Everyone has to have a Swiss National Bank post

Why did the SNB jettison it’s commitment to a minimum exchange rate between francs and euros?

One of the stated reasons was that the Franc had weakened against the dollar, so the ‘peg’ could afford to be dropped against the euro.  This seems a bit unlikely, to put it mildly.  No-one, including the SNB, would know whether the new dollar exchange rate would last.  The SNB itself could not know the exchange rate peg it would need to maintain to hit its target for inflation so precisely anyway.  If the dollar exchange rate was a concern, there was another option, namely, maintain the peg with the euro, but comment that at some point the peg would be recalibrated to compensate if the dollar rate looked like persisting, and that looked like threatening an uncontrollable overshoot of its inflation target (hardly likely).

Presumably the real reason was that it did not feel comfortable with the implications of potentially unlimited franc printing to buy euros to keep the franc/euro rate low.  This discomfort might have been felt now, or perhaps it was the anticipated discomfort of having to mop up larger quantities of euros once an ECB QE program, which would create new euro reserves, was underway.

Why would such unlimited interventions be problematic?

At face value, there is something contradictory in its minimum exchange rate peg.  The commitment was to create unlimited quantities of francs to purchase euros at the stated rate.  Anything less would have meant an exchange rate schedule as a function of euro demand, not a peg, and not the policy announced.   And creating unlimited quantities of francs implies an indifference to the Swiss price level.  Which is contradictory with its mandate.   The calculation was that if the markets’ bluff could be called, and the off-equilibrium threat to spite its own mandate believed, the mandate would be achieved.  If this was what was going on, then the real question is not why the peg was dumped, but why it was adopted in the first place.

Some have characterised it as the SNB worrying about potentially large ‘losses’.  I think this is another – slightly confusing – way of saying what I already have above:  the losses are the potential fall in value of the euros bought by the SNB in pursuit of the peg, if, as it suspects, it later has to be given up.   These losses could, if necessary, be made good by creating more reserves.  The question for the SNB was whether making up for them was consistent with the path for the price level that it wanted.  If the expectation was that the operation would have to be reversed, eventually, then there would be insufficient foreign exchange to buy its own currency.

It’s possible that the SNB was reading an international macro textbook, thinking:  if this exchange rate path is supportable, it ought to be interchangeable with an interest rate path that we are comfortable with given our mandate, and, therefore, even when we drop it, the rate should float at something similar once we make clear the policy rate path that underlay the peg.  However, the rise in the franc/euro rate flouted this thinking, or has so far.

Surely the SNB didn’t intend to implement a policy tightening?  Growth is relatively healthy.  Unemployment is very low, but has been rising slowly for a while.  Crucially, inflation has been sliding and is now negative, despite rates at, and now below the zero lower bound.

For a small open economy like Switzerland, optimal monetary policy probably involves stabilising – amongst other things – the real exchange rate.  But that doesn’t translate to a nominal exchange rate peg.

Spare a thought for the ‘poor’ Swiss, though.  A small open economy buffeted not just by conventional business cycle shocks, but also by ‘save haven’ shocks makes for extremely difficult policy-setting indeed.  And these are shocks not of its own making, but, in essence, due to the fluctuating confidence in the Eurozone’s ability to manage its monetary and financial affairs, something over which Switerland has no control.

Resorting to innovative negative interest rates doesn’t seem like the right thing to do, however.  The public sector has a debt to GDP ratio in the 30s [pps].  Better to stop tinkering with minor changes to interest rates and implement a large fiscal stimulus.

Paul Krugman worries that the Swiss have damaged their credibility irreparably.  I don’t see it this way.  Another way of looking at it is that they have done their credibility a favour by terminating a bad policy sooner rather than later.  Inflationary credibility can be bolstered by deficit spending instead.

 

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The Hawk talks [the same thing whichever way oil prices go]

I couldn’t resist linking back to this article by Andrew Sentance, arch hawk and ex-MPC member, in the FT.  That was 2012, when, as he wrote, oil was ‘picking up again’, and back to about $125 a barrel.  How do you think he was suggesting policymakers respond to that?  Of course, by raising interest rates, to ensure that expectations were anchored, and the oil price did not feed through into a broad-based rise in inflation.

