Some desirable transparency housekeeping for the MPC’s forecast

The MPC will shortly publish its August inflation forecast, and its evaluation of the policy of ‘forward guidance’, commissioned back in March by the Treasury (an action I previously noted was tantamount to saying ‘how about looser monetary policy, folks?).  One presumes from today’s policy decision (to leave all instruments on hold) that there was no consensus for with Odyssian forward guidance, injecting further monetary stimulus by promising to keep rates lower for longer than would have been guessed at from previous MPC behaviour.

So that leaves Delphic forward guidance – just being clearer about your interest rate forecast, given how you expect the economy to develop.  Stephanie Flanders recently posted on forward guidance on her blog, making the interesting point that perhaps there would be no point in such guidance, since the forecast and MPC intentions are already pretty transparent.  As she put it, one might respond to the first words of the oracle:  “have they told us anything that we didn’t already know?”

Well, here are some arguments why, actually, maybe we don’t know all that much, and reasons why the MPC could do some transparency housekeeping.  There are some arguments against the transparency steps implied by what follows, but they have already had enough of an airing, and so far held sway, so I am not going to repeat them.

First, MPC, and particularly it’s former chair, Mervyn King, have, in continually stressing that they ‘face one ball at a time’ [UK cricket speak for not deciding on future rates] confused what might be read from the MPC’s forecast of inflation under market expectations of interest rates.  Those who make their living trading bonds, and bringing about the prices from which we infer market expectations of interest rates, what are they saying to themselves?  Are they saying:  ‘we don’t believe this stuff about facing one ball at a time, we think they do have a plan, and this is it’.  Or are they saying:  ‘we do believe the one ball at a time rhetoric.  But we think that this is how the bowling and batting is going to play out.’  Or a third possibility:  ‘we think they do have a plan, it’s just that the plan changes every period.’  Who knows.  But surely the one ball at a time talk made it harder to guess what would happen, and putting an end to it is going to make life better.

Second, MPC have said nothing about either what kind of monetary policy rule they might use as a guide-post for policy [unlike FOMC members who often pointed to Taylor rules, or the Swedish and Norwegian central banks, who refer to them].    This reluctance to make use of more explicit analyses of policy rules is perplexing because the MPC’s tendency to set rates in a way that adhered to such rules (in more normal times) was probably not that different from other central banks.  Even with rates pinned to the zero bound such analysis would be valuable, because one could gauge the extent of desired monetary easing, if only the zero bound would allow it.

Third, MPC have not been at all clear on how they trade off inflation vs fluctuations in real activity.  For this reason it’s hard to know how they would respond to any given inflation forecast, and how they would view paths expected by the market.  If you don’t know what the MPC are trying to achieve with monetary policy, how can you guess what they will do?  One surely supposes that they have articulated to themselves and to each other precisely what they are trying to do [otherwise how could they discuss their disagreements about interest rates and QE?].  In which case it is perplexing that such discussions have not been made open to outsiders, who need to know what will happen to monetary policy, or who seek to try to verify whether MPC are doing a good job or not.  It might be argued that it is hard to know precisely how goal variables should be traded off, and that for example the academic literature doesn’t give a very compelling steer, and even that this trade-off might have to vary from one situation to the next.  But still a view on this has to be taken, surely, in order to take any policy decision at all,  And if it has been taken, the argument for concealing it from the outside world is very weak.

Fourth, since the morphing of the financial crisis into a sovereign debt crisis that threatened to break up the euro area, and still does, the MPC have excluded the risk of this happening from the fanchart, on the grounds that it was not possible to quantify it.    It is therefore hard to read what their true beliefs about the mean values for inflation and growth are for a given interest rate path.  The position MPC took on this I thought was spurious.  The inference that they can quantify other risks with more precision (eg the risk of our own banks not resuming normal lending) is hard to defend.  Regardless, MPC could think about taking a robust approach to policy which is a way of proceeding if risks are genuinely entirely unquantifiable.  Such an ommission would be coherent if it were uncontroversial that monetary policy would not need to respond to the waxing and waning of this break-up risk, but only to it actually happening.  But this is not the case.

Fifth, messages from the forecast are hard to interpret because of the convention of taking government fiscal plans as given.  For political economy reasons, the MPC does not want to be observed in the business of making forecasts of fiscal policy that differ from the plans of the Government.  To do so would look like it was advising on fiscal policy, or the competence of the government to make plans, which is outside its remit.  But this means that MPC’s beliefs about its own likely future actions, which must be conditioned on its beliefs about the likely path of fiscal policy, are less easy to read from the inflation forecast.

