Why there should be no more fiscal stimulus

In the last year, the protracted weak activity data in the Eurozone, and in the UK, has emboldened those who thought that ‘austerity’ policies were misguided, and that think that a renewed fiscal expansion will help solve the problem.  I think more fiscal stimulus would be a mistake, and explain why below.

We have had high and broadly stable inflation for several years.  Seen through the lens of most mainstream theories of how inflation and monetary policy works, this is not a bad way to infer that there is actually no gap between level of activity we see, and the level that monetary and fiscal policy should seek to bring about.  More demand side fiscal stimulus would push up activity, but only temporarily, and at the cost of a further surge in inflation.  For the boost in activity to be sustained for long periods we would need ever more inflation from either more fiscal stimulus or looser monetary policy.  Policies like this were tried in the 70s, before it was properly understood that higher inflation didn’t buy lower unemployment forever.

You might reasonably ask why output and activity is so low, and unemployment so high, and isn’t there anything the authorities should try to do about that?  There may be all kinds of reasons for this, and many of those would lead to courses of action for the public authorities, but the possibility that it’s the fault of too-weak demand engendered by monetary or fiscal policy is ruled out by our stable inflation rate.  There are those who think that a jolt of increased demand will somehow allow the economy to settle at a higher steady state level of activity, with no extra inflation.  This seems to be the implication of the use of terms like ‘escape velocity’ (by Mark Carney and others).  But I think that this is misguided.

There are theories that allow for such escapes,  that allow for multiple possible resting places for the economy, each consistent with a particular set of beliefs, and where the government can potentially select between them.  However, these theories seem very special to me.  Many of them rest on thinking that the world is characterised by rational expectations for a start, which I think is too extreme.  And some of them would involve throwing out all that we thought we knew about how monetary policy worked in normal times too.  I also remain sceptical that public policy could be used to select between these economic resting places with any precision.  You might retort that throwing away all we knew about how monetary policy and inflation works might be just what we should do:  doesn’t the crisis tell us that?  Perhaps, but it would necessarily follow from this nihilism that more fiscal stimulus is needed.

If demand side fiscal stimulus is not warranted, what about a splurge on supply side public projects, like infrastructure?   These may be a good idea, provided the social returns exceed the costs.  But the case is no more pressing now than before.  For a while at least, their demand side effects (because of the associated spending) will of course exceed the supply side effects (because the project will take time to complete) so such a policy would push up on inflation too, assuming the MPC left monetary policy untouched, and so leave the MPC with the job of figuring out how to trade off the two effects of the infrastructure spending.  In fact, not only is the case not more pressing, it’s arguably less pressing.  For a start, I would hope that small group responsible for forming policy at the top of the government and central bank focus on the financial sector, and not on trying to pull off general supply side miracles.  Second, I think that we need to preserve some capacity to borrow.

To explain:  substantial fiscal room needs to be left to allow for another, large-scale injection into the banking sector.  This might follow a Eurozone break-up, or might be needed anyway.

It’s possible, though not likely, in my view, that the Eurozone may yet break up.   Political instability in Spain and Italy could yet mean that the promise of the ECB to engage in OMT’s to buy troubled sovereign bonds is not credible any longer.  And it’s possible that in this event, there would not be sufficient political support for overt direct fiscal transfers large enough to stop the break-up.  Such a break up would very likely take down our entire banking system, given the direct and indirect exposures to Spanish and Italian sovereign bonds.      If this happens, not only would there be the direct cost of recapitalising banks, but the automatic stabilisers would also be turned on even further, and perhaps also the cost of nominal debt finance would rise too as worries crept in about the government having to fund this with higher inflation down the road.  An outcome like this is not likely, but the possibility is not far-fetched either.  Perhaps there is something like a 2-5% chance?

Even without a Euro break-up, it’s conceivable that the authorities will be forced to conclude that the existing large banks are not going to be able to recapitalise themselves to the point where they can lend normally, and that government assistance is needed.

So the government needs to maintain room for manoeuvre for a very rainy fiscal day.

Of course, a further fiscal stimulus would amount to a disastrous change of course for the Coalition Government, and so it would not happen, probably, without an election.  That itself I don’t think an adequate reason for not doing it.  In general, I do believe that discretionary fiscal policy can and should be used to stabilise real activity, perhaps especially at the zero bound to interest rates.  [I even surmise that the Coalition has been doing it, tweaking the debt target, and feel that its silly and dishonest protestations to the contrary missed a chance to put such policies on a proper footing].  I just don’t think that current circumstances merit looser fiscal policy.

