Posts tagged ‘NGDP targeting’

20 May 2012

How the Bank stole the recovery! (part 1)

I flagged earlier that I wanted to explore some reasons why quantitative easing (QE) hasn’t succeeded in prompting a broader recovery in the UK.

To start off with, let’s think about how QE is supposed to work. There are a number of possible transmission channels – for instance, I took the following diagram from the Bank of England’s Q3 2011 Quarterly Bulletin:

However, I want to focus on a transmission channel that the Bank (given its 2%-inflation mandate) has been relatively quiet about – the impact of QE through nominal variables. I’m happy to be agnostic for now about exactly how this channel is supposed to work, but there are two broad sets of ideas:

  • Keynesians / New Keynesians (such as Paul Krugman) often emphasise the importance of real interest rates in a deflationary environment. Given that nominal interest rates cannot go below zero, a sufficiently-positive rate of inflation is required to achieve the negative real interest rate that a depressed economy might need in order to recover.
  • Market monetarists (such as Scott Sumner) focus on nominal spending as the determinant of aggregate demand. In this view, a central bank can always increase nominal spending by debasing the currency; and, at times when the economy isn’t supply-constrained, growth in nominal GDP (NGDP) is a precondition for growth in real GDP.

Whichever of these views you might hold though, it’s clear that the ability of the central bank to act in an inflationary manner is crucial. In the New Keynesian view, you need to increase inflation expectations so as to reduce real interest rates (since r = i – πe). In the market monetarist view, you need to increase expectations of nominal spending, of which inflation expectations are a component. Either way, to use Krugman’s phrase, the central bank needs to ‘credibly promise to be irresponsible’.

Let’s see how that’s working out for the Bank:

Looking at the 5-year average inflation rates implied by market prices, we can see that QE and a rise in inflation expectations during 2009 did occur together. But also that: (a) inflation expectations started rising from their post-Lehman trough two months before QE started; and (b) more crucially, inflation expectations merely returned to their pre-crisis range of 2-3%, rather than the ‘irresponsible’ levels a central bank might need to target to reduce real interest rates / boost nominal spending, as a depressed economy might require.

Partly, the Bank’s failure to be credibly inflationary is the flip side of the successful introduction of inflation targeting in the UK in the 1990s. People don’t believe that a central bank legally committed to achieving 2% inflation is likely to let prices get substantially ahead of that.

But to some extent, this is also due to the Bank actively telling people that it won’t ‘irresponsibly’ allow QE to be inflationary – even though allowing QE to be inflationary may be crucial to allowing QE to succeed! Here’s Mervyn King at the Treasury Select Committee in February of this year (my bold):

I think actually unwinding [QE] is one of the more straightforward aspects. Either we would sell the gilts that we had purchased back on to the market or if we felt we were putting too many gilts on the market at the same time, or in a short period, we could issue short-term securities, Bank of England bills, and sell those. Actually mopping up the liquidity is a relatively straightforward aspect of this process. I am in no doubt that if we felt the need to unwind the economic effects of asset purchases, it would be a lot easier to slow the economy down when we come to unwind it than it is now to try to encourage growth in the economy by conducting asset purchases. I think going the other way would be a lot easier than trying to stimulate the economy at present.

So what he’s telling people, very clearly, is that the Bank is willing and able to unwind the large increase in the monetary base. In other words, the Bank views QE as a temporary increase in the monetary base – but then why should people assume it will have a permanent effect on the future price level? The Bank is not credibly promising to be inflationary.

This is why I’m increasingly attracted to targeting the level of NGDP, rather than the annual rate of inflation. If we can get the Bank to credibly commit to a future path for the level of NGDP in each of the next few years – with a legal mandate for the MPC to hit that path, irrelevant of what that means for inflation – then I think we’d go a long way to addressing the demand deficiency we’re experiencing. Either nominal spending does drive real spending, in which case hitting the NGDP target leads to real growth too; or nominal spending doesn’t directly drive real spending, in which case hitting the NGDP target means price inflation, which reduces real interest rates and in turn does drive real growth.

But in the meantime, the Bank still has a 2% inflation target – which the market believes it can maintain, in spite of QE, because the Bank is telling everyone that QE will be unwound in the future.

So no wonder all that QE doesn’t seem to have done much for us yet!

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