Productivity and monetary policy

The Bank are warning of imminent rises in interest rates. As Chris Giles points out, we have been here before, and before that, but that shouldn’t mean we should dismiss this talk, because one day it will happen. [1] They (the MPC) certainly sound serious. But why when current growth is so slow are they even contemplating it? Here is a clue from Mark Carney’s latest speech (my italics).

“On the supply side, the process of leaving the EU is beginning to be felt. Brexit-related uncertainties are causing some companies to delay decisions about building capacity and entering new markets. Prolonged low investment will restrain growth in the capital stock and increases in productivity. Indeed, if the MPC’s current forecast comes to pass, the level of investment in 2020 is expected to be 20% below the level which the MPC had projected just before the referendum. Net migration has also fallen by 25% since the Referendum.

As a result of these factors and the general weakness in UK productivity growth since the global financial crisis, the supply capacity of the UK economy is likely to expand at only modest rates in coming years.”

When people, like me, say how can the Bank be thinking of raising rates when demand is so weak, the response from the Bank would be that supply has been at least as weak.

This pessimism about the supply side comes straight from the data. If I hear people talking about the UK being a ‘strong economy’, I know they either have not seen this chart or are just lying.

UK Output per hour, whole economy (ONS)

The red line is a trend that pretty well matches the trend in the data until the end of 2007, with the amount you can produce with an hours worth of labour increasing by 2.2% a year. Since the global financial crisis (GFC) there has been almost no growth at all. If you want to know the main reason real wages have stopped increasing, this is it. [2]

I hear some people say this is just oil and financial services. It is not, as this table from a recent Andy Haldane speech shows.

Start at the bottom: total average growth has been non-existent since the crisis. The rest of the table looks at the contribution of each sector to that total. To see what productivity growth would be excluding financial services, just add that figure to the total: 1.8% 1998-2008, 0.4% 2009-2016. That table makes it clear that the productivity crisis is economy wide.

It is worth looking at aggregate productivity since the GFC period in more detail (same data). I often hear people say the productivity slowdown started before the GFC. From the chart below, it clearly did not. (We have just seen the tenth anniversary of Northern Rock going bust, and the UK productivity slowdown started shortly after that event.)

We could describe this data as five phases. 1) Productivity in the recession fell, as it often does in a recession for various reasons. 2) As the economy begins to grow again, so did productivity growth. 3) As it becomes clear, in 2011, that the ‘recovery’ is going to be very weak because of austerity, productivity growth stops growing. 4) By the end of 2013, with stronger growth under way (although still no catch up to previous trends, so not a true recovery) productivity starts growing again, although rather slowly. 5) Since the 2015 election, with the prospect and then the reality of Brexit, even that modest growth disappears. (My data does not include 2017Q2, which saw a very slight fall.) I could shorten the description as follows: recession, modest optimism, pessimism, even more modest optimism, uncertainty.

That is my gloss on the numbers, but I’ve done it to make a point. Productivity growth invariably requires an investment of some kind. It may not be physical investment, but just training someone up to be able to use some new software. Whether a firm incurs that cost will depend, in part, on their expectations about the future. There is a regrettable tendency in macro (I blame RBC theory) to treat productivity growth as manna from heaven. But the idea that potential improvements in technology stopped after the GFC, and just in the UK, is simply ridiculous. The problem is that firms are not investing in new technology. What I call the ‘innovations gap’ has emerged in the UK because of weak growth and the consequent pessimistic expectations of most firms. [3]

The idea that the economy could get itself in a low growth expectations trap is increasingly being put forward by economists: here is George Evans, for example. The UK has got itself into that trap because on the two occasions that a recovery of sorts appeared to be under way, the economy has been hit with terrible policy errors (austerity and Brexit). But the idea that UK firms are incapable of upgrading their production techniques is nonsense. They will do so initially if they can be confident that the demand for their products will increase, or subsequently when the innovation pays for itself even though demand is flat.

Which is why an increase in interest rates right now would be very bad news. It would confirm the pessimistic expectations of most firms that demand is not going to grow fast enough to make innovation worthwhile. Formally, the job of the MPC is not to worry about productivity but to control inflation. But elsewhere, where the same process may be happening to a lesser extent (the productivity slowdown is worldwide, just most acute in the UK), central banks are puzzled at why inflation just refuses to rise. 

The concept of an innovations gap is one solution to that puzzle. Expanding demand allows firms to invest in more productive techniques, and so there is less incentive to choke of demand by raising prices. I suspect in an alternative world where Brexit had not happened the Bank of England would also be puzzling over why prices were not rising. As a result, if the MPC do finally raise interest rates this year, it would be one more mistake to add to the growing list under the heading Brexit.

[1] On each occasion I also wrote a post saying that they should not raise rates, starting I think at the beginning of 2014.

[2] I discussed in earlier posts why real wages are falling by even more than output per head.

[3] Or perhaps the pessimism of the bank manager lending money to those firms. The Haldane speech shows that productivity growth has remained strong among the top, frontier companies. Why? Because these companies, given their position, will be seeing growth relative to the average, and have got to the frontier through a culture of innovation.

