Sunday, March 11, 2012

Monetary Anarchy in the UK

Has the Bank of England gone off its de facto NGDP target?

I've praised Mervyn King's management of the Bank of England in the past, particularly for what I saw as his unique willingness to follow the basic logic of monetary policy at the nominal zero lower bound when no other central bank seemed to quite get it, even the Bernanke Fed. (That is, when the nominal short-term rate hits zero, countercyclical monetary policy requires one to raise the expected rate of inflation to push real interest rates further negative in order to fully stabilize aggregate demand.)

Now I will offer some significant criticisms -- indeed, what I regard to be the biggest (or maybe only!) failure of monetary policy at the Bank since King became Chief Economist and Executive Director in 1991, since it adopted a 2.5 percent inflation target (later adjusted), or since it gained full independence in 1998.

Simply put, the Bank fell off the bandwagon. Its own bandwagon, really. It had maintained what is widely regarded as a 5 percent annual NGDP rate target from 1992 through 2008. Then, in 2008, it began to raise inflation to support NGDP growth as real output tanked -- up to 4.8 percent -- and then it shied away, letting inflation fall to 1.5 percent and NGDP growth fall to -4.7 percent in the worst of the crisis. That was tremendous malpractice, and I think, more than the Cameron austerity, Britain paid for the Bank's mistake with a sharp downturn in real growth in 2008 and continuing weakness through today. Since then, the Bank has allowed inflation to creep back up -- 4.7 percent now -- but NGDP growth has fallen to 3.1 percent. Those of us who think that the level of NGDP is most important would actually argue for significantly higher "catch-up" NGDP growth. My back-of-the-envelope math says that it would require an 11 percent increase in the price level, holding real output constant, to put NGDP back on its level path.

I suppose what I am wondering is, should we consider this a change in the Bank of England's monetary policy regime? It's missing its NGDP growth rate target by 1.9 percent; it's off the level target by 11 percent. This is a big deal, and I think a big mistake.

I don't know how to explain this, really. One thought is that the Bank doesn't think it can get away with the sort of inflation required for either the rate or level target, but I don't know how consistent this is with the Bank's history or British politics. Although the Bank under law is required to shoot for an inflation target, the data clearly suggests that the Bank targeted NGDP by reducing inflation when real output growth was strong, as in the late 1990s, and raising inflation when real output growth lagged, as in the mid 2000s. Indeed, Bank officials have more or less admitted the existence of an NGDP target to the press.

There has never been a strong enforcement mechanism of the inflation target -- the central bank head was required under law to write an apology letter to the Chancellor of the Exchequer every time the inflation target was missed significantly, who was then required to write back. In recent years, King has merely acknowledged the stability of longer-term inflation expectations and the risks to output growth should he take his foot off the accommodative monetary policy accelerator, and then kept inflation well above 2 percent, but not nearly high enough for target NGDP growth.

This is one reason to hope that the Fed's new longer-term inflation target, like the Bank's, can evolve into an NGDP target over time. In practice, the two targets are really not that different, although one could argue that communications are meaningfully clearer with an explicit NGDP target, particularly when clear communication is particularly important (i.e. during severe downturns in real output).

I'd argue that the Bank's informal NGDP target, when it existed, was an unmitigated success. The U.K. went 16 straight years without a recession, first. Add to that the fact that import demand growth in the economies of major trading partners was cyclical, and that important trading partners saw abysmal bottom-line growth during the 90s (France, mainly). Add to that the fact that for the majority of these 16 years, real output growth ran at or above 3 percent.

Economists, by and large, do not view real output growth in the long run as being influenced by monetary policy (they do acknowledge that monetary policy can influence real variables in the short run). But I think there could be a mechanism by which the UK's stable NGDP expectations could be responsible for increasing the trend growth rate of real output. When firms sense uncertainty in demand and revenue in the medium-term, they are more likely to hold off on marginal investments in capital goods (or other expansions of their productive capacity), given risk- and loss-averse firms.

I think it's time for King to write his apology letter to the NGDP targeters instead of Chancellor Osborne.


  1. Evan
    And so did the US after mid 2008. And so did the ECB and many others.Notable exceptions are Australia and Poland. Sweden managed to correct the "error" pretty quickly.
    And Congrats on your efforts.

  2. Evan,

    As a fellow high school student who discovered market monetarism through Scott Sumners as well, I find your analysis quite interesting. However, something that had been bothering me was what should happen when the regime lost credibility? Scott, in one of his articles, described a NGDP target as almost like an exchange rate band. However this description seems to imply a large shock would render it useless. I started a blog after reading your post, and my musings comprise my first post at synthenomics.blogspot. Hope you can see where your works inspired mine.

  3. Excellent post.

    The Reserve Bank of Australia's target of an average rate of inflation over the business cycle has proved to be a great way to stabilise NGDP under the guise of inflation targeting.

    The explicitness of the target works both ways: anchoring nominal expectations and keeping the RBA "honest". The BoE's performance likely suffered because, under economic stress, its explicit target did not match what it should have (continued) to target.

  4. Great post Evan! Look forward to reading you often. Now when you say,

    "more than the Cameron austerity, Britain paid for the Bank's mistake with a sharp downturn in real growth in 2008 and continuing weakness through today." You are allowing that cameron's austerity hasn't helped?

    I could only wish we had 4.7% inflation in the US. Some might wonder if it's helping England much with a contracting economy.

    However, in that link you suppoied about Mervyn King really targeting NGDP, it pointed out that if nothing else higher inflation helps do something about the debt overhang.

    Certainly I like your central bank better than ours-though at least our Fed is better than the ECB.

    Still I like our fiscal situation better than yours-no austerity-and I think that's part of why we're recovering.

  5. Evan I don't know why I'm talking as if you're British, clearly you are in New Hampshire. LOL

  6. Several responses to write here --

    "Math Person": I'm going to write a longer response for Thursday, because your question of how an NGDP target responds to real shocks is a very interesting one. In short, I would argue that real shocks are, no matter the regime, a serious challenge to monetary policy which forces a choice between containing inflation pressures or preventing the formation of a real output gap. But I think there is a persuasive case to be made that making the behavior of the central bank clear in advance of such a shock will help prevent, say, a rise in oil prices from being transmitted into labor costs and core inflation -- which should mean that NGDP targeting may be able to outperform a discretionary policy even in terms of real output stabilization.

    Lorenzo: The link to the RBA is fascinating -- it sounds marginally more explicit then the Fed's longer-term inflation target, which I find much to vague.

    Evilsax: I admitted to having little background knowledge on UK politics, but the data I examined seemed to suggest minimal spending cuts. (I could not find similar data on changes in tax revenues, however.) From the extent of my knowledge, I don't think fiscal contraction in Britain was really necessary in the short term (look at their gilt rates), but I don't buy Paul Krugman's argument that they are the biggest issue in their economic policy. (I'm clearly more concerned with their bungling of monetary policy since 2008.) I don't know how well what I'm about to say would stand up to a more systematic evaluation of evidence, but if we consider the example of France during the early 90s recession, massive fiscal stimulus in the form of a huge fiscal deficit as a percent of GDP simply did not work. It's worth noting that in the late 70s and early 80s, when Mitterand came to power and France was still reeling from the 70s oil shocks, the Banque de France somehow decided that maintaining 5% real interest rates for two decades would be a good idea. (I'm trying to be sarcastic, if that's not coming through over the Internet.) To me this suggests that the benefits of fiscal policy in recession are oversold relative to the influence of monetary policy.