Inside Economics

A Tale of two Bankers: Carney the reckless and Haldane the wise.Monetary Policy

Posted by Huw Dixon Thu, June 22, 2017 16:57:09

We have seen two recent pronouncements by leading Bank of England MPC members: Governor Mark Carney at the Mansion house and Chief economist Andrew Haldane in an interview with the Telegraph. But first, we have the very welcome announcement that the new committee member replacing Kirsten Forbes is a real economist, Silvana Tenreyro a Professor at the LSE. Just to explain why this is a welcome appointment. The Chancellor is responsible for the appointment, which is made through the cabinet office. Under George Osborne we saw a shift in the type of person being appointed. Out went established academics like Mervyn King, Charlie Bean, Martin Weale. In came “city economists” from investment Banks. Ben Broadbent (Goldman Sachs), Michael Saunders (Citi), Gertjan Vlieghe (Brevan Howard hedge fund). This is the first appointment under Hammond. It is like for like: a serious academic for a serious academic. However, I think we can heave a sigh of relief that it is not another “city economist”.

I see two problems with appointing more than one city economist to the MPC. There is the issue of regulatory capture. The Bank needs to be independent of the City. The Bank has a regulatory role to maintain financial stability: since the investment banks have been major sources of instability it is strange to have their people at the top of the bank. The Bank is supposed to be keeping inflation on target in the interest of the whole nation. Its current policy of allowing inflation to rise and failing to keep interest rates up with inflation (and hence plunging the nation into financial repression) might be interpreted as acting in the interests of the very investment banks and hedge funds from which the MPC members have come. Now of course, city economists are perfectly capable of doing the right thing. Michael Saunders is one of the three who recently voted to raise rates: respect. However, perceptions matter and there is the possibility of a conflict of interest. The next appointments will be a real signal, enabling Hammond (or his successor) to show that the Osborne era is over and that the MPC and Bank of England needs to be independent of the investment banks and the City. Mr Osborne of course has since become part of the city, with his appointment in February 2017 as part time advisor to BlackRock, the world’s largest investment Bank.

Mark Carney made what in my opinion was an amazingly reckless speech at the Mansion house. Inflation is currently just short of 3%, the upper limit of the range. Three members of the MPC voted to raise interest rates. The real implications of having interest rates at 0.25% whilst inflation is 3% are really hitting home to the public and politicians. Carney is of course distracting us by blaming Brexit. I opposed Brexit (as did nearly all economists), but it is rich for the Bank of England to blame inflation on Brexit when the Bank has done nothing to restrain inflation, which is its main job. Real interest rates have tumbled and now stand well below minus 2. The Bank’s own forecasts in mid 2016 predicted a rise in inflation to 2.8% by mid 2017. The surge in inflation was foreseen, but the Bank did nothing. In fact, it made matters worse by cutting interest rates by 25 Basis points post Brexit vote. A classic “Greenspan put” as seen in the run up to the 2008 financial crash. Now, almost 12 months on, his Mansion house speech was a loud and clear statement that “Now is not yet the time” for interest rates to rise. In effect, he is talking down sterling at a moment when inflation may well break through the 3% barrier. If it does go above 3%, I think that Carney should be made to step down. Keeping interest rates at near zero when inflation has risen by almost 3% is just stoking up some huge problems and possibly another crash. The correct policy would have been to start raising interest rates gently last year, with the aim of getting to a level of the inflation target plus 1-2%: that is 3-4%. The US Fed is doing this. Unlike Carney, Janet Yellen is a serious economist who understands these issues and has not spent time in an investment bank or hedge fund.

Andrew Haldane is a serious academic economist. In the recent Telegraph interview, he said “might have to rise this year to nip inflation in the bud and prevent a sharper jump in rates in future”. The phrase “to Nip inflation in the bud” is a bit rich: the inflationary horse has already bolted. Any bud nipping was due last year. The MPC needs to look ahead. Anyway, at least he is starting to think in the right way. More important is his statement “to prevent sharper rises in the future”. Yes, keeping rates so low can actually be a threat to the financial stability the Bank is supposed to be maintaining. Sharp rises in the future are just what is required to trigger a financial crash. Well said Andy! Raising interest rates has become not just an issue of avoiding financial repression and keeping to the Bank’s inflation target, but also protecting the very stability of the financial system.









