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          

A Labour run on Sterling?

The news that John McDonnell was looking at a scenario where the election of a Labour government was met with a run on Sterling was all over the news yesterday. The Conservatives, who of course know all about runs on Sterling having created one just a year ago with the Brexit vote, immediately grasped the political gift they had been given.

Paranoia on the left meets prejudice on the right. But what would really happen to Sterling if Labour were to win the next election? Given announced policies, the answer is quite clear: Sterling would appreciate. The main reason is that under Labour there would be a large fiscal expansion: for certain in term of public investment and to a lesser extent with current spending. (I assume by then interest rates will be above their ZLB: if they are not, the fiscal expansion could be even larger.) There would also be a balanced budget fiscal expansion: even if government spending increases are financed by tax increases, this is likely to be expansionary to some extent because some of the tax will come out of savings.

This fiscal expansion, together perhaps with other labour market measures, would put upward pressure on inflation, prompting higher interest rates from the Monetary Policy Committee of the Bank of England. It is the prospect of those higher interest rates that would make Sterling appreciate. How much inflation rather than output would rise depends on how pessimistic you are about the supply side. If the MPC were doing their job properly, that increase in interest rates plus the appreciation would stop inflation rising very much. We will finally get the rebalancing between monetary and fiscal policy that we should have had for the last decade.

If we are also in a transition period for Brexit, with the final destination unclear, then Labour being elected would also lead to an appreciation because Labour are softer on Brexit than the Conservatives.

So where does the run on Sterling idea come from? The idea that all those traders in currency will get together and engineer one because they do not like a Labour government is nonsense. They may not like a Labour government, but they dislike losing money even more. Capital flight? You might see the share price of power or rail companies fall, but that is not going to be enough to move a currency like sterling. Any depreciation in sterling would be the equivalent of pound notes waiting to be picked up in the City and Wall Street: with higher expected interest rates and a likely future appreciation, who wouldn’t buy sterling?

The only way I can see that you could get a run on Sterling is if enough traders in the markets came to believe that Labour was going to abolish BoE independence because it wanted to keep interest rates low. In that case you could get significantly higher inflation under Labour, which would justify a nominal Sterling depreciation.

Which, of course, is why McDonnell committed to keeping Bank of England independence as one of the first things he did. And which is also why he was very foolish to say what he said, because it might lead some to speculate that he might renege on that commitment. Something tells me he is missing his Economic Advisory Council.

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.

Two related confusions about helicopter money

Confusions about helicopter money is something of a generic title (although Martin Sandbu is thankfully not confused). Because a discussion of helicopter money (HM) cannot normally be found in the textbooks (which have only just caught up with central bank independence), the scope for misunderstanding is huge. Here I want to talk about two related confusions. The first is about whether HM would lead to an increase or decrease in nominal interest rates, as discussed in a recent interchange between Tony Yates and Paul Krugman. The second is whether HM is in competition with the use of fiscal policy to get us out of recessions.  

On HM money and nominal interest rates, there is of course the standard and very basic point that in a market you cannot control both quantity and price, still less move them in opposing directions. So if we want to think about a market for money, you cannot raise the supply of money and raise its price - the nominal interest rate - at the same time.

But this observation ignores what else is going on when you have HM. HM is a large fiscal expansion. Please none of this ‘but if Ricardian Equivalence (RE) holds’: we are talking real world policy here not doing thought experiments, and we have all the evidence we need that RE does not hold (for reasons that are not difficult to understand). Let's also not fall into the trap of doing IS-LM. We are in a world of inflation targeting, and anything that raises demand (as a fiscal expansion will) will tend to raise inflation, and so the monetary authorities will tend to raise nominal interest rates. Any temptation to say ‘yes but in the short run’ becomes dubious because of expectations effects. 

So it is really quite simple. Either the nominal interest rate lower bound constraint continues to bite, which means helicopter money will leave nominal interest rates unchanged (but the economy better off), or there is no constraint (or that constraint is removed), in which case rates will rise (sooner) with HM.

