The Bank for International Settlements crying interest rate ‘wolf!’

The Bank for International Settlements siren calls that central banks around the world should be raising nominal interest rates to choke off an orgy of risk taking grabbed more attention on the chatosphere than I expected, since this is what they always call for, and their reports make for more forecastable reading than the output of lobby groups for pensioners.

I was particularly struck by the pointed remark by the BIS that central banks themselves were not to be trusted to make the right judgement trading off risks to growth and financial stability, since they had failed to predict the 2008 financial crisis.  This is a rare personalisation of the issue.  Policy committees have turned over substantially since pre-crisis times.  Some committees [like the UK’s financial policy committee] didn’t exist at the time they were meant to be foreseeing the crisis.  This is a rather lazy remark by the BIS.  If one wanted to engage in such public banter, one might draw attention to the fact that, like a stopped clock forecasting midnight, the BIS predicted a financial crisis every quarter for the best part of two decades and were eventually bound to be right.  Or, with the rhetorical equivalent of the sliding tackle, we might urge that people ignore the BIS’s interest advice because they have presided over a dilute and inadequate tightening of a capital adequacy regime that was proven and is still too complicated, all without complaint.

As Simon Wren-Lewis points out, the BIS discussion of the issue is extremely one-sided.  They fail to appreciate the gravity of the risks of greatly prolonging time spend at the zero bound and an associated period of deflation, or lowflation, especially considering the relative efficacy of instruments for tightening [taxes, interest rates, macro-pru] as against instruments for loosening [forward guidance, almost expended, and QE/credit easing, likewise].  The BIS seem to omit to mention that overly tight policy carries its own financial stability risks.  Canadian and Australian banks survived the crisis because their banks were lending into a private sector experiencing windfall booms.  A monetary-policy induced recession would increase firm deaths, increase unemployment, and weaken the balance sheets of banks lending to those dying firms and unemployed mortgage holders.

In my opinion they don’t give enough credence to the observation that monetary policy is, fundamentally, a weak tool for dealing with real phenomena, especially those that are slow-burning [highly apt description for financial stability problems] and have real causes [the BIS contest this in this case, with some merit].  A driving force for this argument is the BIS’ intriguing research on the ‘risk taking channel of monetary policy’.   This is manifest in a number of micro studies which show how the riskiness of loans correlates with nominal rates.  And the theory that credit market institutions mitigate towards what should be real decisions about the risk-return trade-off being affected by nominal, rather than real rates.

These views for me have the status of dissident challenges awaiting further work, rather than new wisdom around which monetary frameworks should be arranged.  One way of ensuring that interest rates are high forever would be to announce a permanent increase in the inflation target of 5%, or 10%.  Presumably the BIS wouldn’t be in favour of that, and would not argue that ‘risk taking’ would be forever cured by higher steady-state inflation.  And if not, what exactly is the argument?  Over what horizon, if not the long-run are tightenings effective at curtailing ‘risk-taking’?  Interest rates have been at their floor for 20 years in Japan.  Do we think that the Japanese economy is suffering from irrationally-exuberant risk-taking?

The correlations in these studies are just that, and not conclusive proof of a risk-taking channel.  And if one wants to get serious about pervasive, long run money-illusion, we should be even-handed about it.  If we apply the same logic in labour markets, then a tightening that forced down prices, in the presence of unyielding nominal wages, would price workers out of jobs.

 

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[nerdy] Reply to Hendry and Mizon: we have DSGE models with time-varying parameters and variances

Hendry and Mizon summarised a recent paper of theirs on VoxEU explaining that DSGE models break down in crises because these events involve shifts in the distribution of observeables that fixed-parameter, fixed-variance DSGE models can’t articulate.  They tell the story in a way that a lay reader might conclude is catastrophic for microfounded, dynamic macroeconomics, and/or rational expectations.

But it isn’t.