Carney on the line.Monetary Policy

Posted by Huw Dixon Mon, May 15, 2017 15:19:08

Inflation is getting very close to the 3% upper limit and is well above the 2% target. This was not unexpected: it was indeed predicted by the Bank last year. As I argued last September (2016), interest rates should have been increased then in order to keep inflation closer to target in 2017. However, many forecasters predicted inflation might well rise above 3% in the next few months. For me IF inflation exceeds 3%, this will be a defining point in the recent history of monetary policy. It will demonstrate that Financial repression is the real policy of the MPC and inflation targeting is only secondary. If inflation crosses the 3% line, there is little excuse for Carney. He will blame Brexit. This has been a very successful diversion of attention away from the fact that the increase in inflation was easily avoidable in September last year. A modest rise in interest rates (maybe in line with inflation) would have been enough. The reason the Bank of England is responsible for setting the interest rate is that it is supposed to target inflation. If it is proving unwilling to do this, then its independence is really something we should all question. Blaming Brexit for a failure in monetary policy is a lame excuse.

So what would a sensible policy be? Simple. If we take the view that the real interest rate is 1%, the current nominal rate should be increased until it is equal to this 1% plus the inflation target of 2%: that is 3%. The long-run real rate might indeed be higher, indicating a long-run nominal rate at 4-4%. However, let us take things step by step...3% is at least in the ballpark.








Real Interest rates.Monetary Policy

Posted by Huw Dixon Mon, February 27, 2017 22:06:36

Can there be an equilibrium real rate of interest that is negative? In general, the answer is no. If we think of a steady-state where consumption is constant, then because the household discounts the future, the real rate of interest has to be strictly positive. The real interest rate corresponds to the marginal product of capital. In a representative agent economy, a negative real interest rate is possible as a transitory phenomenon, and would correspond to a decumulation of capital indicating that the capital stock was too large and hence the household would seek to reduce it by maintaining a high level of consumption with possible dis-saving (consumption in excess of income). A negative real interest rate would be a temporary phenomenon on the path to steady-state: along the path, as the capital stock is reduced, the real interest would get back into the positive territory. In the Ramsey model, a very large initial capital stock yielding a negative marginal product would result in a high level of consumption which fell over time, with dis-investment.

Matters are different in OLG models, which are not in general dynamically efficient. In a simple exchange economy without production, it is possible to get a negative real interest rate in equilibrium. If current consumption is cheaper than future consumption, you need to give up more now to get less in the future. The key assumption needed is that there is no storage or capital: one generation trades with another. Eggertson et al (2017) have a model where people live for three periods: they have endowments middle age and when old: they borrow when young. Assuming that the endowment is largest in middle-age, consumption smoothing indicates that they will borrow when young, and save when middle aged to augment their retirement consumption (the old consume everything they have). At any time, there are all three generations living together. The middle aged at time t can only save for when they are old in t+1 by lending to the young at time t, who will repay the old at t+1. Here, the young demand loans (consumption) from the middle aged; the middle aged lend to them so that next period they get paid back and their old aged consumption is increased. The real interest rate here can be positive or negative, depending on the balance between the supply and demand for loans.

In order to link this monetary policy, we need to introduce nominal wages, nominal prices and a nominal interest rate. Making various assumptions, Eggertsson et al show that there can exist “a unique, locally determinate secular stagnation equilibrium” (Proposition 1, page 21. Figures 4 just above the proposition make the essential role of deflation clear). However, the secular stagnation equilibrium must have deflation: negative inflation. If inflation is positive, then there will be full employment. This is because the mechanism reducing output is the increase in real wages. So, in a secular stagnation equilibrium, the nominal interest rate is at the ZLB (zero lower bound), output is below full employment, inflation is negative and real wages above their full employment level (due to downward rigidity). The actual real interest rate is positive (equal to minus the deflation rate): it is a hypothetical real rate that is negative (the real rate that would restore full employment). The ZLB does not lead to an equilibrium negative real interest rate: it prevents the real interest rate from becoming negative when inflation turns negative.

