Carney and McCafferty on oil and monetary policy

Carney and McCafferty delivered a one-two on monetary policy and oil prices.  Both get it wrong in my opinion, but, in diffent ways.  [Remember Tolstoy’s Ana Karenina:  ‘all good economic arguments are alike.  Each bad one is bad in a different way…’]

McCafferty first.

The basic approach he takes is:  we need to decide what caused the oil price to change, because that determines how we respond to it.  That much he has right.  But there are two big problems with how he sets about deciding [and, I infer, in his vote, which we must presume is based on this logic].

First.  What caused oil prices to change.  He rightly sets out on a hunt for oil demand and oil supply shocks.  But in my view he wrongly thinks you can diagnose the oil supply schedule from the quantity of oil produced by the oil-producing countries.  Identification is harder work than this!

I’d suggest three ways of doing it, that parallel those in the academic literature on, for example, identifying shocks to monetary or fiscal policy.  1:  study the motives of those controlling oil production and what they say about what they are doing.  2:  estimate a Vector Autoregression and identify oil supply and demand shocks from the correlations between oil output and oil prices [and other things, perhaps].  3.  Formulate a structural model of the world economy split into oil-producing and oil consuming sectors, and recover the shocks by estimating this model directly.

Second, McCafferty engages in the ‘price level shock fallacy’.  As I have ranted before there is no such thing as a price level shock in the sense meant here.

The logic in McCafferty’s mind goes:  oil causes the price level to fall, and the inflation rate to fall only temporarily.  Therefore there is no need to respond.

However, in fact, ultimately, it’s up to the central bank to decide whether or not even the price level falls in the long run.  Anecdote:  in the simplest versions of the BoE’s New Keynesian model, if inflation targeting is done optimally, [under commitment], NOTHING affects the price level permanently.  So in that world McCafferty’s category of ‘price level shocks’ would be an empty set.  A hypothetical MPC colleague inside that model would retort reading Ian’s speech: ‘oil only affects the price level so we don’t need to respond?  what are you talking about?  nothing affects the price level because we respond in just the right way.’

A related assertion to the one IM makes in his speech might be:  ‘given our planned policy rule, if we don’t deviate from it, that will, by choice, generate a lower price level in the long run than if the oil shock hadn’t happened, but the inflation rate will be no different, so we won’t deviate from the rule.’

But there’s nothing axiomatic about whether this will or won’t be true.  Whether it is  depends on how large the shock is, how activist the planned policy rule is in responding to variables in the economy, and the process driving expectations.  And the proximity to the zero bound.  And the efficacy of alternatives to interest rate policy.  And…

You can’t deduce the optimal response from categorising something as a ‘price level shock’.  That description includes a policy response already [the decision to make sure there is no effect on the inflation rate] .  You have to take a stance on all these other things.

Note too that ‘not responding’ to oil would not mean ‘leaving interest rates unchanged’.  It would not even mean ‘not altering the previously agreed trajectory for rates’. It would mean ‘not altering the previously determined recipe for arriving at the interest rate trajectory’.

But McCafferty has not explained what the [or his] recipe is, or what trajectory it gives you.

In fact, the whole problem here, [to repeat] is that he’s trying to decide something about the recipe [whether or not to respond to a certain kind of oil price movement] based on already presuming a recipe [which leads to that shock changing the price level].

So, away with those ‘price level shocks’.  The term should set of a mental hooter that goes off when you see it.

Onto Carney’s speech.

As was widely reported today, he said that it would be “foolish” to loosen in response to the fall in oil prices, which had led to the chunky drop in headline CPI inflation.

Well, I don’t think it would be foolish.  The motivation for cutting is twofold.

First, a case could be mounted that the oil price fall boosts potential output relative to demand.  In the Bank of England’s own model this puts downward pressure on deflation and would warrant a cut.

Second, to the extent that there is a risk of inflation expectations responding to the fall in headline CPI inflation that we have seen, and of the economy becoming more permanently entrenched at the zero bound, a cut would be warranted on precautionary grounds.  On that logic one would not wait until wage growth or inflation expectations fell.  By that time it might be too late.  So Carney’s qualification that loosening would be foolish “unless” wage growth weakened does not cover this concern.  As Carney stresses in his own text, monetary policy takes time to work.  Hence one has to act on the basis of a probabalistic forecast, always.


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