Sixth, the connection between the MPC’s likely future votes, which are a trajectory of the majority position out into the future, and the inflation forecast itself, which is meant to be a ‘centre of gravity’, is completely obscure at present.  (What is a centre of gravity anyway, in this context?)  MPC disagreements about interest rates or QE are difficult to map into disagreements about the forecast.  For a brief period, while DeAnne Julius and Sushil Wadhwani were on the MPC, when the Inflation Report carried a ‘Table 6b’, explaining how they dissented from the forecast, it was easy to map between disagreements over interest rates and disagreements over the forecast, but never since.  Do individual MPC members articulate to themselves and each other, clearly, how their forecasts differ from the ‘centre of gravity’?  If so, why are they concealed from the rest of us?  If not, why not?  How could a dissenter be so sure of their vote, to within 25 basis points on Bank Rate, or £25bn on QE, without having formed such a forecast?

Seventh, the MPC has never been clear about its views about the output gap or the natural rate of unemployment.  It has also sought to make sure that outsiders cannot reconstruct its own forecasts, with insufficient details about the MPCs main model, or other models, and the judgement imposed on them, disclosed for outsiders to be able to evaluate what the forecast means, and thus what they (or the MPC) would read into a difference between forecast inflation and the target.

Eighth, the MPC adopted the practice of conditioning on the market expected path for interest rates, yet on fixed amounts of QE.  This fixed path for QE is inconsistent with what the MPC have said would happen to QE (which is that it would be unwound at some point when it became clear that interest rates were on a probable even trajectory away from the zero bound, sufficiently probable that there would be no risk of having to resume asset purchases again).

Some of these transparency deficits are of more practical significance than others.  But together they surely make it hard to figure out what the inflation forecast foretells for monetary policy, and one could therefore hope that instigating Delphic forward guidance would be a step along the way to making things clearer.

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A sceptic’s view of QE, an initially irrational policy, the controversies over which were whitewashed

I am, and always have been, dubious about the usefulness of QE, and regret the process by which the Bank and the MPC decided to embark on it, and gave overly confident accounts of how it worked and its impact.  This post elaborates, putting the sceptical side of the QE story that the MPC has sidestepped.  None of these sceptical arguments are original, and all have been made before by people higher up the food chain than I.  I don’t go through the arguments in favour in great detail, as this side of the story has already been told.

There are two main pieces of evidence in favour of QE having been the right .  One is the accumulated ‘event study’ analysis of the effects of tranches of QE on gilt yields, not just in the UK, but also in the US and Japan.  Event studies measure yields just before a QE announcement is made, and then just after.  By timing the measurements tightly around the announcements, they try to isolate the effects of QE from all the other market news on yields.  These effects are extensively documented in BoE work, and also good work by the New York Fed and the BoJ.  The other piece of evidence is more circumstancial, but powerful nonetheless – we have had high and relatively stable inflation for several years despite interest rates hitting their natural floor.

However.

1. It is possible, even likely, that this effect on yields was not persistent.  Temporary effects on yields could be explained by changes in beliefs by particpants in gilt markets about resting places for prices and premia;  and changes in what they inferred from the QE operations about the likely path of future rates.  Other commentators have referred to this as a ‘signalling’ channel;  QE simply signalled the authorities determination to keep rates low, or revealed private information the authorities had about just how bad the economy was (and therefore how unlikely interest rates were to rise).  The temporariness of the effect on yields would not itself be a cast iron argument for not doing QE;  there are circumstances where you would proceed anyway, expanding QE by ever more.  (Perhaps this is behind the Fed’s constant rate of asset purchases policy, rather than MPC’s constant level policy).  However, if QE is really about signalling the path of future interest rates, it raises the possibility that what the MPC should have done was, well, explain their path for future interest rates, rather than do it so indirectly.   Signalling directly would be i) less confusing, ii) lead to less uncertainty about future rates, a good thing in itself, iii) help with any credibility issues, since the progress of actual rates can be monitored.  Another explanation for the temporary effect on yields is that for a while people thought ‘perhaps this will work’, but then later realised it would not.  This is one explanation for why the effect seems stronger for earlier QE announcements than later ones, (an explanation carefully avoided in the BoE studies), though there are others, more supportive of QE, namely, that the early announcements were more of a surprise, while the later ones were largely expected.  (That they were expected doesn’t mean they had any less of an effect, as if QE had not been implemented as expected, yields could have been higher).

2.  Even if QE did affect yields, it doesn’t follow that it lowered the rates anyone in the private sector pays to borrow, other things equal.  Vissing-Jorgensen and Krishnamurthy dissect the effects of QE and argues that purchases of US Treasuries simply widened the spread between those and other riskier assets.  On the contrary, purchases of the debt of the mortgage backing agencies did lower the yields on those assets.  Michael Woodford makes this point too in his Jackson Hole paper.

