The new Governor of the Bank of England, Mark Carney, will appear before the Treasury Select Committee for the first time tomorrow. The Committee asked for evidence that could help them with their questioning, and I obliged with the short note reproduced below, which also provides a useful summary of my current views on UK monetary policy which have otherwise been scattered around various posts. However the new Governor’s first appearance might also be an appropriate point to say something about central bank communication in the era of the Zero Lower Bound (ZLB).
Consider the following alternative things Dr Carney might say:
1) At the ZLB there is really nothing more we can do. We have tried QE, which may have helped at the margins, but decreasing returns have clearly set in, and basically monetary policy is now a spent force.
2) The ZLB means we have to do things differently, but we are still able to achieve the goals set for us using a variety of unconventional policies. The instruments have changed, and everything is more uncertain, but otherwise its business as usual.
I’m sure the first statement will never be made, but I think there is a clear danger that something like the second message will be the one conveyed. I know there are some who think, perhaps with the right choice of target, that the second statement is true, but I do not think it is. The following would I believe be the right thing to say:
3) At the ZLB there are still actions that the monetary authorities can take to try and stimulate demand. However there may be limits to this ability, which means that monetary policy can no longer ensure that the output gap falls to zero and that we hit our inflation target. This needs to be understood when other policy decisions are taken.
It is the right thing to say not only because it is nearer the truth, but also because it is the best way to protect central bank independence in the long run.
I was also going to say something on helicopter money, prompted by the following from a leader in the FT today:
“Demand stimulus by helicopter money need not be more inflationary than other types. It could be less so, since by definition it does not come with a built-in expectation of future reversal through tax rises (unlike public borrowing) or monetary tightening (unlike quantitative easing).”
However I realise it requires a whole post to cover all the reasons why this makes no sense, so here is my piece for the select committee, in which no helicopters appear.
1. Monetary policy has two objectives: to stabilise inflation at an acceptable level, and to try to eliminate any output gaps. As a result, academic work on monetary policy has two ultimate goals for monetary policy: to minimise excess inflation and to minimise the output gap. Views about the relative importance of these two objectives vary, and our knowledge here is very partial, but both objectives matter.
2. The current UK monetary policy regime places one of these objectives - targeting inflation - above the output stabilisation objective. This is in contrast to the regime in the United States, which has a ‘dual mandate’, which essentially corresponds to the two objectives outlined above. So why have in the past most macroeconomists, including myself, been relatively content with focusing on inflation as the primary policy objective?
3. The most important reason was that these inflation targets were interpreted in a flexible manner. (The regime is often called flexible inflation targeting.) Specifically the Bank of England has interpreted this flexibility as trying to hit the inflation target in two years time. The general view was that over this kind of time frame, hitting the inflation target would be consistent with closing the output gap. So although minimising the output gap was not a primary policy objective, that objective would be fulfilled under flexible inflation targeting. The theory behind this view is that inflation is ultimately determined by a Phillips curve, which implies inflation will only be stable in the long run if the output gap is zero.
4. Recent UK experience has unfortunately shown that view to be seriously incomplete. Inflation has been persistently above target, yet output is well below its sustainable level.[1] The MPC has currently set policy to achieve the inflation target in two years time, but it does not expect the output gap to come near to being closed in two years time. So the inflation objective is overriding the output gap objective.
5. There are probably two reasons why we now have a conflict between hitting the inflation target and closing the output gap. The first could be called bad luck. The UK economy has been hit by a series of positive inflation shocks: a large depreciation with lagged effects, increasing commodity prices, and increases in certain government charges and taxes. The second is more fundamental and also more a matter of conjecture. When inflation is low, high unemployment appears to have a smaller downward influence than when inflation is higher. One obvious reason for this is that workers are particularly resistant to nominal wage cuts.
6. Whatever the causes, there is now a clear conflict between what a sensible UK monetary policy would be doing and what is actually happening. Monetary policy is not providing enough stimulus to the UK economy, because it is focusing on the inflation target, and not the output gap. Inflation targeting in the UK is not working, and something needs to change.
