State-of-the-art monetary theory in 1968 from Milton Friedman:
Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction.
State-of-the art monetary nonsense in 2014 from Martin Wolf:
High-income economies have had ultra-cheap money for more than five years. Japan has lived with it for almost 20.
From this weak start Mr. Wolf goes on to conclude that it is necessary either to have “big government” or to “wipe out the rentiers”:
Low interest rates are certainly unpopular, particularly with cautious rentiers. But cautious rentiers no longer serve a useful economic purpose. What is needed instead are genuinely risk-taking investors. In their absence, governments need to use their balance sheets to build productive assets. There is little sign that they will. If so, central banks will be driven towards cheap money. Get used to it: this will endure.
Cheap money? If only. Meanwhile, Gavyn Davies is worried about those naughty capitalists taking, erm, excessive risks:
The case for macro prudential controls is straightforward . During economic upswings, the behaviour of the financial system can become destabilising. Banks’ balance sheets are flattered by the expanding economy and low interest rates, so credit supply expands aggressively. This fuels the boom until risk taking becomes excessive, and even a moderate rise in interest rates produces a financial crash. Direct intervention in the financial system to head off these problems early, through increased capital and liquidity standards, seems to be justified.
So concerned is Mr. Davies that we might have a recession…
While an interest rate rise might be compared to firing a shotgun, macro prudential measures might be closer to a rifle shot. However, the separability of the two weapons raises many issues and difficulties. Both may need to be fired simultaneously in order to get the job done.
… that we might need a little bit of a recession to keep those risk-takers under control. What a fine mess this is.
HT: Marcus Nunes
We need an name for a macro model in which changes in house prices drive changes in aggregate demand. I am going to suggest “Londonism” because this idea seems to be a metropolitan obsession, though better suggestions would be welcome. I will continue be snarky, annoying, and contrarian in my neutral slash positive view of rising nominal asset prices.
This is the Guardian from June 2008, when the UK was already in recession, though we didn’t have the GDP figures to show that yet:
Amid City fears that the Bank of England’s decision yesterday to peg the cost of borrowing at 5% could push the economy into recession, the Halifax, Britain’s biggest mortgage lender, reported that the cost of a home fell by 2.4% in May, wiping almost £5,000 off the cost of an average house.
Back in 2008 those naive City economists didn’t realise that when house prices fall, people can buy more houses. That’s how it works, right? Falling prices mean housing is “more affordable”, rising prices mean “less affordable” houses? No? Am I missing something?
Remember also that monetary policy was “doing all it could” to prevent the global financial crisis from escalating into a UK recession, but yes, Bank Rate continued to be pegged at 5% all the way to October that year. The Graun continue:
Last month’s decline marked the seventh fall in nine months. In the past three months, prices have dropped by 6.1% – faster than at any time since the bank began publishing data in 1983. The biggest fall during the downturn of the early 1990s was the 3.8% decline between August and October 1992, a period which included Black Wednesday.
Wait, there is some link between recessions and changes in house prices? What can it be? Find me a Londonist… Mr. Bootle?
Roger Bootle, economic adviser to Deloitte, said the 8% drop in house prices since their peak was likely to turn into a fall of 20% by the end of 2009, with knock-on effects on consumer spending. “The UK economy is on course for a very deep and prolonged economic downturn, if not an outright recession,” he added.
Ah, there we go. “Knock-on effects” from falling house prices. Mr. Bootle was right about the “outright recession”, but I’d suggest the Bank of England is right about the cause.
1) Are the goals of UK monetary policy “appropriate”?
2) Has the Bank of England set the “tools” of policy (e.g. QE, interest rates) correctly so as to achieve those goals?
I am not sure if Chris is arguing about (1) or (2). The discretionary approach to the labour market data could be taken as evidence the MPC is changing the goals of policy in a more expansionary direction. But the question of whether the Bank should raise rates now is more about (2).
Mr. Giles also says the Bank is “institutionally biased against higher interest rates”. “The Bank” has argued, very forcefully, in favour of 2% inflation targeting. I count in particular Mervyn King and Charles Goodhart. I think it is correct to argue, hence, that the Bank is institutionally biased against higher (nominal) interest rates – but that is a thoroughly hawkish bias. After all, the most hawkish central bank in the world (the Bank of Japan) also has the best record in the world for keeping nominal rates very low.
