Imagine a policymaker, in whatever area of public policy, who acts in a random and unpredictable fashion. One day they say one thing, the next day they say the complete opposite. Would you expect this kind of policymaking to encourage “stability” in the way people act, in the way people behave in whatever area that policy covers?
Well, welcome to British monetary policy.
Carney gave a speech last night which created an instant swing in financial markets. The FTSE 250 (a good indicator for UK domestic prospects) – is off about 2% this morning, though US markets fell late yesterday so we can’t blame the guvnor for all of that.
Carney and friends think that they can use the tools of macropru to create “financial stability”, whatever that means. They are not even able to formulate and stick to a monetary policy rule which avoids creating “financial instability”.
That should be the simplest thing in the world. 2% IT. 5% NGDPLT. Rules are simple. Automatic. Is the inflation forecast on target? Below, we loosen; above, we tighten. Is NGDP on target? Likewise.
Oh, and the inflation forecast is not on target, by the way. In the May inflation report the mean, median and mode projections of the CPI rate are below the MPC 2% target in every quarter of the forecast based on market interest rate expectations. So it’s “obvious” we need tighter monetary policy, and of course central bank governors should go around giving hawkish messages about rate rises. Governors who know exactly what they are doing, using words which have no doubt been chosen with extreme care, to express the right amount of “nuance”.
And here are four carefully chosen words to strike fear into your heart:
That is why an essential counterpart to our monetary stance is macroprudential vigilance and activism.
“Macroprudential vigilance and activism“? Dear God. Osborne, what monster have you created?
Update: Chris Giles also demonstrates the sharp movements in forward rates. Be in no doubt this was a tightening of policy.
Way waaaaay back in the dark days of 2012, which was, ooh, decades ago, Mervyn King used to complain about uncertainty. “Uncertainty” was King’s “excuse” for really bad stuff happening which wise central bankers can’t do anything about. Like real GDP going the wrong way. This is my favourite collection of Merv quotes from his infamous “black clouds” speech:
… a large black cloud of uncertainty hanging over not only the euro area but our economy too …
… Complete uncertainty means that the risks to prospective investments … are simply impossible to quantify …
… the black cloud of uncertainty and higher bank funding costs …
… The paralysing effect of uncertainty, with consumers and businesses holding back from commitments to spending …
… the black cloud of uncertainty has created extreme private sector risk aversion …
… private sector spending is depressed by extreme uncertainty …
… during the present period of heightened uncertainty …
Fast forward to 2014, and this is the “new normal” for central banking, as expressed by Charlie Bean:
Another reason the exit [from the ZLB] may be bumpy stems from the starting point. Implied volatilities in many financial markets have been at historically low levels for some time now (Chart 7). Together with low safe interest rates in the advanced economies, that has underpinned a renewed search for yield and encouraged carry trades. Taken in isolation, this is eerily reminiscent of what happened in the run-up to the crisis. Episodes like the ‘taper tantrum’, which produced a short-lived bout of volatility but no major disruption may also be contributing to a sense of complacency and an underestimation of market risk by investors.
It is inevitable that at some stage market perceptions of uncertainty will revert to more normal levels. That is likely to be associated with falls in risky asset prices and could be prompted by developments in the Ukraine, the fault lines in the Chinese financial sector, monetary policy exit in the advanced economies, or something else. But it will surely come at some point.
In 2014 wise central bankers are now worried that there is not enough uncertainty - there may be that dreaded “search for yield” – or, as those cheeky capitalists like to call it, “higher investment”. This is a bad thing, because, well, there might be “bubbles” even if we can’t define what a bubble is or identify one until after the fact. And we’ll apply the usual post hoc ergo propter hoc fallacy, because there are things which went up in 2007 which also went down in 2008, ergo those things caused the recession in 2008. Even though central banks’ own models tell us that financial crises and recessions have a single common cause: bad monetary policy.
We can be sure of only one thing: whatever happens, central bankers will be quick to tell us it wasn’t their fault.
When oil prices went up in 2008 the media blamed the Bank of England’s monetary policy. When VAT rose in 2010 and 2011, the media again blamed the Bank for being too inflationary. When the price of bonds rose in 2012, the media blamed the Bank (QE) for hurting virtuous savers with low interest rates. When the price of equities rose, the media blamed the Bank (again, QE) for making the rich richer – and hence everybody else poorer (yes, British progressives even brought “fairness” into monetary policy). When the price of London houses rose in 2014… well, guess who gets the flak?
