A short guide to why we should not raise UK interest rates

Everyone expects the MPC to raise rates on Thursday. This would be a mistake. Discussion about interest rate changes in the press normally involve large amounts of data and charts about the state of the economy. Here I want to do the opposite: to present the minimum you need to know to understand that raising UK rates right now is the wrong thing to do.

Everyone should know that UK inflation is currently around 3% because of the Brexit depreciation. But because the impact of a deprecation on price inflation is temporary if wage inflation remains flat, the Bank said they would ignore this temporary rise. The key is to look at whether average earnings inflation is responding to higher consumer price inflation. The answer is they are not: average earnings growth has been slightly above 2% all this year, which is a little lower than the average for 2016.

But what about unemployment being at a 42 year low? Surely that means earnings growth is just waiting to kick off. The first point is that unemployment is not currently a good measure of labour market slack. A better measure is the Resolution Foundation’s underemployment index, which is still above levels before the global financial crisis. And before you say but that was a boom period, it wasn’t. UK core inflation was below 2% throughout, and earnings growth was consistent with this.

The other thing to say is that it is quite wrong to assume that we know what the level of labour market slack is that would lead to increases in earnings growth (what economists call the NAIRU). The NAIRU moves over time. As just one example of why it might move, a labour force that rents is likely to be more mobile than one that owns a house, and so the trend towards renting should reduce the NAIRU.

So looking at the labour market, there is no sign that we are close to a level where earnings inflation might pick up. And that is pretty well a precondition for inflation to exceed its target of 2% over the medium term. That is all you really need to know. If you want to know why the MPC probably will raise rates, read on.

What I suspect the Bank are worrying about is that Brexit has created what economists call a negative supply shock. In particular, both investment and productivity growth are much lower than the Bank were expecting before Brexit. They will point to various survey measures which show firms do not have any spare capacity. But this reasoning I think indicates a conceptual weakness.

Firms have two responses to lack of capacity: raising prices or investment. By choking off demand and raising rates when firms run out of capacity the Bank will discourage investment, and right now what the economy desperately needs is more investment and the productivity improvements that brings with it. The Bank shouldn’t worry about a bit of inflation that might come with higher investment, because 2% earnings growth is an anchor that will prevent inflation deviating from target for any length of time.

That should be enough, but there are two other reasons why the Bank should not raise rates. First, right now the downside risk on the demand side from Brexit surely exceeds the upside risk. Second, as the OBR chart here shows (look at orange bars), after a pause in 2017 austerity is planned to return in 2018 and 2019. Combining fiscal and monetary tightening in a boom would make sense, but we are currently in an economic downturn, with GDP per head growing this year at a third of its average pace since the recession of 2009. [1]

Finally, it is always important to consider risks. Suppose earnings growth does pick up sharply just after the MPC’s monthly meeting. The Bank always says it wants to be ‘ahead of the curve’, to avoid too rapid an increase in rates. This is the mentality that has led inflation to undershoot in the US and Eurozone since the recession, and if you take out the impact of depreciations by looking at the GDP deflator the same is true for the UK. The problem for the UK economy since the recession has not been too much inflation, but far too little demand.

[1] Specifically, average growth in 2017 is 0.1% per quarter, and averaging quarterly growth rates from 2010 Q1 to 2016 Q4 gives 0.3% per quarter          

The NAIRU: a response to critics

When I wrote my piece on NAIRU bashing, I mainly had in mind a few newspaper articles I had read which said we cannot reliably estimate it so why not junk the concept. What I had forgotten, however, is that for heterodox economists of a certain hue, the NAIRU is a trigger word, a bit like methodology is for mainstream economists. It conjures up lots of bad associations.

As a result, I got comments on my blog that were almost unbelievable. The most colourful was “NAIRU is the economic equivalent of "Muslim ban"”. At least two wanted to hold me directly responsible for any unemployment at the NAIRU. For example: “So according to you a fraction of the workforce needs to be kept unemployed.” Which is a bit like saying to doctors: “So according to you some people have to be allowed to die as a result of cancer.”

I have to say straight away that not everyone responded in that way. Some were much more thoughtful and constructive (like Jo Michell, for example). But the less thoughtful reactions are interesting in a way too.

I need to recap what the NAIRU is, particularly because heterodox economists seem to imagine it is many things it is not. Let’s take a very simple Phillips curve

Inflation this period = expected inflation next period - aU +b

where ‘a’ is a parameter and U is a measure of excess supply/demand in the economy. Unemployment will be one measure of that excess supply, but it is far from a perfect measure. (That my previous post was about excess supply, rather than actual unemployment, was obvious from what I wrote.) ‘b’ stands for a collection of slow moving variables. These could include a measure of union power, or how mobile labour was, or the degree of monopoly in the goods market. The NAIRU is defined as

NAIRU = b/a

If U is less than the NAIRU over a sustained period then inflation will rise, which will increase inflation expectations, which increases inflation further etc.