Andrew writes:

“In my view, a policy of “leaning against the wind” of high energy and commodity prices – by seeking to influence the exchange rate and expectations of price increases – is more likely to be successful in anchoring inflation expectations and sustaining central bank credibility.”

Now, with oil prices falling, Andrew takes a different view.   This is despite the fact that – unlike in the tightening scenario – we don’t have a tried and tested way to loosen.  QE may not be so effective as claimed.  And further QE may anyway be a net drag.  Forward guidance was botched last time, and may not offer much now, with the yield curve low and flat.

This time, in the Telegraph, we have:

“[economists are] worrying that very low inflation may be signalling another economic problem – deflation and persistently falling prices. Instead of providing economic relief, deflation is seen as a threat to an economic recovery that now seems to be well established.

In my view, these fears are misplaced. If inflation falls further – as appears likely with oil prices dropping to around $60 per barrel – we should welcome it. And if this leads to a short period of falling prices, that too would be welcome. It is a mistake to associate a temporary period of moderately falling prices with a damaging and prolonged deflation.”

For some reason, the expectations mechanism doesn’t work on the way down, even though it warrants tightening on the way up.  And as oil prices fall, we get text stressing the heartening real income effect.  But nothing about the worrying drop in real incomes on the way up back in 2012.

One way of reconciling this, I suppose, might be for the Hawk to recant his old talk, observing that, contrary to his worries, despite the MPC not listening to him, there was no unhinging of expectations as headline inflation was allowed to surge.  So that would justify not loosening now.  That would be consistent.  (I wouldn’t agree with it, of course, because the zero bound gets in the way of the argument by symmetry.)

I get a lot out of Andrew’s writing and speaking, since his head is in such a different place from establishment macro, and it is therefore constantly challenging, refusing to obey by the econ equivalent of political correctness.  But there are occaisons like this when you wonder if the hawk talks always about tightening [or at least not loosening] whatever is going on in the economy.

0.5% annual CPI inflation. Good news?

That’s what George Osborne’s twitter feed would have you believe.  And it was echoed by Andrew Sentance.  Statements like these are at odds with modern monetary macro, and they are pretty irresponsible.

Why irresponsible?  Well, the Chancellor told the Bank of England’s MPC to hit a 2% target.  How could it be good news that the Bank undershot it by 1.5 percentage points?  Are we to believe that the Chancellor, if he had time to get far enough down into his in-box, would lower the target, to try to ensure more ‘good news’?

A common gripe with Eurozone policy is that the ECB defined its own target somewhat asymmetrically.  It ‘clarified’ the treaty set mandate to achieve ‘price stability’ as obligating it to achieve inflation ‘close to, but below’ 2 per cent.  I doubt that these words mean much any more, since former Chief Economist Ottmar Issing’s departure [this clarification happened on his watch].  But their effect has been quite pernicious, and many people disagree with my assessment that they don’t weigh on policy now and think that the current difficulties reflect the ECB’s deflationary bias.  George Osborne should be more careful about what he says that could colour interpretations of the Bank’s remit.

Why inconsistent with modern monetary macroeconomics?  The suggestion is that if we had prices falling 20% that would be even better.  50%, better still.  No.  The inflation target was set at 2% for a good reason.   The view that monetary policy can’t improve living standards by generating falling prices, or, if we return to the old 70s fallacy, neither can we buy lower unemployment with higher inflation.  The best monetary policy can do is to keep inflation stable and low, additionally weighing inflation stability with real activity stability in the short run. It’s possible that some future generation of macro theory will overturn this wisdom.  But right now, this is what we understand, and this is what informs the remit HMT gave to the MPC, as you will see from the March 2013 remit review.

