This is what Resolution’s Matthew Whittaker had to say about inflation in a piece for the Independent earlier this month, titled “Why the Bank of England should target wages as well as unemployment“:
Nothing at all. There is no mention of the word “inflation”, nor of the “CPI”, nor even “prices” in a piece purportedly about UK macroeconomic policy – about UK monetary policy. I’m sure Matthew is a good guy, and I’m not trying to pick on him specifically, but that is a beautiful illustration of how I see centre-left/progressive economists addressing UK inflation over the last five years. The motto is “Don’t mention the
Yet at the same time the centre-left political movement has been obsessing about inflation – that is literally what the “cost of living crisis” means. Yes, you can come up with a different translation of that phrase, but the CPI really is how we measure “the cost of living”. It is going up, and that is a “crisis”. In fact it is even worse: progressives love to exaggerate the extent to which the “cost of living” has risen, by deflating nominal wages by the RPI (rather than the CPI) to show just how badly real wages are suffering.
This is all both depressing and frustrating to watch. I’d roughly agree with Mr. Whittaker’s eventual conclusion, that targeting nominal wages (or nominal incomes) is a good idea. But he gets there from talking first about real wages, and then median wages (which is almost as bad), without use of the word “nominal”, so it is not totally clear he even wants a nominal target, but let’s assume he does. And so does Mr. Whittaker want the Bank to continue targeting the CPI… and unemployment… and add nominal wages as well? Really? All of those things at once?
I have a relatively simple narrative about what the BoE has been doing for the last five years: roughly what they’ve always done, keeping the “risks to inflation broadly balanced”… around the 2% target. I construct that narrative based on what the MPC have been saying for the last five years, month after month after month. What that means in practice is that the Bank steer a course for nominal demand (NGDP) which is sufficient to keep the CPI on target.
And so the Bank defend their policy stance based on those damn CPI numbers. Is that wrong? Why should it be – hitting the CPI is their legal mandate! How can anybody possibly argue that UK macro policy was too tight ex post, at the same as attacking the government because “the CPI is too damn high”. That would be utterly ludicrous… and it is the critique of Coalition macro repeated endlessly for the last three years.
There are more complicated narratives too. Maybe that unexpected shocks to nominal demand have resulted somehow more in lower measured productivity and output, less in lower prices/inflation. OK, maybe that is a bit true, and I hope it is a bit true. But if that is even a little bit true, then inflation targeting is the worst possible monetary policy you can have, and you need to be openly screaming about that fact. ”Inflation targeting is not working“, you might write.
Instead the best and brightest on the centre-left have been producing critiques of UK macro policy along the lines of:
a) Monetary policy is not a panacea. (Well, thanks so much. Jens Weidmann totally agrees with you.)
b) We need more infrastructure spending. (Brilliant. And what about macro policy?)
c) No really, we need more infrastructure spending. (Yeah, but that’s not a macro policy, is it?)
d) I insist there is a big output gap because X, Y, Z. (Fantastic! The Bank are still targeting the CPI.)
e) Infrastructure spending? (Please stop.)
f) How about we target a real variable like unemployment? (Yeah, the 1970s were brilliant.)
All of that serves only to duck the real question… the nominal question. The nominal question appears to me to be remarkably simple:
What is more important: (1) output/consumer price stability, or (2) nominal wage/income stability?
If you want “price stability” then you can’t have nominal income stability. We’ve tried that. Productivity shocks are horrible, and inflation-targeting seems to make them much worse. And if you want nominal wage/income stability then you can’t have “price stability”. We need to be open about that, with the politicians and the public; “price stability” was a good idea which failed. Can we do better?
Now, please, get off the fence and decide what you really, really want.
Chris Giles’ post on demand vs supply made me very gloomy – look at the comparison with US productivity, the “cost of living crisis” is right there in that data. Here is a slightly different take based on today’s labour market figures.
