Re-specifying the inflation target for low real interest rates

The Fed’s John Williams has commented that the Fed should revisit the inflation target to provide for future episodes in which very low interest rates are needed.

This is welcome.  Blanchard, Krugman, and many others have made the same argument.

A higher target would lead to the resting point for central bank rates rising one for one, roughly, [risk premium calculations aside] making more room for interest rate cuts when the Fed next has to deal with a recession.

QE and conventional fiscal tools can substitute for monetary policy at the zero bound, but the former is less trusted by most and the latter can’t be counted on to be wielded swiftly or with the same technocratic aim as tools used by the independent central bank.

Unless you are a neo-Fisherian – those who think that current low rates are the cause, not the right response to, low inflation – or think that the costs of moderate inflation are very acute, you will be in favour of a higher target.

However, an awkwardness is a Fed official himself arguing for a change in the Fed’s goalposts.  Central bank independence useful because it removes politics from monetary policy.  But it creates a principle-agent problem.  We might worry that the central bank uses its powers for its own political purposes, or those of its friends in the financial sector, or who knows what.

So the Fed – the agent – setting its own target on behalf of its principal [Congress] is not ideal.  On the face of it this invites cynics to guess that the Fed will choose the target to suit itself.  For the case in hand, raising the inflation target might confirm the suspicions of the permahawks who thought QE and low rates was a terrible liberal conspiracy all along.  Or seem like a matter of expediency as the Fed tries to turn rising inflation from a problem into a target.

In the UK there is a clear system whereby the BoE has independence over instrument settings, but the goal is set by the Treasury, so the problem does not arise.  Though of course we have to hope that the Treasury has the expertise and the political support to do what’s right.

In the US, politicians did set the original dual mandate for the Fed, but the monetary part of this  was written vaguely in terms of ‘price stability’.  The current 2 per cent target was a Fed initiative, moved towards at first without explicit quantification, and slowly.  This cautious adoption of inflation targeting was no doubt in part because it was feared that politicians would judge that the Fed had exceeded its powers in refining/changing its remit and/or that this would fuel efforts to reopen more basic discussions about what the Fed should be doing, and set them on one of the crazier paths that some political factions favour.  Williams opening the discussion of raising the target runs the same risks.

An added complication is the Trump administration.  Trump not so long ago accused Yellen of setting monetary policy to suit the Clinton campaign.   A call for higher inflation feels unsettling in this context.  And it comes as Neel Kashkari, who felt he had soon dealt with the ‘Too big to Fail Problem’ by calling for higher capital requirements, has been treading the boards setting up an ‘Institute’ for studying ‘Inequality’ and calling for a transformation of education.

Although the technical arguments for a higher target are very clear, I think you can make a good case for foregoing these benefits in the US, relying on unconventional policy, until such time as you don’t have to worry about uniting Trump and moderate Republicans around the meme that the Fed is a holdover liberal cabal from the Obama presidency.


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Carney, financial sector ethics, and Hogg

Mark Carney gave opening remarks on a panel on ‘law, ethics and culture in banking’.  I thought they were unfortunate.

They come shortly after the resignation of Charlotte Hogg, newly appointed Deputy Governor at the BoE.  She had forgotten to declare that her brother worked at a bank.  This amounted to accidentally concealing a potential for, or an appearance of a conflict of interest, since the BoE regulates banks, and deals with a lot of sensitive information that they would benefit from.

Carney and the Bank initially took a stand hoping that Charlotte Hogg could stay in post, admonished.    It was the Treasury Committee, and Ms Hoggs’ gracious response to that in resigning that concluded the affair in a way that Carney had not planned for.

I don’t have anything helpful to add by way of adjudicating what would have been the right outcome in this case.  This is not my point in writing this post.

My first thought is that Carney’s interjection seems like someone simply trying to get the last word in an argument that they wound up losing.  Why draw attention to all this again, and to what end?