Another thing that the Osborne-Sentance tweets do is mangle all the important subtleties of the conjuncture.  Falling oil prices, other things equal, will impove real incomes, and boost demand, spending, and help return inflation itself to target, allowing policy to escape the zero bound.  But other things are probably not equal.  It may be that the fall is extra information not already factored in about weak global demand, now and in the future, and that will put downward pressure on general inflation.  To the extent that falling oil prices is an increase in potential output, this could – indeed is in the Bank of England’s own New Keynesian model – deflationary.  And further, a fall in oil prices that a rational forecast would suggest should be temporary could lower inflation expectations that are formed more adaptively and increase real interest rates [nominal rates minus inflation expectations] which would also depress demand, and therefore be deflationary.  The most likely case might well be the benign one.  But, with no proven instrument to loosen, the risks weigh very much on the downside.

For me, ‘good news’ would be inflation and real activity rising greatly, signalling that we can soon lift interest rates off their zero floor, and a return to a time when we will have the ability to use monetary policy to counter the next recessionary shock.   In fact, ‘even better news’ would be to hear that the authorities had heeded calls to raise the inflation target at a time when policy had the means to achieve it, so that in the future there was less chance of interest rates being trapped at their zero floor.

Perhaps the Sentance-Osborne tweets are clever, politically astute interventions to talk up the economy and boost demand.  But they are not economics.

Let us not forget, too, that CPI overstates true inflation, and probably by quite some amount.  I won’t go into this again in this post – I wrote about it here – but it’s important to bear in mind when you read the next contribution wondering whether we will tip into deflation, that we probably already have.  So, Andrew/George:  things are even better than you thought!

Conservative lack of fiscal caution

I’ve been struck by the activities of the Conservative Party Twitter rebuttal machine on economics, ‘Tory Treasury‘ on Twitter, who Danny Blanchflower calls ‘aka Rupert Harrison’.  (He being Osborne’s chief of staff).

One theme today was portraying the Labour fiscal plans as incautious.  Tory plans to target a falling debt to GDP ratio were cautious because this would provide room for a subsequent, repeat fiscal expansion to counter another crisis.  I find this somewhat ironic, because their plans also fail to establish that reduction in the actual deficit will be contingent on the economy lifting off from the zero bound, so that we can be confident monetary policy has room to compensate.  One might regard that as being oblivious to risk too.

The Autumn 2014 updated Fiscal Charter which the two parties are agreeing to implement and arguing about at the same time, stipulates that ‘The Treasury’s objectives for fiscal policy..’ include the obligation to ‘support and improve the effectiveness of monetary policy in stabilising economic fluctuations’.

Both parties should take note of this.  If that is an objective of fiscal policy, then it cannot be the case that deficit reduction proceeds come what may, or proceeds at all right now.  With interest rates at their natural floor, further forward guidance likely of limited impact, quantitative and credit easing of questionable impact so far, and some regarding QE at least as close to the point where costs exceed benefits, there may be no scope to compensate for the contraction in aggregate demand that fiscal consolidation would entail.  Theoretical analysis, and ungenerous readings of recent Japanese history suggest that there is the chance to get trapped at the zero bound.  Attempting now to contract the fiscal stimulus, with headline CPI inflation at least heading in the wrong direction, is hazardous.

The card that both parties are playing is the worry about long-term fiscal credibility.  But it is not credible to promise to do something that is obviously not in our interests, and, judging by the stalling in deficit reduction that happened in this Parliament, likely not to happen anyway.  And concerns about credibility are hardly consistent with not specifying how these plans will be met.

Deficit-reduction-come-what-may has resulted from a strange kind of pernicious electioneering, under the spotlight of media commentary that also, so far, has not broached the likely reality of fiscal policy in the next two or three years.  I suggest that this lends weight to arguments that the role of fiscal stimulus, particularly at the zero bound, should be codified further in the direction of Wren-Lewis style fiscal councils.  We used to think that fiscal independence was necessary to stop pre-election booms and post-election busts.  But right now we need fiscal independence to protect the economy against the opposite problem: populist austerianism.

Why did academia settle on the idea of no directed research?