You could say based on that, the UK demand-side recovery is basically complete. Hours worked is back on trend. The demand-side debate is dead. The stagnation of UK output is, and always has been, purely supply-side.
The fact that supply-side optimists find excitement in one month of a still-above-target CPI rate is even more depressing. Has nobody learned anything at all? If the CPI rate is irrelevant when it tells an “inconvenient story” about the aggregate supply/demand balance, it does not suddenly become relevant because one data point confirms your biases. Recognize that oh-so-wise policymakers might not share your rose-tinted view of the UK inflation data, and what implications that has for macro policy when the CPI rate is above target (see also 2008, 2010, 2011, 2012). Yes, the MPC really are steering us towards price stability.
And Dr. Carney… great job, really, great job.
There’s been some discussion of UK productivity recently, Simon Wren-Lewis here, Martin Wolf here, and Scott Sumner indirectly too. What I find interesting is that UK productivity exhibits such a strong positive correlation with nominal demand growth. I’ve graphed here the growth rates of nominal GVA, and market sector output per hour.
Why do we see that procyclical movement of productivity? I’ll offer three views:
1. Firstly, this is simply what we should expect to see under an inflation-targeting central bank. The inflation-targeting CB is trying to control the gap between (growth of) aggregate demand and aggregate supply. When we have a negative productivity shock (2008, 2012) the CB must drive down nominal demand growth to prevent high inflation. That’s all this data shows; Mervyn King and the supply-side pessimists will settle for something like this view. There is no AD problem per se, it’s supply, supply, supply.
That story is muddied only a little by the difference between CPI inflation (the actual BoE target) and output price/GVA inflation. GVA inflation, averaging 1.8% over the last four years, has been stabilised by the BoE arguably more effectively than the headline CPI.
2. Another view is that the GDP data is wrong, at least post-2009. The 2012 productivity collapse is genuinely weird. The fall in market sector output/hour masks the fact that hours worked soared upward, up 2.6% over the four quarters to 2012 Q4, while market sector output contracted by -0.3% over the same period. (The GDP data still show a market sector ”double-dip” in 2012, offset by the positive contribution from the
savage fiscal austerity rise in the volume measure of government consumption). There are a few theories here:
a) The idea that the GDP data is wrong is neatly supported by work on measuring intangible investment (see Goodridge, Haskel et al). I find this quite compelling because it matches an anecdotal view of what is happening in some sectors, e.g. retail. With the shift towards on-line shopping; that sector is investing in intangible assets (web sites, software etc), and there is less demand for new tangible capital (shops).
b) Markit’s Chris Williamson made the argument recently that the official labour market data which is wrong. The ONS disagreed, needless to say. Given that the change in unemployment has roughly tracked the movement in the claimant count, I’m not sure how much weight to put on this idea.
c) The nominal GDP data is right, but the inflation data, and hence output and output/hour, is wrong. A pet theory of this inflation-sceptic blogger. Under five years of 1920s-style NGDP growth we have seen widespread discounting and substitution. For the latter, think about the success of UK budget hotels, airlines, and supermarkets; this is substitution between goods/services of different quality. I strongly suspect such changes are near-impossible for the ONS to capture “correctly” in the price indices, and hence measured inflation is far too high. This makes measured productivity appear to be more procyclical than it should be if we “correctly” measured inflation and output.
3) A third view… it’s demand, demand, demand. The slow growth of NGDP was simply a mistake, it was bad macro policy. Labour hoarding and hand-waving are used to explain away the productivity data. The correlation in the graph really is a causal relation, but it goes from demand to productivity; we’ll see a recovery in productivity with a recovery in AD. So jump to it Mr. Carney/Mr. Osborne.
In optimistic moments I can subscribe mostly to (3), and 2013′s apparent recovery in output along with a recovery in demand supports that argument, in my view. Martin Wolf argues the Bank can “correct… highly visible errors” on inflation later on, after “gambling on growth”. But what is a “highly visible error” if not the last five years of UK inflation?
