Ernst & Young ITEM Club UK Winter Forecast 2013

Postscript – The UK needs a new approach to monetary policy

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In the US, the Fed’s FOMC led the way to recovery with innovative financial policies…

In its Winter forecast, the ITEM Club identifies some of the reasons why the recovery in the US is a lot stronger than in the UK. ITEM believes that a further reason is evident in the sphere of monetary policy, saying that the Fed has been much more innovative than the Bank of England in dealing with the financial crisis and supporting economic activity. The Fed was quick off the mark when the money markets froze in August 2007, immediately recognising the threat to the banking system and the wider economy and flooding the money markets with liquidity. The Bank of England, however, was transfixed by the bogey of moral hazard and did not accept that the game had changed until Northern Rock collapsed six weeks later. The Bank’s programme of Quantitative Easing has focused narrowly upon the gilt market, avoiding the purchases of residential mortgages and other securities that the Fed has made. The Funding for Lending Scheme is certainly an innovation for the Bank, but it leaves the banks with the credit risk while providing cheap funding.

…putting the US economy in a good position to withstand a fiscal contraction

Part of the problem lies in the very specific inflation remit set for the MPC by the Treasury. In contrast, the Fed has a dual mandate, involving both inflation and unemployment. This gives it a great deal of flexibility, which it has used to the full. Last September the Fed’s rate-setting panel, the Federal Open Market Committee (FOMC) announced that it would make unlimited purchases of residential mortgages to stimulate household spending and the housing market until there was a significant improvement in the labour market. Then at its 12th December meeting the FOMC announced that it would keep interest rates close to zero until unemployment had fallen below 6.5% or until inflation was forecast to exceed 2.5%. The Fed’s switch to a pro-growth policy stance should have the effect of making the private sector more confident about future economic activity in the face of fiscal and other shocks, in the same way that its former anti-inflationary stance bolstered confidence in low and stable inflation. In contrast, the MPC’s remit means that it has had to worry about inflation overshoots caused by supply-side shocks that were beyond its control and had a deflationary effect on demand.

The UK Treasury and MPC…

Now, with a new Governor designate, the Bank and the Treasury are in a position to reassess the remit. It is clear that although inflation targets initially worked well in stabilising price expectations, they passed their sell-by date around the turn of the millennium. It is now clear that a favourable supply-side shock taking the form of a fall in world consumer goods price inflation initially kept interest rates artificially low and helped stimulate a credit-fed bubble in asset prices. Then in the second half of the decade the shock turned negative as oil and other commodity prices pushed up to record highs, putting upward pressure on inflation and interest rates and crushing consumer spending power. With the economy in recession, the MPC faced an invidious choice – between further depressing the economy and risking its reputation by allowing inflation to consistently overshoot the target.

…should now adopt a more sensible target….

Money GDP growth targets have emerged as the front runner in the debate about a new remit. The growth in Money GDP (MGDP) is not difficult to understand: it is simply the sum of real GDP growth and inflation and thus gives equal weight to both. This is appropriate when inflationary expectations are well-anchored and the central bank can afford to give some weight to what is happening in the real economy.

…to accommodate supply-side shocks...

However the main argument for a MGDP target is that it handles the effect of external supply side shocks very neatly. The basic idea is that the central bank can control the money value of output but not the way that this is split between real output and prices, which is determined by the private sector. The central bank can, however, steer the inflation trend indirectly by setting the growth in the money value of output in line with the trend in real productive potential and a medium-term inflation target. If an adverse supply side shock (like a rise in world commodity prices) occurs, then output falls below trend and inflation moves above trend for a while, with the opposite happening for a favourable shock. Either way, inflation departs temporarily from trend without seriously disrupting the real economy or damaging the central bank’s reputation.

…and handle measurement problems

This textbook argument for the superiority of money GDP over inflation targets seems compelling in current circumstances. Moreover, the money value of output is not just easier for the MPC to control, it is also much easier than inflation for the ONS to measure. We naturally look at our income and expenditure in pounds and pence, and companies do the same for their management, as well as the taxman and shareholders. Splitting these values into real and price components is relatively straightforward for a manufacturing firm producing standardised products like cars and computers that can be measured as physical quantities, but even there it is difficult to take account of technological improvement and quality change. However this is notoriously difficult (and arguably futile) for service sector firms that have sales invoices and perhaps figures for payroll and hours worked but few tangibles to go on. Digital products present even more formidable measurement problems.

The problems of measuring inflation in the consumer sector have been highlighted by the ONS proposals to change the methodology used to construct the RPI. Technically, it is very difficult to devise indices that do not suffer from an in-built upward bias. The RPI is particularly prone to this problem and has the awkward property that it shows an increase in prices if they fluctuate during a period but return to where they were at the beginning! Indeed, the advent of the new CPIH and the new RPI measures proposed by the ONS in their attempt to duck the issue of index bias has left us with no less than nine official inflation measures. It is also very difficult for the ONS statisticians to allow for discounting. The problem is that the general move to more frequent and pervasive discounts will bias measures of consumer prices up and bias measures of real spending down.

While no measure is perfect…

However, there are one or two caveats. The textbook explanation of money GDP targets assumes that in order to steer the medium-term inflation trend the authorities can assess the output gap and the trend in productive potential. However these are particularly difficult to gauge at the moment. The adoption of a target for money GDP growth would mean that this uncertainty was mirrored in the inflation trend – disappointing economic growth would mean that inflation was higher than expected for example. Also, to get MGDP we subtract the value of imports from the value of total expenditure. This leads to all sorts of statistical quirks and would make MGDP give a misleadingly good signal if a spending boom was met from imports. It would make much more sense to target the growth in Total Final Expenditure.

…pursuing the inflation target destroys the MPC’s credibility

The standard argument for an inflation target is that inflation figures are understood by the general public and are available on a timely basis and never revised, unlike GDP figures. However, any intelligent lay person would understand why it was important to put economic growth on a par with inflation in present circumstances. Moreover, recent inflation target overshoots and debates about the way that inflation is measured have undermined the credibility of the inflation target. Ultimately, with employers now firmly in the driving seat when it comes to negotiating wages, it is not clear that public perceptions of inflation count for very much anyway these days. Perceptions are crucially important in bond and foreign exchange markets but these are surely sophisticated enough to accept the arguments for a change in the remit. These minor caveats apart, there would seem to be little reason to continue to target an indicator that is very hard to measure, let alone control.

It has been argued that by allowing for the weakness in growth by allowing inflation to overshoot the target, the MPC is following a de facto MGDP target. If so, it is not doing very well. The ITEM Club estimates that last year MGDP grew by 2.1%, well below the rate consistent with a 2% inflation rate and a sustainable growth rate. Furthermore, the MPC is damaging its credibility by saying one thing and doing another.

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