Have we observed negative inflation? In the UK and the US just the occasional month in 2016 and (depending on whether you use CPI or RPI) perhaps for a month or two at the height of the crisis. Japan has had more disinflation since the late 90s (disinflation “peaked” at just over -2% in 2009). The Eurozone is a mixed bag: the aggregate inflation rate has mainly been strictly positive with a few exceptions as in the UK and US. For individual countries the story is more heterogeneous. So, if we look at the major economies, there is no evidence of sustained disinflation that might give rise to the high real rates required for Eggertsson Stagnation. In fact we find the exact opposite. The ZLB is combined not with negative inflation, but positive inflation. Rather than positive real rates, we find real rates are negative.

This brings us to the most important an obscure part of the paper: section 8, the model with over 100 equations. Here there are lots of generations and capital is introduced. The key equations are buried in the appendix: A81 and A82. The marginal productivity for capital A81 is the usual: the marginal product of capital will be strictly positive. Then there is A82. This is a little different: there is a price of capital goods term. Greg Thwaites has developed a model of falling real interest rates driven (in part) by the falling price of investment goods. There has been a downward trend in the prices of investment goods (relative to consumption goods), which means that savings leads to more investment (but possibly lower investment expenditure). This can drive down the marginal product of capital. However, in Thwaites model the real interest rate may be low, but is always positive. So what is it in the Eggesrtsson model that can give you their figure 7: secular stagnation with strictly positive inflation (recall, this was impossible in the world of proposition1). I must admit, that I have read the paper and am none the wiser about how this might be possible. The paper just presents a calibration and reports that this is what happens. Unlike the world of proposition 1 there is no clear story or intuition.

I do not doubt that with sufficient inventiveness a model with equilibrium negative real interest rates can be constructed. But it would not be a basis for monetary policy. Monetary policy needs to be based on robust models that have passed the test of time, not on exotica. I will continue to believe that real interest rates should be strictly positive in equilibrium.














Growth in 2016.Monetary Policy

Posted by Huw Dixon Thu, January 26, 2017 14:58:24

It is getting more and more unreasonable for the MPC not to raise interest rates, at least to keep in line with inflation. The ONS has announced that the UK had growth of 2% in 2016. What possible reason could the MPC have for not at least keeping the real interest rate zero, if not 1-2%.......The nominal interest rate should be raised immediately to at least 1%. It should have been raised a few months ago, but better late than never.

There can be no possible reason to leave interest rates at 0.25% when inflation is going to be above 2% for quite some time.



Back to Financial Repression.Monetary Policy

Posted by Huw Dixon Sat, January 14, 2017 16:47:40

The Monetary policy committee (MPC) in the UK seems set to repeat the imposition of financial repression we saw in the period 2010-12. That is the aggresive reduction in the real interest rate by failing to keep the nominal rate up with inflation. Inflation looks set to rise to 3-4% in 2017-18, with nominal interrest rates left at 0.25 or 0.5% (as seems the plan), that means a negative real interest rate of -2.5 to -3.5%. Now in 2010 that may have been an excusable policy: we were in the extraordinary times of the immediate aftermath of the finacial crisis. However, there is no justifucation in the current state of the economy for reducing real rates so rapidly to such a low negative rate. The role of the MPC is to target inflation, which requires nominal interest rates to rise at least as much as infation is expected to increase (i.e. the Taylor principle, that real rates rise when inflation rises above target).

Real interest rates should almost never be negative. Prior to the 2008 crisis, the only time real interest rates had been negative was back in the 1970s during the "Great Inflation". Back then there was an excuse: people did not really understand inflation and how to cope with it. The failure to keep real interest rates positive is widely seen as simply bad policy. Since then, real interest rates have nearly always been positive, with nominal rates being around 1-2% higher than inflation.

In the last year, we finally had a return to a positive real rate: the policy rate was 0.5 and inflation was around zero. However, the MPC and Governor Mark Carney have openly stated that they intend to keep the policy interest rate at its current level whilst inflation will be well above target. This will be seen as an historic failure of judgement by the MPC. Financial repression on this scale will lead to a massive redistribution of income, with the Bank of England in effect becoming a major instrument of fiscal policy, taking from savers and pensioners and giving to borrowers. This sort of redistribution is not what the MPC is about. Its role is targeting inflation, something which it seems to have forgotten.