The concept is of interest to policymakers involved in demand management. They have to decide how much they can push demand before inflation starts rising. If they are independent central banks, they have to accept the world as it is. The NAIRU is a description of how the economy works: nothing more or less. This is why complaints that economists who use or estimate the concept are somehow responsible for those left unemployed are so dumb.

Of course you can criticise the concept of the NAIRU, but logically that has to involve criticism of the Phillips curve from where it comes. It is also reasonable to argue that the concept is fine, but the NAIRU is so difficult to measure that it would be better not to try and estimate it or let it guide policy. I have a lot of sympathy with that view at the moment, which is why I argue that, in the US right now, policy makers should find the NAIRU by allowing inflation to rise above target. But that point of view was irrelevant in my previous post, which was about the concept of the NAIRU, not its measurement.

As far as the concept is concerned, I think the strongest attacks come from thinking about hysteresis, as Jo Michell suggests. But even here, we add a complication to the NAIRU analysis, rather than overturn that analysis altogether. What hysteresis does is to make periods where unemployment is above the NAIRU extremely costly. It also means that periods of being slightly below the current NAIRU might be justified if they reduce the NAIRU itself.

I want to end by adding two reflections. The first relates to modelling the NAIRU. There once was, following the work of Layard and Nickell, an empirical literature that attempted to model for OECD countries a time series for the NAIRU, using proxy variables for things like union power, the benefit regime and geographical mismatch. With the dominance of the microfoundations methodology that work appears to have decreased, although to some extent it is still there in work based on matching models. I would be very interested to know if that time series analysis, now potentially enriched by matching models and flow data, has continued in any way.

The second relates to the sharp reactions to my original post I noted at the start, and the hostility displayed by some heterodox economists (I stress some) to the concept. I have been trying to decide what annoys me about this so much. I think it is this. The concept of the NAIRU, or equivalently the Phillips curve, is very basic to macroeconomics. It is hard to teach about inflation, unemployment and demand management without it. Those trying to set interest rates in independent central banks are, for the most part, doing what they can to find the optimal balance between inflation and unemployment.

Accepting the concept of the NAIRU does not mean you have to agree with their judgements. But if you want to argue that they could be doing something better, you need to use the language of macroeconomics. You can say, as many besides myself have done, that the NAIRU is either a lot lower than central bank estimates, or is currently so uncertain that these estimates should not influence policy. But if you say that the NAIRU has to be Bashed, Smashed, And Trashed, you will not get anywhere.

I also get very annoyed when I hear refutation by reference (as here for example). It would be so easy to write my blog posts that way. Instead I generally try to explain or present an argument that I hope is understandable. Economics is usually not so hard that this is impossible, although finding the right words is never easy. Economics is certainly not a religion, where all you have to do is choose which sect you belong to and then follow great works.     

NAIRU bashing

The NAIRU is the level of unemployment at which inflation is stable. Ever since economists invented the concept people have poked fun at how difficult to measure and elusive the NAIRU appears to be, and these articles often end with the proclamation that it is time we ditched the concept. Even good journalists can do it. But few of these attempts to trash the NAIRU answer a very simple and obvious question - how else do we link the real economy to inflation?

One exception are those that attempt to suggest that all we need to effectively control the economy is a nominal anchor, like the money supply or the exchange rate. But to cut a long story short, attempts to put this into practice have never worked out too well. The most recent attempt has been the Euro: just adopt a common currency, and inflation in individual countries will be forced to follow the average. This didn’t prove to be true for either Germany or the periphery, with disastrous results.

The NAIRU is one of those economic concepts which is essential to understand the economy but is extremely difficult to measure. Let’s start with the reasons for difficulty. First, unemployment is not perfectly measured (with people giving up looking for work who start looking again when the economy grows strongly), and may not capture the idea it is meant to represent, which is excess supply or demand in the labour market. Second, it looks at only the labour market, whereas inflation may also have something to do with excess demand in the goods market. Third, even if neither of these problems existed, the way unemployment interacts with inflation is still not clear.

The way economists have thought about the relationship between unemployment and inflation over the last 50 years is the Phillips curve. That says that inflation depends on expected inflation and unemployment. The importance of expected inflation means that simply drawing unemployment against inflation will always produce a mess. I remember from one of the earlier editions of Mankiw’s textbook he had a lovely plot of this for the US, that contradicted what I just said: it displayed clear ‘Phillips curve loops’. But it was always messier for other countries and it got messier for the US once we had inflation targeting (as it should with rational expectations). See this post for details.