The second confusion is that helicopter money in some way precludes undertaking countercyclical fiscal policy. It does not. Right now, for example, governments could and should announce large increases in public sector investment (where I am using investment in the economist’s sense to include investment in human capital, rather than in a national accounts sense). This would negate any immediate need for HM. Monetary policy adapts to fiscal policy.

When people ask me which we should have, helicopters or fiscal expansion, I'm tempted to say I would love to have the choice! If I did have that choice, right now I would take additional public investment over a helicopter drop, because the micro case for investment is in many cases (and countries) very strong, interest rates are low and investment improves the supply as well as the demand side. In any future severe recession where the interest rate lower bound was likely to be hit [1] I would also advise bringing forward public investment. However I do not see this as a competition (countercyclical fiscal action vs HM) for two reasons.

First, one lesson of the Great Recession is that we cannot rely on governments to do the right thing with fiscal actions, so HM is an insurance policy in that sense. If governments do spend more or tax less as we approach the ZLB, that insurance policy may not be needed. [2] Second, even if governments do the right thing, either lack of good projects [3] or information delays may mean they do not do enough, and so the very quick action that central banks could take with HM could be a useful complement. To put it another way, helicopter money is best seen as an alternative to QE rather than as an alternative to fiscal action.

[1] Because of implementation lags, a fiscal response to an impending deep recession should not wait until nominal interest rates actually hit their lower bound. If that fiscal response involves investment, used in an economists rather than national accounts sense, then there is no great loss if the deep recession does not happen, because it is wise to invest when real interest rates and wages are relatively low.

[2] In the proposals put forward in Portes and Wren-Lewis (2015), the central bank would directly tell the government the probability of the lower bound being hit.

[3] I think the argument that the amount of public investment cannot be adjusted to match macro conditions is often overstated. We are not talking HS2 here (the proposal to build a high speed train line between London and Birmingham and beyond), but improving flood defences, repairing roads and schools etc.

More on UK interest and exchange rates

A lot of stuff written on UK interest rates reasons as follows. Many estimates of the UK’s output gap - the difference between actual output and the level of output that is consistent with steady (domestically generated) inflation - suggest it is almost zero. That cannot be consistent with nominal short term interest rates as low as 0.5%. Therefore a rise in interest rates is long overdue.

This ignores the rest of the world. Although the OECD estimate that the UK output gap in 2015 is zero, they also estimate it is nearly -2% for the OECD as a whole and nearly 3% for the Euro area. That means the UK is selling less goods abroad. For the UK output gap to be zero, we therefore need some other element of UK aggregate demand to take up the slack created by low exports. It is not government spending, which is going in the opposite direction. So it is consumers and firms that have to be encouraged to borrow more and save less. To put it another way, they need to be encouraged to shift spending from the future to the present. That means lower than normal UK real interest rates.

It is still true that monetary policy should be easier in the Eurozone than in the UK, but with active QE it already is. The fact that markets expect UK interest rates to rise well before those in the Eurozone intensifies the exports problem, because it means that exports are being hit not just by low demand but also by becoming less competitive as sterling appreciates against the Euro. [1]

The problem of low demand for UK exports would be made worse still if, as I suspect, sterling is overvalued even after you allow for differences in expected interest rates. Philip Lane, soon to become governor of the Irish central bank, has produced an interesting analysis of the recent deterioration in the UK current account. He concludes that “financial engineering may have played some role”. I suspect he is right, mainly because he is a renowned expert on these matters. However I wanted to stress that my arguments about overvaluation owed nothing to this recent deterioration.

The UK’s trade balance deficit has remained large and fairly constant for many years, despite the depreciation around 2008. That was not offset by investment income, even before the recent deterioration, which is why we have been running current account deficits for over 15 years. There may be good reasons why some countries run deficits for a long period of time, but it is not obvious whether any of these reasons apply to the UK, and those deficits in themselves mean that the equilibrium exchange rate will be depreciating alongside those deficits.