The last 7 years are an argument against inflation targeting

The big controversy since the Great Recession began has been about fiscal policy: government spending, taxes and the budget deficit. In contrast monetary policy has not hit the headlines so much. This is understandable: while fiscal policy has oscillated from fiscal stimulus in 2009 to fiscal austerity in 2010, once the recession became clear (to some earlier than others) monetary policy in the UK, US and Japan appears to have been unambiguously expansionary, with interest rates staying at historical lows. The ECB is the exception, raising rates just before a second Eurozone recession.

Look a little closer however and we find something rather more worrying. Most people who base their view on economics rather than politics would regard the recovery from the Great Recession as disappointing. We have got particularly good reasons to be disappointed in the UK, but many economists think the US and Japan could also have done better at reducing unemployment more rapidly. More worrying still, the recession and the slow recovery may have caused permanent damage. (See Antonio Fatás here on his work with Larry Summers.) In the UK in particular we appear to have permanently lost a massive 15% of income during the recession. That kind of loss over a 7 year period is totally unprecedented in peacetime.

There are well known mechanisms by which short term output losses could lead to a permanent reduction in output capacity, known collectively by economists as hysteresis mechanisms. They include deskilling of the unemployed, less capital and less capital embodied technical progress. Just how permanent they are varies by type, but they all involve real costs in terms of lost output. One that worries me a lot is how expectations about trend output get downgraded, which can become self-fulfilling for quite some time.

The people whose job it is to make sure recessions are short-lived and these kinds of mechanisms do not take hold are in central banks. Yet if you ask monetary policy makers what they think about the last 7 years, they will not hang their heads in shame. They will not say it has been a disaster, but what more could we do? They will not say that, with interest rates near zero, they were powerless to do much, because unconventional policies like Quantitative Easing were poor instruments and government fiscal policy was moving in the wrong direction. Instead they will probably say that overall the last 7 years have not been too bad. This very different view seems both odd and worrying.

The reason however is straightforward. Monetary policy makers either regard their primary target as inflation, or are explicitly told that inflation should be their primary target. While below target now, inflation was above target in 2011 and 2012, so on balance maybe the record is not too bad. So looking at what they were asked to do, monetary policy makers feel little remorse.

In the UK we can put this in a rather startling way. Imagine someone in 2011 discovered a magical new policy instrument that was guaranteed to stimulate the economy, and gifted it to the Bank of England. In all probability they would not have used it. For four months in 2011 three members of the MPC voted to raise rates. We were just two MPC members away from following the ECB’s disastrous course. Just because we avoided that calamity by a whisker does not mean we should pretend it didn’t happen.

This all comes down to what economists have called the divine coincidence. This is the idea that you do not need to target both output and inflation. Ensuring that inflation is on target in a considered way (by for example looking at inflation two years ahead) will stabilise output as well. While the US central bank has a dual mandate (essentially both inflation and output), central banks that were made independent later (like the Bank of England) have inflation as their primary target. One of the main reasons for this was a growing belief before the Great Recession that the divine coincidence would hold. Target forecast inflation and output will look after itself.

The idea of the divine coincidence has not had a good recession! As I explained in one of my better posts, if the divine coincidence worked a central bank in a parallel universe that targeted the output gap rather than inflation should feel exactly the same way about the last 7 years as our inflation targeters. Yet as I explained there and above they would instead feel ashamed and frustrated. We know there are good empirical reasons why the divine coincidence might break down when inflation is low: resistance to nominal wage cuts will mean that monetary policy makers targeting inflation in a recession will overreact to positive inflation shocks like oil price increases and underreact to below target inflation. Add hysteresis, and you can get lasting damage.

So one lesson of the last 7 years must be that relying on the divine coincidence is a mistake. A primary goal of the central bank is to end recessions quickly, and giving it a single primary target of inflation can detract from that. One obvious improvement is to give the central bank a dual mandate, although the best way to specify that is not clear. Another possibility is to combine output and inflation into a single target, and yet another is to raise the inflation target to a level where the divine coincidence might still hold. Luckily for me I have thought quite a bit about these questions already, but in the next few months I may need to come off any fences that remain.

Central Bank Independence and MMT

This is a follow up to my last post on Corbyn and central bank independence (CBI). No apologies for returning to this topic: not often do you get to talk about policies that are in the process of being formulated. One of the influences that is said to be important for John McDonnell (the new shadow Chancellor) and his advisors is Modern Monetary Theory (MMT).

A comment I sometimes get on my posts is that my arguments are similar to those put forward by followers of MMT. I have not read much MMT literature, but in what I have read I have normally not found anything I take great exception to. On some issues, like the way monetary policy continues to be presented in textbooks, they definitely have good reason to complain about the mainstream. However their account of the way monetary and fiscal policy work seems quite a close match to what many mainstream economists think, which I guess is why my arguments can be similar to theirs.

