I didn’t expect to be writing this post so soon! The Governor of the Bank of England announced yesterday that interest rates are no longer at the Zero Lower Bound. This was a rather under-the-breath “Oh, and by the way” announcement, which is kind of funny given how much some economists have staked on the significance of the ZLB. From Carney’s letter to Osborne, my emphasis:
There are risks to the outlook in both directions. To the downside, the fall in near-term inflation could be more persistent than the Committee currently expects. Global activity could continue to disappoint, or if low inflation were to depress inflation expectations, it could become self-reinforcing. In that case, the MPC would need to provide more support to return inflation to the target over the appropriate horizon.
Were these downside risks to materialise, market expectations of the future path of interest rates could adjust to reflect an even more gradual and limited path for Bank Rate increases than is currently priced. The Committee could also decide to expand the Asset Purchase Facility or to cut Bank Rate further towards zero from its current level of 0.5%. The scope for prospective downward adjustments in Bank Rate reflects, in part, the fact that the UK’s banking sector is operating with substantially more capital now than it did in the immediate aftermath of the crisis. Reductions in Bank Rate are therefore less likely to have undesirable effects on the supply of credit to the UK economy than previously judged by the MPC.
In choosing to hold rates at 0.5%, the MPC is choosing to set rates above the new, lower, actual ZLB. The Bank of England is no longer at the ZLB.
The good news is that now the Bank is off the ZLB, reality-based Keynesians will return to talking about UK macro policy in terms of conventional monetary policy and will go quiet about the need to use fiscal policy to control AD. Right? No more talk of building schools to create jobs. We are seeing today the Bank’s preferred path for output and inflation. It leads to 2% inflation and zero output gap. We know, that if the Bank wanted a different path for output and inflation they can use the conventional tools of policy. If you think that path is not optimal, it is either because the Bank has the wrong target, or that you believe they are making a conventional policy error. Either way, no need to talk about fiscal policy.
Economist writer H.C. has an interesting Free Exchange post discussing Scott’s “musical chairs” model and British unemployment. Scott also comments. Here is my curve-fitting exercise:
One of the difficulties in working with the UK macro data is that the ONS don’t produce a good quality high frequency time series for hourly wages. Of the available data we have low frequency, high accuracy data in the Annual Survey of Hours and Earnings (ASHE) based on very large sample of employers’ payroll data held by HMRC. At the other end we have high frequency, low accuracy data in the Average Weekly Earnings (AWE) data, produced from a small survey which deliberately excludes a number of workers (notably, I believe, high earners and small employers). I compared the range of various sources at the beginning of last year.
In this post I’ll use the lower quality AWE data, from which we have time series for both regular (ex bonuses) and total weekly pay, and also for average actual hours worked. I’ll also assume that bonus pay is not very sticky. From either pay series we can then calculate average hourly wages by simple division.
The musical chairs model says there is a strong positive correlation between the unemployment rate and the ratio of hourly wages to nominal GDP. I’ll cheat slightly (I did warn you this was a curve-fitting exercise) and use nominal GVA at basic prices instead of NGDP. An increase in nominal GDP which is accounted for entirely by an increase in indirect taxes would not be expected to increase the resources available to hire workers; since we’ve had big VAT shocks in the UK I think this is a reasonable “cheat”.
Here’s the first version of the musical chairs graph, using regular wages to derive hourly wages:
I would say this has done quite well since 2008: though the recovery is predicted slightly too fast, and the correlation is absent for the period prior to 2008.
A second interpretation is to use aggregate employee income instead of nominal GDP/GVA, so changes in the labour share of GDP don’t affect the results:
This is a better fit.
One thing that either of these models will struggle with, if only because of data limitations, is the shift between employment and self-employment. There have been two very large swings in UK self-employment in the period covered above: a 9% rise in 2003 and a 10% rise in 2013/4. We cannot really measure the wages of the self-employed, and as far as I know those workers are entirely excluded from the AWE data – I would not find it surprising that the musical chairs model appears to breaks down for that kind of shock. If there are studies on self-employment and wage stickiness I’d be interested to hear in the comments.
Back in 2013 I described a (crude) supply-side counterfactual for UK real GDP using the OBR’s 2011 Forecast as the baseline. Here is an update which uses the data from the OBR’s June 2010 Budget forecast and extends to 2014. (I am not sure why I did not find the forecast for hours worked in the 2010 forecast before.)
The exercise is again simple (or if you want, much too simple): I take the OBR’s June 2010 forecast of output per hour, the observed data for total hours worked, and calculate a supply-side counterfactual path for real GDP. That path is compared against both the OBR’s June 2010 forecast of real GDP, and the actual data we have for for real GDP – I’ve rebased this time to highlight the difference since the pre-recession peak.
