The debt-ceiling worries and a possible default: just the kind of expropriation that Republicans should be against

As the expected time at which the US will hit the current debt-ceiling approaches, with no sign of a deal, market participants’ guess at the probability that debt obligations will be defaulted on rises too.  This will act like a monetary contraction, a credit-squeeze, and will put compounding pressures on financial institutions and the sovereigns that back them.  Default threats like this also act just like expropriating taxes of the sort that the Tea Party Republicans balk at.

The debt-ceiling worries change what it means to be the holder of a US Treasury.  There are no shops in Bristol that I have found that will accept US Treasuries as a means of payment. (Many accept the Bristol Pound, so they are more experimental in their means of payment than most).  But in financial markets, they perform most of the functions of money.  Until now, they have been presumed to be virtually default-risk free.  And this means that holders presume other people will presume that their US Treasury will be default-risk free, and so on.  Because of this, prospective holders can predict with great certainty what they are likely to get for their Treasury when they decide to swap it for something they really want, (like cash to pay their extremely well paid dealers in, er US Treasuries, for example).  The fact that a prospective holder of a US Treasury guesses that future buyers of the Treasury in question will make the same calculation, makes him or her even more confident of the eventual sale price.  And so, on, ad infinitum.  Hence Treasuries were a great way to store wealth and pay for things.

As the debt-ceiling approaches, these qualities of US Treasuries erode.  They become less money-like.  Whether or not a deal is done, the erosion of the money-like qualities of Treasuries is likely to be long-lasting.

The debt-ceiling is operating, therefore, like a contraction in monetary services.  And it is entirely natural that this is part of the reason why the Fed backed off its earlier hint that it would soon begin ‘tapering’ (reducing the pace of) its asset purchases.  That way, it can offset the contraction in assets that provide monetary services by creating new ones.  Another way of putting the same thing is that debt-ceiling worries will incrase the marginal cost of funds for those lending to households and consumers, so rates paid by those borrowers rill rise.  A loosening of unconventional monetary policy might hope to reverse this somewhat.

For a given amount of risk in the world that a typical investor has to try to protect against, the debt-ceiling leaves investors more exposed to risk.  Crudely, there is a reduction in the quantity of safe assets.

But, potentially, the amount of risk around does not stay the same, even if the fundamental drivers of productivity, tastes in the world economy, haven’t changed.  To some extent the debt-ceiling worries may operate like the collapse of Lehman Brothers in September 2008.   Olivier Blanchard spoke about this in his interviews with UK radio following the publication of the latest World Economic Outlook.  Actually he was careful to distinguish the debt-ceiling worries, and a possible default, from a Lehman’s event.  The distinction he drew was that the panic then was caused by the fact that no-one knew precisely where the exposures to the newly-worthless subprime mortgages were falling, and precisely what those exposures were.  By contrast, we have much better knowledge about who has US Treasuries, and, although Blanchard didn’t say this in the interview I listened to, we presumably can also much better quantify those exposures.

However, there is a similarity with a Lehmans type event.  Suppose I consider whether to expose myself to an investment bank.  I may know roughly what their US Treasury holdings are.  And I may know something (presumably less) about the holdings of the counterparties to which they are exposed.  And so on.  However, I may know a lot less about their need for certainty in their short-term funding needs.  I know how much they have got, in other words, but I don’t know how much they need.  Because to know that I have to know the rest of their balance sheet intimately.  And not only that, I have to know how much their counterparties need, and so on.  And not only that either, because I also have to worry about what other people know about the investment bank I am going to deal with, because the chance that they will be there to repay their obligations to me will depend crucially on that.

Going back to the crude stories about the rates paid and offered by those who lend on to households and firms:  spreads will rise, forcing up the rates paid by these end-borrowers further, perhaps by a great deal if there is actually a default.  The contraction in monetary services and increase in risk will depress demand pushing downward pressure on inflation.  But the increase in risk and spreads will also be trade-off inducing, strangling supply as firms are starved of credit, in exactly the same way that the 2008 crisis was.