Several papers have taken steps to articulate models that have time-varying propagation parameters, and time-varying variances.  And there is a literature connecting these models to empirical macro models that estimate time-varying econometric counterparts.  None of these papers make it into the citations of the VoxEU post, or the original academic paper.

Part of the discussion is about how the equilibrium laws of motion of the economy, got by invoking the law of iterated expectations, in some cases, aren’t derivable by these same means with time-varying parameters.  This is well-known.  But DSGE modellers who use time-varying parameters, or time-varying variances, know how to solve such models, at least in cases where there aren’t too many things moving around all at once.  Finding expectations that, when used, generate laws of motion whose expectations are equal to what you started with is neat and easy with time-invariant parameters.  But though difficult when they vary, the process of searching for this ‘fixed point’ as it’s called is conceptually the same, and often achievable.

Some examples of time-varying DSGE models:  (i)  Models with ‘stochastic volatility’ [variances of shocks that move around in continuous and random small steps over time], including Caldera et al, and Fernandez-Villaverde and Rubio-Ramirez.  (ii) Or Markov-regime-switching models [models in which parameters like price-stickiness, or policy parameters, move around randomly through a small set of possibilities]. including Foerster et al.

All these models rest on a degree of time-invariance;  in a stochastic volatility model, the shocks to variances are themselves drawn from a fixed variance.  In a Markov-Switching model, the switches occur with fixed probabilities.  But in principle we could push the time-variation one step further if we really wanted to.  [In fact in the case of Markov-Switching I believe there are examples that do this, though I can’t lay my hands on one now].

The article dwells on the notion that from the perspective of agents the mean and the variance of relevant distributions won’t be known ahead of time.  But expectations can be calculated provided that the distributions from which this means and variances are drawn are known.

At any rate, the critique is somewhat academic, because many authors have pushed the boundaries of DSGE models by dropping the notion of rational expectations.  Sargent and coauthors have worked out the equilibria for agents who are Bayesian learners, yet doubt the distributions for relevant concepts implied by their models.  Ilut has figured out a simple DSGE model in which agents respond to changes in the degree of ambiguity about the distribution of technology over time.  Models with learning can be simulated recursively, so there is no problem at all shoving through changes in policy or economic parameters, or changes in variances.  I can’t find an example that does this, but that’s because it’s so easy that no-one would get any points for trying to tell anyone else that this was possible on their computer!

A further point to make is that we will rarely be able to say decisively that the distribution has changed.  A common theme in the stochastic volatility literature is that it is hard to distinguish a high probability draw from a new distribution with a larger variance from a low probability draw from the old distribution with a small variance.   Perhaps the post Great Moderation era indicates a shift to a new distribution of macro variables.  Perhaps it just reveals that the time-invariant distribution involved a higher probability of disasters than we thought before the crisis.  The failure of our pre-crisis DSGE models doesn’t necessarily indicate we need time-varying ones, just models that generate low probability extreme outcomes (like a crash).  We should guard against jumping too quickly from atheoretic econometric analysis which appears to show distribution-shifts, to concluding that time-varying distribution DSGE models are necessary.

Hendry and Mizon make a number of scathing references to the fact that central banks like the Bank of England operate with these fixed-parameter DSGE models, in apparent oblivion to the fact that distributions are changing all around them.  In the BoE’s defence, their modelling staff know the time-varying DSGE and empirical macro literatures well, and some of them have published in these fields, and many of the contributors have presented in the Bank’s seminar series.  Further, the staff and the MPC don’t follow the models slavishly, or necessary believe literally in the assumption of rational expectations which Hendry and Mizon think (mistakenly in my view) is so problematic.

Strictly speaking, the post criticises ‘standard’ macro models.  Leaving open that they accept that there are ‘non-standard’ varieties that are immune from their critiques.  In which case there is no dispute.  But I think this other work deserves a mention.   It illustrates that time-variation in variances isn’t catastrophic for rational expectations or DSGE models.  And anyway, who cares, given the strange and wonderful new work on more realistic, non-rational expectations, which most central banks would, I surmise, subscribe to.

