The lesson monetary policy needs to learn

It seemed obvious to write a post about the Peterson Institute’s recent conference on ‘Rethinking Macroeconomic Policy’, but nowadays I find it more efficient to let Martin Sandbu do the job. We agree most of the time, and he does these things better than I do. It allows me to write something only in the unlikely event that I disagree, or if I want to take the discussion further.

I only have one quibble with Martin’s column yesterday. I think Bernanke’s suggestion that following a large recession (where interest rates hit their lower bound) central banks revert to a temporary price level target is rather more than the tweak he suggests. In addition, as Tony Yates pointed out, level of NGDP targets do not resolve the asymmetry problem that Bernanke’s suggestion is designed to address.

I also thought I could illustrate Martin’s final point that “admitting one has got things badly wrong is a prerequisite for doing better” by looking at some numbers. If we look at consumer prices, average inflation between 2009 and 2016 was 1.1% in the Euro area, 1.4% in the US and 2.2% in the UK. The UK was a failure too: average consumer price inflation should have been higher than 2.2%, because we had a large VAT hike and depreciation that monetary policy rightly saw through. If we look at GDP deflators we get a clearer picture, with 1.0%, 1.5% and 1.6% for the EZ, US and UK respectively.

You might think errors of that size are not too bad, and anyway what is wrong with inflation being too low. You would be wrong because in a recovery period these errors represent lost resources that, as the Phillips curve appears to be currently so flat, could be considerable. Or in other words the recovery could have been a lot faster, and interest rates could now be well off the lower bound everywhere, if policy had been more expansionary.

What I really wanted to add to Martin’s discussion was to suggest the main problem with monetary policy over this period, particularly in the UK and the Eurozone. It is not, in my view, the failure to adopt a levels target, or even the ECB raising rates in 2011 (although that was a serious and costly mistake). In 2009, when central banks would have liked to stimulate further but felt that interest rates were at their lower bound, they should have issued a statement that went something like this:

“We have lost our main instrument for controlling the economy. There are other instruments we could use, but their impact is largely unknown, so they are completely unreliable. There is a much superior way of stimulating the economy in this situation, and that is fiscal policy, but of course it remains the government’s prerogative whether it wishes to use that instrument. Until we think the economy has recovered sufficiently to raise interest rates, the economy is no longer under our control.”

I am not suggesting QE did not have a significant positive impact on the economy. But its use allowed governments to imagine that ending the recession was not their responsibility, and that what I call the Consensus Assignment was still working. It was not: QE was one of the most unreliable policy instruments imaginable.

The criticism that this would involve the central bank exceeding its remit and telling politicians what to do is misplaced. Members of the ECB spent much of the time telling politicians the opposite, Mervyn King did the same in a more discreet way, while Ben Bernanke eventually said in essence something milder than the above. Under the Consensus Assignment we have invested central banks with the task of managing the economy because we think interest rates are a better tool than fiscal policy. As such it is beholden on them to tell us when they can no longer do the job better than government.

A better criticism is that a statement of that kind would not have made any difference, and we could spend hours discussing that. But this is about the future, and who knows what the political circumstances will be then. It is important that governments acknowledge that the Consensus Assignment no longer works if central banks believe there is a lower bound for interest rates, and this has to start by central banks admitting this. Economists like Paul Krugman, Brad DeLong and myself have been saying these things for so long and so often, but I think central banks still have problems fully accepting what this means for them.       

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.

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.    

If only someone had warned us

The title is pinched from a tweet by Tony Yates, who was one of many economists who did warn of the impact of Brexit. Of course we economists need to ask ourselves if and why our message was ignored, but that is no reason to stop us feeling angry that it happened. This post from the economist who did more than most to try and get the message across, John Van Reenen, expresses that anger better than I could.

