I hope readers will excuse this wildly inappropriate and unnecessarily tasteless analogy, but discussion of UK demand policy increasingly reminds me of the Air France 447 disaster, a tragic plane crash back in 2009. The investigators found that the pilots ignored stall warnings and not only allowed the plane to fall out of the sky, but acted in precisely the wrong way to correct the fall:
… the jet continued to respond to the commands until impact. Those commands, however, were consistently inappropriate for a plane approaching a stall at high altitude. Instead of pointing the nose down in order to regain speed, the pilot at the controls drove it higher, worsening the loss of forward momentum and depriving the plane of lift.
In the UK, the nominal economy remains under the control of monetary policy. The monetary policy stance, however, is consistently inappropriate for an economy with a deficiency of aggregate demand. Instead of steering the economy towards faster growth, our central bankers keep aiming to drive inflation lower, depriving the economy of demand.
Over to Gavyn Davies, with an interesting discussion on “gilt cancellation” earlier this month, continued this week. This latest policy innovation comes courtesy of Adair Turner (candidate to be the next BoE Governor) who had floated, but quickly retracted, the idea of “cancelling” some of the government bonds which have accumulated on the Bank’s balance sheet through QE. Mr Davies concluded that doing so would boost aggregate demand (nominal GDP):
Now consider what would happen if the bonds held by the central bank were cancelled, instead of being one day sold back into the private sector. Under this approach, the long-run restraining effect of bond sales would also be cancelled, so there should be an immediate stimulatory effect on nominal demand in the economy. If done without amending the path for the budget deficit itself, this would increase the expansionary effects of past deficits on nominal demand, and would also reduce the outstanding burden of public debt associated with such deficits.
The argument Davies is making here is a familiar one about the effectiveness of a permanent versus temporary expansion of the monetary base. It is thus based entirely around expectations; that destroying a portion of the Bank’s assets boosts nominal GDP exactly because it is a way to signal that (some of) the monetary base expansion will be permanent, and will not (can not) be soon reversed by selling those assets again.
There is an implicit assumption that this plan would be useful because the Bank are not satisfied with the current growth rate, or level of, nominal GDP produced by QE to date. But as documented ad nauseum, this is neither their expressed view nor their revealed preference. The Bank has set expectations around the permanence (and continuation) of QE which are clearly anchored to the 2% inflation target (or more accurately, the inflation forecast). And the Bank has been successful in keeping nominal GDP growing at a rate which is more than sufficient to hit the inflation target; witness years of an above-target CPI rate.
Like the poor Air France pilots, in discussion of appropriate policy we scramble around desperately seeking to avert a crash. The government isn’t spending enough – let’s flip that switch! Banks aren’t lending enough, let’s pull that lever! We must have “structural issues”, the cause must be supply-side! And all the while there is no consideration of the one thing that really matters: the nose is pointing the wrong direction.
If the Bank (and/or HM Treasury) wants faster nominal GDP growth it is neither necessary nor sufficient to start cancelling gilts. I’m not sure that policy tool would be particularly useful; it is possible for the Bank to contract the monetary base by issuing bills or similar non-monetary liabilities. So I cannot see that the inflation target would automatically lose credibility as a nominal anchor.
What is necessary to avoid another crash is to simply point the nose in the right direction: abandon the inflation target and tell us you want faster nominal GDP growth. Set expectations around a clear nominal target, a level target, and print enough money to get expectations pointing the right way.
Oh god. This was Governor Shirikawa of the Bank of Japan back in March 2012:
The first is the burden of balance-sheet repair. Even with monetary easing, economic entities with excess debt neither increase expenditures nor embrace more risk taking until their debts are reduced to an appropriate level. Monetary easing only mitigates pains associated with balance-sheet repair. Moreover, employing this mitigator for a prolonged time comes with costs, as it reduces incentives to lessen excess debt and causes delays in balance-sheet repair, which ultimately is necessary for economic recovery. Needless to say, the effect of low interest rates is extended to those economic entities that have not suffered any damage to their balance sheets. If they bring forward future demand to the present by taking advantage of a low interest rate environment, this leads to an increase in aggregate demand. As balance-sheet adjustment continues for a long period of time, however, the amount of future demand that could be brought forward gradually diminishes even in a low interest rate environment. The above-mentioned cost of reducing incentives to lessen excess debt is not only an issue for private economic entities but also for the government. Once the increased level of government debt is perceived to be unsustainable, this threatens both price stability and financial system stability, as in the case of the European debt problem.