I would argue that the important institutional bias at the Bank is against monetary policy rules and in favour of discretion. The independence of the “nine wise bankers” of the MPC to “make the right decisions” is what is being protected above all else. The uncertainty around the “appropriate goals” for UK monetary policy is extremely helpful in protecting that independence.
Are the Bank targeting 2% inflation on the two year horizon? Is it one year? Or three years? What about the “output gap”, or “spare capacity”? Is it acceptable for the Bank’s forecast to show they expect to persistently undershoot the 2% target, as in February 2009 when the median CPI rate averaged just 0.8% across the forecast period? If so, would it not also be acceptable for them to set policy such that they persistently overshoot the target? What is the “institutional bias” shown in the February 2014 forecasts, where the median CPI rate across the forecast period averages… 1.9%?
Simon makes the case that deflation in Sweden shows what happens if monetary policy is tightened unnecessarily. This gives too much ground to the hawks. Was UK monetary policy “too tight” in, say, November 2008 or June 2010? It is easy for the MPC to deflect this charge following the same logic as Simon: inflation was above target, and mostly stayed above target. And then we can argue till the sun goes down about the output gap, because nobody “knows” for sure.
We are left with this vacuum of policy. Is it right for the Bank to keep rates at 0.5% in March 2014? I agree with Simon that it is right beyond any reasonable doubt. The MPC should continue to duck and weave until inflation (by which I mean nominal GDP) “takes off”, and the more the chattering classes get annoyed by London house prices, the better. It’s also right to dump the inflation target in favour of a clear rules-based policy regime. Other opinions are also available.
We are going to have to watch these guys. This is MPC member Jon Cunliffe:
The self-reinforcing link between property prices, the financial system and the broader economy that operate within the stress test have been key to dynamics in previous UK downturns. As well as lowering homeowners’ wealth, falls in house prices reduce their collateral and so their access to credit. This tends to drag on consumption. Preliminary Bank analysis suggests the most highly mortgaged households have tended to cut their consumption very materially in times of economic stress. And investment in the construction of homes and other property has had a tendency to fall sharply in downturns, with this component of spending accounting for around half of the peak to trough variation in GDP growth across the 2008-9 recession. This combination of lower property prices and a fall in spending across the economy, can, through a rise in defaults, damage banks and contribute to a tightening in credit conditions, creating a further drag on economic activity.
It is Kafkaesque, this world of monetary policy. On Tuesday the Bank of England describes clearly how the Bank of England can, by running a tight monetary policy, cause a recession and falls in nominal asset prices. On Thursday the Bank of England is worried about how the economy might unavoidably fall into a recession when there is an unexpected fall in nominal asset prices.
I was half-joking when I suggested that we drop the CPI target in favour of a house price target. But I am half-serious. If the MPC thinks that stability of house price inflation is a necessary condition for stability of the real economy then they should clearly lay out the model in which that is true. Then HM Treasury should consider whether the MPC should target the CPIH, or whatever, so that there is an appropriate focus on stabilising nominal house price growth. Haldane is apparently going to push for a CPIH target.
Here is a really funny thing. If the UK had applied a 2% CPIH target for the last five years we would have needed an easier monetary policy, because the CPIH rate has been around 0.2-0.3% below the CPI rate. And an easier monetary policy would mean higher nominal asset prices. Thus, if the MPC had been targeting house prices, it’s easy to end up with the conclusion that house price inflation has been too low.
(Because the CPI and CPIH and not equivalent this is really an arbitrary counter-factual; maybe a 1.5% CPIH target should replace the 2% CPI target… or maybe we should stop targeting “inflation” altogether.)
This chart from FT Money supply is neat:
… if you want an illustration of how useless the CPI is.
The graph is a little hard to read, but it says that the real price of “telephones” has flatlined since 2008. (That means the price of telephones relative to the price of entire CPI basket.) The full name of the CPI division which the FT used here is “Telephone and telefax equipment and services”. We touched on this in the comment section recently. The ONS think the actual (not relative) price of “telephone and telefax equipment and services” rose by 18.8% between January 2009 and March 2014. Which seems like an absurd claim, given the improvements in e.g. smartphone quality over this period, never mind the rising popularity of free services like Skype. OFCOM have more stats than you can poke a stick at for those interested. I suspect the ONS simply can’t keep up with the high rate of substitution in this area.