3.  Even if QE did have an effect on bond yields, and even if that was passed on into yields on other assets, it doesn’t follow from this that it was socially beneficial.  The MPC have many times told a story that runs something like this;  we make gilts more scarce, this pushes previous holders of gilts to hold something else more risky, like equities or coporate bonds.  The prices of those assets rise, and that lowers the cost of funding for corporates.  This boosts investment spending, employment, output, and everyone is better off.  So it might.  But, it also deprives the holders of gilts of something they wanted.  If the government were to buy up the stock of oranges, orange-lovers would move into grapefruit, and the price of grapefruit would rise, and grapefruit growers would enjoy a boom, but orange lovers would be poorer for it, no longer able to enjoy that sweet taste so cheaply.  Some of those desparate for citrus of any kind would buy grapefruit and eat them, and we would see their pain and disappointment written into their sour faces.  This point is made forcefully (without the silly fruit analogy) in work by Krishnamurthy and Vissing-Jorgensen.  The logical corollary of this argument is that we need not QE but negative QE, with the proceeds invested in a risky asset.  We need to expand the supply of safe assets, by over-financing government borrowing needs, and take risk, notwithstanding worries about public sector credit-worthiness, onto the government balance sheet.  Pressurising those in the private sector already struggling to bear risk to bear more of it makes them worse off.  This said, the mere existence of these costs doesn’t imply that they dominate potential benefits of QE.  But they might.

4.  A sceptical argument that I anticipate will alienate some readers, and must nonplus BoE policymakers by their revealed preference for QE, is that there is no sound theoretical account of why QE should work.  By sound, I mean one that meets the standards of modern macroeconomic theory, which places a premium on assuming the minimum, making explicit what agents are doing in the economy and why, and works out the effects by adding up the behaviours of all the agents in the economy.   On the contrary, all the models of monetary policy that we do have suggest that QE should be impotent.    Michael Woodford explains this point, in his Jackson Hole paper, and in several before that.  These models are probably wrong too, and not to be taken literally.  But they at least provide a cautionary note.   Non-economists might find it amusing to hear the old joke about economists (that they are people who see whether something that works in pratise also works in theory) turning out to be true.     Isn’t it specious to insist on theory when you have empirical and common sense insights on your side?   Robert Lucas got his nobel prize, in part, for his explanation for why this is important.  If you rely solely on data-based insights, and stop trying to understand what the people in the model you have are doing, you might find the correlations they embody crumbling when you try to exploit them.  Also, if you fail to try to formalise your stories, you run the risk of being fooled by a story that sounds good but is just internally inconsistent or wrong.  In defence of this philosophy, many MPC prounouncements in the past have followed this kind of reasoning, and the same notion lies behind the construction of the Bank’s new model COMPASS.

5.  On the contrary, the monetary models we do have suggest that QE does not work.  What happens is this:  at the zero bound, swapping money for bonds is swapping one default-risk-free, zero-interest-rate asset for another, and not to be expected to have any effect.  (Using the fruit analogy above, QE is swapping oranges for oranges !)   Money’s usefulness derives from it offering a cheap, quick and easy way to transform it into something you can eat or use.  But if you have enough of it on hand anyway, more money isn’t going to be useful.   You have enough to see you through.  Hence money is just like a gilt at this point.   It’s just another safe way to store your wealth.  Why should swapping something almost like a gilt for a gilt change anything?    Robert Lucas, Godfather of modern macro, and Nobel laureate, explained the very same argument in a recent WSJ article.  [He’s in favour of the Fed QE program, but because they are buying illiquid agency bonds].  In these models, QE will work to the extent that markets think the operation will not be reversed and that that will impy lower interest rates than would be expected given likely rules for setting interest rates.  (Because rates would have to be higher, in order for markets to want the extra money).   This is why some think that the empirical evidence showing QE does something indicates a ‘signalling’ effect.  And why if this was the motive, explaining precisely what the implication was for future interest rates would have been a better policy.  Perhaps we will one day find a sound theoretical explanation for why QE works.  But if we do, we can’t guarantee even that it will tell us even that we should do more of it in a recession, not less.  And that same theory might overturn all that policymakers use to inform the setting of their conventional interest rate instrument, or even that interest rates should be the normal policy insrument.