What John’s work showed, backed up by similar analysis in the Treasury and elsewhere, is that Brexit would not just cause a short term economic downturn: cutting wages and increasing unemployment for just a year or two. By making it harder to trade with our immediate neighbours it will reduce UK trade overall, and the evidence suggests that this will permanently reduce people’s living standards. The markets clearly agree, which is why sterling fell immediately and substantially after the Brexit vote. In terms of people’s living standards that was not a ‘might be bad, might be good’ event: it makes everyone in the UK poorer. (Never start from a price change, but ask why prices changed.)

The tricky thing to do now is know how much the current downturn is just a foretaste of that, and how much is something over and above that. To the extent that it is the latter, how much

of that is offset by some short term benefit to exporters (before the impact of actual Brexit kicks in) as a result of the depreciation? That is initially the Bank of England’s problem.

Their response today, a cut of 0.25% plus more QE, tells us it is not just their problem. We are back at the lower bound for nominal interest rates, which is why the Bank is doing more QE. Because the impact of the QE is extremely uncertain, and in the absence of helicopter money, we now need fiscal action to back up this interest rate cut. That is what Labour’s fiscal credibility rule, and the academic work by Jonathan Portes and myself, utilising textbook and state of the art macro, tells us we should do. When interest rates are at the lower bound, forget about the deficit and focus fiscal policy on avoiding a recession. As the Bank’s QE action makes clear, there is no good reason to delay this: it should happen now.

But Brexit was not the first time economists have been ignored. For some years now the clear consensus among academic economists is that, when rates are at their lower bound, you need fiscal stimulus. Although Conservatives have disowned 2015 Osborne austerity, they appear not to have backtracked on his 2010 version. If they do nothing now, we will know that they are wedded to pre-Keynesian 1930s economics.

Some thoughts on Paul Mason’s McDonnell road show talk

John McDonnell has got quite a collection of talent to give talks on economics around the country, and the latest is Paul Mason. His talk is wide ranging and certainly not academic in tone, as befits the occasion, and I agree with the broad thrust of it, although not all the details. Here are a few thoughts.

The impending second crisis.

There seems to be a general presumption in certain circles that we are heading for another crash. (Perhaps I could call it ‘the end of capitalism is nigh syndrome’.) This is always a possibility (of course), but I do not think it is a probability. In the UK, do not be fooled by the referendum blip (or pause). I think it is quite likely that Prime Minister Osborne will by 2020 be presiding over strong growth, as everything that was put on hold before the referendum comes on stream. I also think we may see rapid Eurozone growth before then.

On a related theme, there is also a widely held view that after the referendum the Conservative party will fall apart - it is the Corn Laws all over again. I would put that probability much smaller than the chance we might vote to Leave, or that Boris gets to be our next PM.

Fiscal rule

I’m glad he likes Labour's new fiscal rule. He writes: “There’s a school of thought among Labour supporters, and some academics, that the deficit is irrelevant, that “taxing the rich” solves all your problems. It does not.”

‘I did not know you could do that’

His reference to the Macdonald government coming off the gold standard is certainly apposite. Too often the centre left gets trapped by what it sees as unbreakable economic or political convention, only to see the other side break it (think minimum wage).

Monetary policy

What is said in this central section sounds radical, but I think it is meant to be read in the context of the impending next recession that I talked about earlier. What I think he is worried about is that, in that context, any fiscal action would need monetary support, and with the current regime it might not get it. In other words the economy tanks, the next Labour government wants to stimulate but inflation stays close to 2%, and the Bank of England does not cut rates to allow the fiscal rule's knock out to apply. For this reason he supports the proposal, which has a number of notable advocates, that the inflation target be raised to 4%.

I would agree this could be an issue: what economists called the ‘divine coincidence’ (that inflation would always provide the appropriate signals) just does not seem to work very well any more. Whether raising the inflation target to 4% is the best way of dealing with the problem, as opposed to for example an intermediate NGDP target, I’m less sure about but I’m open to persuasion. I agree with Paul that this is a problem involving the central bank's mandate, rather than its independence.