What about Brexit? Well, Andy Haldane (the chief economist at the Bank of England) has admitted that the Bank's forecasts overstated the effect of the Brexit vote on the real economy. The real effects of brexit have yet to come into play (Brexit has not happened yet). However, the implication is that the post Brexit cut in interest rates needs t be reversed: I have yet to see the MPC indicating that this is what it intends to do.

In the US, interest rates are rising: this is something that the UK would be well advised to do immediately. A policy of financial repression is not what the UK economy needs in 2017.

New Keyensian or neo monetaristMonetary Policy

Posted by Huw Dixon Sun, February 02, 2014 22:40:33

There has been a bit of a flutter of memes recently about new Keynesian economics. Noah Smith digging out Robert Barro’s 1989 harangue and Lars Syll’s comment that new Keynesian = new Freidman.

I just thought I would add my thoughts into the mix. To understand this you really need a grasp of what has been going on in macroeconomics for the last 50 years. There is Keynes’s economics (the stuff in the General Theory and lots of other writings) and “Keynesian” economics that was developed mostly after Keynes had died. Keynesian economics was the stuff in textbooks like IS/LM and AS/AD that dominated macroeconomic thinking until the end of the 1970’s. Don’t forget, some of the key new classical results such as policy neutrality and the neutrality of systematic monetary policy were derived in this “Keynesian” framework by simply adding rational expectations (this happened in the second half of the 1970’s with the “rational expectations revolution”). Indeed, Milton Freidman said that “we are all Keynesians now”. For nearly all macroeconomists, there was short-run nominal rigidity (IS/LM), but in the long-run all wages and prices were flexible and you end up at the natural rate. This was called the neoclassical synthesis, which I for one always associate with Don Patinkin’s masterpiece “Money, interest and prices”.

So, there was an academic consensus about the basic analytic framework for modelling things. There was certainly disagreement: at the time lots of people did not like rational expectations. Also, there were many who thought that the IS/LM framework left out a lot that was essential to Keynes’s original thought: the title of Axel Leijonhufvud’s book “of Keynesian economics and the economics of Keynes” says it all. I could also reference Robert Clower and Hyman Minsky. Robert Lucas was putting forward a rather different view that we could understand everything in terms of competitive equilibrium and Keynesian concepts such as involuntary unemployment were just hokum. However, I think that it is fair to say that up until the late 1970s, most macroeconomics, whether monetarist or Keynesian, adopted the same basic setup.

Things changed in the 1980s. The idea that you could explain economic fluctuations using competitive equilibrium developed into the Real Business Cycle approach. As the name implies, it was a real model and did not even have money in the model or any concept of inflation. In this period there was the first group of work that was at the time designated new Keynesian. The key idea here was the introduction of imperfect competition into macroeconomics (much as the young Paul Krugman was introducing imperfect competition into the new international trade models), which made possible the explanation of nominal rigidity based on an optimizing theory of pricing behavior based on menu costs or bonded rationality (along with other ideas).

In the mid 1990s the new neoclassical synthesis bought these two strands together: the new Keynesian models of nominal rigidity were combined with the RBC model of household behaviour (Euler equations and all that). Now of course, whilst some people stressed the Keynesian aspects of this (for example David Romer in his J.Econ perspectives paper in 1993), others saw it as a neo-monetarist exercise: for example Miles Kimball in his 1996 paper “The Quantitative Analytics of the Basic Neomonetarist Model”. So, there has always been an underlying idea that the prevailing macroeconomic framework, whether 60’s Keynesian, 80’s new Keynesian or 90’s first generation neoclassical synthesis models are really “Keynesian”. Yes, they have nominal rigidity. However, there are lots of elements of the economics of Keynes that have been left out. It is exactly the same now. The first generation new Keynesian models became the second generation models (as exemplified by the Smets and Wouters model, for example).

I am not a historian of economic thought, but certainly from my recollection, the criticisms made of the so-called Keynesian/new-Keynesian models have always been much the same: they include amongst other things the inadequate treatment of uncertainty, money, the assumption of a unique equilibrium. So no change there then.