[Update:  this post, and the Hendry and Mizon paper, sparked a discussion on econjobrumors.  One of the contributors makes a great point that I hadn’t thought of, which is that many DSGE models generate multiple equilibria, which is another class of model that would produce data that might appear to an econometrician to manifest distribution changes, even though the Data Generating Process had not changed at all.]

Tim Harford wants forecasters to take wagers: most of them already bet their livelihoods

In a nice post, Tim Harford explains why it would be desirable for economic pundits or forecasters to place bets based on their punditry and forecasting, citing a recent £1000 wager between Jonathan Portes and Andrew Lilico.  It would put a premium on precision, and it would incentivise the forecaster to make the best forecast possible, not simply one that is sexy or dramatic, and grabs the headlines.  As forecast consumers, the rest of us, worried about whether to get a fixed or floating rate mortgage, buy a car or not, would have forecasts that were more useful.  In fact, my last post covered a recent example.  We can view Mark Carney as a ‘pundit’.  And his recent remarks speculating about the timing of the next interest rate rise as a forecast.  Wouldn’t it be better if the BoE took bets that the forecasts these words were presumably based on were right?

Well, yes.  But what Tim doesn’t say in his post that most forecasts are underpinned by bets of sorts.  Many forecasters work for retail banks, investment banks, economic consultancies or hedge funds.  Their forecasts are backed by two kinds of bets. The first is a reputational bet.  Some of the motive for employing high-profile economic commentators from the outward-facing of these institutions (ie not hedge funds) is about showing off that you have great wise staff on your team.  You clearly don’t want to get a reputation for employing dumb forecasters who always say something that turns out wrong.  The second kind of bet is quantitative, no different really from the bet you would place at the Bookmakers on a horse.  Many of these forecasters are employed, directly, or indirectly [the forecasts are bought and consumed by] traders who are placing bets all the time on the prices of government bonds in different countries, or anything really, which are sensitive to how macro data turn out.  So good forecasts are essential.  Many of my former colleagues at the Bank of England left to engage in this kind of activity and stress a great deal about the calls they make from week to week about what the BoE or other central banks do, because they know they can be quickly fired if they have a run of bad calls.

I tweeted this point back to Tim, and Tomas Hirst replied with the very reasonable point that reputational discipline isn’t necessarily good enough to guarantee the best possible forecasts.  In fact there’s an old and interesting literature arguing that in these reputational competitions there can be an incentive to make a deliberately bad, but striking forecasts, to differentiate oneself and cultivate a brand, presumably when verifying whether the forecast was good or bad ex post is a murky science, as it often is.  [This would be one way of making sense of the otherwise puzzling fact that highly qualified data analysts can coexist that either always make doveish remarks (Blanchflower) or always make hawkish remarks (Sentance) no matter what the data release].

So granted, reputational bets may not be sufficient to give us the forecasts we would like.  But these bets are ubiquitous, and may be helpful.   Indeed, I think it’s precisely because institutions like the Bank of England know that they would be betting their reputations that they are wary of publishing an interest rate forecast, and instead wrestle with signalling what they are doing through more opaque tactics.

[Postscript:  one contact responded to this post saying that traders in his firm regularly invited him, Harford-style, to back his in-house forecasts with a bet.  His standard reply was that if he were to bet, he should bet against his forecast, to hedge against the enormous reputational risk of his forecast turning out wrong.  Likewise, Jonathan Portes and Andrew Lilico ought to be betting on the other to win, to compensate themselves for the loss of face, and associated future earnings, in case they lose the forecast horserace.]