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A look back at the March HMT Review of the MPC remit

This post takes a look back at the Treasury’s review of the Monetary Policy Committee’s Remit, published in March.  This might seem like old news.  But it is soon to be highly topical, as one of the outcomes of the Review was to instruct the MPC to publish an evaluation of the practice of forward guidance in its August Inflation Report.   This wasn’t the only interesting thing about it though, as I will try to argue.

The Remit is dead;  long live the Remit

One of the triumphs of (at least the text of ) the Review was that it resisted any major change in the Remit.  UK monetary history is a sorry tale of successive broken promises and macroeconomic instability.  The financial crisis was the first serious test of the current framework, and there is something to be said for stability for stability’s sake.  There were many (in my view erroneous) calls for changes to the Remit – for example to instruct the MPC to follow a nominal GDP target – and these were resisted.

Why that clause in brackets emphasising textual stability?  A key aspect of the Remit is the extent to which the MPC are allowed to trade-off stabilising inflation and real activity.  There was some ambiguity in the old remit, since it appeared to give primacy to the inflation objective (the ‘subject to’ clause).   As the crisis hit, a shock that drove output down and inflation up, some accused the MPC of an excessive focus on inflation, and some accused it of setting aside the inflation target.  In the Review, the Treasury emphasised that the MPC should be weighing up these sometimes competing goals, and, moreover, that the MPC had correctly interpreted its Remit in the past.  (In the course of doing this, they wrote a remarkably lucid survey of the state of knowledge about what monetary policy should do that should be compulsory reading for undergraduate monetary economists).

However, in accompanying interviews and briefings, a different message was allowed to emerge, one more politically expedient:   that the Treasury had changed the Remit to give the MPC more scope to stimulate the economy and go for growth.  Putting out interviews that were not consistent with the text of the Review was taking a big risk with the monetary framework.  The message seemed to be ‘if you want to know what the MPC’s Remit is, listen to what we say, not what we write’.   The risk was that this would inject uncertainty into guesses about what MPC’s goals would be, because of the different Treasury interpretations of their own Remit, and because of the possibility that there would be future oral Reviews along the way.   From the outside, it looked as though the Treasury were trying to reassure markets and economic commentators with their conservative (small c) text, but at the same time to say what the voting public at large wanted to hear by emphasising the going for growth message, at a time when there was none, a fact that one guesses they wanted to lay at the door of monetary policy.

Instrument but not goal independence

A second triumph was that the Bank’s views were not solicited.  This helped emphasise that though the Bank retains instrument independence, the Government, as the elected body, reserves the right to choose the Bank’s goals.  This is also timely, coming as the Bank re-assumes other financial stability responsibilities.  Any suggestion that the Bank was also being included in the process of deciding on the goals of monetary policy could lead to a future backlash, some political constituency for clipping the Bank’s wings, perhaps to the point of undermining the operational independence of monetary policy too.

For this reason, I thought it was unfortunate that Mark Carney was questioned about his views on the Remit at Treasury Committee, (and that he chose to answer).  Likewise, it was unfortunate once the Review was published, that the Treasury revealed that the previous and current Governors ‘approved’.

Forward guidance:  trespassing on the MPC’s operational independence

The Review took the unusual step of instructing the MPC to evaluate the practice of offering forward guidance on interest rates, a step I think was very unwise.  One of the strengths of the monetary framework was that though the Treasury reserved the right to decide on the MPC’s goals, it allowed the MPC to decide how to achieve them.  The Review trespassed on the MPC’s operational independence.  There is text in the Review emphasising that it is for the MPC to decide whether or not to undertake forward guidance, but most readers will surely see that as being simply for show.  The real intention, one is likely to guess, is to raise the cost of not doing forward guidance considerably.  The Review was published in the context of appointing a Governor who had undertaken forward guidance in Canada, and had also made it clear he was in favour of the same happening in the UK,  and at a time when others were presumed to be against it.  The impression conveyed was of the Treasury using the occasion of the Remit Review to do everything it could to get further monetary stimulus.

Coordination failures:  having sorted MPC vs FPC, what about fiscal policy?