6.  On many occasions, MPC emphasised the importance of expanding the money supply, precisely the mechanism that the models we have says is ineffective.    The first mention is in the March 2009 MPC minutes, where we read:  ‘the Committee had previously chosen to influence the amount of nominal spending in the economy by varying the price at which it supplied central bank money in exchange for assets held by the private sector…. [now]…the Committee would instead be focusing more directly on the quantity of money it supplied in exchange for assets held by the private sector…  By increasing the supply of money in the ec onomy, these operations should, over time, cause nominal spending to rise.’ [Ref 1 linked to below].  That’s ok then:  the message is:  monetary policy is simply about varying the supply of money, which before we did by changing the price, now we do by changing the quantity when the price is pinned at zero.  The argument appears in later documents too.  For example:  ‘The purpose of the purchases was and is to inject money directly into the economy in order to boost nominal demand‘, [Ref 2].  ‘Increases in money should eventually lead to a rise in prices‘, [Ref 3], which states the fallacy more explicitly, neglecting to note that this relationship is probably true, except at the zero lower bound to interest rates.   What monetary economists would have found astonishing is that nowhere in these early deliberations and communications is there an explanation of, or even an attempt to evaluate and discard the account of what happens at the zero bound in monetary macroeconomic models.    The MPC might have worried that by disclosing that an unpleasant feature of its own monetary model, (in fact all monetary models), a feature that implied that QE would not work, this would make it less likely that QE would work, panicking the markets.  But there was a contending risk, that MPC would look like it did not understand monetary economics.  Whatever, MPC seem to have got away with it.

7.  The Bank’s presenation of the evidence is accompanied by verbal accounts of why and how QE should work which are inappropriately confident, and no airtime is given to more sceptical, contrary thinking.  The Bank’s empirical work forms an impressive body.  But in some senses it is a whitewash;  it gives inadequate attention to sceptical readings of the evidence, and presents verbal accounts of the intuition for why these effects should be taken at face value [ie as persistent, and to be regarded as beneficial] with a confidence that is inappropriate (given the practice at large in the profession of not doing this unless there is consensus and or confirmatory theoretical accounts of the same effects seen in the data).   Imaginative conjecture is recounted as conclusive, almost formal analysis.  To give some examples: ‘Purchases of financial assets financed by central bank money should initially increase broad money holdings, push up asset prices and stimulate expenditure by lowering borrowing costs and increasing wealth. Asset purchases may also have a stimulatory impact through their broader effects on expectations and by influencing bank lending, though this channel would not be expected to be material during times of financial crisis.‘ [Ref:  2]  (It sounds good, and makes you think we know the answer, but we don’t.  We can’t even check that it holds water theoretically.)

This unfortunate policy [of sweeping aside worries about QE’s effectiveness] can even be found in the official response to the request to investigate the ‘distributional effects of asset purchases’, in particular claims that (eg) pensioners were being adversely affected.  That response did not appraise the reader that the assertion that QE had worked was highly contentious.  An alternative reading of QE is that it might well have lowered yields on government bonds on which many savers live, and entirely in vain, for it may not have had any effect on anything else.  No weight is put on that argument in the Bank’s official response, nor on the argument that there is even a case, as explained above, for engaging in negative QE.    Thus, in the introduction to ‘The distributional effects of asset purchases’ we read :  ‘Without the Bank’s asset purchases, most people in the United Kingdom would have been worse off.  Economic growth would have been lower.  Unemployment would have been higher.  Many more companies would have gone out of business.‘   Well, maybe, but maybe not!  Perhaps we are about as well off as if they didn’t happen?!

It’s not true that uncerainty is ignored entirely in BoE material.  For example, one can find several references like this in the Bank’s survey of the evidence:  ‘It is difficult to measure directly the effects of policy measures such as QE and so estimates of those effects are highly uncertain‘ [Ref 4].  But, the overriding impression we are directed to, not least since the MPC’s QE (and QE only) actions (and MPC minutes) speak just as loudly, is that it works, and so much better than any other option, that other policies are not even worth considering.  This quote is illustrative:  ‘evidence suggests that the policy had economically significant effects – equivalent to a cut of 150 to 300 basis points in Bank Rate – but there is considerable uncertainty around the precise magnitude of the impact.’  Which I read to mean;  ok, the precise magnitude is not certain, but we are pretty sure it worked, big-time!

This failure to provide a more balanced account of QE might have been motivated by a desire to instill confidence.  But ultimately, it undermines the authority with which the Bank’s voice speaks on technical matters, and will increase the chance that future such documents are not taken at face value, but as energetic and adversarial attempts to justify a particular course of action.