He also supports Corbyn’s original Peoples QE proposal. He cites me as opposing it, but in fact I did not oppose the idea as an alternative to the QE that the Bank would want to do otherwise. What I thought was wrong with Corbyn’s QE was that it appeared either to negate central bank independence, or make a National Investment Bank conditional on the Bank wanting to do QE. In the past I have talked (here, or via Tim Harford here) about how governments and the central bank could cooperate to do money financed fiscal stimulus. In other words Corbyn's QE is fine as an alternative to conventional QE in the context of recession fighting, but not as a general way to finance an investment bank.

I suspect he is also just a little bit worried that the bond vigilantes might finally arrive. I think there is no way that will happen, but we have some history of a central bank governor who worried that it might and gave the wrong advice as a result. If that happened again, we would want monetary policy makers to offer monetary finance of any fiscal stimulus (in exchange for a government commitment to always recapitalise the central bank on request), rather than urge fiscal constraint. Perhaps one way to do that would be to make the central bank’s ability to do unconventional monetary policy conditional on that money finance offer being made.    

Can central banks make 3 major mistakes in a row and stay independent?

Mistake 1

If you are going to blame anyone for not seeing the financial crisis coming, it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells, but instead it produced at most muted notes of concern about attitudes to risk. It may have been an honest mistake, but a mistake it clearly was.

Mistake 2

Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.

Monetary policy makers do not see it that way. They will cite the use of unconventional policy (but this was untested, and it is just not responsible to pretend otherwise), the risks of rising government debt (outside the ECB, non-existent; within the ECB, self-made), and during 2011 rising inflation. I think this last excuse is the only tenable one, but in the US at least the timing is wrong. The big mistake I note above occurred in 2009 and early 2010.

What could be mistake 3

The third big mistake may be being made right now in the UK and US. It could be called supply side pessimism. Central bankers want to ‘normalise’ their situation, by either saying they are no longer at the ZLB (UK) or by raising rates above the ZLB (US). They want to declare that they are back in control. But this involves writing off the capacity that appears to have been lost as a result of the Great Recession.

The UK and US situations are different. In the UK core inflation is below target, but some measures of capacity utilisation suggest there is no output gap. In the US core inflation is slightly above target, but a significant output gap still exists. In the UK the output gap estimates are being used to justify not cutting rates to their ZLB [1], while in the US it is the inflation numbers that help justify raising rates above the ZLB. (The ECB is still trying to stimulate the economy as much as it can, because core inflation is below target and there is an output gap, although predictably German economists [2] and politicians argue otherwise.)

I think these differences are details. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. In other words it is simply a coincidence that productivity growth slowed down significantly around the same time as the Great Recession. Or if it is not a coincidence, it represents an inevitable and permanent cost of a financial crisis.

Perhaps that is correct, but there has to be a fair chance that it is not. If it is not, by trying to adjust demand to this incorrectly perceived low level of supply central banks are wasting a huge amount of potential resources. Their excuses for doing this are not strong. It is not as if our models of aggregate supply and inflation are well developed and reliable, particularly if falls in unemployment simply represents labour itself adjusting to lower demand by, for example, keeping wages low. The real question to ask is whether firms with current technology would like to produce more if the demand for this output was there, and we do not have good data on that.

What central banks should be doing in these circumstances is allowing their economies to run hot for a time, even though this might produce some increase in inflation above target. If when that is done both price and wage inflation appear to be continuing to rise above target, while ‘supply’ shows no sign of increasing with demand, then pessimism will have been proved right and the central bank can easily pull things back. The costs of this experiment will not have been great, and is dwarfed by the costs of a mistake in the other direction.

It does not appear that the Bank of England or Fed are prepared to do that. If we subsequently find out that their supply side pessimism was incorrect (perhaps because inflation continues to spend more time below than above target, or more optimistically growth in some countries exceed current estimates of supply without generating ever rising inflation), this could spell the end of central bank independence. Three counts and you are definitely out?