So we should not expect UK real interest rates to return to their ‘normal’ level until output gaps are closed in the rest of the world. We should also note that the Bank thinks that the normal or natural level of real interest rates is much less than it has been in the past (secular stagnation). Finally with inflation currently low, low real interest rates imply low nominal rates. All this would be true even if you were certain that the current UK output gap was zero, which I am not.

[1] Using UIP, the current real exchange rate is determined by the medium term equilibrium rate (calculated at zero output gaps everywhere) plus expected real interest rate differentials.

More (dark) thoughts on interest rates

The following has numbers for the UK, but the logic if not the numbers also apply to the US: see Mark Thoma here.

Imagine the following lottery. If you win, you receive a total of £5000 over the next few years. The cost of a ticket? The risk that inflation will be 0.5% higher than it would otherwise have been for a couple of years, where inflation includes the rate that wages increase.

To enter the lottery in the UK you need to cut interest rates. This lottery is just another way of describing the key argument I made in Monday’s Independent article (now complete with chart).

Of course you want to know the odds of getting the prize. The odds come in the form of a puzzle. What are the chances that the economy has, over the last ten years, permanently lost 15% of its normal ability to produce goods and services. Something that has probably never happened to the UK before. [1] Those are the chances of you NOT winning.

We can of course discuss those numbers. But in the UK that discussion appears largely absent. Instead all the talk is about interest rate increases. We seem to have collectively written off 15% of national GDP with just a shrug. ‘Oh that must be supply and there is nothing conventional macro policy can do’ is the general view. That view may be right, but it is important enough that this should be the centre of the national debate. Instead we talk about the need to normalise interest rates, as if the real economy was doing just fine.

Time for a DeLong type lament. If you had told me ten years ago that a decade hence UK output per head would be 15% below the 1955-2008 trend, inflation was zero and yet people would be talking about raising interest rates I would have said you were mad. If you had said that at a time when interest rates and real wages are at record lows the government was proposing to not invest for the future because that was the best way to prepare for the next crisis I would have said you knew nothing about business and economics. If you had said that just years after a huge financial crisis, followed by a host of financial scandals, the City regulator would be sacked because the Chancellor wanted less tough regulation I would have said you were thinking about some corrupt state and not the UK. If this is all a bad dream, what will it take to wake people up?

[1] Economies do appear to suffer some permanent loss to potential output after financial crises: there is a handy summary of studies here (table 4.1) - HT Andrew Goodwin   

The UK as a test case for NGDP targets

In an article in the Independent today, I argue that it is about time the Bank of England changed UK interest rates. But they should go down, not up. The essence of the argument is there remains a significant risk that we have substantial deficient demand. Even if the probability of this is below 50%, if it is true the costs of it persisting far outweigh the costs of some mild inflation overshooting.

One point I do not consider in the article are the implications for nominal GDP (NGDP) targeting. Here is the picture.

I use nominal GDP per head, because that is robust to changes in migration flows, which for the UK have been important and variable. The serious arguments are for a levels target, so I’ve drawn in a reference path for 4.25% growth. That is a combination of 2% output price inflation and 2.25% real growth per head, the latter being the 1955-2008 average rate.

If the Bank of England had adopted a NGDP target, as many have recommended, the MPC would be tearing their collective hair out right now trying to stimulate the economy. There would be zero talk of interest rate increases. So there seem to be just two possibilities. Either NGDP targeting is nuts, or monetary policy has slowly gone off the rails by focusing on CPI inflation alone.

Time will tell. But if the possibility that the UK could really grow quite fast right now without inflation getting out of control turns out to be true (and the argument I make in the Independent is just that there is a non-trivial possibility that it might be true), what will history say? I suspect they will talk about Goodhart’s law, which says “when a measure becomes a target, it ceases to be a good measure”. Targeting inflation and ignoring output seemed like a good idea, because of what is called the divine coincidence. I talked about this in what I think is one of my better posts. Goodhart’s law applied to this case says CPI inflation ceases to be a good indicator of both the state of the economy and maybe also the costs of inflation when you try using it as a target.

