Posts tagged ‘UK’

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!

20 May 2012

Chart of the week: 14-20 May 2012

I’ve taken this week’s from the Bank of England’s latest Inflation Report.

In spite of unprecedented monetary stimulus, the Bank still expects CPI inflation to actually undershoot the 2% target in the next few years. I’ve previously suggested that this is because the Bank’s approach to quantitative easing has focussed on buying assets that are close substitutes for monetary base – which may have contributed to a lack of feed-through into broad money.

But other factors could also be at play – and I want to explore some of these in the next few days.

12 May 2012

Chart of the week: 7-13 May 2012

This week’s chart of the week (actually, charts) looks at the Bank of England’s decision to pause its government bond purchases (i.e. quantitative easing) at the current level of £325bn.

Ostensibly, policymakers are worried about prices. CPI inflation currently stands at 3.5%, above the Bank’s 2% target. But in spite of the Bank’s asset purchases, which have increased the monetary base by nearly 300% since March 2009, there is no evidence that this is feeding through to broader monetary aggregates. Indeed, M4 (broad money) has been shrinking since late 2010 – and at an accelerating rate!

Why the discrepancy between QE and falling M4? Because the money multiplier has collapsed, from more than 20 pre-crisis to 7.8 in March 2012. So all this extra monetary base the Bank is creating hasn’t fed through the broader money supply.

It’s therefore questionable that the QE measures up until now are inflationary. Rather, if policymakers want to affect broader monetary aggregates like M4, they’d have to go further up the risk spectrum than they’ve done so far, buying private assets that are less obvious substitutes for monetary base – and hence more likely to feed through to broad money.

10 May 2012

To QE or not to QE…

The Bank of England’s MPC decided today to leave the stock of quantitative easing at its current level of £325bn.

Gavyn Davies attributes their decision to a recognition that the supply side of the UK economy has underperfomed – suggested by the troubling fact that inflation expectations for 2012 have risen even as growth expectations have worsened:

A few thoughts on this:

1) The inflation-vs-growth chart is compelling, but I don’t fully buy the argument that we’re near the limits of what demand can do. The 2008-09 crisis may have had hysteresis effect on potential output, plus  pre-crisis growth rates may have reflected the bubble economy rather than being sustainable – but do we genuinely think all this is enough to leave real GDP today almost 13% lower than it would have been had growth continued on its pre-crisis trend? (Perhaps the answer is yes; but what’s the evidence?)

2) Even if you’re concerned that supply-side weaknesses could lead to more inflation – are the MPC really worried that QE is inflationary? Remember, the Bank of England’s asset purchases involving buying UK gilts – highly-liquid AAA-rated government bonds – or exactly the type of security that the shadow banking sector considers to be part of its (unmeasured) ‘reserves’ on the Singh/Stella basis. CPI inflation may be currently above the 2% target, but it’s hard to argue this a result of monetary factors. Indeed, broader measures of the money supply are falling in the UK: M4 growth in March 2012 was -4.5% yoy.

3) Finally, whilst it’s strictly outside the MPC’s mandate – could the UK not chose to tolerate a bit more inflation over the next few years than we were accustomed to pre-crisis? At least some above-trend nominal GDP growth seems to be a necessary condition for smoothing the process of public- and private-sector deleveraging over the next few years.

Overall then, a disappointing decision. We probably don’t just need more QE, but also purchases of a much wider range of assets by the central bank.

7 May 2012

Spot the difference

Buttonwood points out that Francois Hollande’s plan to eradicate France’s deficit by 2017 doesn’t on the surface look that different to the UK coalition’s latest budget plans to eradicate our deficit by 2017:

TAKE two countries. One has a government “inflexibly committed to austerity”, lacking a Plan B and dragging the economy down, according to its critics. The second country has a new President who has just declared that his victory is a rejection of austerity. The victory has been hailed as a new dawn for European politics.

The first country, the UK, is aiming to balance its budget by 2017. The second country, France, plans to balance its budget by, er, 2017. Funny old world.

In reality, there’s a bit more to it: the French are trying to cut their deficit from 5.3% of GDP last year, the UK from 8.7%. So we here are still looking at an extra 3.4% of GDP worth of tightening over the five-year period.

But this still touches on my earlier point: rather than being inflexibly committed to austerity, the UK in fact seems to already be in the process of switching to a Plan B as the global economy deteriorates vis-a-vis 2010 forecasts. It’s just that loosening fiscal policy in a modern welfare-state economy with automatic stabilisers doesn’t always require a conscious decision by the government.

6 May 2012

Are we already doing ‘Plan B’ in the UK?

Following the Q1 GDP data, there were calls from the usual politicians for the UK to switch to an economic ‘Plan B’ in place of the coalition’s planned fiscal consolidation.

Martin Wolf’s latest FT column (£££) makes a more nuanced version of the argument – in essence, that front-loaded fiscal consolidation is not credible during a recession, so pressing ahead will itself lead the market to question whether it’s politically possible to cut the deficit – and is worth a read. But it raises an interesting question for me.

Wolf points out that the government is already on course to miss its original fiscal targets set out after the election, but this hasn’t led the market to question our solvency:

Yet remember that when the chancellor announced his fiscal plans in 2010, net borrowing was supposed to be just £206bn between 2012-13 and 2015-16. In the March 2012 Budget this was up to £317bn. Did that colossal failure to hit his target destroy credibility and so lead to explosive increases in bond yields? No.

Entirely valid. But I would interpret this failure to hit the deficit targets slightly differently.

Remember, in a modern welfare-state economy, much of the fiscal stimulus during a recession comes through ‘automatic stabilisers’ (falling tax revenue, rising spending on unemployment benefits, etc) rather than conscious government actions. These can be important: note that the UK’s fiscal stimulus announced in late 2008 was meant to be a £20bn package, but public sector net borrowing actually increased by more than £80bn between 2008 and 2009, of which about £40bn was down to equity injections into RBS/Lloyds – so half of the non-bailout part of the increase in the 2009 deficit was not due to a conscious decision by the Chancellor.

And it’s these automatic stabilisers, rather than any deliberate relaxation of the government’s fiscal plans, that will have led to the changes in the fiscal projections in the next few years – reflecting the extent to which the economic environment (in the UK and abroad) has deteriorated over the last 6-12 months.

As a result of what we can call this ‘non-deliberate fiscal stimulus’, as Martin Wolf in fact separately points out on his blog, the path of the UK’s fiscal consolidation has actually now switched to something quite close to Alistair Darling’s original pre-election budget proposals:

Therefore, without the need for any deliberate decision by the coalition, can’t one argue that we’re already in the process of switching to a sort of ‘Plan B’ in UK?…

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