The what-ifs in this post don’t have to stop there.  To the exent that the debt-ceiling worries and a possible default threaten the health of large financial institutions in the US and elsewhere in the developed world, this is going to put pressure on the sovereigns that stand either implicitly or, especially since the crisis, explicitly.  Compounding the worries about their ability to make-good on the promise to repay, and so-on, back through the logic traced out above.

Finally, to explain the title of this post.  I read a fascinatingly scary piece by Newt Gingrich about how endowing the Congress with the power to set the debt ceiling was the Founding Fathers’ wise precaution against the tyranny of Presidential government that would ‘preserve liberty’.  This ‘liberty’ is presumably a reference to the desire to keep citizens free from arbitrary taxation.

No doubt the founders did not foresee the development of integrated financial markets and the role of public monetary liabilities in ensuring their smooth functioning.  If they had, they would not have allowed Congress to be able to threaten default in this way.  Because this threat, and of course its execution, wipes out the value of private citizens wealth through the interdictions in the flow of monetary services, and all the consequent effects explained above.    Such events are expropriations of exactly the same kind that Tea Party Republicans balk at when they come in the form of conventional taxes.  Worse, in fact, since CEOs can get an accountant to check how much poorer a tax will make them.  They are probably also much greater in their effects – at least in some plausible scenarios sketched above – than the difference between the two sides’ ideal profile for taxes.

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Wren-Lewis and Rogoff on UK austerity

A couple of quick points following on from Simon Wren-Lewis’ mainlymacro post in response to Rogoff’s piece about UK austerity.

Simon argues that the insurance against a flight from UK sovereign debt that ‘austerity’ provided (in quotes because, let’s face it, ‘austerity’ still involved a substantial build up in debt) was not needed because we had QE instead.

I think this is a tricky argument.  For two reasons.  One is a counter to an argument not made by Simon, but I’ll make it anyway.  At the outset, there was almost no positive evidence that QE would work.  We had extremely unpromising circumstantial evidence from the long period Japan had already spent at the zero bound, in deflation, trying QE (albeit that there are criticisms to be made about how they went about it there).  We had a few pieces of research on Operation Twist in the 1960s, and on the time-series of debt management, concluding that debt management (essentially the same as QE) doesn’t matter much.  Since then, there has built up a substantial body of evidence that especially the early QE tranches did lower bond yields (though there are reasons to be sceptical about it, as I and others have argued – see here).  But this evidence didn’t exist at the time.  So it would have been highly reckless to rely on QE as insurance.  (And I think it was highly reckless of the Bank to rely on it anyway, regardless).

The insurance benefit that Simon emphasises is the promise or ability to inflate away the debt with QE.  Personally, I don’t see this as much of a benefit.  As an aside, this wasn’t what the Bank was promising.  It stressed at the outset that QE would be reversed, and was in pursuit of, not attempting to subvert the promise to keep inflation at 2 per cent.  So a different policy would have been needed.  But anyway, inflation is default by another means, and would have similar consequences for the cost of subsequent debt finance, and lead to similar constraints in the ability of future governments to do the kind of fiscal stabilisation policy that Simon’s blogging and research argues for.

Although this wasn’t claimed in either of Simon or Ken’s pieces, I also think it unsound to conclude that the insurance motive to be cautious about fiscal stimulus has gone away entirely.  I think the risk that markets simply conclude UK fiscal policy is crackers is non-existent.  But the risk of a euro-area sovereign-banking crisis is still palpable, and conditional on that materialising the risk of our banking system going underwater, given all the exposures to Spain, Italy and peripherals, and to other parties that are, is extremely high.  For that reason, we have to be sufficiently below what might be guessed to be a sustainable debt ratio to handle a further wholesale recapitalisation of our large banks.  That’s why in the past I argued that no more fiscal stimulus was wise, whatever you thought about its desirability on output gap grounds.