My emphasis. This is Governor Shirikawa’s good friend Governor Mervyn King in October 2012:
First, monetary policy supports demand and output by encouraging households and businesses to switch demand from tomorrow to today. But when tomorrow becomes today, an even larger stimulus is required to bring forward more spending from the future. Since the paradox of policy has been evident for almost four years, tomorrow has become not just today but yesterday. When the factors leading to a downturn are long-lasting, only continual injections of stimulus will suffice to sustain the level of real activity. Obviously, this cannot continue indefinitely. Policy can only smooth, not prevent, the ultimate adjustment. At some point the paradox of policy must be resolved.
My emphasis again. It’s almost the same wording. Oh god. How did this happen? How are the lessons of Ben Bernanke and Lars Svensson forgotten so easily?
I am short on time so cannot post more than an idle rant, but, oh god. Please, Mr Osborne, replace this Governor now. Get Svensson in to blow you away with New Keynesian macro done properly. Get Scott Sumner in, or any damn fool who can print money and buy stuff; throw the Keynesians out with the bath water; target the level of nominal GDP. Get Gideon Gono in to show you how far you can debase the currency if you are serious about firing up the printing press. Actually, scratch that one. But please, no more of this. Oh god.
For many years there was a debate about whether policy was better seen as setting short-term interest rates or determining the monetary base. That is no longer an issue. For some time, the demand for money has been purely demand-determined. As a result, central banks can set the short-term interest rate either to influence real interest rates or to determine the path of the monetary base or a broader monetary aggregate. Money remains at the heart of the transmission mechanism but since its velocity is unstable most central banks use interest rates as their instrument rather than a monetary aggregate
King explains in this speech his “Maradona Theory” of interest rates; apologies for the long quote but the whole passage is worth reading:
The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.
Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those expectations were sufficient – at times – to stabilise private spending while official interest rates in fact moved very little.
That pattern is sometimes described as “the market doing the work for us”. I prefer a different description. It is the framework of monetary policy doing the work for us. Because inflation expectations matter to the behaviour of households and firms, the critical aspect of monetary policy is how the decisions of the central bank influence those expectations. As Michael Woodford has put it, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. Indeed, one can argue that the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations. The precise “rule” which central banks follow is less important than their ability to condition expectations. That is a fundamental point on which my later argument will rest.
How did King go from such an enthusiastic endorsement of the “expectations channel” to talking incessantly about uncertainty? King’s 2005 view of monetary policy seems so close to the modern-day market monetarists, if you merely (and it really does seem “merely”) shift the focus from the short term interest rate onto the size of the monetary base, and target level of nominal GDP as the nominal anchor in place of the inflation rate.
From the October MPC meeting minutes published today, we get this:
31. There were, as ever, limits to what monetary policy could be expected to achieve. The
Committee discussed the likely effectiveness of further asset purchases, should they be required. Some members felt that there was still considerable scope for asset purchases to provide further stimulus. Other members, while acknowledging that asset purchases had the scope to lower long-term yields further, questioned the magnitude of the impact that lower long-term yields on corporate debt and equity would have on the broader economy at the present juncture.
How depressing. What happened to the spirit of March 2009:
Given the Bank’s role as monopoly supplier of sterling central bank money, the Committee had previously chosen to influence the amount of nominal spending in the economy by varying the price at which it supplied central bank money in exchange for assets held by the private sector. Under the operations now under consideration, the Committee would instead be focusing more directly on the quantity of money it supplied in exchange for assets held by the private sector.