8.  QE was not a rational policy at the outset, when the (for some) supportive event study analysis was not yet available.    Suppose you adopt the position that history has proved the MPC right, and QE effective.  And you dismiss all the contrary arguments set out above.   Still, at the time the MPC first embarked on it, we did not have the supportive event study analysis that QE might lower yields.  [The introduction of the corporate paper facility can be set aside as a detail, since it was never intended, and never evolved into a way to intervene on a large scale].  The examples we did have were the old evidence on operation twist in the 60s, which at that time showed very little effect of changing maturities in the hands of the private secor [effects revised up since in work by Swanson], and the evidence of Japan, which was singularly unencouraging.  There were other possible reasons for the failure in Japan, but at least one possibility was that QE had little or no effect.  The only thing in favour of QE was the belief that although our monetary models said that the power of money injections to generate inflation was undermined by the zero bound, there was something different about the real world which meant that monetary injections still had potency.  So, faced with many possible options at the zero boud, the MPC chose to place almost all its eggs in an extremely unpromising basket.  One can argue that empirical evidence has proven them right, but that does not rationalise the decision made initially, before this evidence existed.

9.  Other more promising alternatives were inappropriately discarded.  There were two other promising alternatives to QE at the time:  forward guidance on interest rates, and credit easing, or large scale purchases of private assets.    Both were discarded.  In the March 2009 minutes, I can’t see any discussion of forward guidance at all, though from Spencer Dale’s speech later that year, we can guess at what the consensus view might have been.  As for private sector assets, there is some discussion of this, but the decision about what to buy is described as secondary to the decision about how much to buy (something that is a corrollary of believing that it’s not the nature of the assets the central bank takes on its balance sheet that matters, but the quantity of monetary liabilities it creates, something I view as a mistake, as explained earlier).

10.  The BoE executive railroaded the external MPC members over who does what, based on the faulty logic that only the size of the balance sheet mattered.  Judging from the March 2009 minutes, and subsequent votes on asset purchases, it’s clear that the practice was settled on whereby the MPC decide on the quantum of QE, and the executive decide what to buy with the proceeds.  The MPC appear to have submitted to this when there was no unambiuous, legal reason in the Bank of England Act for them to do so.   It was also illogical, as though the quantum was all that needed to be decided in order to best hit the MPCs remit, and the asset purchases themselves were a technical detail best left to market experts.  This reasoning is unsound.  Not only because the quantity of monetary liabilities created might well have been irrelevant.  But also because purchases of private sector assets could have substantial beneficial supply side effects, boosting credit supply, supply itself, and perhaps even lowering inflation.  [The opposite perhaps of the constriction to credit that constituted the financial crisis the MPC were trying to combat].  The matter of whether one embarks on a trade-off improving policy intervention (credit easing) as against a trade-off preserving one would seem to be exactly what the MPC should be deciding on collectively, and not an implementation matter for the exeuctive of the BoE only.   I recall that this operating procedure (as well as the focus on gilts) was questioned in public by Adam Posen, but others appear to have gone along with it.   It’s a shame that HMT’s review of the MPCs remit, published in March this year, did not take the chance to codify these responsiblities properly.

Ref 1:  MPC minutes, 4,5 March 2009, paras 30/31.

Ref 2:  Quantitative easing explained

Ref 3:  ‘The UK’s quantitative easing policy:  design, operation and impact’, p201

Ref 4:  ‘The distributional effects of asset purchases’, p1.

Ref 5:  Same as Ref 3, but p204.

Matthew Hancock’s ‘duty’

Recently Conservative minister Matthew Hancock declared that UK companies had a ‘duty’ to give preferential treatment to British workers applying for jobs in competition with foreign applicants.  Here are a few reasons why it was an astonishingly ill judged thing to say.

1.  It’s ridiculously (and frankly ominously) vague.  How much preferential treatment?  Is there any difference in CVs that would merit employing a foreigner in preference to a Brit?  Should someone living 400 miles away but within the UK be treated less preferentially than someone living in the same town?  Is their duty to an applicant inversely proportional, therefore, to how far the job candidate lives from their factory?  How British is British?  Is being a citizen ok, or should an applicant be born in the UK?  Are we going to name and shame companies who don’t fulfil their ‘duties’?   Do you have to be white to qualify?  Do you have to own a house?  If the Scots vote for independence, would companies cease to have a duty to them?

2.  It’s cheap talk.  It is a way for the Conservatives to curry favour with the voters they worried they were losing to UKIP, without annoying their other mainstay – the corporate sector, who can rest assured that there is nothing the Tories can or will do to enforce it.  Because companies would be breaking the law!   Cheap talk devalues the next thing the Tories float orally, however sensible.