The Review devotes time to instructing that the MPC and the Bank’s new Financial Policy Committee must seek to ensure that their actions are well coordinated.  This is very welcome;  clearly, and especially at a time when the financial system remains in poor health, monetary policy decisions affect financial stability, and decisions made by the FPC on macro-prudential policy will affect lending and therefore growth and inflation.    However, the elegant reassurance offered on this topic is rather hollow when there is no discussion of the other coordination problem in macroeconomic policy:  the coordination of monetary and fiscal policy.

A kind of fiction underpins the status quo on monetary and fiscal policy.  The fiction is that beyond a once and for all setting of the automatic stabilisers, the government stays out of stabilisation policy, sets fiscal policy to meet supply side and distributional goals only, and stabilisation is instead left to the MPC, who therefore have no active strategic player to coordinate with.  A better description of reality would be:  a succession of Governments only ever stated its fiscal rules vaguely, changed them periodically, and abused them in the interim.  Discretionary fiscal policy was used to macro ends.  Through some combination of bad luck and this bad behaviour, finances were in dire straits when the Coalition took over.  The Coalition felt it had to refresh a promise not to engage in discretionary fiscal stimulus regardless of what happened in the macro economy.  This promise was unfortunate and not credible anyway.  Unfortunate because precisely at the time when discretionary fiscal policy would have been most useful (at the zero bound) it was ruled out.  Not credible because there were surely some circumstances that would force a change in course (as indeed we found out).  We just did not know how extreme those circumstances would be at the outset, and the deliberately opaque and obviously false assertion that there was to be no turning no matter what simply served to increase the risk that behind the scenes more mischief was being made, defeating the worthy purpose of establishing fiscal credibility.

In an ideal world, the Government would recognise that the automatic stabilisers are there in part to help with macro stabilisation – i.e. to help achieve the same Remit the MPC are striving for.  And it would recognise that from time to time further discretionary fiscal stabilisation is appropriate – for example at the zero bound to interest rates – and is on occasion applied to these ends.  Of course, no such framework could be offered now by this Government as signing up to it would look like admitting that the opposition were right.

I say all this myself not believing that any further fiscal stimulus would be appropriate.  But that’s not the point.  First, many do wish for more fiscal stimulus.  A proper framework within which such policies could be scrutinised and evaluated would help that debate.  Second, the Government itself has changed a vague and incredible plan in ways that look like discretionary fiscal stimulus, and it would be better (I mean would reduce the risk of markets taking fright at fiscal developments) if the use of fiscal policy for MPC Remit purposes were more clearly encoded.  The Remit Review was a missed opportunity in that regard.  These are points Simon Wren Lewis has made for many years, in different ways, by arguing for fiscal councils.

Forward guidance on forward guidance?

There are two ways to read today’s statement by the Bank of England’s Monetary Policy Committee, accompanying its decision to do no more QE, and leave rates at their agreed floor.

One is that it is advance warning (forward guidance) of forward guidance, to be entered into after the August policy meeting.

However, a different way to read it is as follows.  Forward guidance Bank of Canada/Fed style, is, roughly, communication to markets that understood correctly how you behaved previously, (and had formed forecasts of the trajectory of rates away from their floor in the future based on that understanding), stating the intention to leave rates on hold for longer, relative to that previous (and previously understood) behaviour.

MPC could be read as saying something different.  (Hold your breath):  ‘Even absent any future intention to enter into forward guidance (defined above), markets interpretation of the recent inflow of news and how that would translate into interest rate decisions has been different from ours.  We saw that news as corresponding to what we would have expected when we last agreed an inflation forecast in May.  At that time the forecast under market interest rates delivered profiles for our goal variables that we were broadly content with.  Markets expectations of what we were going to do therefore could be taken as roughly matching what we ourselves thought we were going to do.  Our forecasts of what we were going to do have not changed much, (because the activity news has been in line with what we predicted), yet markets’ forecasts of what we are going to do have.  They are entitled to their view of course, but provided you believe what we say, you should take our forecast as more accurate.’  This view says nothing about whether forward guidance of the lower for longer variety is needed.  And it would be something that those who were not in favour of more monetary stimulus could have agreed to, because it amounts only to saying that the MPC as a whole, though not happy with a further stimulus, didn’t want a tightening either.

Why forward guidance could be a step backward

Mark Carney’s arrival as Governor, and his well publicised support for the policy of ‘forward guidance’, has had markets guessing whether he will be able to sway other Monetary Policy Committee (MPC) members to pursue this in the UK.