The area which stands out in the graph is the cost of education. Again, this is merely a statistical illusion. This is what the IFS said about education in the CPI:
Education saw the fastest price increase of all CPI categories, increasing by 67% since 2008. The price change for this category was largely driven by increases in fees for higher education from October 2012. The impact of these fee increases was to push up the measured price of the education CPI category by 19% between October 2011 and October 2012, and by a further 10% between October 2012 and 2013. That said, the increase in the price of education as measured by the CPI arguably does not reflect the change in the total cost of education faced by individual students completely accurately. The ONS takes the price of education to be the cost of fees less any grants (but not less student loans).
However, in some ways, the loan system became more generous to students at the same time as the changes to fees were introduced, meaning that for many students the total lifetime costs of education are now actually lower than they were before.
Got that? Total lifetime costs of education have fallen, and the measured cost of education went up 67%.
Market monetarists have long argued that tight monetary policy (“nominal GDP falling below trend”) would tend to lead to financial crises, rather than the other way round. Keynesians have made similar arguments about Japan, holding the Bank of Japan’s tight money accountable for the “lost decades”. The same intuition dates back at least to Irving Fisher and debt-deflation, so it’s not a novel idea. The Bank of England published their stress test scenario for the UK banking sector yesterday, and it appears they agree. This is the scenario they want the banking sector to prepare for:
- Perceptions of a permanent productivity shock raise concerns over the sustainability of debt positions. This leads to a rapid re-assessment of prospects for the UK economy.
- This is associated with a sharp depreciation in sterling and a build-up of inflationary pressures in the UK.
- This combination of shocks leads to an assumed tightening of monetary policy as well as a rise in long-term interest rates.
- This leads to a marked downturn in economic activity, with real GDP falling by about 3.5% from its 2013 Q4 levels, and a pickup in unemployment, with the headline unemployment rate peaking at around 12%.
- House prices and commercial real estate prices fall by around 35% and 30% respectively in the stress in nominal terms.
My highlight above.
The scenario above is a perfect description of what happened in 2007/8 in the UK, if you ignore the point about interest rates. We had a productivity shock starting in late 2007; inflationary pressures built up (rising CPI rate), and Sterling depreciated in 2008. This “lead to” a tight monetary policy as the MPC drove nominal GDP down 5% over 2008/9 to defend the inflation target. That lead to a collapse in real GDP, a rise in unemployment, and a sharp fall in nominal asset prices.
The interesting question is whether the point I’ve highlighted is a policy error. Why should the Bank tighten monetary policy after a productivity shock or Sterling devaluation? The Bank is clear that everything else follows on from there. It is not that a productivity shock causes a rise in unemployment. A productivity shock causes a tightening of monetary policy which causes a rise in unemployment.
Maybe (and a big “maybe”) that’s correct for an inflation-targeting central bank. But then central bankers should be honest with the public about the insane implications of inflation targeting. The Bank of England thinks the Bank of England will sometimes cause major financial and economic crises in order to defend the inflation target. So the banking sector should prepare for the worst. Oh, and good luck everybody!
A few things worth linking to, about which I have little to say:
1. Martin Weale’s speech from last week, “Slack and the labour market” is excellent. Weale estimates a 1.1% shortfall in total hours worked, accounting for over- and under-employment. This translates to a 0.8% shortfall in real GDP due to labour market slack. I would like to see some serious responses to this from supply-side optimists. One possible line of inquiry is on self-employment, which Weale only addresses briefly.
2. Tony Yates has a very interesting post on “One big hubristic consultancy jargon firework display” as he describes the BoE review. Worth a read if you are interested in BoE politics, as is Tony’s blog.
3. The John Mills/Civitas “There is an alternative” paper is out, and is very strange. Mills wants to devalue the pound, and sees that being an “alternative” to “monetary policy”. He doesn’t say how we should devalue the pound, though he favourably references the Yen devaluation under Abenomics. Mills does (implicitly) want faster NGDP growth and accepts that 3% CPI is a necessary consequence, but believes none of that has anything to do with monetary (or indeed fiscal) policy. The paper also exhibits a very, very bad fetish for manufacturing. Ben Southwood already provided a very good critique of the Mills proposal last year.
The UK CPI rate is now down to 1.7% over the twelve months to February 2014, a rambling post follows. It would be easy to point to the falling CPI rate in the UK and the rising CPI rate in Japan, then point and laugh at idiotic UK politicians celebrating falling inflation… my usual cheap gags, in other words.
It’s never that simple, because we still have to care about supply and demand. There is little evidence saying that UK aggregate demand growth has slowed over the last twelve months. There is a lot of evidence that UK aggregate demand is growing faster. Therefore it is something of a challenge that the inflation rate has fallen.