3.  It could start to differentiate companies’ profitability with regard to how they interpret Matthew Hancock’s intervention.  If there is any scope to bend the law in the privacy of firms’ HR departments (let’s hope not), some companies with the resources and sophistication to read this properly will realise that the Tories cannot force anyone to comply with this edict, and ignore it.  Others might interpret it as a threat, and start to do something about it.  Still others might think that an intervention like this signals some future policy change (not realising that such a change would be in contravention with the European Single Market), or reveals something about a struggle within the party over this policy,  and decide to change their procedures now.  A dispersion in returns will open up that reflects how sophisticated they are in reading the runes of senior Tory speeches.  This will have real economic costs.  In an efficient marketplace, the only dispersion in returns should be related to how good the firm is at producing what people want.4. Speeches about such corporate duties may generate genuine economic policy uncertainty (perhaps the Tories will find some way to punish those who don’t employ the right numbers of locals, perhaps not) that will be costly for firms.  Is this a code for hinting that there is a constituency in the Tory party for instituting some kind of tax on foreign employment by UK firms, and withdrawing from the single market?  Or that such a tax might be part of a renegotiation of our relationship with Europe?

5.  The notion that firms have duties to the populaces that comprise the marketplace in which they operate is fine.  But the proper way for those duties to be fulfilled is through taxation, which the government can then use to ensure that if locals are disadvantaged in an unfair way (exposed to de-skilling unemployment or poor education through bad luck, for example) resources can be directed at them.  Declaring that firms have some unspecified duty in this regard seems like desperation, a recognition that the government cannot find a way to do its duty, or cannot afford it given current tax and spending plans.  Even if it were legal, and even if we agreed with the premise (that local people should be given preference), leaving up to the conscience of shareholders would provide a lottery for workers;  those lucky enough to live close to dutiful firms would benefit, others would not.

6. What other duites are going to be announced to try to fix the problems with capitalism?  Are we going to expect climate change to be addressed by solemnly imploring drivers that they have a duty to walk?  Are we going to be expected to buy British products?   And British products made by firms that in turn buy raw materials and intermediates from other British firms?   Are we supposed to buy British shares?  Of firms that in turn don’t have foreign holdings?   Should we drop regulations currently placed on firms and replace those with duties too?  Perhaps health and safety legislation should be scrapped in replaced with equally solemn words from Mr Hancock that firms really should not let people fall off ladders.  What about replacing the laws of contract while we are at it, chaps?  Surely we can just settle our disputes over a beer?  We don’t need all this terribly complicated law stuff, do we?  Should universities discriminate in favour of British students?

7.  Are we to take it that the Conservatives recognise equal duties on firms abroad to discriminate against UK citizens who go abroad looking for work?

8.  What other laws is Mr Hancock going to encourage firms to break?  Is the subliminal message that it’s just the annoying ones emanating from Brussels?  Or is this a green light to wider disregard for anything that goes against good old Conservative notions of common sense?

Perhaps there is not much to read into this at all.  Perhaps it’s just the silly season for the political process, where No 10 relaxes control over junior ministers, safe in the knowledge that nothing anyone says or does really matters until people come back from holidays and the real work starts again in the Autumn.  Let’s hope so.

Economist ‘free exchange’ blog post on forward guidance

Here’s a link;  it goes over ground in a previous post, but more lucidly, after the expert input of The Economist‘s Britain editor Richard Davies.

The row over bank capital and Nationwide

Recently Nationwide has complained to the Treasury that its ability to lend is being threatened by the Prudential Regulatory Authority’s insistence on it raising more equity capital.  Vince Cable took the unfathomable step of coining the phrase ‘capital Taliban’ to refer to the regulators, something more out of the student union bar than minsterial office, making it clear that he was on the side of the banks.  The FT today took the side of the regulator, arguing that it needs to be left alone to get on with its job.  I think the FT is spot on here, but I think some of the arguments as to why need teasing out further.

We are in the early phases of a new regulatory regime, and Vince Cable makes a gross procedural error by complaining in public about the PRA’s efforts to force Nationwide to raise capital.  This is an error because it will encourage further lobbying, setting the implied precedent that the ultimate regulatory arbitor will be the Treasury press briefing, not the discussions on the Financial Policy Committee.  This will make it harder for the FPC to achieve what it wants to, because banks will hold out thinking that they can pressurise the FPC into a change of heart, and perhaps will make the PRA less effective in applying directives of the FPC, since it may be inclined (or, simply to get results, forced) to split the difference with the banks.

The FPC mandate is new and fragile.  The Government had ample time to frame it as it wishes, and now it should leave well alone until a decent interval has passed.  If there is discontent with how that remit is being interpreted, it’s too late, frankly, to rewrite it now, and discontent should be pursued entirely in private, but preferably not at all.  The regulators will rightly find such private pressure intolerable;  they will be held to account by Parliament through the Treasury Committee for their actions in pursuit of the FPC remit, and if they give in to private pressure they risk being seen not to do their jobs, without any verifiable evidence as to why they chose a different course.