‘Forward guidance’ is the term that has come to be used to describe the practice of central banks explaining what will happen to interest rates in the future, in particular when interest rates have hit their natural floor of zero.  (The MPC previously decided that the practical floor for rates in the UK would be 0.5%, but I will leave this issue for some future post.)  Unable to cut today’s interest rates because of this floor, forward guidance seeks to lower tomorrow’s interest rate, by inducing the expectation that rates will stay at that floor for longer than might previously have been guessed given how the central bank responded to inflation and real activity in the past.  The idea is that by lowering forecasts of future interest rates this will reduce the rates paid on fixed interest longer-term loans, and will give those thinking of taking out a loan on variable rates more confidence that rates won’t rise shortly, encouraging more spending.  Judging from their actions, the majority of the MPC are not in favour of this policy:  if they were, they would obviously have implemented it already.  None have deviated from the practice of their former Chair, Mervyn King, who would insist that they face ‘one ball at a time’, using a cricket analogy (which for the uninitiated, translates as not talking, even, for some, not thinking, about future rates).

I am not in favour either, with one qualification that I’ll come back to at the end.  I think there are several problems with the policy.

First, it seems to me dubious that any more monetary stimulus is needed.  We have had above target and broadly stable inflation for six years or so.  A crude way of reading this is that there is no gap between actual output/employment and the level that monetary policy (or fiscal policy for that matter) should be seeking to do anything about.  There is clearly a big gap between activity and the level that would have prevailed had the economy continued to grow on its pre-crisis trend.  But that gap is plausibly a consequence of the supply side of the economy having been strangled by the dysfunctional financial sector.  If this view is right – I don’t pretend there could be any certainty that it is – then the consequence of more monetary stimulus would be a short-term surge in activity and inflation, but one that would, if it were to be sustained, have to be followed by another stimulus, and another further increase in inflation (and so on).  Ultimately, following this course will not lead to activity being any higher, and will probably damage the real economy as the costs of high and uncertain inflation bite.  Whether more stimulus is needed is a difficult topic, which I haven’t really done justice to.  However, even leaving aside this problem, there are others.

Two objections centre around the view by proponents of forward guidance of how expectations are formed in the private sector.  The assumption is that expectations are rational;  agents understand how the economy works, what motivates policymakers and how they view the world.   For the moment let’s leave aside whether this is realistic and assume that expectations are rational.  The operating assumption of forward guidance is that if the central bank announces that rates will be lower for longer (than one might have guessed from what the MPC did in the past) then this will be believed.  The problem is that the policy is not, in the jargon, credible, or time consistent.  That is, when the time comes for rates to be lower for longer, it won’t be in the interests of the central bank to follow through any more.  At that point, the recovery will be secure, inflation will be rising, and, concerned to achieve their mandate of stabilising inflation and the real economy, the preferred policy (ignoring past promises) will be to raise rates as quickly as one would have expected given previous behaviour.  (Because that previous behaviour was guided by the same concern to hit the same inflation target as today).  To combat this, the Fed, for example, accompanied its latest brand of forward guidance with announced thresholds for unemployment and inflation that would have to be met before rates rose.  This might make the policy credible, or it might not.  If the economy picks up sufficiently quickly, there is always the chance that the MPC will be sufficiently worried about stoking up another boom (so soon after the last one) that the thresholds will be altered or put to one side.  Especially since those thresholds will have been set in the context of a lot of uncertainty about their key ingredients – the natural rate of unemployment, and the risks of de-anchoring inflation expectations.

Forward guidance of the Fed variety, holding interest rates lower for longer, guided by thresholds, is the practical analogue of Michael Woodford’s analysis of the consequences of following through on a commitment to set policy optimally, made in normal times,  when the shock that interest rates are responding to is large enough to take rates to the zero bound.  However, there is an important difference between the original academic proposal and the practical.  Lower for longer as was practiced by the Fed and the Bank of Canada was introduced when convenient (when they had run out of room to do what they normally do and simply cut today’s interest rate).   One interpretation of past policy is that it ignored Woodford’s prescriptions about how to set interest rates, right until the moment when there was no other option.  Given that record, many might guess that just as a leopard can’t change its spots, the central bank won’t be able to resist doing what’s convenient for it in the future either, namely, raising rates promptly when inflation and real activity start to pick up.