One area of apparent difference, however, is CBI. You will sometimes hear MMT people talk about CBI being a ‘sham’, whereas mainstream macro attaches great importance to CBI. So which is right? Part of the problem here is that CBI in the UK (where the government decides the goal the Bank has to achieve) is rather different from that in the US (where the Fed has much more discretion over the choice of targets) and the Eurozone (where the ECB is largely unaccountable and has huge power). I’m just going to talk about the UK set up. (For a MMT perspective on the US, see here.)

CBI in the UK, established by Gordon Brown and Ed Balls in 1997, is no sham. The Monetary Policy Committee (MPC) decides when and by how much to change interest rates, and government has no influence on the MPC. How do I know this? From observation and from a huge number of conversations with MPC members. Since 2009 the MPC has decided when and by how much to do QE. Any Treasury authorisation to do QE was a formalisation that essentially followed Bank wishes, but it never specified when and how much QE should happen. So a fair description of the UK set up is that the government defines the goals and instruments of policy, and the MPC decides how to use those instruments to best meet those goals.

I would agree with the comment that this set up leaves the government taking big strategic decisions, like what the target should be. But CBI as defined in the UK still has two major advantages over the pre-1997 alternative

1. party political motives for changing interest rates are ruled out. I know such motives influenced at least the timing of rate changes before 1997. (How do I know - same answer as before.)
   
   
2. it forces governments to be explicit about their goals, and the relative priorities among these. I personally believe this has an important role in conditioning (but not determining) expectations, which is very useful. (Yes you can call me a New Keynesian for this reason.)
   
   

You could add time inconsistency and credibility issues in there as well if you like. (Giving this to secondary importance perhaps makes me less of a New Keynesian.)

Are there any negatives to set against this? One argument you often hear is that CBI is anti-democratic, but I really think this is just nonsense in the UK context. Government delegates technical decisions all the time, and as long as there is strong accountability (which in the UK there is), the right people are on the MPC and they are truly independent (from government or the financial sector) this works well. When governments only face elections every 5 years and elections are won or lost over a whole range of issues, quite why a Chancellor deciding when to change rates following secret advice is more democratic is unclear. It also improves democracy because, as Chris points out, the Chancellor is not held to account for the technical mistakes of his advisors.

A more important argument against CBI is that it makes money financed fiscal expansion much more difficult. A government that is obsessed by the size of its deficit might not undertake a bond financed fiscal expansion when a fiscal expansion is needed. It might have undertaken a money financed fiscal expansion, but CBI prevents it doing this because the central bank controls money creation. However this problem can be easily avoided by (a) taking a more sensible view of government deficits and debt, as MMT would also advocate, or (b) allowing helicopter money.

It is (a) that makes the debate over Corbyn’s QE particularly ironic. A National Investment Bank can be set up perfectly well based on borrowing from the market, and you can ensure it gets the funds it needs by a government guarantee. The only reason you would avoid trying to do that is because the NIB debt would count as part of the government’s deficit, and you were worried about the size of the deficit. The last people who should be worried in this way are followers of MMT.

Scott Fullwiler has an elaborate discussion of why Corbyn’s QE does not interfere with CBI, but concludes: “As such, government guaranteed debt of the NIB would be effectively the same thing as plain vanilla deficits, which as shown above is not different in a macroeconomically significant way from Overt Monetary Financing of Government via People's QE.” Which begs the question, why not go with plain vanilla deficits to fund the NIB. If it is because you are worried about the political costs of higher deficits, that will be as nothing compared to the political costs of instructing the Bank to finance a NIB.

So where does this apparent antagonism for CBI come from? Perhaps it comes from a tendency of some from the mainstream to make too much of CBI. To imply that the more independent a central bank is the better, regardless of who determines goals, whether there is accountability and who makes the decisions. Proof that independence is not all that matters is provided by the ECB. But we should not let the bad drive out the good. If Labour abandons the innovations made by Brown and Balls, I think it will be a classic example of the triumph of ideology over both good economics and self interest. 

How to change the inflation target

The longer interest rates stay at the Zero Lower Bound (ZLB), the stronger the case (pdf) for raising the inflation target becomes. (No, that is not a good reason to raise interest rates today, but perhaps it helps explain why some are so keen to do so!) However there seem to be two political barriers to this happening. Central banks seem to live in mortal fear that any move to raise inflation targets will shatter their ‘hard won credibility’ and inevitably lead to inflation ‘taking off’ and inflation expectations becoming ‘unhinged’. Where politicians have control (as in the UK), they worry the public will interpret any increase in the inflation target as a further erosion of their living standards. Yes, I know Abe raised the target rate in Japan, but only to the 2% that has become the consensus for the major developed economies.

Tony Yates suggests a very British solution to this problem. In the past, a standard way that UK politicians have handled such tricky questions has been to establish an independent commission to examine the question. (One famous example in the past was the Macmillan committee, set up after 1929 to establish the causes of the UK depression. Keynes’s role on that committee is vividly described by Peter Temin & David Vines in their recent book.) Tony calls it the Inflation Remit Review Commission. This commission could take evidence (from the central bank and others) on issues such as what the medium term natural real interest rate is likely to be, and compute the costs and benefits of any change. This sounds like a good way of trying (as far as possible) to depoliticise the issue, and putting the central bank’s inflation paranoia in context.