It remains true that a purely demand-side view of the UK recovery seems to prove too much. At least, it is hard to see that the weakness of RGDP relative to expectations circa June 2010 can be explained by a demand-side view; the shortfall in output is simply not a reflection of a shortfall in employment.
IFS chief Paul Johnson laments the absence of political debate about productivity:
What happens next to productivity will define our economic performance over the next five years. In the end growing productivity is the key to our economic wellbeing. As the Nobel Laureate Paul Krugman once put it, productivity isn’t everything, but in the long run it is almost everything. Strong productivity growth will lead to higher earnings, higher living standards, and an easier job reducing the deficit. If productivity growth is weak, then we are in for some more tough years.
So why don’t we hear more about this from the politicians? Whatever they may say, they really can’t just legislate for higher earnings and lower prices. Those will come only as a result of a more productive and efficient economy.
It’s funny really. Some will attribute the stagnation of living standards since 2010 (or 2008) to mostly demand-side causes (e.g. Coalition austerity), and get extremely cross that politicians don’t take the AD policy seriously… and others get extremely cross that politicians don’t take supply-side policy seriously enough. The spectrum of views between the two extremes is also available.
I get more frustrated that we lack a common methodology or understanding of how to interpret the macro data. How do we decide the extent to which each view is true? Without that, I’m not sure why we should expect politicians and policymakers do much better than pick some position. (To be fair, many fail even that test.) Crazy models like the “paradox of toil” – which are taken seriously by some academics – make a mockery of the idea we can or even should separate the supply-side from the demand-side.
Unemployment towards the end of 2014 was 0.3% higher than in early 2007. Is it unreasonable based on figures like that, to say sure, the stagnation in UK living standards has been “clearly” supply-side? I could pick other data: low inflation or wage growth maybe, low (forecast) nominal GDP growth, and say, yes, demand-side problems remain.
But it’s complicated. If productivity growth has fallen to around 0% (god forbid) then nominal wage growth at around 2% is consistent with something like “full employment”. The argument goes back and forth… it only appears satisfying if you have strongly held prior beliefs and find a data point to confirm them.
Congratulations to the Ralph G. Hawtrey Chair of Monetary Policy! Making my way through some of the references from George Selgin’s monograph “Less than Zero” recently, I ended up reading a transcript of a Chatham House discussion from 1929 on “The International Gold Problem”. The transcript is a bit rough in places, but whole thing is a fascinating read; here’s a contribution from Hawtrey to add to Scott’s collection:
Mr R. G. HAWTREY: In my view one of the most serious evils arising from fluctuations in the value of the currency is the trade. Whatever the causes of the trade cycle may be, one thing is common ground to every one, and that is that the trade cycle include the fluctuation of the price level combined with a fluctuation of productive activity. The two go together. Fall in price were due to increased production and the rise in scarcity, no further explanation would have to be looked for. But in fact the fall coincides with diminished production and the rise with increased production. The total value in money of the output of the world is increased both by the percentage by which prices rise and by the percentage by which the physical volume of production rises. Likewise, the subsequent fall in the price level is superimposed on the shrinkage of production. These wide fluctuations in money value of output are clearly a monetary phenomenon. A fall in the price level due to monetary causes brings about business depression and unemployment. The depression of the ’eighties, following the general adoption of the gold standard and the heavy fall in prices from 1873 onwards, supplies a well-known example.
More than eight decades later and it is now a minority view that the “wide fluctuations in the money value of output” … i.e. nominal GDP since 2008… are “clearly a monetary phenomenon”!
A mea culpa. I posted a chart of UK inflation expectations last month which showed no decline in gilt market-implied inflation expectations with the decline in the oil price. I was puzzled that published forecasts of expected inflation did not show the same decline as the market data. The reason is that my data was wrong. Sorry!
In fact I had posted the chart which was based on data for the forward measures of inflation, which comes from a different sheet in the Excel spreadsheet which the Bank publishes for the yield curve.
The correct chart for implied RPI inflation over the next 2.5 years is:
By looking at the change in inflation expectations across different durations, we see that shorter-term inflation expectation have declined with the fall in the oil price:
Here is the comparison with the forward measure which I used by mistake in the old post; the green line is expected inflation over the period from today to 2018, the blue line is expected inflation over 2018 to 2021.
It’s important to remember that the supposedly “orthodox” interpretation of the liquidity trap theory predicts that it was impossible for the Swiss National Bank to devalue the Swiss Franc in 2011. Monetary policy is all about interest rates, and when you have run out of interest rates, as the SNB had, there is nothing for your highly-paid central bankers to do. Perhaps they can meet up every now and then, and write a strongly-worded letter asking for fiscal stimulus if the expected path for inflation is a too low.
