This speech is an interesting overview of the difficulty that faces monetary policy mandate designers in this era of low equilibrium real interest rates.
AGH tilts towards reforming monetary institutions to allow for substantially negative interest rates, rejecting permanent use of QE, or a rise in the inflation target.
In the past, I’ve plumped for raising the inflation target to 4%. Or more particularly, HMT setting the inflation target, perhaps on instruction from a third party, every 5-10 years, based on an assessment of the equilibrium real rate, which we might well expect to move around further.
A few points on AGH’s cost-benefit analysis.
Andy points out that inflation is costly, and so an extra 2 percentage points of it is proportionately more costly. Yet it seems to me that allowing negative interest rates on digital cash increases the cost of 2 per cent inflation somewhat. Formerly, consumers get zero interest on their notes and coins holdings, while they depreciate at an average of 2 per cent a year. With occasionally negative rates, these ‘shoe-leather costs’ of inflation increase a bit, proportional to the time spent below zero, and just how negative they go. A reminder: during the dark days of the previous crisis it was commonly thought that rates would ideally have gone down to about negative 7% or 8%.
Second, I query the judgement that eliminating cash and using negative rates would be less damaging to the credibility of monetary institutions than bumping up the inflation target. Ultimately, in the absence of good models of how reputations are won and lost, this argument is really about trading hunches. But mine is that there is a risk of a serious WTF moment when the no-cash system is explained, or people find out that they actually have to pay large sums of money simply for the privilege of having it. Anecdotally, we know from many models of money that equilibria where money is valued are quite fragile – specifically, it’s quite easy to write down models in which it is not.
It’s worth noting too, that the MPC ran substantially above-target inflation for some years during the crisis, and, despite the warnings of some, the faith that central banks were still targeting 2 was not much diminished. An open, pre-announced, and well-explained move to 4 per cent [in my view once we have shown we can hit the current target, and not before] would not be fatal.
Third, AGH is dubious about making more use of QE. This is interesting in the context of the current debate, in which since the departure of Mervyn King, one senses, despite protestations by others to the contrary, that there is a shift in sentiment against this instrument.
Haldane is worried about the intermingling of monetary and fiscal policy [a worry that has come to the fore recently with the debates about Quantitative Easing for the People]. These worries are legitimate, but not insurmountable.
Two finesses might help.
First, there is no need in my opinion for QE to involve the creation of reserves. One can simply have the DMO issue short-gilts and trade them for long. QE becomes a twist. The twist part of QE was always the part that was most convincingly effective anyway, via its squeezing of the term premia. Think of current QE as a two-step. First, the creation of reserves to buy a short gilt; second, a swap of a short for a long. The first is just conventional monetary policy, which will have no effect at the zero bound. [Leave aside the detail that rates stopped above zero and we have IOR]. Unless it meant some lowering of interest rates in the future to accommodate the correspondingly higher money.
A second finesse would be to make policy announcements take the form of instructions from the MPC to HMT for them to undertake the twist themselves. Since the BoE is already insulated from the fiscal effects of QE through the indemnity, this is a natural next step, if worries about intermingling weigh heavily. This etiquette could be used to underpin a more vigorous credit easing [ie issuing gilts to finance purchases of private sector assets]. And it might also help the DMO avoid conflicts such as one might argue we had this time, between what its right hand is doing [issuing long gilts like crazy during the crisis] and what it’s [BoE operated] left hand is doing [hoovering them up via QE].
A final point to note is that AGH does not mention that the armory could be supplemented by more vigorous use of discretionary changes in conventional tax and spend fiscal instruments at the zero bound. Although Haldane considers changing the inflation target, which is on the face of it is HMT’s business and not his, discussing conventional fiscal policy like this was probably thought a step too far.
Full-blown fiscal councils of the sort recommended by Wren-Lewis are considered too much for democracy to swallow by some [not me]. But there is a half-way house. One writes down an agreement ahead of time that in the event that the zero bound threatens or is hit, HMT and the BoE would discuss together, in an open and minuted forum, an appropriate, discretionary, fiscal response, explaining the loosening and the nature of the subsequent tightening later down the road to repair the debt/GDP ratio. Ideally, both parties would agree at the launch of this institution on rough orders of magnitude, linking additions to the deficit to estimates of the missing interest rate stimulus, to be referred back to as and when this tool is activated.