I have just one suggestion to add. This commission, at the same time, should examine whether it remains appropriate that the inflation target should just involve the consumer price index (and in particular, whether the rate of change of wages should also be targeted), and whether the target should involve the inflation rate or a path for prices (a price level target), or indeed national income. These questions naturally go together with the choice of the level of any inflation target. If there is a target for the path of prices rather than its rate of change, then the consequences of hitting the ZLB are less severe, for example. In addition, the possibility of ending the tyranny of the consumer price index, or changing to a level target, suffer from much the same conservative bias from politicians and/or central banks as the value of the target itself.

Whether the idea of a commission would work in the US I do not know. In the Eurozone there are strong grounds for setting up a similar body, not only to review the questions set out above, but also to permanently oversee the performance of the ECB. At present the ECB has minimal accountability. Appearing every three months before the European Parliament just does not count, I’m afraid. (For further discussion, see this Bruegel paper by Claeys, Hallerberg and Tschekassin.) This in itself is a strange state of affairs for an institution with such power. In addition its performance since 2011 (at least) has been very poor relative to the Fed and Bank of England. (See for example this post written over a year ago which I think reflected the clear consensus among macroeconomists at the time.)

Tony does not suggest who might sit on this commission, except to say that they should not be part of the government, or the central bank. My own view is that it is vital that at least some are academic macroeconomists, because academic macroeconomists do understand these questions better. For the UK obvious candidates are ex-external members of the Monetary Policy Committee, unless you think they have become (or were perhaps selected because they were) too indoctrinated with the central bank view. Suggestions on who might comprise an oversight commission for the ECB would be very welcome.      

Hawkery, or is the Bank biased

An interesting contrast in my evening reading yesterday. In the US, Matt O’Brien in the Washington Post’s Wonkblog making fun of reporting that inflation is just around the corner. There is one particularly nice line: “Well, there's always demand for pieces about why we need to raise rates — mostly from 60-year-olds who think it's always 1979 …” The contrast is with the Financial Times’s Chris Giles, who in yesterdays FT accuses the Bank of England of ‘institutional dovishness’, which he compares to institutional racism. The Bank is “institutionally biased against higher interest rates.”

Now, lest I be misunderstood, let me say three things before addressing Chris Giles’s charge. First, I’m pretty sure Chris is well short of 60. Second, Chris is no fool who blindly follows some party line: this piece on the Treasury’s exercise in dynamic scoring is as good as economic journalism gets. Third, central banks can suffer from what I and others prefer to describe as ‘groupthink’. Laurance Ball argued that this happened at the Fed when it came to not trying what I call forward commitment (promising higher inflation and a positive output gap in the future to combat the zero lower bound).

Having said that, Chris can occasionally pursue a line that, while popular in some quarters, makes little macroeconomic sense. The idea that UK austerity did not matter much had him clash with not just the usual suspects (including me), but also US academics Alan Taylor and Oscar Jorda. (I discussed an earlier version of their paper here: their latest version is here). In a similar way, over the last few months Chris has relentlessly pursued the idea that UK interest rates should rise very soon.

Chris’s charge against the Bank is that they keep moving the goalposts. For example, they say they will think about raising interest rates when unemployment dips below 7%, but when unemployment does go below 7% they decide that there is no reason to raise rates, and so on. But for the Bank the goalposts are the inflation target, and inflation is below target.

In the past I have made the point that, given uncertainties about the size of the output gap, it is best to err on the side of expansionary policy. This is because the Bank can easily deal with inflation if it does begin to rise, but because of the lower bound the opposite is not true. Chris responds that “no one should expect that an overheating economy will quickly set prices and wages on the climb”. “As the pre-crisis period showed, economies can overheat and develop dangerous imbalances without displaying the usual warning sign of inflation.” He is of course talking about house prices. But raising rates is a very inefficient way of dealing with a housing boom, which is why we now have the Financial Policy Committee at the Bank with its macroprudential tools. It is also very inefficient for the Bank to be trying to undo effects caused by the Chancellor’s policies (Help to Buy).

To see what can happen in this situation, we just need to look at Sweden. Sweden raised interest rates from almost zero to 2% beginning in 2010, because they were worried about overheating in the housing market. They now have deflation: inflation was -0.6% in March. As a result, the central bank has had to bring interest rates back down again. Lars Svensson, one of the world’s leading macroeconomists who resigned from their equivalent of the MPC while this happened, can only say I told you so.

While we are on the subject of premature interest rate increases, let us not forget the ECB raising rates just before the second Eurozone recession. And let us not also forget that the MPC almost followed their lead - not much evidence of institutional dovishness there.

I suspect and hope that the Bank and MPC have their eyes on the big picture. UK GDP per capita is currently around 15% below the level we might have expected it to be at if it had followed pre-recession trends. At no time since WWII has the economy not come back to this trend. We have no even half decent theories about why this trend should have dramatically changed. In these circumstances, starting to put on the brakes when we have only just begun to catch up lost ground, and when inflation is below target, just seems dumb and dangerous. 

