Monetary-fiscal coordination

People may differ on the effectiveness and desirability of unconventional monetary policy. But most of those in the sensible camp would agree that if we were about to head into recession, the most important aspect of the policy response is not what the Bank of England will do but how the Treasury will respond. To that end now is one of those times when it would have been much better to have had monetary and fiscal policy coordination hard-wired into the framework. My preferred system for doing this would be one in which the Bank of England’s monetary policy committee decides, after considering the limits to both conventional and unconventional monetary policies, how much stimulus it thinks it is missing. It then communicates this in some commonly understood units (perhaps equivalent changes in VAT) and then it is over to the Treasury to consider both whether it agrees with the missing stimulus analysis and, if so, how it intends to respond. The office for budget responsibility then has a role in checking whether the Treasury’s response is consistent with the long-term fiscal framework. The closest approximation to this  that we have seen was the counter to the Osborne fiscal Charter, owned by John McDonnell, and presumably written by Simon Wren Lewis. The situation we find ourselves in now is one in which the Chancellor talks of ‘resetting’ fiscal policy, which no one really understands, and where central bank governor claims to have all the tools necessary to hit the inflation target, which we know cannot always be true but which is an understandable attempt at instilling confidence.

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QE for the sceptical Monetary Policy Committee people

On the assumption that the Monetary Policy Committee loosen at their August meeting, the question arises as to what unconventional policy might be undertaken. There is a clear indication in the July minutes that this is under consideration. I have been asked many times in the last two weeks what they will do and find myself at a loss to guess. There are two difficulties in trying to figure it out.

First, by revealed preference, Carney and others have been sceptical about the worth of purchasing government securities. A few reasons for saying this: to begin with I’m sure that Carney himself went on record while he was at the bank of Canada on the subject, though my RSI prevents me from doing a thorough check now. If anyone knows for sure, please let me know. Another reason: during the time between Carney was appointed as governor in 2013 and when he actually took up post, the bank was reviewing the usefulness of forward guidance as a means to impart further stimulus  which there was a fair case for that time. Carney was clearly very much in favour. And that was no talk then of simply extending asset purchases and not bothering with what might have been viewed as a risky communications innovation. Of course by the time late summer 2013 came, the economy had moved on somewhat and the case for further stimulus evaporated. So although forward guidance was undertaken Carney was left with the awkward task as presenting it not as a means of further stimulus but as a means of providing clarity about future interest rates. A final piece of evidence: one can view the last two years as a sequence of disappointments as inflation continued to stay stubbornly below target refusing to return back to it as previously projected. The committee under Carney was content to respond to these disappointments by signalling either explicitly or implicitly – and not always terribly well – that the time at which interest rates would begin to rise had been postponed. An alternative, course, would have been to undertake more asset purchases. The fact that this alternative was set aside indicates that such purchases were maybe viewed as undesirable or ineffective.

The Committee may think instead about purchasing private sector assets. But getting into a position where the bank can execute these on any significant scale requires many operational steps, several of which will be hard or impossible to undertake in secret. For example, to do this in an orderly way, and in a way which minimised financial risk to the bank, or reputational risk, would require announcing in advance what kinds of assets will be purchased, consulting on the design of platforms on which this will be done, and the design of reverse auctions, and perhaps even hiring significant credit risk capacity (which the Bank of England does not currently have) all contracting this out somehow.

So my best guess would be that if the bank is thinking seriously about this it is only as a contingency, and they would not currently be anywhere near ready to do it. The post Brexit evolution of the macroeconomy does not look good. [Viz this morning’s PMI release].  That said, some of the really scary scenarios involving a meltdown in financial markets, do not yet look like materialising. But that said, given how seriously the bank clearly took such possibilities before the vote, it’s curious  – if indeed I am right about inferring this lack of readiness from a lack of outward signs– that more was not done in advance by way of practical preparation for the purchase of private sector assets on behalf of the monetary policy committee.

So, if you are one of those who has not yet asked me what the Monetary Policy Committee will do in August, you can see from the above as it is probably not worth asking me.

The Bank of England expects it will want to loosen, but didn’t

Yesterday the Bank of England’s monetary policy committee decided not to cut interest rates, despite most forecasting that it would. There was an innovation in monetary policy communication however. Although it would not cut rates today, the minutes revealed that most MPC members expected to vote for more stimulus at their August meeting.   This was  a very clear departure from the old practice, under the previous governor, of, as Mervyn King used to put it ” playing one ball at a time”.   This part of the decision is welcome. Many both inside and outside the Bank of England have been explaining the benefits of this kind of forward communication. Monetary policy works not just via current rates but via expectations of future rates. If a committee has a sense of what it intends to do in the future, it should communicate that as clearly as it can to those who are affected by its decisions.   Policymakers that I spoke to usually objected to this logic  on the grounds that it was too difficult for committee to vote formally on an interest rate path,  and that was a danger of a forecast being taken as a promise, and therefore of the committee suffering reputational damage when it did not keep the apparent promise.  To some extent these difficulties seem to have been swept aside by this little detail of the July 2016 minutes.