I gain no pleasure in writing this. I think a set-up like the MPC is a good basic framework for taking interest rates decisions. But I find it increasingly difficult to persuade non-economists of this. The Great Moderation is becoming a distant memory clouded by more recent failures. The intellectual case that central bank independence has restricted our means of fighting recessions is strong, even though I believe it is also flawed. Mainstream economics remains pretty committed to central bank independence. But as we have seen with austerity, at the end of the day what mainstream economics thinks is not decisive when it comes to political decisions on economic matters. Those of us who support independence will have to hope it is more like a cat than a criminal.

Postscript (11/04/16). If you think that those who are antagonistic to central bank independence are only found on the left, look at the Republican party, or read this. 

[1] Unfortunately I think some of this survey data is not measuring what many think it is measuring. More importantly, not cutting rates after the Conservatives won the 2015 election was a major mistake. That victory represented two major deflationary shocks: more fiscal consolidation, plus the uncertainty created by the EU referendum. So why were rates not cut?

[2] But not all German economists, as this shows.         

Political economy assignments

Suppose you have two objectives for monetary policy: financial sector stability and real economy stability. You have two main instruments: interest rates and macroprudential policy (things like changing the capital requirements of banks, or making it less easy to get a mortgage; often called macropru for short). Should you assign one instrument to one objective (often called an assignment), or try and achieve both goals with both instruments?

As Tony Yates points out, assignments are rarely optimal from a purely macro point of view. Even if, say, interest rates are less effective at achieving financial stability than macropru, you would still want interest rates to contribute something to that objective. An exception is when one instrument completely dominates the other: then assignment is optimal. An example of this exception in a certain class of model is monetary over fiscal policy as means to achieve real stabilisation, as discussed here and here (less technical discussion here). But this type of result is unusual, and even when you get a result like this for a certain class of models it is not hard to add real world complications that remove the result.

If assignment in the case of real and financial stabilisation is not optimal, does this imply that those setting interest rates should take financial stability into account? It is important to understand what we are talking about here. We are not talking about how financial conditions might influence what interest rates need to be to achieve real stabilisation, which is the kind of issue discussed in this post by Bianca De Paoli for example. Nor is it talking about allowing for risk as I discussed here. Instead it would be saying that institutions like the US Fed should have a triple mandate when setting interest rates, where the third mandate was financial stability. Interest rates could be changed if financial stability was a concern, even if this had no implications for inflation or output. Equivalently, interest rates could move to help financial stability even if this took output and inflation away from target.

However we already have assignments that are clearly suboptimal from a purely macro perspective. Fiscal policy is assigned to the control of government debt, and reducing debt is certainly not a monetary policy objective. But in standard models this assignment is clearly suboptimal: when debt is high, reducing interest rates can be quite effective in reducing debt (particularly if government debt is mostly short term), and undesirable knock on effects on output and inflation can be countered by fiscal policy. Yet the mainstream consensus is that monetary policy should not be used to reduce debt.

The reason for this suboptimal assignment is most probably because of political economy concerns. Or to put it another way policy is mainly concerned about knowingly sub-optimal decisions. Reducing interest rates to reduce debt sounds too much like fiscal dominance. There is a fear that if there is no institutional assignment, politicians will depart from optimal policy and by keeping rates too low to reduce debt they will allow excessive inflation.

Can such political economy concerns be applied to financial stability and monetary policy, particularly as the same actor - an independent central bank - is in charge of both? My instinct is that it can, because central bankers are heavily influenced by pressures from the financial sector. As a result, there is a danger that if interest rates are set with both objectives in mind, central bankers will depart from optimal policy and, for example, needlessly raise interest rates before the real economy requires them to rise. The recent experience of Sweden is a clear example where this happened. For this reason I rather like the UK institutional set-up, with a separate MPC and FPC and a clear assignment for each.

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.

Faith in multipliers

Economists could skip to the penultimate paragraph

The multiplier is the size of any decrease in output that results from a fiscal contraction (lower government spending or higher taxes), both measured in the same units. Why am I confident that multipliers that result from temporary decreases in government spending in current conditions will be somewhere around one rather than somewhere around zero? It is not because of empirical studies that try to directly estimate multiplier sizes.