The ubiquity of the New Keynesian Phillips Curve (NKPC) in current macroeconomics should not fool anyone that we finally have the true model of inflation. Its frequency of use reflects the obsession with microfoundations methodology and the consequent downgrading of empirical analysis. We know that workers and employers don’t like nominal wage cuts, but that aversion is not in the NKPC. If monetary policy is stuck at the Zero Lower Bound the NKPC says that inflation should become rather volatile, but that did not appear to happen, a point John Cochrane has stressed.

I could go on and on, and write my own NAIRU bashing piece. But here is the rub. If we really think there is no relationship between unemployment and inflation, why on earth are we not trying to get unemployment below 4%? We know that the government could, by spending more, raise demand and reduce unemployment. And why would we ever raise interest rates above their lower bound?

I’ve been there, done that. While we should not be obsessed by the 1970s, we should not wipe it from our minds either. Then policy makers did in effect ditch the NAIRU, and we got uncomfortably high inflation. In 1980 in the US and UK policy changed and increased unemployment, and inflation fell. There is a relationship between inflation and unemployment, but it is just very difficult to pin down. For most macroeconomists, the concept of the NAIRU really just stands for that basic macroeconomic truth.

A more subtle critique of the NAIRU would be to acknowledge that truth, but say that because the relationship is difficult to measure, we should stop using unemployment as a guide to setting monetary policy. Let’s just focus on the objective, inflation, and move rates according to what actually happens to inflation. In other words forget forecasting, and let monetary policy operate like a thermostat, raising rates when inflation is above target and vice versa.

That could lead to large oscillations in inflation, but there is a more serious problem. This tends to be forgotten, but inflation is not the only goal of monetary policy. Take what is currently happening in the UK. Inflation is rising, and is expected to soon exceed its target, but the central bank has cut interest rates because it is more concerned about the impact of Brexit on the real economy. That shows quite clearly that policy makers in reality target some measure of the output gap as well as inflation. And they are quite right to, because why create a recession just to smooth inflation.

OK, so just target some weighted average of inflation and unemployment like a thermostat. But what level of unemployment? There is a danger that would always mean we would tolerate high inflation if unemployment is low. We know that is not a good idea, because inflation would just go on rising. So why not target the difference between unemployment and some level which is consistent with stable inflation. We could call that level X, but we should try to be more descriptive. Any suggestions?

Did the Bank of England cause Brexit?

Suppose that by the mid-2000s, immigration from the EU (and the potential for additional immigration) had led to an important shift in the UK labour market. The possibility of bringing labour from overseas meant that old relationships between the tightness of labour market and wage increases no longer held.

You might think that was bad for workers, but that is not so. It would mean what economists call the natural rate of unemployment (or NAIRU) has fallen. Unemployment can be lower without leading to wage increases that threaten the inflation target, because workers fear that the employer can resort to finding much cheaper overseas labour. It reduces the power of workers in the labour market, but also leads to overall benefits. (This is just an example of the standard result that reducing monopoly power is socially beneficial.)

But it is only good news if the Bank of England recognises the change. If they do not, we get stagnant wage growth and unemployment higher than it need be. The obvious response is that the Bank will know there has been a change because wages will start falling faster than they would expect based on previous relationships. However that effect may be masked by the well documented employee and employer reluctance to actually cut nominal wages. Add in the shock of the financial crisis, and this change in the way the labour market works might well be missed.

Here is the big leap. Suppose the above had happened, and the Bank of England did not miss the change. Monetary policy would have been much more expansionary, bringing unemployment well below the 5% mark. Nominal wage growth would have been stronger, and a buoyant labour market would have generated a feel good factor among workers. With more vacancies and less unemployment, concerns about immigration would have begun to fade. The Brexit vote would still have been close, but would have gone the other way.

You may say how could monetary policy be more expansionary given how close we are to the Zero Lower Bound? If that was the case the Bank should have said they were out of ammunition, and placed responsibility with the government and austerity. But for the last two years at least, the Bank could have cut interest rates and has not. You could blame the relentless expectation in the media and financial sector that rates would increase, but the Bank should be able to rise above that.

Of course the Brexit blame game is easy to play when the vote was so tight. The most speculative aspect of this chain of thought is the initial premise about a shift in the NAIRU created by immigration potential. While the possibility makes sense, whether the data backs it up is much less clear. Yet there is some evidence of a structural shift in the UK labour market in the mid-2000s, as Paul Gregg and Steve Machin report.