Can’t we get back to that?
Today’s news is that the OBR made some forecasts and some of them weren’t quite right.
Over at the Bank of England, I suspect there is widespread relief that the CPI numbers are behaving as expected for a change, after the September bulletin was published today. The CPI rate is following almost exactly the median forecast set out in the Inflation Reports of November 2011 and February 2012:
I wonder if the hawks (Ben Broadbent and Spencer Dale) might claim the disinflation program they initiated in May worked exactly as desired, with a two-month interval in the extension of the monetary base allowing the strength in Sterling, and the associated import deflation pushing down domestic prices.
‘It is certainly not self-evident to me in the light of the apparent stickiness of inflation that substantial extra support for the economy would be compatible with the inflation target,’ he explains. ‘I am concerned about the stickiness of inflation.’
He adds: ‘The persistent worry we have is that if people get used to the idea of high inflation, if they take the view that the Bank of England isn’t bothered about the inflation target, it can lead to increased inflation risks and can affect the way in which people negotiate wages and set prices.’
Weale also warns that Britain could suffer an unprecedented ‘triple-dip’ – meaning the economy slides back into recession later this year after the briefest of revivals.
‘I certainly would not say there is no risk of that happening,’ he says. ‘What we have learned over the last four or five years is the capacity of the economy to surprise in ways people might not have thought possible.’
So. We’ve had a “double-dip”, we might even have a “triple-dip”, and it is not “self-evident” to Martin Weale that the economy needs more “support”. Because all that matters is price stability!
The Bank of England’s Monetary Policy Committee was given power to steer the nominal economy in 1997 by the new Labour government. They are given a moderately flexible legal mandate by the Chancellor: maintain price stability as defined by a 2% CPI rate, and subject to that, avoid unnecessarily volatility in output. The MPC is legally accountable to Parliament, and are required to report regularly to the (cross-party) Treasury Select Committee every quarter.
In practice, the MPC have followed a “inflation forecast-targeting” model whereby they set their instruments (usually the short term interest rate, Bank Rate; more recently, the size of the balance sheet) such as to ensure their forecast for inflation looking two or three years out is around 2%. They did this very successfully up to 2008, and more recently they have done it very badly, persistently targeting sub-2% inflation. Under this forecast-targeting model, we have most of the information we need to hold the MPC accountable; the Bank should be commended for their commitment to transparency, one area in which they score well in an international comparison.
The MPC could and should go further on the transparency front, publishing their estimate of the “output gap”, and/or potential real GDP; they obviously have such estimates since they are paramount in their decision-making. When the Bank’s Chief Economist says he wants to “get inflation down” he does so because he has an absurdly pessimistic view of the potential output.
This should be a matter of great concern to Parliament, and in particular, to the Treasury Select Committee. (That we have a union chief sit on the Bank of England’s Court of Directors who does not complain loudly about the disastrous effects of the Bank’s low estimate of potential output is a mystery to me.)
So the fact that the Treasury Select Committee have launched an inquiry into the practice of UK monetary policy would be welcome. Except that they have chosen to investigate… “the distributional effects of Quantitative Easing“.
Imagine that a cruise ship hits an iceberg and sinks; many of the passengers die. The committee responsible for health and safety at the ship owner decides to investigate. They concentrate on whether the ship had the right number of deck chairs.
What a tragedy. The MPC are failing. When the MPC fails, the people of the UK suffer; they cannot work, they cannot prosper. When the MPC fails, governments fall. And Parliament sits idle, counting deck chairs.
This is how Olivier Blanchard and Daniel Leigh introduce their statistical analysis in the recent IMF WEO report, when revising their estimate of the fiscal multiplier:
Our basic approach is the following: focusing on the recent episode of widespread fiscal consolidation, we regress the forecast error for real GDP growth during 2010–11 on forecasts of fiscal consolidation for 2010–11 that were made in early 2010.
I won’t quote any more, because honestly, what is the point?