John Taylor the Republican contradicts John Taylor the economist

 

[Title amended to copy Noah Smith’s catchier tweet of this post]

I am just back from a conference on uncertainty hosted by the Federal Reserve Bank of Dallas.  John Taylor spoke over lunch about what he thought the causes of the crisis were, and what would improve policy now, articulating a view he has made many times now.  (For example, here).   His basic diagnosis is:  the principal cause of the crisis was interest rates being too low during the early 2000s, as indicated by deviating below what the Taylor Rule would have recommended.  He acknowledged that fiscal uncertainty was weighing against the economy, but argued that that was because of the Obama stimulus package of early 2009, which was a departure from ‘predictable’ and sound fiscal policy.  He also explained that he thought QE was creating economic uncertainty, and that the world would be better without it.  So, in his view, we would be better off with tighter monetary policy, and greatly tighter fiscal policy.  And the other smoking guns causing the crisis (lax regulation, global imbalances, irrational exuberance, politically motivated lending to subprime borrowers, etc) were a sideshow.

Taylor’s normative monetary policy analysis was conducted in sticky price models.  In those models, fiscal policy has very similar effects to monetary policy.  At the zero bound, fiscal policy can be indispensable.  Ok, there are many (like Cochrane, for example) who are greatly sceptical of these models, and that government spending is the solution to weak demand.  But Taylor can’t be in that camp, surely, because he has arrived at views about the efficacy of monetary policy based on a belief in sticky prices and wages.  If you want to deny the benefits of conventional fiscal stabilisation, then you have a hard job explaining to yourself why Taylor Rules are a good thing.  Without the stimulus package, which many argue was too feeble, the recession would surely have been greatly deeper and perhaps even more protracted.  What would be more ‘predictable’ about that?

One interpretation of what he said might be:  ok, I buy that in these idealised model worlds fiscal stabilisation policy works, especially at the zero bound.  But in the US, right now, attempting to pursue such a policy was bound to lead to open warfare with the Tea Party Republicans.  So it would have been better to forgo the benefits of the stimulus and avoid the danger of a fight over the debt ceiling.  This is at least a coherent argument.  Although it’s highly contentious.  And I don’t think it was what Taylor was saying.

As for deviations from the Taylor Rule causing the financial crisis?  This argument seems to me to be stretching things beyond belief.  For a start, monetary policy just isn’t that powerful in the models in which Taylor was led to conclude that following a Taylor rule was a good idea.  Beyond the very short run, they display what’s called the ‘classical dichotomy’ in the economics profession.  You might dispute the classical dichotomy.  (Plenty suffering in the periphery of the euro zone at the moment would).  But if you do, you have to throw away what you thought you had learned about the Taylor Rule.  Second, what is so special about the Taylor Rule anyway?  Even in the model worlds, you can do much better.  Who knows what the right rule for monetary policy is in the real world?  Bernanke argued (eg here) against Taylor explaining that rather than following Taylor Rules, (which prescribe that interest rates should respond to today’s inflation rate…) a central bank would be better advised following rule that responded to forecasts of future inflation (etc).  Looked at that way, rates weren’t too low in the early 2000s.  The Fed was facing the real prospect of deflation, and had watched Japan struggle for 10 years already at the zero lower bound, and was determined to avoid it.  Taylor offers no arguments that weigh heavily enough against Bernanke’s response.

Taylor’s remarks sounded like a classic Republican critique of monetary and fiscal policy.  Many Republicans objected to QE, fearful that it would stoke up inflation.  And they objected to the stimulus package because it went against their preference for small government.  But this Republican critique flies in the face of Taylor’s own path-breaking work took on the causes of the business cycle, what monetary policy can do about it, and, by very close analogy, what fiscal policy can do too.  Personally I hope that this Taylor Critique of current US policy continues to be ignored by the Fed and the US Treasury.  To do otherwise would, in my view, ignore the real wisdom that Taylor’s own pivotal work conferred on macroeconomics.

Forward guidance: talking about it, changing it, and disagreements with the yield curve

Recently the Fed was criticised for talking about tapering and then, when it saw how much the yield curve and asset prices reacted, backing off.  The UK’s Monetary Policy Committee has likewise been criticised as somehow messing up forward guidance because UK expectations of interest rates price in a rise in rates sooner than is consistent with the MPCs own forecast.  Seen through the lens of modern macro, these central bank behaviours are perfectly proper, and don’t indicate incompetence, contrary to what you might read in the newspapers.