Supply-side optimists cannot sit on the fence and pretend the 2008-201X CPI trainwreck never happened. It’s surely more convincing to argue we should take productivity – and inflation – out of macro policy altogether. Set a stable path for nominal incomes and let the supply-side puzzle itself out.
A speech from BOJ Deputy Governor Kikuo Iwata last night:
More recently in the United States, nominal rates went up, inflation expectations came down, and the expected real rates picked up after market participants started forming a view that the Fed would start tapering the pace of its asset purchases in light of Chairman Bernanke’s testimony on May 22, while in reality this was meant to slow the pace of increase in excess reserves. By contrast, the FOMC’s decision to continue with its quantitative easing on September 18 led to a decline in nominal rates, a rise in inflation expectations, and a decline in the expected real rates (Chart 23).
How beautifully ironic that the BOJ board is able to produce a critique of Bernanke’s tight money. Iwata continues:
What should we make of these episodes? In my view, they owe much to the fact that market participants make judgments on the monetary policy regime after they see changes in the monetary base and the excess reserves, and then form projections for the money stock, the future course of interest rates, and projections for prices.
What matters to interest rates and inflation expectations is the monetary policy regime of a central bank and market participants’ views on the prospects for the money stock based on such a regime. The current level of money stock is irrelevant. It is in this sense that the simple “quantity theory of money,” in which there is a one-to-one relationship between the current money stock and prices, does not hold in practice. Nonetheless, there is a close relationship between the projected future course of the money stock and inflation expectations, and the present rate of inflation is determined based on inflation expectations formed in that way.
I enjoy reading the Hansard achives from the 1930s… what an amazing resource. It is not hard to find parallels to modern-day debates about macro policy. The following quote is from David Mason MP speaking in Parliament in July 1934 during a debate which appears to be mostly about monetary policy:
It is rather interesting to see how complete is the analogy in many respects between that period of history after the Napoleonic Wars and the period through which we are now passing. Of course, there is the difference of time, and increases of population and so forth, but there were inflationists and deflationists, paper money men and bullion men just as there are now, and it is curious and interesting to find, if one will take the trouble to read up the Debates in this House, comments and statements made almost similar to those that are being made to-day.
I believe that, if His Majesty’s Government would announce in due course that they were prepared to set up an inquiry into the monetary system and into monetary policy, they would be astonished at the flame of enthusiasm that they would arouse throughout the country, especially among the younger people. They are not satisfied with world conditions as they are to-day; they are not satisfied with any policy of going back to 1924 or 1914; they feel that the productive capacity of the world is immense, but that it is not being utilised owing to the defects in the monetary system, which should facilitate the exchange of goods and services all over the world.
I love that clarity. So many today talk about monetary policy only in terms of borrowing and lending or banks or interest rates… how about sticking with “facilitating the exchange of goods and services”? A little later from Loftus, here is that history we’re repeating:
We know the effect which, as my hon. Friend the Member for East Aberdeen has pointed out, deflation has had upon our people; and we know also that to-day the economic problem is linked with the political problem. In Yugoslavia you have revolutionary discontent. Why? There is deflation. In Italy under the surface there is revolutionary discontent, Why? Deflation. In France, riots and revolutionary discontent. Why? Deflation. What was that bloody business in Germany the other day caused by but the pressure of deflation constantly driving down the standard of living? That was the main cause.
The loci of the riots and deflation only a little different this time around.
The Riksbank’s loss is the blogosphere’s gain. If you are not following along already, Lars Svensson has a great post on Fisher and debt deflation, following an earlier VoxEU post on the effect of monetary policy on debt and income. I can’t read Swedish but Google Chrome can. Here is the translation provided:
A dangerous thing when it comes to debt is what Irving Fisher (1933) called “debt deflation”. It is usually described as deflation causes the real value of nominal debts are growing.Leverage and debt ratio also increases as the nominal debt is fixed while the nominal value of the assets and nominal disposable income falls. This could damage the economy in that it can lead to bankruptcy, “deleveraging” (savings to reduce debt) and “fire sales” (quick sale) of assets with consequent fall in prices.