Adapting forward guidance

I have a personal form of forward guidance: that I try and wait a day between writing and publishing blog posts. So yesterday I wrote a post reacting to the previous day’s news that UK unemployment had fallen rapidly to 7.1%. That news led to some speculation that the Monetary Policy Committee (MPC) of the Bank of England might change the number for their unemployment ‘knockout’ (the point at which they might start thinking about raising rates) from 7% to, say, 6.5%. There has been similar speculation about US monetary policy. I wrote that I thought this would be unlikely, but rather than let guidance wither away, they would instead prefer to change the nature of their guidance.

So today, as that post laid waiting on my hard drive, I read that Governor Carney indicated that the Bank has decided not to revise its 7 per cent unemployment threshold. “We’re trying to get across that it’s all about overall conditions in the labour market . . . We wouldn’t want to detract from that focus by unnecessarily focusing on one indicator.” So I’ve lost my opportunity of showing that I can anticipate MPC thinking. Perhaps instead I can write about why they might be thinking this way, and what they might specifically do.

The place to start is with why unemployment has been falling much faster than expected. As Chris Dillow explains, it indicates that UK productivity continues not to grow. The Bank hoped that the return of output growth might be accompanied by a resumption in productivity growth, so that unemployment would come down more slowly. They can hardly be blamed for this. Zero productivity growth for four years during a recession was puzzling, but continuing flat productivity when there is a recovery in output growth is in macroeconomic terms just weird. 

So how might forward guidance change? Here we need to make one point, and then ask one question. The point is that forward guidance is all about providing information to the public about what policy might do if events deviate from forecasts. As a result, those critics of such guidance who use poor forecasting as an argument completely miss the point. It is not what I call forward commitment. This leads us to the question: what is it that makes the MPC relaxed about the unexpectedly rapid fall in unemployment?

The answer is in this chart, which shows year on year growth in private sector earnings (source:ONS).

  

The series can be erratic, in part because of bonuses. Indeed, to quote the Bank’s inflation report (pdf): “... growth was volatile in 2013 H1, rising from 0.1% in Q1 to 2.8% in Q2. That largely reflected some people taking advantage of the reduction in the top rate of UK income tax in April 2013, and deferring bonus payments and earnings they would have received in 2013 Q1.” So we can call this the ‘Osborne hiccup’. However smoothing this out, year on year growth has been gradually moving down towards a little above 1%, and there is no sign so far of any reaction to falling unemployment. (Public sector earnings are not growing at all.)

With earnings growth at 1%, and productivity flat, that means unit labour costs are rising well below the inflation target of 2%. If earnings growth stays at 1%, there is no reason coming from the labour market for raising interest rates. If private sector earnings do start increasing by more than 2%, then the focus will then shift to productivity growth. Only if this fails to match the increase in earnings will a rise in rates become a distinct possibility.

So the natural way to change forward guidance is to incorporate this thinking. The unemployment knockout could be replaced with one that says interest rates increases will not be considered as long as private sector earnings growth is not more than 2% above private sector productivity growth. And now I think I should post this, to avoid another rewrite. 

Will the MPC raise UK interest rates in 2014?

Chris Giles of the FT thinks they will. His reason is straightforward: economic growth will continue to outstrip productivity growth, implying unemployment will fall below the MPC’s 7% threshold, and the MPC will worry that inflation will start rising.

While I try an avoid making forecasts (see my first answer to the FT questionnaire here), I would agree that strong growth in 2014 is more than possible. The savings ratio could continue to fall, net trade could pick up and non-residential investment may begin to recover. It would be bad news if this was accompanied by continuing near zero productivity growth, but as we do not know why UK productivity growth has stalled, we cannot rule this out.

Yet if interest rates did rise as a result, it would be extraordinary. To see why, just compare the UK with the US. US GDP began growing strongly at the end of 2009. So the UK is a full three years behind. Yet the US still has interest rates at their zero lower bound, four years after their recovery began, and has only just begun to scale back increases in its quantitative easing programme. (The MPC stopped increasing their programme some time ago.) So if we followed the US, there would be no question of raising rates this year.

The UK has been unusual in the past because of inflation. While US inflation has been at or below target for the past year and a half, it has been above target in the UK for 4 years. Yet the UK inflation rate is now down to 2.1%, despite the recovery in output. So it increasingly looks like high UK inflation in the past was down to a number of temporary factors, which the MPC rightly ignored. This is consistent with other measures of UK inflation, which have been lower throughout.

Now of course if inflation really does look like taking off in 2014, the MPC will raise rates. But what would ‘taking off’ mean precisely. As the MPC focuses on inflation two or so years down the line, I think it would have to mean a sudden tightening in the labour market. Given that unemployment is currently around 7.4%, and averaged 5.25% between 2000 and 2008, and earnings growth is currently running at 0.9% in nominal terms (!), we seem to have a long way to go before anyone could argue the labour market is about to initiate a wage price spiral.

Think of it another way. UK GDP is currently between 15% and 20% below where it would have been if it had followed past trends and there had been no recession. Past trends involved average growth rates of at least 2%. With that historically unprecedented gap, if two years of GDP growth one or two per cent above that past average meant monetary policy had to be tightened, it would mean accepting that something catastrophic and irredeemable had happened to the UK economy. That is why a rate rise this year would be extraordinary.