How so?  If the world were populated by agents who had what economists called ‘rational expectations’, who knew how the economy worked, and this knowledge was shared by central banks, we could not have seen either phenomenon.  The Fed would have known what would happen when it talked about tapering, and there would have been no need to back off.  In fact, there would have been no need for talking about it, as, unless there had been a change of plan, all there would be to do would be to execute it according to how the data dictated as it unfolded.  And there could be no divergence between the UK’s MPC forecast of its instrument, and forecasts of markets.  At the most basic level, all that these recent events reveal is that the world is not like this.  But that should not be news to anyone, except a few nutty rational expectations literalists.

A plausible conception of the world is that the central bank and markets have different views of how the recovery will pan out, because they have different views of how strong the effects of QE and interest rate stimuli are, and how they come about, different views of what caused the contraction in the first place.  And markets may understandably be unsure of the central bank’s precise intentions.  (Neither central bank has tried to spell them out very precisely).  The point of forward guidance is that you are trying to lower long rates because you have run out of room to cut short rates.  And you do this by manipulating forecasts of future short rates.  Central banks in this world of differing and imperfect world views ought to be forming views about how private forecasts of what it will do are formed, how they will react to events as they unfold, including how they react to information about its own intentions.

Seen this way, the Fed’s actions are entirely reasonable.  The Fed started out with a conception of private sector forecasts of the short rates (and associated wider asset price movements) that was less responsive to what it was contemplating saying about tapering than proved to be the case.  When the taper talk caused all the fuss, the Fed revised its conception of how private forecasts were made.  Tighter rates and lower asset prices naturally led the Fed to back off its initial taper talk somewhat because tapering was always going to be data-dependent, and included in that data would be data on asset prices.  The Fed have not opted to describe what they did in these terms exactly, but a story like this is consistent with what they did.  And if it is the right explanation, then what the Fed did is perfectly reasonable.

One can detect elements of this kind of thinking in the Bank of England’s behaviour too.  Faced with the yield curve that predicted rates were going to rise before it was forecasting them to, the MPC determined to re-emphasise the benefits of forward guidance, to try to assuage concerns that they were really committed to it.  And to clarify elements of the guidance, such as the status of the unemployment rate ‘staging post’, which was not to be considered a ‘trigger’ for rate rises.  The MPC was clearly attempting to diagnose the ‘incorrect’ yield curve, and provide information to private forecasters that would pull their forecast into line with the MPCs.

But there is something missing from the MPC’s execution.  Although there’s evidence of the MPC forming a conception of how the yield curve is arrived at, there’s no sense communicated of how the interest rate plan responds to that, if at all.  To see why such a response might be necessary,  imagine a world in which, once Carney announced forward guidance, market forecasts of central banks coincided perfectly with the MPCs.   There would be nothing more to do in this world except PR and responding to data as it came in.  (Which is pretty much what the MPC have done so far).  However, we are not in that world.  In the real world, the yield curve has turned out tighter than the MPC hope.   Some of the reasons why that might be the case would actually warrant looser policy than in the imaginary world the MPC were hoping for.  For example, if markets thought there was a fair chance that the inflation and financial stability knockouts, notoriously vague as they are, could be manipulated to provide a way for the MPC to renege on its forward guidance, and forecast tighter rates as a consequence, MPC would plan to keep rates lower for longer (or undertake more QE).  (To be fair, there are also arguments weighing in favour of tighter policy too, but just for simplicity’s  sake let’s omit them).  What is missing from the MPCs execution so far is the explanation of how the differing conception of the world that gives rises to the discordant yield curve affects the MPCs own plans.  Such a response is consistent with tying forward guidance to the unemployment rate, but is so far kept private.

So, I think the widespread media commentary on the two central banks is wrong to ridicule forward guidance.  There is nothing wrong with changing your mind about a taper per se based on what you find out about people’s reaction to it.  And the fact that you can’t ensure the private sector shares your forecast doesn’t mean forward guidance has not worked – their forecasts of rates may be lower than in the absence of forward guidance.  But executing forward guidance in a world of evolving an imperfect private sector interest rate forecasts involves forming a model of those forecasts, and how they react to what you do and say, and devising the guidance accordingly.  Central banks cannot simply say what they plan to do and pretend that they will stick with it regardless of how others see the world unfolding, even if the central bank is, in a sense, right about how the world is going to unfold.