The circumstances surrounding Carney’s appointment can be read in ways that are not that favourable to this problem either.  One reading is that the Government, suffering in the polls, wanted more monetary stimulus to boost growth, saw forward guidance as a way to get it, and appointing Carney, whose support for forward guidance was well-known, as a way to implement it.  This may be stretching things a great deal, but that is beside the point.  The possibility that this was behind him getting the job adds to the circumstantial evidence that monetary policy is being guided by short-term convenience, and will continue to be in the future when the time comes to decide whether or not to respect the promises made at the time of the announcement of forward guidance.  And one can add to this the accusation that the Bank of Canada itself reneged on its own forward-guidance, firmly rebutted, of course, by Carney himself.

It might be argued that there is no harm in trying forward-guidance (provided you think more monetary stimulus is needed).  But the cost of it not working could well be the erosion of credibility more generally, surrounding the operation of other instruments, perhaps even those controlled by the Financial Policy Committee (FPC).

So far we have gone with the assumption that expectations are rational, and questioned, if they are, whether promises made by the MPC will be believed.  An entirely different objection is simply that expectations are not rational.  Clearly there are some market participants, and others whose job it is to forecast the behaviour of the central bank, who do take a forward-looking and close look at what the MPC does, and will do.  However, even they don’t understand how the economy works precisely, just as the MPC surely do not.  We don’t know how forward guidance would work under these circumstances.  And there are vast numbers of other agents whose lives may be better served by forming a more simplified view of things, perhaps just projecting forwards what they see in their own industry or town into the future.  For these agents, promises about future rates would be irrelevant.

Another concern focuses on a different aspect of the models used to inform forward guidance:  the way prices and wages are assumed to be sticky.  This is a long and controversial subject itself, and is going to seem esoteric and technical to some.  In brief:  the analysis behind forward guidance is based on a model that assumes that there is a fixed probability that firms will get to change prices each period.  (Some assume that in addition prices are indexed in between times when they are reset optimally).  Including this in a model helps it fit the data, gives the central bank a job, (without sticky prices there would be no role for active stabilisation policy and defines the job it should do (the relative weight that the policy-maker should place on inflation and real activity is related to this degree of assumed price stickiness).  However, this assumption is made for mathematical convenience.    There are two reasons to be extremely sceptical that this model could provide useful quantitative guidelines about the effects of forward guidance.  One is that the economy may be far from its natural resting point.  And so the assumption of this fixed probability of price-resetting may be a long way off, even if it does a good job when the economy is bobbing long close to its resting point.  The second, is that we are contemplating a marked shift in the way policy is conducted . Robert Lucas’ 1976 ‘critique’ was that features of economic models designed simply to fit the data, would likely break down if policy were to change significantly.  This is surely one of those features.

Forward-guidance as conceived by Woodford was something to be embarked on as a large shock hit, and in part, as a preventative measure, to reduce the time spent at the zero bound.  The situation we face now is rather different.  We are more than four years into a zero bound episode, and with future interest rates already very low (though rising somewhat in the last few weeks) and looking for a cure.  With less room to lower future rates, it might take a commitment to a very long period of flat rates to make any appreciable difference to real activity and inflation (again, supposing that this is what is wanted, which I question).  This raises two problems.  First, current MPC members can’t bind their successors in the way that such a commitment would imply.  This aggravates the credibility problem sketched earlier.  Second, the MPC may be in the dark when trying to figure out how much guidance they should do.  The sticky-price models that are used to inform monetary policy behave very strangely when rates are held fixed for long periods, [something we know from Carlstrom, Fuerst and Paustian (2012), for example].  This strangeness adds to the suspicion that the model is not a good tool to study policy in such unusual times, or to study such large shifts in policy behaviour (the Lucas Critique again).

All this said, forward-guidance, if implemented, or even if simply debated, may leave a good legacy.  If it were to lead to monetary policy being discussed as a plan for interest rates, (i.e. not just facing one ball at a time), this would be a good thing.  The economy is a sluggish dynamic system, and controlling it involves conceiving of a plan for the instrument-settings.  Once the MPC published such a plan in pursuit of forward-guidance, it would be hard to stop doing it in more normal times.  This would forever discipline future MPC members to think of their policy problem in terms of a plan (it’s clear from their writings that not all policymakers understood what they did in these terms), and force them to disclose it, which help others hold them to account, and, in my view, lead to a beneficial reduction in uncertainty about monetary policy.