 

Governor: no more cheap yield curve talking, let’s have an MPC interest rate forecast please

Yesterday [24 June] Mark Carney’s doveish remarks at Treasury Committee – particularly the emphasis on weak nominal wage growth – caused the yield curve and Sterling to fall.  This was but 12 days since his Mansion House speech, where, surely knowing the effect his words would have, he pointed out that rates could rise sooner than expected, causing the yield curve to tighten and Sterling to rise.

In principle, you could imagine a perfectly successful monetary policy communication strategy leading to just this sequence of events.  Markets may not necessarily share the insights or information the Monetary Policy Committee have about how news hitting the economy will affect inflation and real activity, and thus MPC’s future policy settings.  Sometimes they may understate future interest rate rises, and need correcting, and sometimes they may overstate the rise.  But it’s stretching it to see these latest two interventions by Carney in this way.  From the outside, it looks much more like MC tried to talk the yield curve up, realised that he had overdone it, and then felt obliged to reverse course.

Carney’s latest remarks included text that tries to resist this interpretation.   Some of them were designed to emphasise the continuity in communication:  the gradual nature of rate rises, and their likely end point being lower than recent historical resting points for Bank Rate.  And he also noted that Mansion House was his speech and therefore should have been read, and should be read, as his view.   The code here is ‘you were the ones at fault for thinking my Mansion House speech signalled a sooner rate rise than was priced into the market’.  Although we are mistaken for conflicting reasons.  The first reason we were mistaken is that there wasn’t much difference in what was being said from one speech to another.  The second reason is that he was giving his own view, not that of the Committee, so we put too much weight on those (supposedly) unchanging words.

I was left wondering quite what he meant by his own view.  His own view about what should happen, if all Committee members saw the world the way he did?  Or his own view about what would happen, given the insights he has about the other MPC members’ views and what would persuade them as the recovery progresses?  It’s to be applauded that the Governor stresses that he does have a view and wields his vote that way.  In eras past it was thought – on both sides of the Atlantic – to be damaging for the Chair to be seen to be in the minority.  Carney’s predecessor, Mervyn King, solemnly allowed himself to be seen in the minority, emphasising that the Chair’s role as facilitator, and Chief Executive of the Bank, can legitimately be separated from the role as individual with expertise in monetary policy.  Carney’s words reassure us that this desirable state of affairs will continue.  However, it’s also been the custom that the Governor, in leading events like the Inflation Report Press conference, speaks to the collective view of policy and the economy (when differences are small enough to allow one to be articulated).  So it’s natural to presume that this is what is going on when he gives other set piece speeches like one at Mansion House.  So, now, we have a new protocol, that Carney’s speeches articulate his views.  Except, presumably, when they don’t.  Because one has to hope that someone does continue the practice of trying to recapitulate the collective narrative of policy, or it will become harder to understand.

This see-saw in verbal policy signalling would be unfortunate enough were it not taking place in an era when the MPC were still supposedly bound by a new strategy framework of Forward Guidance.  This has already had two incarnations and many unfortunate words spilled by Carney about it.  [Recall the ‘no more stimulus’ debacle, also at Treasury Committee, whose lack of additional stimulus ‘secured’ the recovery].  Clear attempts to talk the yield curve around are bound to reduce the probability that outsiders put on the latest incarnation amounting to anything concretely different from normal monetary policymaking.

The last two Carney interventions make me wonder if the Bank of England is not occupying an uncomfortable half-way house of transparency.  Carney made a bold break with the fiction that MPC don’t take a view on future interest rates, which is to be applauded.  Monetary policy is inevitably about expectations-management, (especially when your current instrument is up against its floor), and Carney’s talking recognises this fact.  But the end-point of such thinking is that the Bank should move to publishing regular interest rate forecasts consistent with its own forecast of inflation and output.  With such a forecast out in the open, the ambiguity of remarks like ‘sooner than expected’ [Mansion House] or Haldane’s front-foot/back-foot cricket metaphor will be gone.  Yield-curve talking will then be about explaining why the MPC’s forecast might have changed [economic news, a change in MPC reaction function?], or confronting an apparent discord between what MPC thinks it will do, and what markets think MPC will do.  On top of publishing such a forecast, the MPC should reveal how it models its own behaviour in the forecast – its description of its own reactions to news.  And discuss any more nuanced features of how it processes news that can’t be expressed in such a reaction function.  Having done so, changes in interest rate forecasts can be compared to this description of what it does.  ‘You see:  we said we’d respond like this if that happened, and we have done just that.’