But central to the idea of “debt deflation” is not in and of itself that it becomes deflation, i.e. negative inflation. What is important is that the price level will be lower than expected. This means that the real debt, leverage and debt ratios are higher than expected and planned. All probably have not realized that this is something that the Riksbank has caused by overriding objective of price stability and for a long time to pursue a policy that provides an inflation well below target. The Riksbank has therefore caused real household debt, leverage and debt ratios become much higher than the inflation rate remained on target.
This is great stuff. But one problem which the UK data illustrates perfectly is that the price level can tell us the “wrong” story about real debt burdens, whereas nominal GDP (or nominal wages) lights the way perfectly.
Mark Carney tried to explain Woodfordian monetary policy to some reasonably smart MPs today and he failed completely. ”Train wreck” would be a moderate description of how badly that Select Committee meeting went.
Is the 7% unemployment rate a target? Erm, well, you see…
What will happen if the 2.5% inflation knockout triggers? Erm, well, you see…
Are higher interest rates a sign of looser or tighter monetary policy? Erm, well, you see…
Is forward guidance a loosening or a tightening of monetary policy? Erm, well, you see…
That was an awful public performance and painful to watch. Carney has an impressive grasp of the UK data, but he was struggling to explain something as simple as the stance of monetary policy when forced to rely on the language of interest rates and “state-contingent guidance”, etc. I’m sure it would be much simpler if he could stick to money and nominal incomes!
I’m back from the beach… and I want you to recall the quotes from Mervyn King’s infamous “Black Clouds” speech of June 2012:
… 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 …
Contrast with the quotes I can cherry-pick from Mark Carney’s first speech as Governor:
We aim to get there in part by reducing the uncertainty that has held back growth.
… First, we are giving confidence that interest rates won’t go up until jobs, incomes and spending are recovering at a sustainable pace.
… Our forward guidance provides you with the certainty …
… should give greater confidence …
Our forward guidance acts as a stabiliser, …
However much I dislike the specifics of BoE policy, it would be churlish of me not to say it: this is much, much better. This is how a central bank Governor should talk; certainty, confidence, stability. Mark Carney is doing his job, and that is a good thing.
The Riksbank continue their brave fight against employment, inflation and debt. The July Monetary Policy Report has a lengthy discussion (pages 42-48) of the trade-off they are making; here’s a quote:
Two monetary policy alternatives have been illustrated in this article: a higher and a lower repo-rate path. During the usual three-year forecast period, the lower repo-rate path provides better expected target attainment in terms of inflation and resource utilisation. However, as a lower repo-rate path can contribute to increased indebtedness, it also increases the risk of an unfavourable scenario beyond the forecast horizon, for example in the form of a fall in housing prices in connection
with a high level of household indebtedness. This scenario entails major losses, for example in terms of higher unemployment, which in itself can also be aggravated by a high level of indebtedness at the outset.
A monetary policy that takes into account financial imbalances therefore means that the choice between the two repo-rate paths in this case becomes a trade-off between attaining the target in the short and long term: inflation’s deviation from 2 per cent and unemployment’s deviation from a normal level during the normal three-year period are weighed against the expected course of development beyond the forecast horizon (see Figure A5).
I think Yossarian would appreciate all this. The Riksbank are deliberately missing their targets – keeping inflation below target for longer, and unemployment higher for longer. Why? Because if they tried to hit their targets then the bogeyman named “household debt” might jump out from underneath the bed. So what, you might ask? Well, if the debt bogeyman strikes, the Riksbank might miss their targets.