7. Some commentators suggest that a change in personalities may be sufficient to deal with this problem. I think this is quite wrong. It is clear to me that the MPC takes the Bank’s interpretation of inflation targeting very seriously. It was put very well by Adam Posen in his recent (22nd Jan 2013) evidence to this Committee: “anyone who was on the [MPC] basically took the equivalent, in my opinion, of an oath of office. They were serving on the committee under the terms of the given inflation target.” Posen was generally a ‘dove’, not because he wanted inflation above the target, but because he thought inflation would come down more quickly than others.
8. For this reason, I do not think the MPC would be able to do what the US Fed is currently doing with monetary policy. The Fed has said that they are willing to see inflation go (a little) above their 2% target in order to get unemployment down. I believe the MPC would regard that as violating their remit. It would be useful if the Committee could see if the new Governor takes a different view.
9. If I am right, some change (or official reinterpretation) in the UK monetary regime has to take place. There appear to be three types of change that could be explored: moving to a dual mandate, looking at other measures of inflation, or getting rid of the inflation target completely.
10. Perhaps the most straightforward change would be to make monetary policy in the UK more like policy in the US, by adding an output gap or unemployment objective alongside the inflation target. It would not be necessary, and given current uncertainties it would not be desirable, to specify a particular number for unemployment or output. Instead the MPC could be charged with ensuring output was at a level consistent with long run inflation stability, or some similar phrase. The risk that this change would lead us back to the 1970s is zero. What this change would enable the MPC to do is allow inflation to be above target in 2 years time if they expected the output gap to persist.
11. Another possibility would be to stay with an inflation target, but to broaden the range of inflation measures that were looked at. There is no reason from economic theory why consumer price inflation is the ‘right’ inflation measure to target, and other measures (like output prices, or wage inflation) may be at least as relevant. Unfortunately the series of positive inflation shocks the UK has recently experienced have their maximum impact on consumer prices. Monetary policy in the UK would now be very different if the inflation target was for earnings growth - and there is no reason in terms of the macroeconomics why it should not be.
12. Both these suggestions have one apparent disadvantage: we lose the simplicity and clarity of a single target. By specifying more than one target, and not specifying the trade-off the MPC should use when the targets conflict, we are leaving more to the discretion of the MPC. However, such a regime would still give less discretion to the MPC than monetary policymakers in the US or Eurozone currently have. The targets would still be set by the Chancellor.
13. The third alternative is to replace a single inflation target by a single target for something else. Targets for nominal GDP have been widely canvassed. It is absolutely vital that here a clear distinction is made between targets for nominal GDP growth, and targets for the level or path of nominal GDP. It is the latter that many economists have recently suggested might offer some clear advantages over inflation targets, and which were discussed in a recent speech by the new Governor.
14. As some eminent macroeconomists, like Michael Woodford, have been arguing for the advantages of such ‘history dependent’ targets for some time (well before the recession), a debate on their merits is overdue. Although this issue is widely discussed in the US, we have very little discussion in the UK. This may be because the natural host for such a discussion would be the Bank, but the Bank has felt that it would be inappropriate for it to question its own remit. I hope the new Governor does not take that view, and it would be useful for the Committee to ask him about this. If the Bank, under its new Governor, still felt it inappropriate for it to lead a discussion on the merits or otherwise of NGDP targets, then the Committee itself should think about undertaking this role.
15. While I would welcome an extensive discussion of this type, it would be unfortunate if that debate put on hold any change in UK monetary policy. As I have argued above, policy is providing insufficient stimulus to the UK economy now, because of the form of the current monetary policy regime. Changes could and should be made to that regime now, without in any way prejudicing the results of a more extensive debate on NGDP targets. That is why I think it is important to address the possibility of moving to a dual mandate, or looking at alternative inflation measures.
[1] Macroeconomists use almost as many names for this sustainable level as there are estimates for its magnitude (natural rate, NAIRU, natural level, output potential...), but unless anyone wants to suggest that none of those currently unemployed are capable of working, there can be no doubt that UK output is currently below this level.
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