You could imagine a policymaker saying:  Hang on, I’m not going down this road, because down this road leads to infinite regress.  This might well be true.    As well as forming a conception of how private sector forecasts evolve, central banks might, under some such conceptions, have to form a model of how those forecast evolutions depend on how the central bank responds to the private sector’s forecasts, and so on, ad infinitum.  However, if it were true, it would not necessarily do simply to brush it aside.  And you can’t just cut through it by pretending you won’t react, or hoping that the world will somehow become more like a rational expectations world if you set the problem to one side.

This infinite regress would not be there for all possible models of private sector forecasts.  For example, the central bank might believe that the private sector will set rates equal to their long term average plus something times the output gap, plus something times the inflation rate.  On this view, the private sector aren’t trying to pick the central bank’s brains.  They are using a mechanical tool to forecast rates.  So there is no need for a view of what the central bank would do about a yield curve disagreement to enter their forecast.  And hence no need for the MPC to worry about infinite regress!  Unfortunately, in a world like this, there would also be no real room for forward guidance either, as no-one is listening.  All that is going on is the mechanical feeding through of data.

As you read this, you might start to feel as though this is all just academic fun and games.  However, it’s not.  In some sense, forward guidance, as conceived in the original academic work, and from which both the Fed and UK varieties draw inspiration (no matter what the UK’s MPC says), embodies a contradiction.  The original work was expressed in models of rational expectations.  In those models there is no need for any announcements.  There is only the matter of figuring out how to bind the hands of the policymaker (to stop her tightening rates when the recovery gathers pace, and the old worries about recession and deflation are long forgotten).   The private sector know all there is to know, so they don’t need Beige Books or fancy Inflation Report forecasts.  The fact that all these things exist illustrates the obvious, that we are not in a world of rational expectations.  However, since we are not in that world, the appropriate forward guidance will differ from the one devised in the academic studies (and presumably not just by the trivial fact that the real one has to be announced and described and reported on).   The (somewhat unrealistic) example above with the private sector that simply forecasts rates based on a Taylor rule is a case in point, a case, in which, to repeat, forward guidance would be futile.

Central bank solvency, QE and the price level

This post is prompted by an exchange on twitter with Noah Smith [which you can see here] about why some people worry about the effects of QE on central bank solvency and eventually the price level.

In short, the argument is this.  Suppose the central bank lowers interest rates to their floor.  It is stuck for a way to stimulate the economy further.  The central bank  contemplates buying, for example, real estate.  [Fathom Consulting were suggesting this at one point], exchanging it for central bank reserves, electronic money created by the central bank.  [The transaction would involve a few more steps than that, but that’s what it would amount to in the end].  What’s wrong with this?  Well, such a policy might be the right thing to do.  But something that has to be thought through is the fact that the real estate may not fetch what the central bank paid for it when it comes to be sold.  Presuming that it will be sold in the end, and that the central bank doesn’t want to get into the business of real estate management permanently.  [It shouldn’t, because it won’t be as good at it as real estate managers, and the activity will consume capital.   Which is a problem we will come to.]  Once the real estate is sold at a loss, the central bank winds up with less capital than it had originally.  Does this matter?  Yes.  Sooner or later, when the central bank wishes to do something, unless the capital it previously had was surplus to requirements, it will find itself unable to finance it.  It could be a new bail-out, or a PC on which Mark Carney or Ben Bernanke is going to write a speech.  Can’t the central bank just create some more electronic money to pay for these?  Yes, but it can’t do that and simultaneously hit the monetary policy targets for the price level that it has been instructed to do by the government.  Aren’t these amounts small, so that they would be lost in the gamut of other things that hit the price level?  After all, central banks are always complaining that the price level index is being shunted around by one thing or another outside its control.  Surely a bit of money printing like this could be hidden away.  Yes, it probably could, these amounts could well be small, and very likely hidden in some Inflation Report waffle about price level shocks (of which there is ample precedent), but that’s the problem.  The act of central banks engaging in risky asset purchases will raise the concern that it will be forced at some point to engage in monetary financing, and that it will try to hide it with waffle about price level shocks.  It could beg for a recapitalisation by the finance ministry, but who knows how that will turn out.  Perhaps the money will be handed over, but perhaps in exchange for easier monetary policy, and easier monetary policy hidden amongst waffle about price level shocks.  Perhaps observers would calculate that this kind of arm twisting would be considered intolerable by a modern, reputation-conscious central banker, but perhaps not.  Who knows how policymakers might behave in the aftermath of a fiscally draining crisis.  If, like Gordon Brown, they are contemplating putting troops on the street, central bankers would surely see that covert inflation was in the long-term national interest.  Or so the thought process of the private sector might run.