Do not get me wrong. Such studies are very important, as are meta studies that try and pull together and synthesise the large number of individual studies. However I tend to use them to either confirm or question my priors. My priors come from thinking about models, or perhaps more accurately mechanisms, that have a solid empirical foundation. Let me explain.

Some of the terminology makes more sense if we talk about an increase in government spending (for example, a new school being built), so from now on I’ll consider that. A multiplier around one means that for every school built GDP increases by the cost of that school (a multiplier of exactly one) plus or minus some private sector expenditure (hence around one). If private sector expenditure falls we talk about it being crowded out, but if private sector spending increases we can talk about that expenditure being encouraged or crowded in by the additional public spending. The first point to note is that by thinking in this way I’m focusing on aggregate demand rather than aggregate supply, which I think is appropriate in the situation we have recently been in. If, in contrast, everyone was already working as much as they could, it might be more natural to start from a multiplier of zero, because the school will have been built with labour that otherwise will have built something else. A multiplier of zero is called complete crowding out.

Will we get crowding in or crowding out? Here my starting point is to note that because the increase in government spending is temporary, any impact on pre-tax income or taxes will be relatively small relative to a consumer’s lifetime income. As a result, aggregate consumption is likely to change either way by an amount that is a lot less than the cost of the school. For similar reasons firms think long term when planning investment, so they are not going to invest that much because of a temporary increase in government spending and GDP. There is a lot more we could say here, but I want to keep it simple.

We next need to think about whether this reasoning could be upset by some change in a price that results from the extra school being built. The two key prices here are the real exchange rate and the real interest rate. My basic model of exchange rates is that they are grounded in some medium term view concerning competitiveness, plus beliefs about what might happen to short term interest rates. If the spending is temporary medium term competitiveness is largely unaffected, so what happens to real interest rates is critical. If they rise as a result of the additional employment required to build the new school, then this might lead to a real exchange rate appreciation. This will reduce the demand for domestically produced goods, and higher real interest rates will also discourage private spending directly. So what happens to interest rates is critical.

This is the second point at which actual circumstances are important. Nominal interest rates have been stuck at their Zero Lower Bound, which suggests that they would be quite likely to remain there despite any increase in employment generated by our additional school. If the additional GDP adds a bit to inflation, real interest rates might actually fall, leading to crowding in. (The point is reinforced if we reverse the sign and think about fiscal austerity - central banks will be unable to cut rates to offset austerity’s impact.)

That is where my priors come from: thinking about the structure of the economy, and situation we are in and the nature of the experiment involved. The problem for empirical studies that directly relate changes to output to changes in government spending is that they face huge difficulties in relating the data to particular circumstances and the kind of experiment involved. For example, is any increase in government spending observed in the data expected to be temporary (with relatively minor consequences for tax) or permanent (with implications for tax that could lead to complete crowding out as a result of lower consumption)? Some studies try and take account of this by focusing on shocks to spending, but that is not quite the same thing. (A new school will tend to raise GDP whether it is expected or not.) Even if the change in government spending is expected to be temporary, if any additional borrowing is paid for by cutting future spending rather than increasing taxes this will in theory make some difference.

Up until recently studies have not really controlled for monetary policy, which as we saw was crucial. This recent study from the IMF is an exception, although if you read it you will see just how difficult trying to control for monetary policy actually is. They find that monetary policy does have a large influence, which fortunately agrees with the analysis above. What some earlier studies have shown (I’ve often referenced a study by Jorda and Taylor, but here is another, and a meta analysis is here) is that multipliers tend to be larger when economies are depressed. What has not been clear is whether this is picking up a monetary policy effect (if economies are depressed, monetary policy is unlikely to try and offset the impact of any fiscal expansion), or whether it is picking up something else (for example, multipliers could be larger in a recession because more consumers are credit constrained). This IMF study, which is just based on US data and which does allow for monetary policy, finds no additional depressed economy effect. It will be interesting to see if that result proves robust to alternative treatments of monetary policy and data for other countries.         

