I want to clarify since I always feel a bit dirty after doing pessimistic posts about the supply-side:
1) I have very low confidence in any views about “potential output” and whether the productivity data is “correct”. That is doubly true for my own half-baked views.
2) I think the productivity data should have a 0% weight in setting monetary policy. Zero, zip, nada, zilch. And I think nominal wages
and/or incomes should have a 100% weight.
It is this second point which made me particularly angry at Carney’s (latest) hawkish move: the new data this year is telling us that nominal wage inflation is at record lows. Hence we need tighter monetary policy because…? Well, it’s not clear.
It is half true that the UK is looking more like Japan in 2014 than ever before. The CPI rate is below target and now looking kind of “low“. Nominal wage growth is dead. Tax revenues are sluggish; there is a gigantic fiscal deficit and public sector debt is heading up to the moon. The currency is looking pretty strong – something which plagued pre-Abe Japan regularly. Almost everybody is a supply-side pessimist. Our central bankers are hawkish. And even Her Majesty’s Loyal Opposition has been campaigning on the basis that “prices are too high”. (Maybe Ed Balls read all the Japan ZLB literature sitting on his head?)
But that is not the whole picture. I still don’t see any convincing sign that nominal GDP growth is slowing from around 4-5% y/y, a rate which should normally be consistent with the Bank’s mandate. The “low CPI rate” today is as useless a demand-side indicator as the 5.2% CPI rate was in September of 2008 or 2011. Inflation expectations are very stable and consistent with hitting that 2%. Confidence indicators are at multi-decade highs. I think “steady as she goes” would be a pretty reasonable monetary policy if you do want to take the inflation target seriously.
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.
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.)
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.
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.
What’s the state of UK macro according to the NIESR?
Recent GDP growth has been driven by domestic demand growth, especially consumer spending, which contributed 1.6 percentage points to growth in 2013. This has come despite further falls in real consumer wages. We expect consumer spending to remain the key driver of recovery in 2014 and 2015, supported by continued buoyancy in the housing market. House prices have seen a dramatic rise throughout the year, concentrated in London and the South East. There is considerable uncertainty over the magnitude of the impact of the second Help to Buy Scheme: stronger house price inflation would lead to even stronger consumer spending growth in 2014.
That is from last month, I quote it only because it’s typical of what City commentators are saying about UK macro. It is interesting how ZLB macro narratives change in the UK. It appears to me we have have shifted into phase three:
1) In Phase 1 it was asserted that monetary policy will have no effect at the ZLB – it’s a liquidity trap – printing money is pushing on a string. Ergo, fiscal fiscal fiscal.
2) In Phase 2 it was accepted that in fact monetary policy will have an effect, but it will “only boost asset prices”, it will not help the “real economy.” Boosting asset prices had “distributional effects” and was zero-sum: rich people owning assets gained, poor people lost out. After all, if house prices go up, housing is “less affordable”! Similarly monetary policy could obviously boost commodity prices – again a bad thing for the little people who want to consume those commodities. Phase 2 was monetary policy viewed as creating supply-side inflation. Fiscal policy, in contrast, could build real things like bridges and ergo was a better idea.
3) In Phase 3 there is a recognition that boosting asset prices does have effects on the real economy but this was probably a bad thing because it’s “unsustainable”, and it’s also due to fiscal policy in any event.
It is not obvious to me why any level of house prices would be “unsustainable” any more than any level of consumer prices would be “unsustainable”. It’s just a price index. If macroeconomists really believe that house prices are really the key (or a key?) to boosting real growth and employment – then why not have the Bank of England target the house price index?
There is nothing magical about stabilising the CPI rate, but the HPI is special…. if only we’d known this in 2010! Worried about the effects of fiscal austerity on employment? Never mind, have the Bank of England target 20% y/y house price inflation, which will boost consumption and “drive the recovery”.