How Tight Money and Fiscal Stimulus Failed in 2008
Scott Sumner, Marcus Nunes and Simon Wren-Lewis have all commented on Charlie Bean’s speech on NGDP targeting. With such illustrious company I doubt I can add anything of substance to the debate, but I wanted to pick up on what Marcus said since I think it helps better frame the debate that’s going on in the UK regarding the use of fiscal and/or monetary “stimulus”.
Thinking about monetary policy in terms of the central bank “doing things” is often unhelpful. In late 2008 the Bank of England was “doing lots of stuff”. They were very busy adjusting interest rates downwards; most people think of the Bank’s actions as “aggressive“. Cutting Bank Rate from 5% to 0% in six months is “monetary stimulus” par excellence – right?
The November 2008 MPC minutes are instructive. Here is what the MPC discussed:
33. The projections in the Inflation Report implied that a very significant reduction in Bank Rate –possibly in excess of 200 basis points – might be required in order to meet the inflation target in the medium term. However, a number of arguments were discussed for not moving Bank Rate by the full extent implied by those projections.
This says that the Bank’s internal models say they needed to cut Bank Rate by more than 2% to keep inflation on target at the forecast horizon. They instead decided to cut by 1.5%, and give four reasons why they didn’t do more:
34. First, the projections had used the normal convention that they were based on the Government’s most recent published tax and spending plans. The Government had already announced its intention to bring forward some planned spending commitments. Moreover, the changing composition of output would lead to a fall in effective tax rates from those assumed in the projections. Consequently, it would make sense for the Committee to reassess the required scale of monetary easing after the Chancellor’s Pre-Budget Report.
This is a demonstration of the “Sumner Critique”. The Bank is offsetting fiscal stimulus by cutting interest rates less than they otherwise would have done if no fiscal stimulus had been planned.
The second reason for not cutting the rate the full 2% is that they don’t have a clue what is going on in the banking sector. That seems like a good argument to do more not less, but then I’m not the one who bangs on about uncertainty all the time.
The last two arguments are what can only be described as a catastrophic policy error; my emphasis throughout:
36. Third, a key concern was the degree of surprise to financial markets. Too large a surprise could pose upside risks to the inflation target if the resulting depreciation of sterling was excessive. There was a risk that such a move might be misinterpreted as a change in the Committee’s reaction function, which would damage the credibility of the inflation target. That suggested leaving some of the required monetary loosening until after the Committee had had an opportunity to explain its change of view on the outlook for inflation in the November Inflation Report, and to assess the market reaction to both the Report and the decision.
37. Fourth, some members thought there was an argument for leaving some of the required policy loosening to the months ahead to support confidence as the economy weakened.
I know I tend towards the melodramatic, but I honestly believe that people reading those sentences today should be shocked and disgusted.
The MPC are deliberately cutting Bank Rate less than is necessary to keep forecast inflation on target because they are worried about the “credibility of the inflation target”. Does that make any sense to you? It should not. It is the kind of nonsense which should get policy-makers removed from office with immediate effect.
And they are refusing to cut the rate so that they can later on “support confidence” as the economy weakens? “Why, yes, Captain, I have just turned the ship in the direction of the iceberg. This will allow me to later on swerve away from the iceberg so I can demonstrate my excellent navigation skills… if all goes to plan, ha ha!”
Now go and read the quote Marcus provides from Charlie Bean again; or this one:
But there is a danger of expecting too much from monetary policy. The Great Recession of 2008-9 was unlike earlier policy-induced downturns aimed at reining back excessive inflationary pressures.
It is true that there is a danger of expecting “too much”. Monetary policy can’t solve supply side problems. There is a perfectly reasonable argument that the demand shock which started in 2008 Q2 was not anticipated by the MPC.
But if you read the minutes above, how can you possibly agree that “reining back inflationary pressures” had no place in the MPC’s reaction to the crisis? Or that, from the implication in the quote Marcus gives, the MPC did “as much as they could”? Or that giving monetary policy makers total discretion over the policy stance is a really good idea?
Here is what happened to the three year market inflation expectations in 2008:
Since index-linked gilts are based on the RPI not CPI, you should take off 0.5% to 1% to get the expected CPI. By the start of December markets were expecting the Bank to provide three years of deflation.
Alistair Darling was talking about the UK being in a quasi-Depression in August that year, yet did nothing about Bank Rate being at 5%. He proposed a fiscal stimulus package in the Pre-Budget Report of November 2008; from the PBR:
Discretionary action of £16 billion will deliver a fiscal stimulus package of around 1 per cent of GDP in total in 2009-10, in addition to the support provided by measures in 2008-09.
Annual nominal GDP fell by 3% in 2009, rather than the “0.5 to 1%” rise expected in the PBR forecasts. Fiscal policy was the wrong focus in 2008, and it’s the wrong focus in 2013. Regime change, please, Mr. Osborne.