Now you might say a small increase in UK short term interest rates would still mean that monetary policy was easy, but just a little less so, and so a modest rate rise would be no big deal. The Resolution Foundation would strongly disagree. In a recent report they looked at the impact that various different scenarios for interest rates would have on households. The following chart indicates the key point.

The left hand panel gives the proportion of households paying over 25% of their disposable income in debt repayments (light pink), and over 50% (dark pink). The key point is this. The 2011 proportions are not very different from the average over the previous two decades, despite interest rates being much lower. In other words, we have not seen a wave of defaults and repossessions following the recession because the MPC cut interest rates to the bone. If interest rates rise but real wages do not (because productivity growth continues to stall), then that wave may happen after all. (See the right hand panel.)

As a result, even a small increase in interest rates is likely to have a large impact on at least some parts of the UK economy. The Bank is well aware of this (pdf, HT Pieria), so members of the MPC should not take this action lightly. As I have argued before, given the risks and uncertainties associated with the economy’s current position, it makes much more sense to take risks with inflation than to risk stalling the recovery. But I also thought that in 2011, when GDP growth was flat, and a third of the MPC disagreed, so nothing is for sure.

We can at least be thankful that interest rate decisions are not made by the so called ‘Shadow MPC’, a group set up by the Institute of Economic Affairs. They have been voting since February 2013 to raise interest rates! How can you vote for higher rates before a recovery starts, when it is obvious that there is large scale involuntary unemployment and underemployment? Well back in the 1940s Michal Kalecki had a theory, but then he was a Polish immigrant!

The MPC’s Forward Guidance

So, as expected, the MPC (pdf) is catching-up with the Fed, in introducing forward guidance that looks very similar. There are two notable differences: the unemployment threshold is 7%, rather than 6.5%, and there is a caveat (which the MPC calls a ‘knockout’) about financial stability as well as a caveat about inflation expectations. The MPC has also committed to not cut back on its QE purchases as well as not raise interest rates until unemployment falls below 7%, provided expectations of inflation do not exceed 2.5% and these caveats/knockouts do not apply.

We should be grateful for small mercies. This does clearly show that the MPC is not targeting 2% inflation two years ahead regardless, which I have argued it seems to have been doing recently. It focuses on unemployment, which does at least marginalise the idea that there is currently no spare capacity in the economy. In addition, by saying they do not currently expect unemployment to fall below 7% before mid-2016, they have provided a forecast of interest rates of sorts. The 7% unemployment figure is not a guess at the NAIRU, but just an upper threshold, and there is no commitment to raise rates if unemployment goes below 7%. To those in the Bank, where the regime has hardly changed since 1997, all this will seem like a big deal, even if to outsiders it seems less radical.

Yet this remains a very weak recovery, as the new Governor concedes. Although the Bank has raised its forecast for future growth, it is still a fairly pathetic 2.4% in two years time. The choice of 7% for the unemployment threshold is very conservative: UK unemployment did not go above 6% from 2000 to 2008. A ‘knockout‘ of 2.5% for expected inflation may copy the Fed, but given how high UK inflation has been recently, it is arguably more conservative - and anyway pretty low. I am not surprised by any of these things, because Carney had to get every member of the MPC to sign up to this, and so the numbers were always going to reflect the position of its more conservative members.

One additional thing has become clearer. By saying that, even with this new guidance, they do not expect unemployment to fall below 7% until 2016, the MPC has made it more transparent how prolonged this recession is going to be. Only two conclusions can follow: either high inflation is preventing the MPC from doing something about this, or they do not think they have any effective instruments left. If the first is true, that should focus discussion on whether consumer price inflation should be allowed to be such a tight constraint on growth. If the second, then why not turn to a proven instrument for stimulating demand?  

NGDP targets and UK Monetary Policy: Criticism and Reaction

In my presentation to the Bank of England advocating the adoption of NGDP as an intermediate target, I added at the last moment the following slide near the beginning of the talk:

Context

•     UK macroeconomic performance since 2010 has been disastrous, both in comparison to previous recoveries and to the US.
•     I have not seen any remotely persuasive ‘structural’ reasons why this has to be so, but there are some fairly obvious policy related explanations. (Austerity + ZLB + a string of cost-push shocks.)
•     For a policy mistake of this magnitude, it seems unlikely that either fiscal or monetary policy bears sole responsibility. It also seems sensible to ask to what extent the macropolicy regime caused or enabled this mistake.

Understandably this was just a little provocative to an audience of Bank of England economists and some MPC members.

Is this an example of the Rogoff-Krugman dilemma in how to confront policymakers? I suppose I could have said instead that it was mostly fiscal policy’s fault, and that the Bank had done a reasonable job in difficult circumstances, but I just thought they might tweak things a little bit. But if I had done so, this would have been an argument for something like forward guidance, not a more radical change like NGDP targets.