So I enjoyed Carney and co sticking two fingers up at the Inflation Report today. At the press conference we again saw a long stream of questions about housing from the hawkish journalists who mostly live in, wait… where is it… let me guess… Aberystwyth? Carney and co did a great job of throwing them off, here is a choice quote from the Guv’nor:
Guy Faulconbridge, Reuters: Perhaps it’s a stupid question, I didn’t quite understand – do you see signs of a bubble in the housing market in London? And another stupid question probably, but you’ve been in your job nearly a year, what have you found most difficult about doing your job? Thank you very much.
Mark Carney: Answering stupid questions Guy, that’s the most difficult thing.
You probably didn’t understand on the first question because at no point in the Report or in the press conference did we talk about housing in a specific city, a specific borough in a city, because we make policy for the United Kingdom.
Quite right. Spencer Dale even debunked “Londonism“:
The other question is – is, independent of that, do increases in house prices have a material impact on economic activity? And in the past one can observe quite a strong correlation between increases in the house price and economic activity.
The question is, is it house prices themselves that are driving that or is it something else? And we published some work in that box which tried to get at that by looking at, as house prices move, do the consumption behaviour of say renters, people who rent houses, change very differently to those who own their house? And if it was house prices themselves, you’d expect to see very different movements.
In fact, in terms of the cross section of data, you don’t see very different movements. So we don’t think house price movements in themselves are a big driver of activity. And so when we’re thinking about the macroeconomic implications it’s the transactions, which is where we think is the main driver.
This is not a post about monetary policy and that’s something we should celebrate. The Riksbank have made household debt a focus of Swedish monetary policy and it is proving a terrible policy failure. The ECB is emulating the Bank of Japan. The MPC has declined the opportunity to screw up UK monetary policy and is rightly ignoring changes in London house prices. Bravo!
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.)
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.
A short note. Faisal Islam got his hands – literally – on the giants and titans. A fascinating quirk of British monetary history is the existence of £1m (“giants”) and £100m (“titans”) Bank of England notes, which are used as assets backing sterling banknotes issued privately by commercial banks in Scotland and Northern Ireland.
The video is here and is mostly about Carney’s speech on Scottish independence. The Bank’s web site has more information about Scotland & NI currency and the “backing assets”. George Selgin wrote a very good post on Scotland and the pound last year.
I am curious, how many objects are there in the world worth (nominally) £100m which you can hold in your hands? Some artwork… jewellery?
The Bank’s forecasts for real GDP growth over the next two years. 2014: 2.8%, 2015: 2.3%. WHAT A BOOM. What an explosion of growth! In the Inflation Report press conference today, the press first asked lots of sensible questions about forward guidance and monetary policy – you know, the things the MPC are actually responsible for. But there was an elephant in the room, something was weighing on the minds of assembled hacks… see if you can spot it.
Richard Barley, Wall Street Journal: … Because I guess the concern is that so far we’ve seen perhaps some worrying signs of returning to the old normal and greater lending, reliance on house prices.
Guy Faulconbridge, Reuters: Just a follow on on the housing, I see you have a section on property. Do you see any signs of a bubble in any regions of the British housing market, because overall it’s fine to say that perhaps prices are still below the 2007 peak, but in London dinner parties the prices that you pay for prime real estate in London is kind of the main topic of discussion.
Tim Wallace, City AM: Governor, another one on housing.
Maybe hold the press conference up North somewhere next time?
Paul Tucker is leaving the MPC later in the year. That’s the good news. Here’s a quote from his speech today which I cannot resist ridiculing:
It is sometimes suggested that independent central bankers are more averse to inflation than to periods of low growth and increased unemployment.
Gee whiz, Paul, really? Why could that be?
I hope the past few years have demonstrated that, in fact, it is the credibility of the Bank of England’s commitment to price stability that enabled us to provide such exceptional monetary support to help the recovery.
Oh. So… during a period with the worst real GDP growth on record, and high unemployment, what you’re saying… as you and your colleagues have done in speech after speech… is that what really matters is the Bank’s “commitment to price stability”?
It is unimaginable that, prior to Bank independence in 1997, any government would have been able to hold the policy rate at effectively zero and make a further monetary injection of £375bn without inflationary expectations – and government financing costs – spiralling out of control.
Inflationary expectations… hmmm… wait. For some reason I am getting the impression that independent central bankers are more averse to inflation than to periods of low growth and increased unemployment. But it must be the voices in my head.
(Those three sentences really are placed together in that order in his speech, I’m not making this up. Tucker also has a delicious reference to his definition of the phrase “escape velocity”, with a footnote referencing his remarks in 2011 to the TSC. It’s hard to know what he is getting at.)