It appears my timing could have been better in calling UK macro boring.
Those are not my ideal measures but the closest for which I have good data. The 2.5 year implied RPI has fallen by 0.5% over the last thirty days, to 2.4% as of yesterday, implying a significant undershoot of the 2% CPI target over the Bank’s forecast period (2-3 years). The FTSE 250 is at the lowest level for a year.
I caught a Newsnight discussion on the UK inflation data which was perfectly introduced by Duncan Weldon, who asked the right question: is the fall in inflation driven by the demand-side or supply-side? The studio debate which followed was a little disjointed from the reality in which the UK CPI rate has been a consistently bad indicator of UK demand-side strength. In fact it’s a contrary indicator, since periods of stronger real growth have been associated with weaker inflation and vice-versa. George Magnus would have us believe that the inflation data is giving us textbook (“Economics 101″) evidence of a “chronic deficiency of aggregate demand”. Chronic deficiency!? If you ignore the fact that CPI inflation has averaged 2.9% over the last eight years, sure, Mr Magnus.
But I’d answer Duncan’s question like this. If we see inflation running below the expected path and real GDP above the expected path, that looks like a positive supply-side shock. If we see both falling short, that’s a negative demand-side shock.
Here for each quarter I take the Bank’s median forecast of the CPI rate and RGDP growth from the Inflation Report four quarters earlier, and compare with the outturn:
The unexpected weakness of inflation and unexpected strength of real GDP growth does look like favourable supply-side news so far this year. That’s a backward-looking analysis.
What matters now is policy today, which is forward-looking. If the fall in UK inflation expectations is evidence of a positive supply-side shock then we should see a symmetric rise in UK real growth expectations. So who has upgraded their forecast of UK growth over the last month? The answer is… nobody has… and the fall in the equity markets (and gilt yields) makes it clear that growth prospects are falling too.
The Bank’s defence of inflation targeting as a policy regime, and their defence of the MPC’s decision-making under that policy regime, has always been consistent: what really matters is ensuring that inflation expectations are firmly anchored.
So… do it! Carney and friends have been making hawkish noises in speech after speech through the summer, trying to prepare the ground for rate rises. Does anybody seriously believe that there is even a single MPC member who believes the Bank is stuck in a “liquidity trap”, desperate for higher inflation but doesn’t know how to get there? No: that is just a convenient fiction.
For the MPC, the facts have changed, and policy needs to aim at raising inflation expectations so they are consistent with the target. Bravo to Andy Haldane for shifting in a dovish direction. As for Martin Weale… what can you say.
UK macro is really quite boring at the moment, and I cannot be happier to report that news. Of course boring events do not get reported as “news”, but that’s why we have blogs. Sure, there is a lot of debate about Scotland and so on which is related to macroeconomics – but UK macro events are not really capturing the headlines. UK GDP updates, labour market news… well, there’s a war on… let’s talk about Putin.
Contrast with the Eurozone. Mario Draghi is exciting! He is doing things. Pulling levers! Fiddling with interest rates. Easing credit conditions, improving financial conditions. Trying to get that CPI rate up… maybe. Oh, and allowing inflation expectations to collapse. That’s news.
Mark Carney expressed a worthy ambition in his statement to the Treasury Select Committee in 2013, that he “would like to achieve an exit in 2018 that is less newsworthy than my entrance”. I think he is well on the way to achieving that. This is how it should be. Central banking should be boring – nominal stability should be boring. If the nominal economy is stable, all the “news” will be “real”, in the sense of being supply-side.
For the first time in years I could not be bothered to watch the Inflation Report live last month, but skipping through the recording, the Broadbent, Carney and Shafik show is delightfully dull. Carney even takes pleasure from his own boringness:
What we’re putting emphasis on, and I know it’s boring and repetitive and it doesn’t clip into a new headline, we’re focusing on the path, the likely path of rates, the limited and gradual adjustment in those rates over the medium term, because of the headwinds that are facing this economy.
First and foremost it’s about the path for rate increases. I know it’s dull, I know it’s repetitive, but that’s the problem with consistency, it’s dull and repetitive.
Bravo Dr. C, bravo. And the annoying cricket metaphors are gone too.
This is what short-term inflation expectations (from gilt yields) looked like when UK macro events were newsworthy:
Quite the roller-coaster. I use the 3.5 year measure because it’s the most complete time series. Note this is RPI not CPI, and RPI at 3% is roughly equivalent to CPI at 2%.
Here is the last year and a bit:
What a dull, dull graph. Carney and the rest of the MPC deserve the highest praise for making macro policy boring.
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.)