Whether you call the existing crop of models “new Keynesian” or “neo monetarist” is really a matter of taste. However, one thing is for sure: whilst the choice of name might have political or ideological overtones, it sure as hell makes no scientific difference as to how good the models are!





Repressed inflation and Tapering....Monetary Policy

Posted by Huw Dixon Tue, September 17, 2013 14:54:36

Well, the action seems to be hotting up. The story so far: long term bond rates of the UK and US have become closely related, and guess which one is the tail (UK) and which one the dog (the US). Both long term rates have recently been hovering over the German rate which is around 0.5-1% lower. Currently, the UK/US 10 year yields are near identical at around 2.75%, whilst the German rate is a little under 2%. The trend is upwards: in early May (before Bernake’s “Tapering” announcement to Congress), the same rates were US/UK 1.6% and Germany 1.3%. Hence we have a simple story. Germany can be seen as the reference point. The US and UK have higher rates, reflecting “inflation risk”. With all of the QE going on markets believe that there is clearly much more of a risk of inflation over the next decade. Also, the Germans seem to be keeping as hard a grip as possible on the expansionist tendencies of super Mario at the ECB. France also has higher long rates than Germany: this could stem from a combination of “Euro break-up” risk (any post-breakup French currency would devalue against the new DM) with default risk.

Now, back to Bernanke on the 22nd May announcing the possibility of tapering commencing soon: well now in fact. QE, which has meant the Fed buying up lots of the US national debt has kept US government bond prices high, and hence the long rate low. Stopping buying up government bonds can have only one effect: bond prices fall, and long term interest rates rise. But, of course, the markets are forward looking. If prices are going to fall in a few months, people will start to change their positions and hold less of the bonds, leading to rise in interest rates well before any tapering has actually happened. The BBC has been following this, particularly in relation to the effect on emerging markets. The prospect of rising US interest rates has led to money flowing out of emerging markets, reversing the flow caused by QE pushing investors onto emerging markets in search of “higher yield”.

But of course, the effect will not just be on emerging markets. If we leave aside the Eurozone for the moment, which has its own special dynamic, the UK will be affected by this too. Enter Mark Carney, with his forward guidance in July. No tapering in prospect, with long-term interest rates to be kept low if necessary with more QE (oh, with a long list of conditions of course, but let’s stick to the main story). Well, is it possible for the UK to have substantially lower interest rates than the US? Well, of course it is possible: however, it will have consequences. Let’s see how the markets reacted. After the Forward Guidance, markets seemed to give Mr Carney some credibility: UK 10 year rates fell below US rates, about 20 basis points and remained below until late August. Now they are back together. Well, markets realised that the Bank of England will not be able to have lower rates than the US for long. The consequences would be a devaluation of sterling, which would almost certainly lead to more inflation. The recent experience of Sterling’s devaluation against the Dollar would indicate that a large part of it would pass through into inflation over 2-3 years. Since inflation is currently well above target, devaluation would be most unwelcome. And of course, one of Carney’s caveats referred to interest rates having to respond if inflation became too high.

So, what is the take home for economists? Well, the most unnatural state of affairs with low interest rates is a bit of a Prisoner’s dilemma. Most of the developed world needs to follow the policy of “repressed inflation” , the key feature being sustained negative real interest rates to help with public finances and reduce the growth in debt-GDP ratios. However, as in the Prisoner’s dilemma, they can only do this if they stick together. If one of the main players (The US, the ECB, BOJ, maybe even plucky little BoE) decides to break and offer higher interest rates, funds will flow to it. In order to keep savers and investors in thrall to negative real returns, they need to have no safe alternative. Emerging markets may look attractive but are subject to lots of “other” risk (politics, potential crises etc.). If the US is going to offer more attractive interest rates, it will be hard for the Bank of England to persuade investors to buy British bonds. Of course, a devaluation against the Dollar might be attractive for some countries: Japan for one might be quite happy as this will help them generate some of the inflation they want to create. But not the UK. Forget forward guidance? Maybe the markets already have. Or maybe Mark Carney has something up his sleeve….let’s see how this continues to evolve over the coming months as tapering (probably) becomes a reality…Isn’t economics exciting: you never know quite what is going to happen next…