Wednesday’s Treasury Committee hearing with the Bank of England’s Monetary Policy Committee featured an apparent squabble over whether exchange rate depreciations ‘worked’ or not. It reads like something we could set students. ‘OK who is wrong here, if anyone, and why?’
Andrew Haldane said, uncontroversially: “A combination of the weaker pound, and a stronger global economy, has worked its magic….. Depreciations work. And that’s how they work.”
Prompted by MP Alistair Jack, Sylvana Tenreyro commented: “[in Argentina [Jack’s words]] depreciations make people poorer.”
Mark Carney seemed to take Tenreyro’s side: “Depreciations don’t work. They have an economic effect, but they’re not a good economic strategy. They may be an outcome of various things… but it’s how you make yourself poorer.”
Students of open economy macro would probably find this fight confusing. Everyone is right. We might reasonably suppose – just as the Bank itself has – that the fall in Sterling after the EU Referendum result in June 2016 was prompted by i) a rise in the risk premium, on account of increased uncertainty about the near and long-term outlook, ii) a revision down to expected long term income per head in the UK [thus the real exchange rate] and expectations of looser monetary policy.
The combination of underlying causes that led to the depreciation [Brexit, basically] will make us poorer; and the depreciation won’t alter that. But the monetary policy response which in part prompted the depreciation will mean higher income per head along the transition. So to that end Andy Haldane was right – they do work, which is why the MPC consciously engineered one. They don’t leave us better off than in the counter-factual situation in which the UK had voted Remain. But they leave us better of than if MPC had attempted to fight to maintain the old level of Sterling. In that case, we would be poorer along the necessary, unavoidable transition; if they continued to try to do this, we might be very much poorer, and we would quite likely see a large recession and associated undershoot of the inflation target.
I doubt that Haldane, Carney and Tenreyro disagree about this at all. But in the heat of the moment, Carney in particular seemed to turn the exchange into a fight.
All this has to be taken with a pinch of salt, of course, since DSGE macro has had questions asked of it of late; and open economy macro was anyway more famous than most sub-fields for its long list of ‘puzzles’. But this is how the BoE thinks about it, and is what is buried in the workings of the BoE’s forecasting platform COMPASS.
If I was still a staffer, I’d be urging one of the senior MPC members to rehearse a clear up of this mess, and refresh the commentariat’s understanding of how they think the exchange rate bears on monetary policy under inflation targeting. It’s quite an important part of the framework, and it is necessary on occasion to deflect opposition to it from those with long enough memories to wish we still did target Sterling, and others with a tendency to view Sterling’s level as a matter of national pride, and anything that undermines it – eg nasty Remoaner monetary policy makers – as part of the problem.