Carney stresses that what he describes as [and seems to be, precisely] an ‘honest mistake’ is not ‘a firing offence’.  But again, what is being said here, and of what use? One translation is merely: ‘It’s not a firing offence, but, as we have seen, events are likely to be taken out of our hands so that you will, in fact, finish up without your job, but you’ll have the satisfaction of knowing that we will keep on batting for you with our words after the fact?’  No comfort to Ms Hogg.  And not much comfort to her successor.  Surely Carney needed to either accept that this is, essentially, a job-ending offence, (call it ‘firing’ or something else if you prefer), or do something material to suggest how next time it won’t be.

Carney draws attention to the fact that he disagrees with the outcome generated by the Treasury Committee, which ‘reached its own judgement’ which ‘I fully respect.’  Respects but respectfully judges to be flawed and disproportionate, we surmise from his speech.  Why highlight this, if there is no credible plan to push his own view of how things should play differently next time?  Absent this, these sentiments look like sour grapes, achieving little other than revealing that he is fed up about it.

The speech develops an unfortunate analogy between the Hogg affair and the problem in regulating employment in finance in general.  He seems to suggest by the speech that if we terminate contracts because people forget to declare an important potential/appearance of conflict of interest, there will be a talent shortage.

Really?  This seems totally implausible to me.  Is anyone really going to be dissuaded from applying for a £300k/pa compensation package because they might lose it if they forget to write down what their family members do for a living?  Of course not.  Carney also seems to try to raise the stakes in support of his personal lost cause in the BoE: ‘it’s not just our DG recruitment that will suffer:  it’s the entire talent pool in finance!’

Carney’s broad substantive point is fine:  At some point, make the penalties so severe and the talent pool will indeed suffer, harming the industry and those on behalf of whom it intermediates.  But the argument suffers from the inappropriate analogy made with what happened to Charlotte Hogg at the BoE.

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Brexit and Scottish Independence: It May have been time for some bad game theory

The SNP have called for a second referendum on Scottish independence, and many feel this is the direct result of the Prime Minister steering us towards a ‘hard Brexit’:  exit from the single market and the customs union.

This seems both right and wrong.

It’s wrong in the sense that one could argue that the real driver of a hard Brexit is the EU’s strategic determination to keep itself intact, post Brexit, and what it has decided best serves that end.

As seemed likely before the June 23rd vote, the EU would figure that to avoid a chaotic renegotiation of its constituent Treaties, it would basically offer the UK a take it or leave it option.  Pay for single market membership, or be out of it.  No menu of alternative options.  The emergency brake on immigration and the other concessions Cameron wrung were no longer to be pursued because there was not the incentive of keeping the UK inside the union to make it worth the strategic risk (to its own integrity) to pursue them.

It’s right that May has driven us to this point because she observed that the one thing that might have avoided it is agreeing to these EU terms, and hoping that a symbolic Brexit would placate the Brexit constituency in her party.  Some hoped that this might be chosen as a ‘compromise’ solution balancing the interests of Remainers and Brexiteers.

But it would not have been a coherent compromise to anyone who understood beyond symbolic terms what full EU membership and ‘Norway’ options meant.  For the intelligent Brexiteers the ‘compromise’ amounts to what it is:  the status quo without representation to go along with the taxes that are paid for the benefits they don’t value.  And it also closes of pursuing the fantastical project of trying to improve on free trade with Europe by freer, but far from free trade with the more distant rest of the world (which requires existing the customs union).

One calculation amongst all this game theory might have been that though a proper compromise deal was not likely to be on the table, the best way of increasing the chances of it being there were to try to convince the EU that the UK was prepared to tolerate the hardest possible of Brexits.  That would cause the strategic unity of the EU negotiators to buckle, generating otherwise absent compromise offers, which in turn would make Brexit look less damaging to Scotland, and independence less attractive to those who would seek it to preserve the old terms with the EU.

However, if this was what was going through May’s head, it seems so far to have been a miscalculation.  There has been no buckling yet, and the SNP have been able to use the threat of a hard Brexit to relaunch its long-term campaign for independence.  Scottish independence was to have been made less likely by the bluff tactic, but in fact it has been made somewhat more so.