Sticky wages both sides of the Atlantic

At the beginning of last year, there were many who were predicting a rise in UK interest rates in 2014. By then UK unemployment had been falling for many months, and we had had four quarters of solid growth. However I said that if rates did rise in 2014 it would be extraordinary. One of the reasons I gave was that there was absolutely no sign of any increase in nominal wage inflation. I thought it would be particularly odd if UK rates rose before US rates, given that the UK’s recovery was lagging a few years.

Unemployment continued to fall rapidly. By June 2014 even the Bank’s governor, Mark Carney, was giving indications that rates might rise sooner than some were expecting. US monetary policymakers showed no signs that they were about to raise rates, and I still thought they should be the first to move, but I was worried that the MPC was sounding too itchy. Sure enough in August two MPC members voted to raise rates. But wage inflation showed no signs of increasing.

Move forward to March 2015, and the prospect of rate increases seem to be receding on both sides of the Atlantic. On Wednesday the FOMC revised down their forecasts for inflation, and also revised down their estimate for the natural rate of unemployment. The reason is straightforward: despite continuing falls in unemployment, wage inflation refuses to budge. John Komlos argues that this state of affairs is unlikely to change anytime soon.

Much the same seems to be true in the UK, as this excellent account from Andy Haldane makes clear. In the UK there is an additional twist. To quote Haldane: “Back in 2009, the MPC’s judgement was that the benefits of cutting rates below 0.5% were probably outweighed by their costs, in terms of the negative impact on financial sector resilience and lending. With the financial sector now stronger, the MPC judges there may be greater scope to cut rates below 0.5%.” It now looks like the Zero Lower Bound (ZLB) may actually be zero.

Haldane goes through in great detail the possible reasons why wage inflation seems so sticky. Moving to the monetary policy implications, he talks about asymmetries, and many of the issues that I raised here he also raises. However he ends with something that I think is even more telling. The chart below shows an optimal interest rate path, using the Bank’s COMPASS model, and assuming a ZLB of zero.

What it does is confirm a suspicion that both Tony Yates and I had about the MPC’s current stance. The policy of doing nothing, and waiting for the inflation rate to gradually converge towards 2%, does not look optimal even if the Bank’s forecast is completely correct. 

Monetary policymakers as boyfriends

An MP who is a member of the Treasury Select Committee has described the Bank of England as an unreliable boyfriend: “one day hot, one day cold". City economists make similar complaints. The same is frequently said in the US about supposed Fed communication failures. Are these complaints justified?

In judging whether a central bank is really ‘blowing hot and cold’, we need to distinguish between public information about the economy on the one hand, and how policymakers will behave given new information on the other (in technical terms, their ‘reactions functions’). If you start flirting with your boyfriend’s best mate, you should not be surprised if he starts going a little cold. If, on the other hand, he had been attentive and considerate until the World Cup started, since when you have been completely ignored, you have probably learnt something about him that you did not know before.

The problem is that we cannot know for sure how each MPC or FOMC member will react to new bits of data as they emerge. So when Mark Carney in his Mansion House speech said “There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced.” he could have just been reflecting the fact that recent data had been surprisingly strong. As everyone had seen this data, there was no useful additional information in that statement.

However he went on to say “It could happen sooner than markets currently expect.” The intent of that statement is clear. For some reason markets had not reacted to this recent data (and therefore advanced their expectations about when the first rate increase would occur) in the way Mark Carney or the MPC as a whole had done. So they had got the Bank’s reaction function wrong, and Carney was telling them so.

This is why the market reacted strongly to Carney’s speech, and Carney intended them to do so. The trick was to reference something tangible - the market’s forecast for when interest rates were likely to rise. But this raises an obvious question. If part of the Bank’s communications strategy is to make comments about market forecasts of interest rates, wouldn’t it be both clearer and more efficient to have the Bank’s own forecast about interest rates. This is a point that ex-Bank economist Tony Yates makes here.

