The Monetary Policy Committee's search for guidance
- 16 July 2013
- From the section Business
The slightly better-than-expected inflation figure for June continues the run of good news for Mark Carney. Of course, it would be better if inflation were going down, not up. But it could have been worse.
It leaves the way clear for him to focus on his most pressing task: coming up with a way to make "forward guidance" part of the Monetary Policy Committee's tool-kit for supporting the economy.
That is indeed a big job, which some in the Bank do not feel they have been given much time to complete. George Osborne wants a decision in time for the next Inflation Report press conference on 7 August, which realistically means that the new approach will need to be there to inform the monetary policy decision the previous week, on 1 August.
At bottom, there are really two questions that the chancellor asked the MPC to answer.
First, would it be helpful to the UK economy for the Bank to offer more "forward guidance" on monetary policy?
Second, following on from that, should that guidance include an "intermediate threshold" - a staging point that the real economy needs to meet for policy to change - and if so, what should that threshold be?
You'll be relieved to hear I'm only going to talk about the first question here. I'll think you'll find that's more than enough to be getting on with.
The most often-talked about model for forward guidance is the one developed by the economist Michael Woodford, which I've talked about before.
Very briefly, that says that in the deflationary environment following a financial crisis, the central bank might be able to bring forward what might otherwise be a very slow economic recovery, by persuading the markets that it is willing to keep interest rates lower - and let inflation go higher - than its usual approach would suggest. (You can read the spoddy version here.)
If individuals and companies internalise this advice - and borrow and spend in the expectation of that recovery - the model says the growth will actually come sooner than it would have done, and the central bank might even be able to limit the overshoot in inflation, in practice, by going back on its promise. Win-win. All that matters is that everyone believes the guidance when it's offered.
So far, so interesting. The problem - as I've mentioned before - is that it's just not very relevant to the UK. The risk of falling prices in the UK right now is more or less non-existent. Everyone already expects inflation to overshoot - the only question is how far and how long.
But, you'll be thrilled to hear, there are other ways of thinking about guidance, now being vigorously debated inside the Bank, which are more relevant to the UK - and, for that matter, the ECB.
The first is simply as a way of correcting investors when they have got things wrong. If the expected path of monetary policy built into market interest rates is inconsistent with what the Bank's own policy framework would suggest, you say that.
That is the kind of guidance we had from the MPC earlier this month, and you might say it was entirely consistent with policy under Sir Mervyn King. In fact, Sir Mervyn told the Treasury Select Committee more or less the same thing, in his last appearance there, just a few days before Mark Carney arrived.
Observing that the markets have got it wrong is not inconsequential, especially when interest rates have moved as far as they have in response to Ben Bernanke's comments in May. But it can only get you so far.
You can imagine the MPC going a step further down this road next month, to say that not only are rates "inconsistent" with economic fundamentals, but flat-out wrong.
You could also imagine the MPC using guidance to materially change everyone's expectation of when the first rate change will be. That should cut short- to medium-term rates as well - meaning cheaper borrowing costs, hopefully, for companies and households. But I suspect that many on the MPC would consider this step a loosening of the target, given that the economic environment has not really changed.
However, in his past speeches on this subject, Mark Carney has spoken of another way that guidance can "correct" market rates - even when people already have an accurate view of the Bank's expectations.
This comes from a curious feature of life when the official policy rate has gone as low as it can go. Namely, that "interest rate risk is asymmetric: short-term rates can rise, but they cannot fall. This asymmetry causes the mean or expected outlook for short rates to be greater than the mode or most likely path."
In other words, even if most people expect rates to stay at 0.5% for three years, market rates will end up higher than that central expectation - if there's any uncertainty about it at all - because that uncertainty can only go one way: we know for sure that rates cannot go down.
That, in turn, means long-term rates get pushed up and credit conditions are tighter than market expectations of future policy would lead you to expect.
Guidance can correct this, Mark Carney argues, by getting rid of some of that uncertainty about rate rises. Even if the guidance is exactly in line with what the markets thought before. Tah-da.
By now, you probably think you know all you ever wanted to know about the technical arguments for policy guidance by the MPC. (If you haven't stopped reading hours ago.) But let me throw in one other way of looking at it - which I'll call "transparency with a purpose".
Stanley Fischer, the distinguished economist and former head of the Israeli central bank, had some wise words for me on this subject: he said policymakers will get themselves into trouble if they think they can use guidance as a way of "tricking" the markets into a combination of inflation and growth that would otherwise not be on offer. In his view, the only sensible way to think about guidance is as an extra dose of central bank transparency.
You might think central bankers should always be as transparent as possible about everything that could affect their future decisions. But that's not really true.
After all, they have their credibility to consider. Also their flexibility. Arguably, transparency can be bad for both - especially if it publicly ties itself to a particular way of looking at the world which it later finds it would like to reverse.
If there is a spectrum of views on the right balance between transparency and flexibility, for central banks, it is fair to say that Sir Mervyn was on the side of flexibility. He did not think it was helpful for the Bank to admit publicly that it had changed its mind.
And he did not think it was helpful for the Bank to "tie its hands" in advance. With him, it was: "We take every meeting as it comes."
Mark Carney clearly takes a different view. In the speech I referred to earlier, he says, in effect, that today's post-crisis circumstances might well tip the balance in favour of more transparency.
In this environment, he suggests, the central bank might well find it is more effective if it tells the markets and the public more than it would usually want to tell them - not just about the level of inflation it is willing to tolerate, but also about the real economic outcomes it will be looking for when it sets policy in the future.
That's not transparency for transparency's sake: it's transparency with the express purpose of helping the domestic economy, in a situation in which the central bank's normal tools for guiding the economy are seriously impaired.
As we know, there's still a lot of uncertainty about what's going on in the real economy, and how fast the UK can actually grow before domestic wages and price pressures pick up. (See all my previous stuff on the "productivity puzzle" and other delights.)
This way of looking at guidance would have the Bank saying how it plans to live with that uncertainty: how it will be monitoring the capacity of the economy going forward, and how it plans to adjust policy in line with those observations.
Depending on how it was framed, the message would be: "We're going to err on the side of expecting too much of the economy, rather than too little."
I don't get the impression that most MPC members would be hugely opposed to the "transparency" kind of guidance. Whether a majority thinks it would make a big practical difference is another matter.
Much will depend on how, exactly, the MPC spells out its intentions, and the economic yardsticks it says it will use along the way. What those yardsticks might be, I will write about (phew) in a later post.