That this might have been a miscalculation – if anything like this was calculated at all – ought to have been apparent.  For one thing, the EU can see the costs and benefits of different outcomes for the UK without the UK itself declaring them.  For another, the tactic was ripe for being taken advantage of by the SNP, which might be presumed (from its name) to value independence for its own sake, and not because of the trade relationships which forgoing it confer on Scots (a mindset that Tory strategists ought to have had some exposure to).

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If Brexit means Brexit, we are not doing what we need on macro policy to make the best of it

Budget day.    Article 50 is about to be invoked.  From here until actual EU exit, there is a sizeable risk of a sharp reduction in growth, or even a recession, as information emerges about the likely terms of trade with the EU post Brexit, and in particular, the chance of existing on WTO terms only.

The Bank have in the past frequently opined to the effect that they ‘have the tools’ to pursue their mandate of inflation and employment stability.  But at present, their tools are mightily constrained.  Central bank interest rates are at their effective floor, and have been since March 2009.   QE purchases currently at £435bn.  No-one is going to go for negative interest rates nor helicopter money in a hurry, and, in my view, rightly so.

The job of stabilising the economy is therefore going to fall to the Treasury.  Relying on the automatic stabilisers [the tendency for tax revenues to fall, and transfers to rise] won’t be enough.  So discretionary changes in either taxes or spending, or both, will be needed.  If the past is anything to go by, the government is likely to be slow to respond.  A better position to be in would have been to pre-empt these risks with a stimulus, forcing the BoE to respond [raising rates] and create room for itself to provide the marginal stimulus if needed.

In addition, the Government should have been to put in place a modest, conditional delegation of at least advice over discretionary stimulus in the event that the BoE deems that its own instruments can’t do enough.  This falls short of the full fiscal council suggestions others like Simon Wren Lewis and Jonathan Portes have recommended.  But it would help.  And to recap it would comprise something like the following:  BoE advises HMT on missing stimulus in units of interest rate changes.  HMT reflects.  Either rejects and explains why.  Or agrees and devises fiscal response, including plans for an unwind, reviewed by the OBR for consistency with long term plans.

In the face of uncertainty and policy tools that are constrained in one direction, the BoE ought also to be giving thought to engineering a conscious overshoot of the inflation target on their most likely outcome for the economy.  That is the way to ensure that the target is hit in expectation.  We don’t hear them talking about this at all.  And this is coherent with the previously voiced ‘we have the tools’ view.

If Brexit means Brexit, we are not doing what we need on macro policy to make the best of it.

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Monetary policy mistakes, and central banks’ reluctance to discuss them

Watching the Bank of England Inflation Report Press Conference webcast this week, the subject of whether a monetary policy mistake was made in the aftermath of the Brexit vote in June loomed, with questions from Ben Chu and others.  This potential mistake is the corollary of the August 2016 forecast that, ex post, has turned out too gloomy.

Aside from the substance of this particular issue around Brexit, it struck me again how reluctant central banks are to discuss their current plans in terms of responses to things they have already done that ex post look like mistakes, and even ex ante might have been mistakes.

Mervyn King, former BoE Governor, used to bat away questions with this kind of implication with words like ‘it’s for you to judge us‘.

There is certainly a trap that can be fallen into if one marks ones own performance in public.  (Of being too kind to oneself).  But, there could be big advantages in terms of clarifying current policy strategy, and enabling scrutiny and accountability.  My experience was that the reluctance wasn’t about problems in facing the public with this:  there was no appetite internally either to couch the analysis of policy in terms of past policy mistakes.

Analytically, extracting the monetary policy mistake and responding to it is important.  In the BoE and other central banks’ models, a monetary policy mistake demands its own particular response from monetary policy today [and in the future].  And one potentially different from a re-examination of some other disturbance, say to the supply side.