Here is how Reuters report the SNB doing nothing this morning:
The Swiss National Bank shocked financial markets on Thursday by scrapping a three-year-old cap on the franc, sending the safe-haven currency soaring against the euro and stocks plunging amid fears for the export-reliant Swiss economy.
Only days ago, SNB officials had described the 1.20 francs per euro cap, introduced in 2011 at the height of the euro zone crisis to prevent the strong currency leading to deflation and a recession, as the cornerstone of the bank’s monetary policy.
The U-turn sent the franc nearly 30 percent higher against euro in chaotic early trading. It came a week before the European Central Bank is expected to unveil a massive bond-buying program that might have forced the SNB to intervene repeatedly to defend the cap.
We’ve also been told a few times that currency devaluation is zero-sum (since global aggregate demand is fixed), and so I presume the European economy will get a welcome boost from the devaluation of the Euro against the Franc. I suppose somebody, somewhere, is celebrating that the Swiss have stopped “sucking demand out of the world economy”?
Lars Svensson’s Foolproof Way has always seemed like the best option for the SNB to me.
CPI rate at 0.5%! It appears we are well clear of the “boring period” for UK macro. Shame. I am impressed by the media commentary around inflation. Go read our good friends at the FT, and Allister Heath at the Daily Telegraph.
A quick reminder of the modus operandi of inflation hawks witnessing above-target inflation:
1. Acknowledge that inflation can be driven away from target by supply-side shocks as well as demand-side shocks.
2. Identify an alternative inflation measure which attempts to strip out those supply-side effects and supports a demand-side interpretation of high inflation.
3. Remind the world that there are serious consequences of allowing inflation to deviate from target (unanchored inflation expectations, a wage/price spiral, the 1970s, civil unrest, meteor strikes, etc), ergo we need tighter monetary policy.
I exaggerate only slightly there. Now here is Simon Wren-Lewis:
This is also why looking at some measure of core inflation is important. If below target inflation is just due to lower oil prices, say, which in turn are just lower because of increased supply, say,  then this is no reason to think resources are being wasted. Just as inflation targeting central banks should largely see through any inflation caused by higher oil prices, they should also do the opposite. However in the UK, US and Eurozone core inflation is significantly below target, suggesting resources are being wasted everywhere.
I groaned all the way through Simon’s post. There is no official measure of “core inflation” in the UK, and the MPC rarely makes any reference to such an index. The ONS variant of the CPI which strips out energy, food, alcohol and tobacco is probably closest to what would be a textbook “core inflation” index. Here is the chart of that series:
As you can see, “core inflation” was above 2% all the way from 2010 through late 2013. I’ll predict the response: “Look at 2010 and 2011. Obviously we should strip out VAT too, you idiot!” OK, that’s sensible, I agree, but there is no ONS index which does that. The ONS produces literally hundreds of different price index series, and you want to argue that the one which really matters when setting monetary policy… doesn’t actually exist. Really?
Regardless, even with stripping out VAT in 2010/11, we are left with above-target “core inflation” in 2012 and and most of 2013. So, who was citing that data and arguing that we obviously had a too-expansionary monetary policy, and clearly there was little or no output gap with inflation pushed safely above target? I don’t remember Simon doing so. Yes, we can qualify the inflation data even further. Let’s strip out train fares, water prices, tuition fees, other administered prices, all prices which went up, etc. Those are (ahem, mostly) reasonable arguments. But recognize that this is basically the same logic followed by the hawks.
I could make a fence-sitting argument where I say the hawks might have been “correct” to take a demand-side view of high inflation in 2011, just as Simon might be “correct” to take a demand-side view of low inflation in 2015. But I don’t believe that. I think the hawks were mostly wrong before and I think Simon is mostly wrong now in taking a demand-side view of supply-side shocks. From my previous post, the recent downward revision to forecasts of inflation for 2015 happened at the same time as downward revisions to forecasts of unemployment. That is simply not what a negative demand-side shock looks like.
The “balance of risks” argument is reasonable, and it might be true that a slightly looser monetary policy will do little harm now – hey, after all, there is a risk house prices in London stopped going up*. In fact, sterling fell in response to the inflation data surprise, indicating precisely that money got slightly easier, so a “dovish” reaction to low inflation surprises is already embedded in current policy. In the long run I think we’ll have a more stable economy if monetary (and fiscal) policy makers can be encouraged into looking at “inflation” in a way which doesn’t require sharp swings in aggregate demand in response to supply shocks.
* This is a joke. Also it’s not a joke. Having UK monetary policy target the oil price with too high a weight would be likely to create excessive volatility in nominal demand and hence other nominal asset prices, so I think we’d expect to see more boom-bust housing cycles.