However Bank economists were right to be provoked, because the slide conflates two things: the weak recovery everywhere, and how the UK has performed relative to the US. I should have ignored the latter. As I have previously noted, the difference in productivity growth between the UK and US is substantial, and unlikely to be down to just labour hoarding. Although that post and others have speculated about what is behind that difference (see also below), in truth no one really knows. As a result, using relative UK/US GDP growth performance in a simplistic way to criticise policy is too easy.

That said, I do think that macropolicy has been better in the US than the UK. In terms of monetary policy, I would note the following:

1.        The US was quicker to recognise the severity of the crisis and reduce interest rates
2.        In spring 2011 the UK came close to raising interest rates, while the US did not.
3.        The US introduced forward guidance that countenanced exceeding the inflation target, whereas the UK has yet to do so. (The fact that actual UK inflation has generally exceeded 2% misses the point, because the idea should be to raise inflation expectations as long as unemployment remains high.)
4.        Bernanke has recently been explicit that US austerity means that monetary policy may not be able to meet its goals. Either UK policymakers do not believe that to be true, or they are keeping very quiet about it.

None of these are huge differences. I have argued that the lack of a dual mandate in the UK has been an important contributory factor behind the first three points above, which was the idea behind my last bullet point on the slide, but which rather got lost in debating the second. But perhaps the more basic point, which I should have focused on, is that in both countries the intended output inflation trade-off in this recovery has been wrong. In terms of decisions within the context of their respective mandates, I’m not sure either committee has done better than the other.

So that is one example where the Bank’s criticism would lead me to improve my argument. Another point that I perhaps should have tackled head on is the idea that the UK’s problems start and end with its banks (rather than the Bank).  The story goes something like this. UK banks, unlike US banks, remain undercapitalised, and undercapitalised banks are very reluctant to lend. In additional small and medium sized firms are more reliant on bank finance in the UK than in the US. This might help explain the UK’s poor productivity performance. So far this is believable, although the survey evidence on why firms fail to invest is not that supportive. The argument then goes that if banks are the problem, then changing bank behaviour (rather than raising inflation expectations) is also the solution, and policies like the UK’s FLS are unconventional but appropriate. To put the same point another way, it is the effective interest differential between short rates and bank lending rates that is the problem, and not the zero lower bound.

Unfortunately changing bank behaviour has proved rather difficult. In that situation, it is not the case that the only remedy is to tackle the cause. For example, although fiscal expansion is second best to lower nominal interest rates, when we are at the ZLB it can largely eliminate the impact of incorrect real rates on output with relatively low costs in terms of distortions. Equally expanding demand could offset the impact of risk averse banks on the economy as a whole. Indeed it might even encourage these banks to think rather more optimistically about their loan book.

Those are two specific issues. What about the general reaction to my proposal for establishing a path for NGDP as an intermediate target for policy? On the idea of raising inflation to raise output, this visit reinforced my impression that once you spend a lot of time in central banks, you become infected with the strange belief that while it is quite easy to get inflation expectations to increase, subsequently reducing these higher expectations is much more difficult. I would love to see the evidence or model on which that idea is based. But more generally I think the Bank’s reaction to NGDP targets goes back to where this post started.

My impression from this and other evidence is that the Bank has a form of what I have called ZLB denial: it thinks it can still do its job with unconventional monetary policy.  That in turn must imply that it bears responsibility for intended outcomes, and here I get mixed messages about the output inflation trade-off it is aiming for: maybe it is optimal because the UK output gap is pretty small (but what about all those unemployed and underemployed?), or maybe it is because the inflation target is primary. But either way I get the impression that the Bank thinks that it has done reasonably well in difficult circumstances. With these beliefs, the case for radical change seems underwhelming. 

Why a Dual Mandate is Essential

Monetary policy has two crucial roles. The first is to set the medium/long term inflation rate. Pretty well everyone understands this. The economy will not by itself settle down to an inflation rate of 2% or whatever - it needs monetary policy to set this rate and help achieve it.

The second is to ensure that aggregate demand matches aggregate supply. Now here there is sometimes confusion, even among the best economists. [1] The basic idea is that there is a ‘natural’ level of output determined by supply side factors, like how much people want to work, the degree of monopoly in the labour market, the state of technology etc. [2] There will be a real rate of interest associated with this level of output, which we can call the natural interest rate. On the other hand how much firms produce in the short run is largely determined by aggregate demand: firms tend to set prices, and do not ration demand. There is no reason why aggregate demand has to equal supply in the short run in a monetary economy. The difference between actual output and natural output is the output gap. If the output gap is not zero, problems will arise. For example with excess demand we get inflation, and with deficient demand we can have wasted resources and the misery of involuntary unemployment.

Aggregate demand depends on real interest rates. As monetary policy can influence real interest rates in the short run, then its job is to try and match aggregate supply and demand, by bringing the real interest rate as close as possible to the natural interest rate. [3]

These two roles for monetary policy map nicely into the two objectives macroeconomists typically ascribe to policy makers: minimising excess inflation and the output gap. With two goals there will also be conflicts, producing a trade-off between short run inflation stability and eliminating the output gap. Macroeconomics has extensively examined what to do when these conflicts arise.