What is most depressing to read is that they are clearly trying to avoid the perceived mistakes of other central banks:
One way of estimating the consequences that a fall in housing prices could have for the Swedish economy is to produce a scenario based on international experience. The scenario is based on the average macroeconomic effects of a number of episodes in OECD countries where house prices have fallen and indebtedness has been high. As additional comparisons, the average course of development in Denmark, the Netherlands and the United Kingdom during the latest financial crisis is also illustrated, as well as the course of development during the Swedish crisis of the 1990s.
Failure begets failure; the lesson learnt from the UK’s failed inflation targeting regime is apparently that tight money is a good way to avoid recessions.
The Riksbank have “successfully” driven nominal GDP growth down to below 2% and headline inflation to around 0% with a well-timed series of repo rate rises:
Here is Winston Churchill discussing the “cost of living” in Parliamant, as recorded in Hansard in 1925 (via a paper by Susan Wolcott via Bob Hetzel), attacking the ideas of one Professor Keynes:
The hon. Member for Keighley was deploring a fall in prices, but what does a rise in prices mean? It means a rise in the cost of living, and what does that mean? It means a diminution, in exact mathematical ratio, of the real wages which are received by the working classes.
The Labour party echoes those words by choosing to campaign in 2013… on… wait for it… rising prices and falling real wages, the “cost of living crisis“. Somebody in the Labour party should read Nick Rowe, if not Keynes on the economic consequences of (thinking like) Mr. Churchill.
Simon says I should hold Osborne responsible for the UK’s macro policy failure. Did Keynes hold Churchill responsible for returning the UK to gold at a level which required a great deflation? Keynes wrote, on Churchill’s decision:
Why did he do such a silly thing?
Partly, perhaps, because he has no instinctive judgment to prevent him from making mistakes; partly because, lacking this instinctive judgment, he was deafened by the clamorous voices of conventional finance; and, most of all, because he was gravely misled by his experts.
My emphasis. That perfectly captures how I feel about Osborne: yes, failing to change the MPC remit is awful and stupid, but is not terribly surprising given the advice he’s had.
The Bank of England has mounted a lobbying campaign to keep the 2% inflation target over the last nine months. Mervyn King’s choice of words for those who consider a departure from 2% CPI was downright vicious; “unrealistic”, “painful experience”, “illusion”, “terrible price”, “wishful thinking”, “the dreamers”. And that’s before I start on Spencer Dale or Martin Weale. If I were to summarize the MPC consensus it would be that they could target anything other than 2% CPI but it would be a very, very bad idea.
Macroeconomists outside the Bank are broadly split into two groups. The “fiscalists” think our demand-side [edit: problems] can only be solved using fiscal policy, because monetary policy is interest rates and we ran out of interest rates. And there’s the supply-siders who think our problems are mostly supply-side because of the CPI data (or political bias, take your pick).
There are others (like Simon) who cannot be so narrowly categorized, and have more nuanced views. But why should HM Treasury listen to Simon Wren-Lewis and Scott Sumner and ignore Mervyn King and Charles Goodhart (who is cited twice in the remit review discussion of NGDP targeting)? It is not credible to crucify Osborne on a cross marked “ignorant of basic economics“, when he is following the advice of experts like King and Goodhart.
I think Osborne went somewhat beyond the consensus view of modern-day “experts” in asking the Bank to do forward guidance, and he deserves quiet applause for that. I believe a range of policy options was available to the MPC under the guise of “forward guidance” and MPC members should be held to account both for the policy choices they make, and for the policy advice they give HM Treasury.
I also think the Labour party are also being “gravely misled” by today’s experts who have convinced them that UK demand-side problems are purely fiscal “because ZLB”. That is not what New Keynesians should say about optimal macro policy at the ZLB. Here’s New Keynesian Lars Svensson in 2006:
Japan has certainly tried an expansionary ﬁscal policy. This has not led to an escape from the liquidity trap, but it has certainly led to a dramatic deterioration of Japan’s public ﬁnances.
That is the kind of thing the Labour party should be hearing from macro experts. Oh, and drop the “cost of living” nonsense.