Hang on!  [Excuse the Tim Harford rhetorical device here].  What if the central bank is just buying government securities?  The Bank of England’s QE is almost all government securities.  The Fed is buying a lot of debt issued by the Federal mortgage backing agencies, but these organisations are now explicitly backed by the government, so the debt should be considered as gold-plated as a Treasury.  Does buying government securities not get us out of this central bank solvency problem?

No it doesn’t.  The shift in bond prices doesn’t matter for the central government, who still has to redeem the face value of the bonds.  But it does matter for the central bank.  And if the central bank winds up selling the bonds back to the private sector for less than it bought them for, the central bank loses capital, and so on.

This is the reason why central bank solvency is important, and why central banks should not get involved in real asset markets without explicit government support.  That’s why Mervyn King insisted that QE would be operated using, ironically, a special purpose vehicle, the Asset Purchase Facility, whose balance sheet is separate from the Bank of England’s.  Ironic because it was off balance sheet vehicles in the public sector that got the government in trouble in the first place.

This institutional arrangement hopefully helped, but it can’t be considered a cast iron guarantee of monetary good behaviour.  After all, it’s only words on paper, not statue.  The agreements providing for QE and other policies to be conducted off the central bank balance sheet could be revoked, and in extremis who knows the central bank policy makers might agree to it.  Not very likely, but not completely impossible either.

Involving the central bank is a good thing in some ways.  If a policy instrument is needed for monetary policy purposes, it makes sense for operational reasons to hand over control to the central bank.  If the MPC had to vote to recommend to the Treasury that QE of £x billion was undertaken, it might be less effective, since there might arise the concern that the Treasury could refuse.  But these policies are inevitably fiscal in nature, and, as such, raise the spectre of monetary financing.

As a final word some, like Chris Sims, have argued that this spectre could be very helpful.  The worry that massive central bank balance sheets might have to be monetarily financed might, if the expectation was that political constraints on conventional tax and spending instruments meant those would not be used, generate a rise in the price level to revalue nominal debts (incurred by the central bank) could be repaid.  And if avoiding deflation was a prime concern this would not be wholly bad.

Puzzling differences between QE at the Fed and the Bank of England

On Tuesday this week, the FOMC decided not to begin to reduce the scale of its monthly asset purchases, as Bernanke had previously signalled it might.  This highlighted for me the starkly different QE policies that the Fed has compared with the UK.

In the UK, the LEVEL of assets purchased will be kept constant at least until unemployment falls to 7%.  In the US, the FOMC will keep the RATE of purchases constant until it sees adequate improvement in the economy.  The FOMC had a similar unemployment criterion to the UK, but appears to have reduced the emphasis placed on this now.  One might think of this as a necessary criterion for both policymakers, but less likely to be sufficient for the Fed than the BoE.

What could possibly explain why one central bank operates a rate of change policy, and another operates a levels policy?

One possibility is that in the US, the effects of a given quantity of asset purchases are mostly temporary, while in the UK, their effects are mostly permanent.  In this case, for the Fed to apply the same stimulus as the UK’s MPC, it would have to buy about the same quantity of gilts each month as the UK’s MPC has accumulated throughout the entire life of its Asset Purchase Facility. (And perhaps more, in $s, as you might think, especially from what policymakers have said about how the benefits of QE come about, that purchases should be proportional to GDP, and the US economy is roughly x times larger than the UK).  The Fed is not buying anything like that quantity.  So if this were the explanation, (QE has temporary effects in US, permanent effects in UK) then, other things equal, we ought to see the economy in the US entering free-fall, and term premia steadily rising in the US relative to the UK.  Which doesn’t seem to be the case.  The Fed is also buying a lot of agency debt.  Since these agencies are now backed by the Government explicitly, this ought to be a close substitute for plain vanilla US government securities.  But they aren’t, at least according to the markets.  If the stories about how the policymakers say QE work are to be believed, the Fed’s QE purchases ought to have more of an impact than those of the MPC, not less, and there is nothing about this debt that would suggest that its impact effect, whether larger or not, should be more temporary.

