate its economy by depreciating its currency, this is often called a “competitive devaluation” or a “beggar-thy-neighbor policy,” invoking associations of negative consequences for trading partners. For instance, Fischer (2001) suggests that a yen depreciation could not be pushed too far because of beggar-thy-neighbor concerns.
However, we have already seen that the optimal way to escape from a liquidity trap, which involves expectations of a higher future price level, would directly lead to a corresponding depreciation of the currency. Indeed, absence of a currency depreciation indicates a failure to induce such expectations.
My emphasis here; and a quick diversion to look at what has happened to Sterling over the last year. Has the Bank of England induced expectations of a rising future price level?
Not obviously; Sterling is up 6.5% in the year to August 2012.
Back to Svensson:
The Foolproof Way is just a method to implement approximately the optimal way to escape from the liquidity trap through the back door, by starting with a currency depreciation. Indeed, any expansionary monetary policy that succeeds in increasing expectations of the future price level and lowering the real interest rate will imply a currency depreciation. Thus, opposing a currency depreciation is an argument against any expansionary monetary policy – which seems nonsensical.
Because of the short-run stickiness of the domestic price level, a currency depreciation implies a temporary real currency depreciation, that is, an increase in the price of foreign goods relative to domestically produced goods and services. This is a terms-of-trade improvement for the trading partners and in itself beneficial to them. But one concern is that this will increase the domestic trade balance, the net export from the country and hence decrease the net export to the country from the trading partners.
But the effect on the trade balance involves both a substitution and an income effect, of opposite signs. The substitution effect due to the change in relative prices from a depreciation favors domestic exporters and import competitors and increases the trade surplus (or reduces the trade deficit). But the income effect due to increased output, consumption and investment in the domestic economy implies increased import of raw materials, intermediate inputs and final goods and reduces the trade surplus (or increases the trade deficit). The net effect on the trade balance may therefore be quite small, as indicated by simulations in Coenen and Wieland (2003) and McCallum (2003). Thus, a currency depreciation will involve some sectoral shifts, but it need not involve any beggar-thy-neighbor policy. For Japan, with an economy operating far below potential GDP, the income effect on the trade balance, which is favorable to the trading partners, could actually be quite large.
The Economist has posted the ad:
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The closing date for all applications is 8:30 am on 8 October 2012.
Simon Wren-Lewis invites us to consider a metaphor:
In the case of central banks, zero lower bound (ZLB) denial would be a belief that ‘unconventional’ monetary policy is almost as effective or reliable as conventional policy not on the merits of the case, but because the central bank must be seen to be in control. Now no one wants to hear a pilot tell passengers that they are no longer in control of the plane. However a better analogy here would be the pilot not telling the co-pilot, because fiscal policy can also be used to stabilise the economy.
Simon cannot possibly expect to get away with this without having the blogosophere descend on him like a tonne of bricks. Especially the day after Scott Sumner day. (September 13th: my calendar is marked)
The Bank of England is tasked to control the rate of growth of the UK Consumer Prices Index. They hit the zero bound in March 2009. Fiscal austerity started in 2010, 2011, or whenever exactly it was that George Osborne started “talking down the economy“, depending on your level of fiscal fanaticism.
Now, please, somebody show me exactly when the Bank lost control of the nominal economy. I’ve graphed here a 2% level path starting from the UK CPI level as of March 2009, against the path of the actual CPI level, and the CPI at Constant Taxes for contrast.
My name is Britmouse*, and I suffer from “ZLB denial”. The issuer of a fiat currency determines its value. It’s that simple. Monetary policy steers the nominal economy. Interest rates are but a tool.* Actually it’s not.
It seems the righter-wing end of the Conservative party has had a think about their party’s 2015 electoral prospects, looked at the GDP figures, and gone into a little bit of a panic. Not necessarily a bad thing. What is their plan?
Liam Fox today gifted a stream of “nasty party” quotes to the Guardian sub-editors, allowing them to concoct headlines with the words “slash” and “welfare” carefully arranged to maximize the righteous indignation of their readers. David Davis last week made a speech calling for a government “growth strategy” – and the growth strategy that he and Fox have in mind is no more and no less than “radical” supply-side reform.
Davis and Fox remember that Thatcher won elections, and Thatcher loved supply-side reform. So they revert to this primitive ideal of Thatcherism which says “supply-side reform wins elections”.
But they have forgotten that a good part of Thatcherism was demand-side, with the adoption of monetarist targets for the broad money supply aimed at providing lower, and stable inflation. Cobham’s book on UK monetary policy makes the point that this was more an evolutionary change than a revolution; monetary targets had been used but completely ignored in the 1970s; after the targets were made more explicit in the 1980s, they were still ignored or revised when policymakers found that convenient.
Regardless, the demand-side policies under Thatcher brought down nominal GDP growth from an average annual rate of 16% in the 1970s to 9% in the 1980s. Some volatility remained with inflation and NGDP soaring in the first years of the decade and another (less severe) spike at the end during the “Lawson Boom”. The intervening period saw marked stability in nominal GDP, real GDP and inflation. Lawson’s abortive ERM experiment was another unnecessary screwup, but the subsequent adoption of inflation targeting in 1992 set the stage for 16 years of stable growth.
My point is not to elevate the record of demand management under the Tory governments of the 1980s, a record which is certainly not above criticism. But it was generally a lot better than what came before. Davis’ idea of a “growth policy” is simply to pretend the demand side does not exist, or in his words:
when I talk about a growth policy, be clear that I am not talking about an exercise in Keynesian demand management.
He is similarly dismissive of Japan’s experience with “suppressing interest rates to zero”. Milton Friedman keeps on turning in his grave.
Davis does come out in favour of government-funded infrastructure spending, but purely for its benefits in improving the supply-side and long run growth. This support is conditional; it must only be infrastructure spending on things David Davis thinks are really good. Which apparently means that high speed rail is out, and gigabit broadband is in, because South Korea has gigabit broadband and therefore, um, handwaving here. I’m not sure Davis has fully grasped the Hayekian critique of central planning embraced by Thatcher.
The (short) list of supply-side reforms which Davis deems necessary for growth may well (or may not) be sensible ideas. Jonathan Portes is surely correct to point out that an “easy win” from supply-side reform would be to relax the immigration rules tightened under the Coalition, a subject which the likes of Davis and Fox are curiously silent on. But supply-side reform will not help escape from the demand-deficient slump we are in. UK nominal demand growth has been weaker over the last four years than any other period on record, and there is no obvious recovery imminent.
For these politicians to abandon any consideration of demand policy right now not only contributes to their party’s electoral suicide, but is a repudiation of the Thatcherism they claim to admire. Monetarism’s “second counter-revolution” offers an escape from what might be considered “Keynesian” demand management, but the Tories have little time to embrace it.