If the MPC already had an interest rate forecast out there, none of the problems with Carney’s last two yield-curve chats would have occurred.  It would have been obvious whether he was articulating his own view or not.  And the fact of the forecast being there would have made it impossible for him to say ambiguous things like ‘sooner than expected’.  Other meanings like ‘sooner than MPC previously expected’ / ‘sooner than I previously expected’ / ‘sooner than markets expect, despite having seen MPC’s forecast for interest rates’ would be sifted, by a speechwriter confronted with the undeniable fact of there being an agreed, collective forecast out there against which any talking has to be measured.  An open interest rate forecast would discipline yield-curve talking to adhere to the same standards of quantitative clarity inherent in that forecast.  It would discipline such talking in other ways too.  The Bank would not publish a forecast lightly.  Each one will be deliberated on in minute detail.  Anyone seeking to offer an update, or establish a quantified, alternative interest rate forecast, would be pressured to explain themselves carefully with reference to the already public benchmark.

Right now, it’s easy to talk about future rates, because with a bit of careful back-tracking, if you see that it didn’t go well, you can pretend that you didn’t say anything out of the ordinary.  In that sense, yield curve talking is currently cheap, but with an interest rate forecast out there it would be more expensive.

 

Andrew Haldane’s spin

Andrew Haldane’s first speech as a monetary policymaker is built around a cricket metaphor.  It seemed de rigeur that any response followed suit.  But all I could manage was this pretty silly and mostly inappropriate pun in the title – the cricketing equivalent of bowling wide of the wicket – which I will explain later.

The speech makes for interesting reading on many counts.

AGH chooses to label himself with hawkish tendencies, in deciding that  those who favour playing on the ‘front foot’ have the balance of the argument.  Batsman who move forwards to the ball are likened to policymakers who seek to raise rates to tame the boom sooner rather than later.  If we think of him as a like-for-like replacement for Spencer Dale, whose inclinations were similar throughout his tenure on the MPC, then this itself won’t change the complexion of the Committee.  This opening contribution chimes with what I digested from his writing during his financial stability days.  From that I took that he put weight on the idea that monetary policy had too narrowly focused on short term macroeconomic indicators, and neglected the evidence of a low-frequency money, liquidity and credit boom.  Extrapolating somewhat, we might deduce that he thought monetary policy, if not a main contributor, at least a partly amiss in not being tighter soon enough before the bust, and that that history risks repeating itself.

By resolving in favour of playing on the ‘front foot’ Haldane judges that the costs of finding out that one has raised rates too late are greater than the costs of discovering they have been raised too early.

For me those arguments tilt pretty clearly on the other side.  The cost of raising rates too early is in tipping the economy into a protracted period – perhaps inescapable – at the zero bound, repeating Japan’s experience since the mid 1990s.  The cost of moving too late is stoking up another boom, and perhaps a bust akin to the one we saw in 2008 [followed by a protracted period….].  Both seem pretty disastrous, but the asymmetry comes in the efficacy of the tools we have to combat them.

