Fiscal policy: as if Carney had said ‘we won’t stick to this forward guidance’ and then stuck to it anyway

Another thought on the Coalition’s attempt to manage expectations about fiscal policy.

My last post on the Coalition’s fiscal policy, in a nutshell, said that although the eventual path of the deficit, ex post, turned out not too far wrong, (in that, in combination with monetary policy, we ended up with at least as much inflation as we wanted, and perhaps even then some), there were politically calculated mis-steps along the way.  In particular, the failure to set out a policy that could i) promise fiscal responsibility, but ii) allow for changes of plan if fiscal risks turned out to be less than at first thought, or the recovery weaker (exactly what happened, of course).

My conjecture is that if instead they had promised a loosening if conditions allowed, at the outset, expectations of the future would have been brighter, and the recovery sooner to take hold.  Modern macro stresses a great deal the management of expectations.  One of the phrases in Michael Woodford’s tome Interest and Prices that sticks in my mind is that ‘very little else [apart from expectations] matters’.  In this respect, the Coalition failed miserably in expectations management.  Of course, they did so in pursuit of generating expectations that the UK would be fiscally solvent.  It was right that they viewed these two kinds of expectations management as competing.  But they went after fiscal soundness expectations in a mistaken way.  Ex ante, no-one should have believed them when they said that they would stick to their ‘Plan A’ come what may.  Ex post, they didn’t stick to them anyway.  So if anyone was fooled, they would have been disappointed.  So the Coalition ended up with depressing expectations of future demand [bad for current demand, ie bad for demand back in May/June 2010], without enhancing expectations of fiscal soundness.

To make an analogy with central bank ‘forward guidance’.  It would be like Carney saying:  “there’s no way we can keep interest rates this low for this long” [ie deliberately stoking up expectations of a rate rise] and then confounding expectations by keeping them low for that long.

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