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. 

Deflation, inflation, oil prices and asymmetries

When both headline and core inflation rose above target after the financial crisis, helped by rising oil prices, the Fed and Bank of England kept their nerve and did not raise interest rates. They saw through what was a temporary episode. The ECB’s judgement was not as good. Even in the UK it was close, with three out of nine MPC members voting for a rate increase for a few months. But it was the outcome that mattered - excess inflation was ignored because it was temporary. To what extent is what we are seeing right now just the mirror image of this period?

In terms of where inflation is and the monetary policy response, the situation today does indeed look like a mirror image. Headline inflation is or is about to be negative, and core inflation has fallen below target. As Tim Duy points out for the US, core inflation seems to be heading lower rather than returning to target. However I think that is where the symmetry ends. While the dangers of letting inflation rise above target because of temporary shocks are small, the dangers in the opposite direction are more serious. 

One of the arguments used by the inflation hawks when oil prices were high is that even if the impact of higher oil prices on inflation was itself temporary, there was a danger that inflation expectations would increase, and the central bank would lose its anti-inflation credibility. My response at the time was three-fold: first, the private sector can see the reason that rates are not being raised (the continuing recession), so credibility should not be in danger; second, the best indication that the expectations that matter have shifted is when nominal wage inflation starts to pick up (which it did not), and third when that happens it will be easy to restore credibility and reduce expectations by raising rates. [1]

None of these arguments apply with deflation today. Then unemployment was clearly too high. Today unemployment is not clearly too low. How far we are from the natural rate is unclear, but no one would argue that we are in a boom that is the mirror image of the recession a few years ago. The second argument is that we could use changes in nominal wages as a clear indicator that the inflation expectations that mattered had shifted. That argument is not symmetrical because of the well known resistance to nominal wage cuts. Finally if credibility does seem about to be lost, the central bank will find it very difficult to take action to restore it because of the Zero Lower Bound (ZLB).

Please allow me to get technical for just one paragraph, which can be safely skipped. As has often been pointed out, the ZLB means that there are two steady states in the economy associated with a given real interest rate: the ‘intended’ equilibrium with target inflation, and the ‘ZLB equilibrium’ when inflation is negative. I recently discussed a paper that treated agents views about which equilibrium was appropriate as a ‘belief’ and that perhaps the liquidity trap could be a manifestation that agents believed we were heading for the ZLB steady state. The controversial aspect of this analysis is the suggestion that this belief could be shifted by the monetary authorities raising rates. I find that very unconvincing, but it would be a mistake to dismiss the exercise completely on that account. In that post I did suggest an alternative rationalisation for why we might be heading for the ZLB equilibrium: agents no longer believed that the monetary authority had the means to stop it happening.

This last asymmetry is the one that troubles me the most, and why I am not as relaxed as monetary policy makers appear to be about deflation. There are three interpretations of this relaxed attitude to negative headline inflation. The first is the one I suspect monetary policy makers actually hold, which is that the beneficial impact of lower prices on demand will with a year or so push inflation back to target, so there is no reason for concern. [2] I think the probability is that they are correct, but good policy does not just think about the most likely outcome, but should also be robust to risks, particularly risks with large consequences.

The second interpretation that the private sector could give for the relaxed attitude by central banks in the US and UK is that deviations above and below 2% are not treated symmetrically. In theory this should be more of a concern in the US than the UK, because in the UK asymmetry is against the central bank’s mandate. However I’m not sure the private sector thinks that is as important as MPC members do. There is one obvious additional asymmetry between now and a few years ago: many of those calling for higher rates back then are still pushing for higher rates today.

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

[1] A footnote for macroeconomists: this is why I have never been convinced by Cochrane’s worries about using the inflation target as a transversality condition.

[2] Resistance to nominal wage cuts may also dampen any the deflationary path, giving time for these positive effects to come through. However resistance to nominal wage cuts does not mean the ZLB equilibrium will never occur – in the paper I discuss in this post, it is the reason why that equilibrium is associated with high unemployment.