The costs of moving too early weigh more heavily for me because of the lack of powerful, well understood means to stimulate the economy in the absence of being able to cut short rates further.   There would be broadly 4 options.  Loosen fiscal policy, engage in further QE, indulge in more forward guidance, undertake credit easing.  Looser fiscal policy on any significant scale would be possible (politically, supposing that the time would come after the expiry of the Coalition), but not particularly desirable with finances already strained.  For me, QE, despite all the intriguing event study analysis (and not all of it given the central bank gloss), remains an uncertain instrument.  We don’t know if its effects persisted;  or if they lowered spreads on risky rates;  even if they did we don’t know for sure that this amounts to observing a policy that has imparted a benefit [QE has costs].  We also don’t know for sure that its effects weren’t simply about causing changes in private forecasts of future central bank rates.  Also, we already have large stocks of assets on the central bank balance sheet:  could we double them without generating (albeit irrational) fear about the integrity of monetary and fiscal policy?  Forward guidance might be possible, despite all the missteps in the last year, but rates are already low right along the curve, and when the time came to manage them lower, they might be squeezed even harder against their expected future floor.  More credit easing would be possible and desirable, but the existing FLS has not been a spectacular success (rubbishing another of my forecasts).  Other variants could be contemplated, (large scale purchases of corporate debt, for example) but these are untested and bring their own risks (financial and reputational).

By contrast, if MPC find that they have not raised rates quick enough, there are better options.  Fiscal policy can tighten and assuage market worries about the longer term trajectory of the debt/GDP ratio to boot.  Short rates can be raised quickly and by as much as the MPC choose.  The MPC could also engage in ‘tightening forward guidance’.   The BoE can close the FLS.  And the FPC can tighten its macroprudential instruments (granted those also untested as yet).

The speech is interesting is in its adding to the accumulation of words about the current forward guidance.  As with Mark Carney’s speech, this one carries the same ambiguity.  Is he speaking for himself, or the Committee?  Where do these words leave the framework for monitoring the commitment not to raise against the 17 indicators?  Unpicking the cricket analogy, where are the front and back foot positions to be judged relative to?  Would a batsman following the market trajectory for short rates be someone playing off the middle foot?!  One meaning in my daft cricket pun ‘spin’ refers to the trickery of a bowler who bowls with a flick of the wrist to make the ball spin to make the batsman uncertain what will happen when it bounces.  A spin bowler injects uncertainty into the confrontation.  This meaning doesn’t really work for me.  AGH doesn’t inject uncertainty, but I don’t think he exactly resolves it either.

Another reason I found the speech interesting, is in wondering how AGH would address the task of cranking the monetary policy handle.  His speeches as Executive Director for Financial Stability often touched on how the crisis had shown that our mainstream DSGE models and the economics canon more generally were misguided.  His authoring of the introduction to the report by the Post Crash Economics group on the state of the economics curriculum, for example, has been interpreted this way.  The MPC’s current model of choice is as plain vanilla a DSGE model as you can get.  It doesn’t even have a financial sector in it.  MPC forecasts are anchored, therefore, by a model that one must presume AGH thinks is not fit for purpose.   The staff and MPC are not fools of course.  The financial sector is left out, one infers, because they think existing ways of modelling it cause more problems than they solve.  Too much complexity eventually makes a model unmanageable.  Financial frictions models don’t fit everyone’s stories about the crisis.  The stories they tell that we do like can be incorporated in the forecast in other ways:  each forecast is overlaid with healthy doses of judgement.  But, if you think that your core model is fundamentally flawed, how do you know how to get from its predictions to predictions that are not?

Haldane alludes to a large program of investment in technology and people drawing on the analogy of the Met Office, which upped its game after the mistakes forecasting the 1987 storms.  This is to be heartily welcomed.   But good luck with producing something usable in the next twenty years.  A lot of people have been working in the top 30 economics departments in the world on the same task, absorbing funding many multiples of the increment that the BoE will commit, and paying much higher salaries too, and not only since the crisis, but for many years before it, and the profession is where it is.  Meanwhile, what should the MPC use to figure out the effects of its forward plan for interest rates and the Asset Purchase Facility balances?  The analogy with the Met Office is provocative, but I don’t think it works.  Senior staff there told me that the small-scale physics was pretty well understood.  What was needed was greatly expanded computing power so that their understanding of the small-scale physical laws could be used to confront the difficulties of large-scale dynamic chaos.  In economics, we don’t yet understand the small-scale economics.  We don’t have settled models of how people comprehend the problems they face, and how they go about solving them.

