The polls are tightening, and it’s estimated now that there is a 30 % chance of the UK voting to leave the EU. The Bank of England somehow has to produce an Inflation Report and a policy decision that reflects and responds to this, as Chris Giles urged recently.
In the past, I’ve sketched that I think a vote to leave could lead to a chunky drop in confidence and demand, requiring interest rates to fall, and/or remain lower for longer than otherwise. This would be despite the fact that corresponding capital outflows would be associated with a fall in Sterling. The temporary push to inflation that would bring would rightly be ‘looked through’ by the MPC.
There is a less tangible but not negligible risk of a more serious problem afflicting wholesale funding markets. In the event that that happens the push down on Bank Rate would be more pronounced, but rates paid by borrowers could actually rise.
In the face of this risk, there is an argument that policy should already have been loosening, to head off the asymmetric costs of hitting the zero bound. In order that the MPC hit the inflation target on average, they have to try to overshoot it on their most likely guess. The more these risks blow up, the greater the required overshooting, and the looser policy should be now. So far, the MPC have eschewed this overshooting strategy.
A practical problem confronting MPC is how to present their deliberations in the May Inflation Report.
In the past, the chance of a Eurozone breakup was simply excluded from the fancharts, amounting to conditioning on the assumption that the Eurozone would not break up. (A forecast that so far has proved correct). One has to hope that a similar tactic is not used this time.
The monetary policy decision ought to be one taken by choosing amongst a whole set of possible inflation forecast distributions, which reflect all the risks, and where there is one such distribution for every possible reaction function for policy instruments. The policy choice is the one that corresponds to the first instruction from the reaction function that led to the most appealing forecast distribution for inflation. Where ‘appealing’ is judged relative to the inflation target mandate given to MPC by the Treasury.
In order to transparently communicate the decision and the deliberations that led to it, the outside world need to be appraised of what those distributions – which reflect the probabilities of a Leave and a Remain vote – look like. Ideally we would also see the distribution of interest rates that corresponded to the MPC’s chosen reaction function. In the case at hand, this would be useful, since Carney has already made it plain that he thinks the MPC ‘has the tools’ to deal with a Leave vote. We must be interested to know more precisely what he meant, whether those ‘tools’ include monetary policy instruments, and, if so, how they would be used in the event of a vote to leave.
Failing this, we should at least see how they assessed all the risks weighing on their goal variables, Brexit included.