However, the July decision by the majority (one dissented) begs the question: if the committee thought it would  loosen at its next meeting, why not loosen now?   The reasoning seems to have been the following: although the committee recognised that monetary policy was too tight, it did not know exactly how much loosening was needed, and it would not know with enough precision until the staff had gone through the process of compiling the August inflation report forecast. There was therefore a possibility that the committee might loosen now, and then have to loosen by more in August, or even undo some of the loosening. The majority must have judged that the risk of looking incompetent by tinkering with the instruments each month in this way outweighed the benefits  of moving promptly.

The dissenter, Jan Vlieghe, took what I interpret to be a more nuanced view.   The logic may have been something like this. It was clear that interest rates would have to be cut down to a new lower floor, and more easing would need to be imparted by asset purchases. It was highly unlikely that a 25 basis point cut to rates would need to be reversed. Even if this were so, it is pretty costless to reverse interest rate changes. Zigzagging asset purchases could be much more costly and make a mess of debt management. So cut rates now, and wait until there is more certainty about how much extra stimulus needs to be imparted through asset purchases.

Why the others could not go along with this is not clear. Perhaps the others don’t agree that  the new floor is 25 basis points.  If the new floor was judged to be zero, then cutting that far in advance of an inflation forecast would raise the chance of having to reverse course later.Or perhaps they think that the shock and awe effect would be diminished by imparting stimulus with one tool in one month, and another tool in another month.

Today, text of a 30th of June speech by Andrew Haldane was released, in which he calls for a “prompt” and “muscular” loosening. For my money, the loosening won’t be as prompt as it could have been. Although I can see the logic of waiting, I’m sceptical that much will be got by way of precision about exactly how much loosening will be needed from doing another inflation forecast. And it remains to be seen whether, however much unconventional monetary policy is undertaken, this is effective enough to amount to something that could be described as ‘muscular’.

Post referendum contingencies and leavers’ outrage

A theme in the aftermath of the referendum has been prominent Leavers’ outrage at the apparent lack of contingency planning for a vote to Leave on 23rd June.

But I struggle to think what could have been done that would make any difference.  It would have been ideal to have in place a strongly counter-cyclical fiscal policy response.  But that is not realistic, since the vote to Leave inevitably meant the disappearance of the government, and any authority that there might have been to launch such a response.  It would also have been better to have had a firm idea what ‘Leave’ meant;  a target set of proposals to take to the EU in some form.  But this was not possible.  Leave could not agree what they wanted, placing themselves at distinct points on the trade-off that involves sacrificing free trade for free movement, or denying the existence of the trade-off altogether.  So what would civil servants do, embarking on some hypothetical contingent actions?  Chat about alternative trade models, thumb the indexes to trade rule books.  Not much more.  The only real planning to be done, in the absence of a government, was at the other end of town in the Bank of England, in which regard Leavers can have no complaints.

The post-vote chaos and economic uncertainty is partly unavoidable, and partly the fault of the discord amongst Leavers themselves.

Post Brexit hangover and monetary policy

The MPC have now started deliberating about their next decision on interest rates and asset purchases.

The outlook for the UK economy post Brexit  is not great, but not yet as bad as it could have been.

We already have evidence of some fall in consumer and business confidence after the referendum result.   And there is an  anecdotal evidence of cancelled investment projects and an interregnum the housing market.  The sharp fall in the pound and the fall in the stock indices  like the FSTE250  and others that include more domestically oriented firms  gives  us the markets’ negative and predictable judgement about the situation.

The fall in the pound/stocks comprises several things.  The expectation of looser monetary policy for longer;  the distaste for the extra uncertainty in the UK at the moment;  and the expectation of lower income per head in the medium to longer term.

Although looser monetary policy for longer doesn’t necessarily mean a cut in rates below what had previously been established as the floor of 0.5%, my guess is that this is what will happen, and what is needed.  Indeed, I thought that a cut would have been warranted as an emergency precautionary step in the aftermath of the referendum.  The cut would come in advance of much hard evidence that the economy has weakened, but it would echo the precautionary step the Financial Policy Committee have taken in lowering the cyclical capital buffers for banks, which has also come in advance of hard evidence about the state of the cycle.  Even without the guess that demand has fallen/will fall, looser monetary policy would follow from the motive close to the zero bound to rates to loosen [to minimise the chance of losing control of monetary policy in the event that the central expectation of the outlook proves overly optimistic].

A cut would resolve the uncertainty that the BoE described about the appropriate response of policy.  Recall that the May Inflation Report analysis described that this response was ambiguous, since there are offsetting supply side and exchange rate effects pushing up on inflation.   I doubted that the BoE really were uncertain about what they would do, and markets seemingly share this view.  Probably that uncertainty derived from a general central bank reluctance to appear to engage in commitments to courses of action, or less charitably, to the desire not to complicate statements by the Chancellor to the effect that mortgage rates might rise post Brexit.

