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!