I have argued for this for some time (e.g. here, para 105), and was therefore enthusiastic when the Fed started to publish rate forecasts just after I started this blog. The idea is obviously not to commit the central bank to some path: a forecast is a forecast. Nor is the idea that the central bank somehow knows more about the data than the market, or that its ability to forecast is better. What publishing a forecast allows the market to do is get a better idea of character of their ‘boyfriend’. (It also allows the public to check that their boyfriend is not being time inconsistent, as I also explain here.)

It is only a matter of time before the Bank of England does this, and continues in its tradition of following the Fed. One interesting question of detail remains, however. Should the Bank publish a single forecast, or follow the Fed and publish the forecasts of each MPC member? (I give an example of the FOMC ‘blue dots’ in this post.) There are arguments for both. The Bank publishes a forecast for inflation and other aspects of the economy, but only on the basis of market guesses of future rates. It would be much more efficient and informative to publish forecasts based on the Bank’s best guess about the future path of interest rates.

The problem with having just one forecast is illustrated by the Carney speech. Was Carney at the time giving his view, or the view of the MPC? If the latter, how unanimous was that view? If subsequently a member of the MPC says something different, is that consistent with the majority view or a change? This problem becomes particularly acute when new MPC members replace old. Questions such as these can only be answered if individual MPC members give their own personal forecasts, as FOMC members currently do but with, in addition, their names attached.

When it comes to monetary policy, we have not one but many ‘boyfriends’. Now boyfriends can get annoyed if you keep asking them ‘what are you thinking’, but in this case we do rely on them (and pay them) rather a lot, so I think we are entitled to know.   

The race to raise interest rates

If you do not like the sporting metaphors in the post below, you can blame new MPC member Andy Haldane whose speech I have just read. Or maybe the World Cup.

When it comes to monetary policy, in recent years the UK has consistently followed the US. The US Fed started reducing interest rates in September 2007, and hit the Zero Lower Bound (ZLB) at the end of 2008. The UK’s MPC started reducing interest rates in October 2008, and hit the ZLB in March 2009. The lag between the two shortened considerably with Quantitative Easing, which the UK started just two months after the US. The MPC also followed the Fed with forward guidance, using a very similar formula.

The big question today for monetary policy in both the US and UK is when interest rates will start to increase. Until very recently this looked like a race that neither central bank was keen to enter, at least for a while. But that all changed last week following a speech by UK Governor Mark Carney. That led Gavyn Davies to ask what implications UK hawkishness might have on the US. It is very easy with such things to get lost in the immediacy of each new data release. In this post I’ll try and focus on the fundamentals.

Both central banks prioritise price inflation. UK inflation remains comfortably below target at 1.5%. US inflation had been in similar territory. The CPI rose by slightly more than 2% in May, but that is more volatile than the measure the Fed targets, so it is too soon to know whether this represents the beginning of a return of inflation to target. The FOMC committee’s latest forecasts indicate that inflation will remain below target for some time.

If the May CPI figure in the US turns out to be a blip, then there appears to be no immediate pressure to raise rates. However interest rate changes take time to feed through to inflation. As a result both central banks would like to start raising rates before rather than after the underlying level of inflation starts to exceed its target. Whether this is a sensible strategy I will discuss later, but it means the focus in both countries is on what determines future price inflation.

Here the UK seems to be in the lead, with stronger GDP growth than in the US. However economies often grow very rapidly when emerging from a deep recession. US growth was strong in 2010, but the Fed did not start raising rates then. The US has been growing at a moderate pace ever since, while the UK economy stagnated in 2011 and 2012. With this perspective, the US has not raised rates even after 5 years of recovery, so it seems odd that the UK should raise rates after just two years.