One place where mistake-silence causes a problem is in the communication by and perhaps even decisions by the dissenters.  It used to baffle me how dissenters would position themselves a consistent x basis points away from the consensus.  Each time their vote was overruled, they ought to be noting a monetary policy mistake demanding its own response.  This was not spoken about.  And if it was accounted for, something else in the analysis came along to perfectly offset the amplification of the dissent that you would expect to get as a vote was overruled again and again.

The invitation by the Treasury Committee for written submissions evaluating the BoE’s policy is a welcome counter to this state of affairs.  I hope it does not prove to be a one off.

For one thing, my own submission will make the point that it was a mistake for the BoE to refuse to characterise its own evolving strategy in terms of (perhaps perfectly forgiveable) past mistakes.


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Perceived grievance/wrong-headed sop vortex, updated

Last year, I wrote this post.  Worrying about a vortex of ever lower prosperity and policy rationality.  It was in the aftermath of the EU referendum in the UK, which can be taken to be a vote against immigration and globalisation.  That is the perceived grievance.  The wrong-headed sop is the withdrawal from the deep, free trade structure of the Single Market, leading to immigration controls, non-tariff barriers restricting our trade in services, reducing prosperity and the feasible size of public services.  Next round the grievances are felt even more acutely, and the policy sops worsen.

You can change some of the nouns and the story is the story of the US, or wherever.

Looking back, and taking in the Trump victory, and the way he and his associates have handled the transition, the story seems to miss something.  The vortex described above is fallen into almost by accident, as a misinformed but pivotal part of the electorate demands something that will make itself worse off.

But the vortex we – that is the West – risk falling into is one that was partly designed.  The perceived grievances did not arise by accident, but have been stoked and crafted ruthlessly.  And in an environment where the media and expert checks on pernicious policy can be circumvented or deflected, the policy measures, [the wall, import taxes, trade agreement dismantlement], although they make things worse, can be sold as a success, whose ill effects are blamed on simply not punishing the imaginary villains enough.  And the next round follows.

The vortex is stoked and our descent into it  is piloted in the name of the ‘will of the people’.  But in fact the journey is in the service of the populist-controllers who have managed to sell the people the bad policies.  What do they get out of it?  Publicity, gratification, media careers, control over policies that affect the net worth of companies they and their associates are connected with.

In the UK, the vortex piloters [this is not a spoof blog post, honest] seem more subtle than Trump & co.   But the deliberation is still there.  Repetition of ‘Brexit means Brexit’ and ‘we are going to make a success of it’ makes it easy for us to read that as ‘whatever we get, we are going to sell it as a success even if it isn’t’.  And our desire to find something to substitute for the single market with the US makes us a supplicant to the US vortex, warping not just our trade, but our approach to defence, security and human rights.

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Political economy of pre and post crisis Eurozone inflation

Before the financial crisis, a standard assumption [I subscribed to] was that the Southern peripheral countries were on a path converging their income per capita to Northern levels, and as such, through Balassa-Samuelson effects, experiencing faster inflation.  The Balassa-Samuelson effect describes how increases in traded-goods-sector productivity in the South bids up the price of non-traded goods their, relative to abroad.

For the conservative North that was uncomfortable with the 2 per cent inflation target [hence ‘below, but close to’ in the ‘clarified’ wording] this was fine, since it meant that hitting 2 per cent inflation in aggregate in the Eurozone would imply <2 per cent for them.

However, after the crisis, history in the South looks rather different.  The price of non-traded goods was bid up not by durable increases in productivity, but by excessive domestic demand, borrowing against future income that was not going to arrive, facilitated by spreads that were too low, ex post.  The South has been embarking on a protracted and painful internal devaluation.

The political economy of the aggregate 2 per cent target is now not so favourable to the North, since it means Northern inflation has to average >2 per cent to hit the target while this devaluation is going on.  Lo and behold, the aggregate inflation target is persistently undershot.

I think there are less conspiratorial reasons for the persistent large undershoot of the target:  the effect of the debt overhang on equilibrium real rates, and the zero bound.  But the political economy problem sketched here is intriguing.




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