The second meaning in my daft cricket pun ‘spin’ is the one associated with modern politics:  putting a favourable gloss on a policy.   I applaud the generously funded modelling-revisionism in progress at the Bank, but I bet that we will have to be more patient for usable results than AGHs words suggest.  In the meantime, the MPC could be more openly pluralist in ways that exploit existing technologies.  But that is for another post.

 

Blogging is still mostly unpaid hot air

Paul Krugman blogs on an old theme, how the econoblogosphere has displaced journals and formal academic research as the focal point for debate.   Old formal credentials like being a Professor at a reputable university, or holding a top job at a policy institution don’t count in the new, open and democratic discourse about economics.

But are things really so different?  My sense is that the econoblogosphere hasn’t intruded on the academic or policy debates so much, as growing the space for debate previously taken by the op-ed and letters pages of the quality press.  Funding for academic activity in economics departments (teaching, research, data collection, experiments, conferences) is alive and well, despite the endowments for some of the rich institutions taking a hit.  Academics mostly talk to each other about their work in progress, and periodically deign to present their stuff to policymakers, when the latter are prepared to fly them out to somewhere nice to do it.  And those who either never did formal research, or who have given up on it, do what they always did, which is write for this space that used to be op-ed columns, but now includes blogs.  Policymakers do what they always did, which is get their minions to digest formal research for them and to draft speeches for them, and to deliver them, having no use for the discipline of submitting themselves to refereed journals, (not now, and not ever before).

Another way of looking at it is who gets the pecuniary rewards from economics.  Positions at universities go to those with publications.  Blogs count for nothing (and are possibly even regarded as a kind of hard-stuff-avoidance-behaviour).  Positions at policy institutions go to the same kind of people that they always used to:  with experience in academia, other policy institutions, finance or business.  Once again, blogs don’t count for much.  The most successful blogs that reap monetary rewards, those syndicated to the (old established) newspaper outlets, are those authored  by those who earned their feathers in the traditional econ professions, not blogs.  So far, I haven’t earned a cent from mine!

I don’t see any harm in this continuity.   I see formal academic research as vital to progressing debates about how the economy works, and what policy should do.  It’s not useful for everyone to be involved in this.  And it’s hard to contribute or follow it if you haven’t given up years to invest in the tools used.  So it’s natural that that goes on in working paper series, conferences and journals, and not blogs.  If you share my world view, the natural function of the econoblogosphere is to sift through the outputs of this activity, not to supplant it.  Of course, many don’t.  Some see formal academic research as blinkered, misguided, shackled by the politics of getting on in academia.  If it were, we should eventually see some of the indicators above turning:  bloggers earning lots of money, getting top policy jobs, displacing lecturers at reputable universities.

Mark Carney’s eyebrows

Mark Carney used his Mansion House speech to talk up the yield curve and the Sterling exchange rate, warning us that interest rates might rise sooner than markets think. On the face of it, this seems like a pretty regular central bank thing to do, an old-fashioned wiggle  of the Governor’s eyebrows.  However, I didn’t like it.  It’s a return to old-style smoke-and-mirrors monetary policy communication.

First off, was he speaking for himself or the majority on the MPC? Were these comments a pre-release of the next MPC minutes? If so, why? Why couldn’t he wait for the next MPC minutes to come out, when MPC deliberations are set out more clearly? By acting out of the normal protocol, was he signalling that markets were misinterpreting events by more than normal? If he wasn’t, didn’t he realise that this would be one way to read him? What did the words actually mean anyway? They could mean: we haven’t changed our strategy, or our view, but markets seem to have changed their minds. Or they could mean: we have changed our strategy, and I’m giving you advanced notice. Or they could mean: we haven’t changed our strategy, but the data have heated up in our view more quickly than market seem to appreciate.

