A Resolution Foundation report on UK monetary policy reminds me of the near absence of discussion about devaluation. The report has a section on policy options to deal with the ZLB, giving five choices: QE, negative rates, higher inflation target, fiscal policy, and structural reform. You could substitute “devaluation” for QE and/or negative rates; the section on the latter only mentions the exchange rate in passing:
Nevertheless, there is much uncertainty over the longer-term consequences of this approach – with exchange rate impacts likely to be a particularly important consideration for an open economy like the UK. And of course, even if the bound can be pushed below zero, at some point a limit must be reached.
The exchange rate does not have that lower bound. In fact, if you really believe the ZLB is a problem, a sensible policy reform would be to stop targeting interest rates (plus “doing QE”) and target a currency basket. The Monetary Authority of Singapore does exactly this. The UK often seems like a small open economy with delusions of being a large closed economy. We should dump the delusions.
I am not sure why there is so little debate about devaluation compared to e.g. fiscal stimulus. This is surely not a monetarist vs Keynesian argument. The theory behind pegging the exchange rate as a way of avoiding the ZLB is arch-Keynesian. Lars Svensson and others have been writing papers on this for decades. Are memories of Harold Wilson still haunting us? I would like to believe it is not because people have supply-side views of inflation, but I suspect that’s large part of it, at least in the media. (Inflation is something that lowers our living standards, and devaluation just causes inflation.)
p.s. The Resolution report is also unreasonably ungenerous toward central bankers’ anticipation of the ZLB, citing as evidence that the BoE Governor had only used the phrase “QE” in one speech prior to 2008. That is a bit silly because the term QE was not widely used prior to 2008. Mervyn King had long discussed the liquidity trap, and persistently rejected ideas of “monetary impotence” at the ZLB. See e.g. King (1999) or his fantastic 2002 paper, “No money, no inflation“. I’d suspect we have Merv to thank for delivering QE to the UK in the face of sceptics both inside and outside the Bank.
When central banks want to shift towards a different policy stance, market expectations are usually carefully and gradually managed through speeches, hints, and off-the-record leaks. The steps required to move the Bank of England from “not doing forward guidance” to “doing forward guidance”, for example, started with the appointment of Mark Carney in November 2012, continued through the various hints and nudges toward MPC remit review, only concluding with the actual guidance announced in August 2013. With forward guidance at best a fine-tuning of the short-run trade-off under the inflation target which the Bank should have been doing anyway, that’s really a tortuously slow process.
Policymakers like to think they maintain “credibility” by not making policy announcements which surprise the market. This makes sense to an extent, but it can go too far. To abuse a nautical metaphor, as is traditional, it’s sometimes too easy to imagine central bankers like the captain of the cruise liner who refuses to make a large course correction after spotting that the ship is going to hit the rocks, because making large course corrections might undermine confidence in the ability of the crew.
The insistence on not making large policy changes creates an environment which is actually very convenient for central bankers who want to hide their mistakes. In particular it lends a lot of credence to the theory that monetary policy has “long and variable lags”. If you only ever make small adjustments to policy it is never going to be very obvious that large changes could affect the economy in near real time. After the fact, you can always blame unexpected shocks, uncertainty, the imprecision of forecasting, etc, if your steering looks questionable.
British central bankers have announced for much of the last six years they expect to “hit the rocks” – undershoot the inflation target, and in private they might admit they could devalue the pound by 10 or 20% at any time, which would raise inflation a lot during the forecast period, i.e. avoid those rocks. But a 20% devaluation is a such crazy, non-serious idea that only an ultra-naive blogger would even suggest it, and surely most people realise that such a policy shock would undermine the credibility of the MPC?
I took a long-winded route to Switzerland. Here is the FT:
On January 15, the Swiss National Bank shocked markets by abandoning a three-year old ceiling on the franc’s value against the euro. In the hours that followed, the currency chart looked like the sheer face of an Alpine mountain as the franc shot up.
Swiss business soon felt the impact, and the economy contracted by 0.2 per cent in the first three months of the year.
Meanwhile, January’s turmoil and persistent, below-zero inflation rates threaten the central bank’s credibility. The SNB forecasts inflation will fall to a low of minus 1.2 per cent in the third quarter of 2015 and turn positive again only in early 2017.
I find it strange that it’s so simple to associate a monetary shock with an almost immediate contraction, but harder for people to imagine how a monetary shock can cause an almost immediate expansion. Could monetary policy possibly be so asymmetric? The FT article discusses four options for the SNB, all of which “entail risks, pushing the traditionally-conservative SNB further into untested policy territory”. Yes, switching from Policy A (the old weak franc policy) to Policy B (new strong franc policy) has caused things to get worse… so… what should they do now? It’s a real head-scratcher.
In case anybody thinks I’m pulling a fast one and weaker Swiss RGDP was just one of those funny co-incidences, the Swiss Federal Government’s official forecast group was very clear about cause and effect when revising their forecasts back in March; they do not expect the the slow down to be particularly severe, but slightly higher unemployment and lower output and inflation has achieved… what, exactly? The FT article contains one suggestion:
The SNB’s concern is financial stability, says Mr Harvey. “It has kind of given up on its price stability mandate, and prioritised balance sheet risk,” he says. “It is a very Swiss approach.”
A quick look at the SNB’s web site appears to confirm the expected: the tight money (strong franc) policy has been associated not only with lower interest rates but also a larger balance sheet, so if there are “risks” from expanding the monetary base, they are not going away with tighter money. It all sounds rather Swedish to me.
Carney has stuck by his line that the falling oil price is “unambiguously positive” for the UK economy, repeating it in the Inflation Report last week The oil price collapse started in September 2014. I’ve charted here the latest three median forecasts produced by the Bank in each Inflation Report, for both CPI inflation and real GDP growth:
What do we see? A huge downgrade to the expected path of inflation concentrated on 2015. You do not see revisions like that very often. At the same time we have a very slight downgrade to real GDP growth over the year to 2015 Q1, and a rather small upgrade, mostly in 2016. So, the “unambiguously positive” effect seems a bit ambiguous to me, less a Draghi-esque “with low inflation, you can buy more stuff“, but something more like: “with low inflation, a year later you can buy more stuff.”
Here’s a crazy theory – let’s call it the Bernanke, Gertler, Watson theory. The effect of the falling oil price has little to do with oil, or even the relative price of oil, but is mostly a reflection of the central bank’s reaction to the effect of the oil price on headline inflation. Though interest rates are definitely ambiguous, in September 2014 the Bank was expected be raising rates from early 2015. Today, the MPC is not expected to be raising rates until late 2016. The Bank’s CPI/RGDP forecasts are based on the market curve, and the forecast model will have “lower rates for longer” cause faster growth.
Alternatively we could look at the “unambiguously negative” effect of the rising price of oil in 2011 on the Eurozone: similarly, very little to do with oil, and everything to do with the ECB’s reaction to the rising oil price: two rate hikes aimed at slowing AD growth and inflation. They declared that policy a success!
Really, no big surprises here. An honest Governor could confess: “The falling oil price is a good thing because it means the MPC is less likely to screw up like it did in 2008 and 2011” – although he might look a little foolish.
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.
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”!
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.