I am early into my involvement in the job market for new PhDs as an academic, though I was involved for many years hiring as a central banker.   The two activities differ in many respects.  But the one that struck me is the risk incurred hiring a new PhD into a university economics department on account of not knowing how well they will make choices that affect the productivity of their research.

These choices include:  how hard to push to publication what they did in their PhD, and when to give up and try something new.  How much to specialise and deepen versus diversifying.  What topics they will choose next.  What skills they will invest in acquiring in the future.

Following a new hire into a central bank, a good deal of this risk can be mitigated by directing research to some degree;  having those decisions made by a more experienced hand.  At one extreme this could and sometimes does mean having the junior hire work on ideas suggested by the research manager.  But it also includes agreeing plans of action on all the things that affect the development of the junior hire’s own research.

Why, I wonder, did the industry settle on this model in academia?  Would it be so unpalatable to new PhDs?  A loss of some independence is bad if one values it for its own sake;  but if it comes in return for extended supervision and guidance, then it might be attractive.

PS on inflation targets

A post script to my last post.

To be clear, on the substance, as to whether owner-occupation costs should be included, Andy Haldane and Mark Carney, from what I read of their reported words, seem to have it right.  Inclusive is better from a theoretical perspective (optimal policy is to conserve the value of money in terms of an appropriately weighted average of all the goods and services purchased in a period), and from a practical perspective (more inclusive measures will be perceived as more legitimate).  Obviously, one cannot update for every new insight that is thrown up on the measurement of inflation, or the monetary regime will begin to look farcical, but changing once every 5-10 years might be worth it.  Note that we already had one index change, and a recalibration of the target from 2.5 to 2, in 2003, when the inflation target was changed from RPIX to CPI.

Another point on my proposed compromise between the issues of exploiting Bank expertise and the impropriety of the Bank being involved in setting its own target.  That was the model adopted when the Bank contributed to the work on the ‘five tests’ that determined whether the UK would push for membership of the single currency.  Peter Westaway, then at the BoE, was seconded to lead research work on the five tests, for the duration of that project.  It would have been awkward in the extreme for the Bank to be commenting on an issue of such political controversy that lay outside its mandate.  Yet the BoE had much expertise, personified as Peter Westaway, in open economy macroeconomics, that from society’s point of view needed to be harnessed to the Euro question.  So the secondment enabled the cake to be had and eaten at the same time.

BoE should keep out of debates about the ideal inflation target

As Ben Chu reports, an ONS report by Paul Johnson has recommended that CPI be “replaced” with CPIH, which additionally includes imputations of the costs of owner-occupation.  Replying to a tweet of mine saying that the BoE would keep out of this debate, Ben put me in my place.  A Telegraph article he linked to reveals that Andy Haldane had explained to Treasury Committee that Bank staff were engaged in a working dialogue about the technical merits of the two measures, and that he preferred the more inclusive one.  The article also pointed out that Carney had been similarly approving.

I worry about the BoE speaking out about this, or making public that even at a working level it was seeking to influence its target.

The essence of the current system is that the Bank has independence over the setting of its instruments, but is given its goals by the Treasury.   This arrangement is a good one, because it is good for the government, which is directly elected, to retain control over the goals of the agents of policy.  Getting involved in setting the goals corrodes this separation and sets a bad precedent.  The Bank does not want to be accused of fixing its goals to make them easier to achieve.  And there are distributional consequences to changing the target, both via monetary policy, and, potentially, through any effects on the remuneration associated with index linked gilts.   As far as possible, the BoE should stay out of matters that have distributional consequences like this.

The dilemma is that through the Bank’s monetary policy making, it has accumulated a great deal of expertise in the matter.  No doubt HMT and ONS are capable of marshalling resources to make this decision, but it would seem to be inefficient to ignore the deep pool of knowledge about inflation and monetary economics in the Bank.

Is there a way out of this?

How about this:  in future, if required, the Bank seconds out of its building experts to work on reports like those by Johnson, and into HMT if necessary to help with the decision-making process.  While those staff are out of the Bank they don’t work with or consult their former colleagues at the Bank.  And the Bank itself – particularly its most senior officials – avoid commenting.