Will the BoE will go to 0.25pp or even lower, and will they engage in further asset purchases?  My guess is that they will stop at 0.25pp, but signal that this would be in place for some time, and that there would be no further asset purchases.  Although MPC have signalled that 0.5% is no longer the floor to rates, they have also continued to rehearse the arguments that at some point rates hurt retail bank and building society balance sheets (roughly, because while loan rates track Bank rate, deposit rates can’t fall).  And those arguments are thrown into sharper relief by the fall in bank shares in the UK.  Some, like Vlieghe, have also drawn attention to the fact that asset purchases are not ideal substitutes for rate cuts.  And Carney’s revealed preference is to avoid them:  he has preferred to allow the disappointments in the outlook for inflation to lead to corresponding changes in the expected time at which interest rates rise, rather than to push for further asset purchases.  And in the run up to his appointment to his Governorship, when the initial push for forward guidance was motivated by a clear desire and need for further monetary stimulus, he was pretty clear that this should happen by signalling about future rates rather than further QE.  [By the time he had arrived, the case for a loosening had weakened, of course, even though forward guidance was implemented anyway, for motives linked to eliminating uncertainty about rates, rather than loosening policy].

I started out by saying that the outlook was not as bad as it could have been.  And the intention there was to point to the fact that there is no full-scale financial crisis in prospect.  That said, there are some worrying things to watch, like the fall in bank shares already mentioned;  the problems in Italian banks, which could, in combination with difficulties orchestrating a good response from the Eurozone authorities, spark more generalised difficulties in financial markets;  the small increase in the spread between Bank Rate and LIBOR;  and the stops on redemptions in funds invested in commercial property.  None of these ought to be critical for financial stability.  But that is the sort of thing I used to write in memos in the Bank of England when the first data that were to lead to the 2008/9 crisis emerged.

The Post Brexit Budget

This morning on the Today programme we were told about the fact that both George Osborne and Alastair Darling agree that a post Brexit budget would involve tax rises and public spending cuts. This must be right in so far as it pertains to the long-term. As most economists have pointed out, Brexit will shrink the economy in the longer term. So either public spending has to fall, or, to keep the State at the same proportion relative to the private economy, taxes have to rise.

However, in the short-term, things are much less clear. If interest rates were not constrained by their natural floor, it might be sufficient to respond to the recessionary shock that a vote to leave would impart by simply letting the automatic stabilisers and the Monetary Policy Committee do their work. However, right now, with the Bank of England unable to inject much more stimulus (it’s clear that the MPC don’t view QE as an adequate substitute for interest rates any more), the economy would be in need of a discretionary stimulus to take the place of monetary policy.

Such a stimulus would not be undertaken lightly, however, since the uncertainty hanging over the process of sorting out what Leavers want to ask for, and our negotiating partners want to give us, would rightly constrain a rational Chancellor of the Exchequer.

It is interesting to read that 57 Tory MPs have said that they would block a post Brexit budget of the kind that Osborne warned of. I wonder how many of those were calling for a discretionary loosening from 2010 onwards, at a time when Osborne was likewise refraining from a discretionary stimulus of the kind that many called for?

Post Brexit EU fiscal policy

Hugo Dixon warns the EU against going for ‘more Europe’, and in particular fiscal union, if the UK votes to Leave, on the grounds that doing so would provoke a populist backlash.Looser fiscal policy is desirable instead, he writes.

However, those countries who could most benefit from looser fiscal policy (at least within the umbrella of a credible policy framework), such as Greece, Portugal, Spain, France and Italy, don’t have the option of pursuing it.

And the one major country that can afford or act independently to enact a large fiscal stimulus, and would probably benefit from it, Germany, doesn’t want to do it.

So ‘looser fiscal policy’ means providing the resources, either transfers, or at the very least,  fiscal guarantees, [eg pooled Eurobonds, at one extreme], for those who can’t afford it to do it, and compelling those who don’t want to provide these to give them.   Looser fiscal policy is not currently possible without elements of fiscal union.

The EU needs to make the Euro sustainable and that means enacting as much fiscal and banking union as possible. It can’t purchase political acceptability amongst the Eurosceptic constituencies with fiscal disunion, without undermining the future of the Euro.

Some other way of purchasing political support needs to be found.  It might be hoped that the experience of better counter-cyclical fiscal policy would cool populist angst, which tends to prosper in the aftermath of recessions.

Failing that, the EU could look to other aspects of political union that were not necessary for the Euro, or for other institution building, or to issues of Commission or European Parliament governance.

It could even, perish the thought, revisit the decision to allow the ECB to effectively set its own monetary policy goals; or to narrow the discretion it has over matters of financial stability in its member states, a matter that aggravated the handling of the crises in Greece, Portugal and Ireland.