We also don’t know what is in the MPC’s mind about the likely path of other instruments the Bank of England controls via the Financial Policy Committee. Are rates set to rise faster than markets think because these other instruments are to tighten slower than markets think? [Unfortunately there aren’t traded instruments that allow us or the Bank to figure out precisely what people think about FPC instruments]. Have the MPC organised with FPC a joint path for all the instruments? At such a pivotal moment for monetary policy, it would seem opportune to do so.

These ambiguities suggest to me that at such an important moment the Bank should refrain from remarks like this and simply publish their forecast of future rates. Then all would be clear. What is achieved with these coded words? What would be risked with a less coded interest rate forecast? What, in fact, is so urgent that it couldn’t wait until the next Inflation Report? And if it was sufficiently urgent, given the gravity of what he was communicating, why not commission an update of the forecast to make clear how the MPC see things to have changed?

In the same speech Carney repeated his claim that Forward Guidance had helped secure the recovery. Recall that Forward Guidance was initially not intended to inject any more monetary stimulus than MPC planned in August 2013, but to clarify that rates wouldn’t rise quite as quickly as markets thought then, implying quite a small tweak down in long rates. Well, tweaking long rates would take a while to have any effect, and wouldn’t have much of an impact anyway. In the context of a very large, mature literature on the real effects of monetary policy changes [for which Sims won his Nobel Prize], it is peculiar to claim that such a small change in the UK could have any great effect. It’s not even certain that the long rate ‘tweak’ persisted, and it would not be surprising if it had not, given how the initial launch was fluffed, [in the confusion over what it meant that the recovery could be secured by a policy that meant no more stimulus: recall Carney’s awkward exchanges with Andrew Tyrie at Treasury Committee over this]. A lot was made of the hoped for reduction in interest rate uncertainty then, but this also flew in the face of all the evidence about how much a tiny bit of interest rate uncertainty reduction would affect real spending. [An effect substantially smaller than the effect of the small tweak down in long rates on real activity.]

An unfortunate contradiction that arises is: Carney’s words say that policy might have to be tightened sooner than we think. But the effect of saying this is that long rates rise now, and policy effectively tightens now. An intended prediction about a future policy tightening becomes an instantaneous policy tightening. This is unavoidable, and not Carney’s fault, but it does mean that such a policy change has to be thought through, sanctioned by all the policymakers concerned, and clearly explained in all its detail.

Given that Carney must have known what his words would do to yields and the exchange rate, how does such a speech fit in, procedurally, to the system MPC set up themselves under Forward Guidance 2? Are we now to figure that as well as the quarterly review of the 17 guidance indicators, there will be future open mouth operations conducted without any review against these measures? Indeed, does this speech signal a new modus operandi, where the formal system of indicator monitoring is dropped, and we simply get updates on a hidden interest rate forecast through events like this?  I doubt the proper indicator monitoring is to be replaced by Forward Guidance 3 just yet. But such determined talking sits oddly with the existing framework.

Some reacted to this speech interpreting it to be a breach of a promise, damaging monetary policy credibility.  [See this, for example, in the Wall Street Journal].  But I think this is going over the top.  Forward Guidance wasn’t ever meant as a Woodford style interest rate policy where there was a promise to keep interest rates lower for longer than would have been expected given historical experience.  In so far as it was a promise, it was a promise to keep on setting interest rates how they were always set, but with a communications strategy designed to make it clearer, and ensure that markets understood better what would happen.  We might scold Carney for a breach of MPC protocol, but there was not enough in it to detect a change in interest rate behaviour, and there would have been no motivation for it.  However, the very fact that some reacted in this way illustrates the danger of operationally off-piste interventions like this.