A permanent non-zero output gap is not compatible with stable inflation in the long run. As a result, it is possible to reduce both roles to one single objective, the stabilisation of inflation, as long as that stabilisation is done ‘flexibly’. Hence the idea of a single, but flexible, inflation target. I now believe having only an inflation target, or making it 'primary', is an important mistake for two reasons. We can label each mistake as MPC and ECB for short.

The first (MPC) is due to persistent shocks to the relationship between the output gap and inflation (or equivalently to the Phillips curve). This sets up a potential conflict between the two goals. Although we know how to optimally deal with this conflict, the policy that results can appear inconsistent with inflation targeting, which puts a strain on an inflation targeting policy. The problem can be ‘solved’ by making inflation targeting even more ‘flexible’, but this in turn makes the policy less clear.

Of course macroeconomists have always acknowledged this possibility, but have thought that the impact of excess or deficient aggregate demand would always be strong enough for this not to matter in practice. However, as the recent IMF study I discuss here shows, either low inflation or credible inflation targets (or both) seem to have weakened the impact of the output gap on inflation, which makes the problem of persistent cost-push shocks more important. This has been the problem the MPC in the UK have been grappling with in recent years, and I believe the lack of a dual mandate has made their decisions less optimal. More generally, as Paul Krugman says here, thinking that stable low inflation must mean everything is OK could be very wrong.

The second (ECB) is that, in the wrong hands, the flexible inflation targeting regime can become a severely non-optimal policy that pays too little (or asymmetric) attention to the output gap, even in the absence of supply side shocks. In academic language, we could express this in terms of Rogoff’s conservative central banker (giving less weight to the output gap than the public does), but it also allows bad policy enacted by an incompetent central bank (that does not understand the importance of the output gap) or a malevolent central bank (that wants to achieve its own objectives that may not just involve hitting an inflation target).

There is a nice quote by Duisenberg from February 2003 contained in this paper by Jörg Bibow (page 35) that a comment from an earlier post pointed me to. In discussing what price stability meant, he said it “implies that, in practice, we are more inclined to act when inflation falls below 1% and we are also inclined to act when inflation threatens to exceed 2% in the medium term.” [4] Now Andrew Watt and others would argue that this is not a good reading of the ECB’s actual mandate, but it seems to me a good reading of what they actually do, and it is one that a single rather than a dual mandate helps them to get away with.

So what is the objection to a dual mandate? As it reflects how an academic thinks about monetary policy, it should not lead to suboptimal policy in the hands of an informed and benevolent policy maker. So the fear must be that it will misdirect an uninformed policy maker, and encourage non-benevolent behaviour. The exemplar here is the 1970s, but for reasons I discussed here, I do not think that period should be used as evidence against the dual mandate. I discuss here why I think the standard inflation bias story is also overrated in this respect.

Is there any evidence that the US with its dual mandate has done better compared to inflation targeters? There has been some discussion of that recently (e.g. here and here), although the data analysis is not very sophisticated. [5] Until we see good evidence that having a dual mandate worsens outcomes, then I believe the presumption must be that the dual mandate is better because it reflects the two goals of monetary policy.

My argument here concerns higher level objectives. It is not about how best to achieve those objectives, which is where I would locate questions about the wisdom of nominal GDP targets. It does not address the relative weight that the two objectives should have, or the extent that the objectives should be vague or concrete. My own view is that the benefits of a publicly announced inflation target are overwhelming - indeed so much so that I recently forgot how new this ‘innovation’ was for the Fed. How best to express the goal of matching aggregate demand with supply is more difficult, because of the uncertainties involved in measuring the output gap. However output gap uncertainty is not so great that we should ignore the concept, and so this uncertainty cannot justify a single inflation mandate. There are lots of things in life that are difficult to define, but which are still worth striving for.

[1] See, for example, Brad DeLong here. The reasons for this confusion are interesting, but I have speculated on this elsewhere and do not want to get distracted. Of course none of this implies that the natural level of output and its associated interest rate need be in any sense optimal or efficient, but that should be a different and separable question.

[2] There is nothing mysterious about the natural level of output. It is the output which pretty much every macroeconomist not investigating problems of aggregate demand analyse. It could be called the level of output that comes out of an RBC model, for example. It is often described as the level of output that would occur if prices were completely flexible, and here I do have a quibble, because at a zero lower bound and with inflation targets I cannot see how increasing the flexibility of prices will ensure that output reaches the natural level.

[3]

If monetary policy cannot do this, then fiscal policy can help reduce the output gap. We could describe this as fiscal policy raising the natural interest rate, but an equivalent and more intuitive description is that fiscal policy just raises aggregate demand.

There are plenty of caveats to this econ 101 account, such as the possibility that actual output might have an influence on longer term aggregate supply.

[4] If the implied asymmetric differentiation between actual and possible future here was a slip, I’m tempted to suggest it was a Freudian one.

[5] For example, MPC decisions since the recession have tended to define flexibility as ‘seeing through’ actual inflation and focusing on expected inflation two years out. Inflation targets then become a constraint when the impact of cost-push shocks persist for two years or more.