Government interference of this sort creates regulatory uncertainty, since it will undoubtedly raise in financial participants’ minds the possibility that the FPC remit will be changed, or that there will be private pressure to force the FPC to interpret the remit differently, and this, just as with all kinds of uncertainty, is bad.   Observers will wonder whether the FPC remit should be gleaned from the remit, or from what Vince Cable has said lately.  [Recalling how the MPC remit review was spun, with the text saying ‘no change’ and the interviews saying ‘go for growth’].

The interference with the operational independence of the FPC is damaging.  The parallel with monetary policy is close.  Political interference [eg compelling the MPC to evaluate forward guidance, a tool for monetary loosening, not much removed from compelling them to evaluate looser policy itself] raises in observers minds the possibility that the monetary policy that results will in part be a function of what the government wants from day to day.  The BoE’s MPC was made independent of the government precisely to avoid this, because what the government wants from day to day (usually looser policy) was not in the long run interests of the populace, since this would leave us with high inflation (and no lower unemployment).  So interference defeats the point of the regime in the first place.  So with the FPC.  The fact that the FPC exists is (in part) testament to the view that the government thinks itself incapable, day to day, of correctly balancing the short and long term costs and benefits of tight financial policy.  As many have opined before me, tight financial policy brings long term benefits, fewer crises down the road, lower tax burdens from bailouts, but those benefits are felt mostly by someone else (some future government).  Loose financial policy brings benefits now (powerful friends who might offer you a non-exec when you get kicked out of the Treasury, higher tax revenues, etc) but costs down the road (which some other poor government, kicked out in electoral retaliation, has to pay).

The Government collaborated in a laudible, and relatively open effort to make a technical judgement about the right balance to strike here, in drawing up the FPC remit.  One can argue about whether the right balance was struck, or enough clarity was achieved.  But to interfere in this way Vince Cable puts at risk the gains hoped for in drawing up the legislation in the first place – that financial policy would be governed by long-termism, not what would run well in the newspapers on the day.  That’s why the FT is right to argue that they should let the FPC get on with doing what they were told.

Response to Simon Wren Lewis: the output gap and inflation, necessity for a fiscal stimulus, and all that

Simon was very kind to dignify my blog post on why there should be no more fiscal stimulus with a response.   I don’t have much to add:  Simon inhabits (is in fact a far more senior participant in) the same empirical/New Keynesian macro world that I do, and probably knows what I think better than I know myself.  However:

I accept that the low level of output, relative to its level pre-crisis trend, and relative to either a straight or bendy line drawn through a long time series of output, is neither normal nor desirable.  I also accept that high unemployment is neither normal nor desirable.  My position is that seen through the lense of almost all coherent accounts of the macroeconomy that we have currently, high and constant inflation is another way of inferring that the undesirably abnormally low output and high unemployment is not something that monetary or fiscal policy can do anything to alter permanently.   Once again, looking at the issue through these same models, both instruments could be used to boost output temporarily, at the cost of a temporary surge in inflation.  But no permanent improvement in the real economy could be bought without ever increasing inflation, which, ultimately would impoverish all of us, and hit those least indexed (protected from inflation) first, which usually means the poorest.

I don’t mean to imply that just because conventional monetary or fiscal policy stimulus shouldn’t be used to try to lower unemployment and increase output, there is no role for public policy to improve things.

I think it entirely plausible that there are other reasons beside deficient demand for high unemployment and low output.  The macro-models of financial frictions that we have explain how starving the productive sector of access to funds will reduce the demand for factors (eg labour), and inhibit the reallocation of funds across different sectors in the economy.  The recent literature on ‘misallocation’ is set in the stark world of real business cycle models, which I think are question-begging, but they demonstrate that there can be very chunky changes in the aggregate economy’s capacity to produce coming from changes in how well funds are allocated across sectors, (eg in the 5-10% range).  I don’t claim that this is the whole story, but it convinces me that this is a plausible account of high unemployment coexisting with high inflation.  And if this is part of the story, then the role for public policy to improve output and lower unemployment lies in unlocking the flow of finance to firms who can’t get enough of it.  This could in fact involve more government borrowing (eg if it entailed funding some new body to lend to SME’s, or recapitalising further existing Banks).  (A little confusing, that, since up to this point I have been arguing against further government borrowing.)