Economists would normally say that the more relevant measure for inflation is the output gap: an estimate of how much actual GDP is below the level at which inflation would be stable. Here most estimates suggest the UK is ‘winning’: the latest OECD Economic Outlook estimates for 2014 are UK -1% and US -3.1%. Now output gap estimates should normally be taken with a pinch of salt, but for the UK in recent years this pinch has become a spoonful. Most UK estimates assume that the marked decline in UK productivity growth since the recession (the UK ‘productivity puzzle’) is largely permanent. But as no one has any idea about why this decline has happened (hence puzzle), there is no compelling reason to assume it is permanent rather than reversible.

We can make the same point in a very simple way. UK output is currently around the same level as it was in January 2008, while US output is over 6% above its pre-recession peak. This would normally imply that the UK should be following well behind the US in raising rates.

      

What about the labour market? Here is a chart comparing unemployment in both countries.

I have taken the OECD’s latest Economic Outlook forecast for the US, but I have used much more optimistic numbers for the UK: 6.4% for 2014, and 5.7% for 2015. (Unemployment in May was 6.6%.) It is true that for unemployment, the lag between the UK recovery and the US recovery is shorter than for GDP growth. However they seem to be in similar territory at the moment, with unemployment unlikely to return to 2000-2007 numbers by 2015. In addition, there may be more labour market slack than is implied by these numbers, although for different reasons in each country. One final point worth noting is that, with free movement of labour within the EU, any labour market pressure in the UK can be offset by inward migration as long as Eurozone unemployment remains high.

There is no indication of any tightening in the labour market in either economy from data on wages. In the US real wages are stagnant, and wage growth in the UK continues to be below price inflation. In the UK, there is even some doubt whether rising real wages would put that much upward pressure on price inflation. Some part of the UK productivity puzzle must be the result of factor substitution: using labour rather than machines because real wages are low relative to the cost of capital. If that is the case, there is scope to reverse this if real wages start to rise, meaning that wage increases are not fully passed on into prices.   

One area which is often talked about where the UK is well ahead is the housing market, with UK prices rising rapidly. House prices are not part of the consumer prices index, but some argue that they should be. This is problematic conceptually - rents are the price of housing services, and house prices are the price of an asset. As I pointed out here, what we have in the UK at the moment is a rise in house prices relative to rents, which may in turn reflect the combination of falling interest rates and static supply, plus perhaps a bit of froth on top. According to the ONS data, rents have not been rising rapidly since the recession.

As John Williams among many others have emphasised, using interest rates to calm the housing market when inflation is below target has proved disastrous for Sweden and Norway. A housing boom is not a reliable indicator of incipient inflation. The UK should certainly not follow the Scandinavian example in this particular respect. 

Taking all this together, who will be the first to raise rates? My feeling is that US monetary policy makers are on reasonably solid ground, and are not even in their starting blocks. The output gap in the US is sufficiently large that there is little need to start raising rates now. UK monetary policy makers are in a much more difficult place, because of the UK productivity puzzle. The Carney speech has in effect tightened monetary policy by appreciating the exchange rate, as he must have known it would. Before this I had hoped that they would at least wait until real wages started rising significantly, but now I’m less sure. I fear after the Carney speech that they have entered the starting blocks, and any noise might trigger a false start.

The problem for the UK is that the strategy of wanting to start raising rates before inflation exceeds the target is inappropriate given the extreme uncertainties implied by the productivity puzzle. As Mark Thoma explains, and I have argued before, the risks are not symmetric. It would be unfortunate if inflation started rising before interest rates started increasing, but the costs of a few years of excess inflation would not be that great. The MPC has after all been there recently, and the world did not come to an end. The costs of prematurely choking off a recovery are much greater when recent productivity and output losses might be recoverable (as they were in the early 1980s and 1990s). These are very strong grounds for the Bank of England to continue to follow the US Fed, and not jump the gun.  

Postscript: Tony Yates elaborates on this last point, and also has more on the Haldane speech.

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.