It is possible to argue that holding aggregate demand growth constant the falling inflation rate is mildly positive supply-side news, and we should grasp such news with both hands. This is how 99% of newspaper commentators interpret the inflation data anyway. Keynesians will find some vindication in their view that the inflation rate is related more to the “output gap” than to AD growth, although it comes after six years of UK macro data which generally did the opposite.
Despite some crowing from Tories in the press about the imminent rise of real wages, I see absolutely no indication that hourly wage growth has picked up at all. If anything, wage growth slowed through 2013. It remains hard to get reliable high frequency nominal hourly wage data (see previous post) but I can torture the data to give you this little graph:
The data really is tortured to produce that; I take the series for Average Weekly Earnings Regular Pay and divide by average weekly hours, and then apply a 3-month moving average; using the total pay measure inclusive of bonuses produces an extremely volatile result for hourly wages. Take all this with a pinch of salt. (What do erratic City bonuses imply for stickiness of hourly wages – arguments in the comment section?)
The other supply-side indicator giving me a little doubt about demand-side revival is a slight fall in total hours worked in recent labour market updates. I have said it before, but it is hard to overstate how strong the expansion in the UK labour market has been since 2012. Over the 24 months to October 2013, total hours worked grew 5%. There is no period of employment growth this strong since the Lawson boom in the late 80s. The survey evidence for UK employment this year is looking good so there is hopefully no reason to have doubts about the labour market.
It’s the liquidity trap, stupid! Everybody knows you can’t devalue the currency at the ZLB. Everybody, that is, apart from the central banks of Switzerland, Japan, and the Czech Republic, everybody who has read about forex market gyrations after British, European or American central bankers engage in those almost daily “open mouth operations”, Lars E.O. Svensson, Ben Bernanke, students of economic history, and now Labour Party donor John Mills:
In the paper, which is due to be published this week with the think tank Civitas, Mr Mills has called for an immediate devaluation of the pound. He argues that the UK will be consigned to years of mounting debts and austerity unless manufacturing and productivity levels are boosted. As a major importer of goods, from kitchen gadgets, irons and sports bras, Mr Mills says manufacturing will only return to the UK if the costs come down. De-valuing the pound is the fastest way to achieve this. “We’ve got to get the pound down to make light manufacturing profitable,” he told The Telegraph. “At JML we would buy UK products but we can get everything we sell produced in China for two-thirds of the cost. This is almost entirely an exchange rate issue. And as a result, industrial output just goes down. We can’t pay our way in the world and the economy stagnates – that’s what we’re heading for.”
He said that UK politicians are only using two of the three major ways that a Government can influence the economy – fiscal policy, monetary policy and exchange rates. “Everyone is fixated on the first two and has totally ignored the third,” he said. “And this is the big, big policy mistake that has been made.”
It will be interesting to read the paper; the “real” policy mistake is the choice of nominal anchor, not the level of the pound per se. I hope the proposal is more substantial than a call for a “discretionary” one-off devaluation, but retention of the CPI target.
A quick note. An ONS report today on hedonic quality adjustment carries the following table showing the items for which hedonic quality adjustment is performed in the CPI basket:
Table 2: Hedonic items in the UK consumer price statistics
|PCs||1996||CPI – 2003
RPI – 2004
Source: Office for National Statistics
And that’s it! (For background on hedonic quality adjustment, the BLS has a nice FAQ.)
I was very surprised to discover that hedonics are only applied to such a small set of items. The ONS note that the US, by contrast, adjusts for items described as “Clothing, Footwear, Refrigerators, Washing Machines, Clothes Dryers, Ranges & Cooktops, Microwave Ovens, TVs, DVD Players”.
The ONS say they find hedonics complicated and expensive; for goods which are now weighted less than than 1% in the CPI basket, it’s hard not to be sympathetic:
In practice hedonics has proven to be a resource intensive process in the ONS and therefore a costly method. This is due to a number of factors, including the technical nature of the method and the large volume of price and product attribute data that needs to be collected and managed for the production of each hedonic model. Additionally, each hedonic model is updated several times a year to stay relevant to technology changes (for example the introduction of Windows 8 in 2012) which compounds the work involved.
Those who believe that “the price index” captures something real, tangible, and objectively measurable, should be wondering how it is possible to make an objective assessment of the change in PC quality taking account of the “introduction of Windows 8″!