Another possibility is that the two central banks plan to do drastically different things with the interest rate instrument to compensate for the very different QE plans, leaving the overall monetary stimulus roughly the same.  This doesn’t wash.  Both from the yield curves in the US and the UK, and the forward guidance chatter from each set of policymakers, we can see that the paths for the instruments are roughly the same.

Yet another explanation is that the size of the recessionary impulse the Fed is trying to offset is much greater, and, moreover, is an impulse that is still gathering pace, compared to the UK, where the impulse was smaller, and has peaked.  If the recessionary shock were still growing in the US, this would require ever looser monetary policy, a growing stock of assets held by the Fed.  This seems unlikely to be the explanation.  The fall from pre-crisis peak to trough has been of the same order of magnitude in the two countries.  The recovery from the trough has been more marked in the US.  Strictly speaking, we can’t refute this answer by looking at past output, because we don’t know what would have happened to the two countries’ output in the absence of the monetary and fiscal response.  The impulse imparted by the financial sector one would have guessed to be larger in the UK, where the balance sheets of the financial sector are larger relative to GDP.  So that goes the wrong way.  The US has had to contend with the fiscal cliff, and is looking forward to another one.  But the UK has had less stimulatory fiscal policy throughout.  So this explanation doesn’t seem to work.

Of course it’s possible that QE has the same effects in both countries, it’s just that either one or both policymakers has the wrong view about this, and is doing either too much or too little.  This is hard to square with the facts.  Again, we would expect to see one economy taking off (say the Fed mistakenly believing that QE’s effects are temporary), or the UK going into free-fall (the MPC mistakenly believing the effects of QE are permanent).   Unless there were drastically different fiscal policies to compensate.  Which isn’t the case.  There’s also no great evident divergence in the policymakers views about the effects of QE.   Both central banks have conducted research using event studies of QE announcements, and there is a broad consensus on its impact, and no evidence so far published that the effects are much more temporary in the US than the UK.  Although it would be hard to disprove this, given how many other things affect yields, asset prices, and, further down the chain, the rest of the economy.  Central banks tend to avoid overtly criticising other central banks, so it’s conceivable that there is a big disagreement behind the scenes, but I doubt it.

One version of this argument that does fit the facts is that QE has no direct effect whatsoever, except in so far as it signals what policymakers intend to do with the policy rate itself!  This is a rough approximation of Woodford’s view, expressed, for example, in his Jackson Hole paper of 2012, and paraphrased in a previous post on this blog.  If this were the case, then two economies hit by the same shock, and responding in roughly similar ways with fiscal and interest rate policy, could sustain totally different QE policies.  (In the same way that they could sustain totally different policies regarding the typeface the policy announcements are made in.)  Bernanke could announce triggers that would keep any derivative of QE constant until certain conditions were met – the level, the rate of change, the rate of change of the rate of change, or the rate of change of the rate of change of the rate of change – and it would not make a blind bit of difference.  Except in so far as what was inferred about the path of the policy rate.

This way of reconciling UK and US QE, also has to answer a lot of questions.  First, why did the event studies of the effects of QE record any effect?  Answer:  either i) because markets mistakenly thought it should, then later realised their portfolios were not much different, and so the effect dissipated, or ii) the effect was only an effect brought about by signalling news about future policy rates.  ii) on its own is tricky, because some of the work showed that the effects of QE were bigger in the asset classes in which the operations were carried out.  But i) and ii) together might work as an explanation.

This nihilistic view about QE, though it reconciles the coexistence of starkly different rates of change (Fed) and levels (BoE) policies, begs further questions.  If the effects of QE are simply due to what is being signalled about future policy rates, how come markets come to infer signals about the policy rate via the change in QE in the US, but via the level of QE in the UK?  According to this view, this is roughly what must be happening, if you think the two economies were hit by roughly the same size and kind of shock, and the path for expected future rates is roughly the same.