If you are trying to measure the effects of fiscal policy on aggregate demand you cannot use real GDP. You will measure something which is part demand-side, part supply-side, and no way to separate the two. Real GDP measures output not demand.
Instead, you could think about how fiscal policy effects the nominal economy. And how can you measure the effects of fiscal policy on the nominal economy, without considering the role of monetary policy in providing a nominal anchor? Blanchard and Leigh only mention the “constraint” of the zero bound. They should read some more Sumner.
Here is the number of months during which the Bank of England has been unable to hit (as in “has undershot”) its nominal target during the Coalition’s fiscal consolidation:
So what “constraint” is the zero bound on monetary policy again? UK fiscal policy has so harmed the nominal economy that we have had thirty-three consecutive months of above-target inflation?
Again we see any semblance of helpful debate die in a ditch. The Bank of England’s Chief Economist wrings his hands and talks about how the Bank needs to “bring down inflation“, and the Keynesians lobby the Treasury to take the fantastic opportunity to borrow and spend.
Epic fail, and epic tragedy.
The IMF have apparently converted to the Keynesian view.
Having found no inspiration from trying to think about how deficits could determine the level of nominal GDP, I took at look at the UK government spending data. This table shows the percentage growth over four quarters in the levels of nominal GDP, nominal government final consumption spending, and nominal government gross capital formation:
So… what’s the fiscal multiplier? I’d suggest these series are not strongly correlated.
But it prompted me to look through Mr Tucker’s old speeches. Here he is talking to the IEA in 2010 about how to use “macroprudential” policy tools to “lean against” credit bubbles:
Monetary policymakers would need to be attentive to the use of such instruments, as they would affect credit conditions. Such instruments would also help to underpin the consensus that monetary policy should focus on the path of nominal demand at the aggregate level, with macroprudential policy seeking to address over exuberance in particular sectors or in credit markets generally and the resilience of the banking system.
My emphasis… does that wording sound familiar?
Returning to that recent Euroweek interview, the media picked up on Tucker’s comment that QE is losing its “bite”, when asked about the Funding for Lending scheme:
EUROWEEK: Presumably Funding for Lending acts as a complementary stimulant to quantitative easing.
Tucker: In 2009, QE played a very important role in helping to avert disaster. There is an understandable debate about the distributional effects of QE, but without it, everybody would have been a lot worse off.
The economy has moved sideways for a few years, which is uncomfortable for everybody. But it is much better than sliding into some modern version of the Great Depression.
I’ll break here so we can all take a moment to give thanks to the central bankers who insist we are not going through a “modern version of the Great Depression” whilst we experience what can reasonably be described as… a modern version of the Great Depression. Just as the central bankers during the Great Depression assured people “how much worse things could be” if not for their wise actions.
OK, are you feeling better? I thought not. Back to Tucker:
We still think QE works, even if in some respects it does not have the same bite it used to have. We essentially buy Gilts from long term institutions. That gives them money in the form of deposits with banks, which are fairly unattractive in terms of returns and risk. So that increases their demand for sterling corporate bonds, which since QE began have been issued by many more companies than usual. Some have used the proceeds to pay back bank loans, which delivers benign deleveraging.
QE does not have “the same bite”? I often wish central bankers would avoid speaking in metaphors. What could Tucker mean? That they will be unable to hit their inflation target using QE? Repeating the quote from later in the interview in my previous post:
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.
So obviously he still thinks QE can affect inflation, otherwise there could be no “risk” posed by printing money and buying stuff. And can you imagine George Osborne getting away with a quote like that?
Well, technically we could borrow and spend more. It’s just a question of what we think the risk to inflation would be.
Osborne would be laughed out of office. Alright, Osborne is being laughed out of office. But here is the man deemed most likely to be next Governor of the Bank of England… and when asked about demand stimulus his first thought is not the risk to growth, not the risk of running years of high unemployment. But the “risk to inflation”.
Cancel the optimism, we’re still doomed.