I don’t accept the argument that the usefulness of the inflation rate as a window into the output gap is any diferent at high or low inflation.  This is not a statement you can make in the context of empirical models only.  At least if you define the output gap to be the difference between actual output and the imaginary level that monetary or fiscal policy should seek to bring about.  It’s interesting to observe that the correlation between a change in inflation, and the difference between actual output and alternative trend lines, is itself dependent on the level of inflation.  However, in the absence of a sound theory to explain them, in particular to connect those gaps between actual and trend to quantities that monetary or fiscal policy could or should do anything about, I don’t think they are suggestive of whether there should or should not be more fiscal stimulus.   The variability of this correlation also does not invalidate many of the kind of models I’m talking from:  in fact, my hunch is it only invalidates the simplest New Keynesian model with one shock, in which there is no structural change.  That’s not to say that data-based, what we could call atheoretical, empirical research isn’t valuable.  (Most of what I have done falls into this category!).  On the contrary, it’s essential.  However, it’s hard to draw policy conclusions from it alone; or, at least, if one does, you run the risk of falling foul of the Lucas Critique.  [of finding that the correlation you exploit doesn’t survive the attempt to exploit it].

The use of ‘sound’ and ‘coherent’ is a shorthand really for  models that the successors to Kydland, Prescott and Lucas would approve of, at least in the sense that the models display an attempt to grapple with the issue of what people and firms are trying to do in the model and how they do it.  (All three would disapprove of the sticky price sticky wage world of modern monetary policy models, and the many other reasons those models give for why business cylces are not efficient, but they would at least recognise the recipe used to build them).   For examples of the kind of models I do think are capable of speaking to fiscal policy, well, see Simon’s webpage, and his previous research on fiscal policy with, eg, Campbell Leith!

The comments I make about the undesirability of more fiscal stimulus do not hinge on assuming that there is linearity in the world.  For example, constant inflation would indicate a zero output gap [once again, not necessarily desirable or high output] in the original nonlinear sticky price model.

All of my comments hinge on believing that the mainstream macro models are what we should be using to answer the big macro questions of our day. I don’t believe that these models are correct or should be taken literally.  The crisis is warning enough that many of them are missing lots of things whose ignorance hampered macro and financial policy.  The appropriate way to answer these questions is not to put your faith in any one model either, but, if you were to do it mechanically, lay out all the models you might believe in, put probability weights on them, and analogously probability-weight the corresponding policy implications.  Its certain that all of the models you will have at your disposal are wrong.  And so the precise truth about what fiscal policy should be won’t ever be known. But it’s not at all obvious to me that the as yet unknown right model, articulating all the exotic nonlinearities we often sweep away, would tell you that demand is deficient and more fiscal stimulus is needed.  Even if such a model did, one would have to contemplate the equally plausible exotic possibility that we are on the knife edge of causing an unstoppable inflationary spiral, as observers conclude the consensus for low inflation is evapourating.   I don’t personally believe this is a material risk, but equally, looking at the evidence, I don’t think it’s any more outlandish than discarding the diagnosis that no more stimulus is needed encoded in the high and stable inflation rate.

Finally, if its not apparent already, I accept that reasonable people can disagree on this, and Simon’s challenge to me (and to the macro literature which I am speaking from) is very fair, and, given the evaporation of the ‘great moderation/stability’ recently, far from answered in this post.

Deft footwork by the hawks, and the subtleties of forward guidance when the causes of yield movements are unknown

Following the publication of the minutes of the MPC meeting on 3rd/4th July, I think a tweak is necessary to my reading of the press statement accompanying the decision. The minutes suggest the possibility that the tightening in the short end of the yield curve did not accurately reflect market expectations (eg were unrelated to movements in surveys of economists’ interest rate expectations).  If indeed that tightening was caused by an increase in some other premia, the previous path for interest rates preferred by MPC would no longer be adequate, since the rise in yields caused by the change in premia would be expected to feed through into the rates paid by borrowers, and depress spending and therefore inflation.  Hence, it would be necessary for the central bank rate to remain lower for longer.  Not lower for longer than would historically have been guessed by markets given what they understand about central bank concerns, (therefore not strictly warranting a Fed or BoC style forward guidance commitment) but lower for longer than would have been the case had there not been a rise in this unnamed premia.

Because of the difficulty of getting an accurate read on interest rate expectations, the task of deciding on and then communicating about future interest rates is especially delicate.  If interest rate expectations in markets are misalligned because of some difference in view about the conjuncture or what the MPC is trying to achieve, it’s possible that allignment will be achieved by talking clearly about future rates.  Though it’s possible that it won’t, and, in that eventuality, lower rates than otherwise would be warranted, a scenario that MPC could communicate about.  If there is no misallignment, but simply a change in the premia driving a wedge between prices and expectations, then lower rates will be warranted, and presumably expected.  But there is also a hybrid possibility of course; there may be a difference in view about this premia between MPC and markets.  The reality is that MPC presumably have to weigh up all three possibilities, and explain that that is what they are doing! [and what they would do if they were misconstrued, etc etc]