Well, we could rationalise a situation like this.  Suppose that those pricing the yield curve know that QE is pretty much impotent, but just try to put themselves in the mindset of the Fed, even if they don’t believe it.  They learn that the Fed thinks a given monetary stance is maintained by a given rate of change of QE , and they infer from what the Fed says about its likely path for purchases what the Fed’s view of the state of the economy is.  They make some calculation about whether the Fed will ever learn the truth (hypothetically, here, that QE has no effect at all), and work out what the Fed will eventually do to the policy rate.  Those same investors listen to the BoE swear that it’s a particular level of assets held that maintains a given monetary stance, and infers from the level it says it wants what it thinks is happening to the economy, and so on.

 

The supposed benefits of reducing uncertainty via forward guidance constitute another transparency mishap for the MPC

One of the benefits of forward guidance that the MPC is counting on, and has trumpeted, is that it will reduce uncertainty about future interest rates.   Lower uncertainty should increase spending as economic agents need to put less aside to see them through potential scenarios for high interest rates, which would mean high cost of servicing mortgages and other debt.

However, the BoE has not made much of the fact that its main economic model (‘COMPASS’), used to evaluate the effects of forward guidance, omits this channel entirely.  (In the jargon, the model displays ‘certainty equivalence’).    This is not oversight on the Bank’s part.  Solving and simulating a model as rich in detail as COMPASS is that did incorporate the effects of changing uncertainty would be extremely difficult and cumbersome.  And with current computing speeds it would probably be impossible to estimate such a model to get it to describe UK data well.

The emphasis placed on the reduction in uncertainty in the language describing forward guidance leads us to think that this is a relatively important effect.  Since this effect is omitted from the main model, one must presume that the MPC’s own forecast of what it will do with rates (or, equivalently, how long it will take unemployment to fall to 7% at constant rates) incorporates some judgement applied to the forecast to guess at the effect of the missing uncertainty channel.  If so, how strong are these effects estimated to be?  Where do those estimates come from? One could produce estimates using much simpler models that omit monetary policy entirely (and my hunch would be that changes in interest rate uncertainty of the magnitude that one might hope for through successful forward guidance would have very small effects).  Has this work been done?  How much uncertainty about future interest rates was there prior to forward guidance?  By how much is forward guidance hoped to reduce this uncertainty?  Are the MPC hoping that all of the reductions in actual uncertainty are translated into reductions in perceived uncertainty too?  How are the Bank intending to monitor whether these reductions are coming through as hoped for?  If they don’t materialise, would there be some compensating loosening via another instrument (for this would surely be required as otherwise inflation and unemployment would be undesirably low).    So far, we have not been told.

My own surmise is this.  The effects of uncertainty about future rates, one-sided as they are when rates are pressed against their presumed floor, would be small even if all of the hoped for reduction were to come through (which seems unlikely, given the variable reception forward guidance has had so far, and the fascinating ambiguity that has been allowed to persist around what forward guidance was intended to do).  The emphasis placed on the effects of uncertainty is probably just PR.  If it wasn’t, there would be some compensating tightening, which there does not appear to be, and it would be hard to conceal it.  It would not matter much that this was just PR, except for the fact that the whole point of forward guidance is to make monetary policy more transparent.  Transparency is required so that everyone can scrutinise whether the MPC is doing what it said it would.  Ideally, such transparency creates the expectation that the MPC will do what it said it would, because if it strays, it will be noticed.  It looks to me like the emphasis on uncertainty is one of those things plucked out of the textbook to add to the list of reasons why forward guidance is a good thing in principle.  If that was what was required to tip the balance so that this policy looked like a good thing to do, then perhaps it was a good thing.  But without the information to understand how it figures, practically, in the estimation of the effects of the forecast period of constant rates, this kind of talk makes it harder to understand the MPC’s real thinking.   And that will make it less likely that the MPC can manipulate expectations of future rates and get the hoped for stimulus. So, to add to the catalogue of transparency mishaps surrounding this policy (which featured prominently the question of whether forward guidance intended to loosen monetary policy or not) we can add the benefits of reducing uncertainty.