Over the course of recent weeks there has been a shift in
the message communicated by monetary policy makers. The monetary authorities on
the other side of the Atlantic have long been ahead of their European
counterparts, with the Fed having raised rates four times since December 2015
and three times in the last six months. But it has now gone further and
announced in mid-June that it “expects to
begin implementing a balance sheet normalization program this year, provided
that the economy evolves broadly as anticipated.” A week prior to that the
ECB changed its assessment of the balance of economic risks to “balanced” rather than “tilted to the downside” whilst only last
week, Norges Bank removed its previous guidance that interest rates could be cut this year. Also this month, the
Bank of England only narrowly voted to hold rates at their all-time low of
0.25% with three members of the Monetary Policy Committee pushing for a 25 bps
rate hike.
The narrowness of the BoE vote came as a surprise with the dissenters concerned that inflation had overshot relative to expectations, reaching a four year high last month, at the same time as the margin of spare capacity in the economy has clearly diminished. My initial reaction to this reasoning was that it was flawed: Inflation has surged largely because of the impact of currency depreciation and so long as this does not impact markedly on inflation expectations, which leads to faster wage growth, the BoE may simply have to swallow the problem. Indeed, with wage growth slower today than before the EU referendum, higher interest rates at a time of falling real wages will not do anyone any favours. That said, with the unemployment rate close to the BoE’s estimate of the NAIRU, such concerns are understandable.
My own view is that the uncertainties surrounding Brexit will suffice to keep UK inflation expectations in check for some time to come. Indeed, across much of the industrialised world, it is proving difficult to drive up inflation: In both the US and euro zone inflation is struggling to reach the central bank’s 2% target – a trend which will not be helped by the recent decline in oil prices which has supported headline inflation in the past year. Although central banks have a mandate to control inflation, and in many cases have to meet particular targets, it is difficult to explain to the wider public that there is no automatic link between price growth and interest rates – just as there is not, and never has been, one between inflation and money supply growth, despite the best efforts of many politicians and (some) economists to convince us otherwise. As if we needed proof, consider the case of Japan where despite running a balance sheet equivalent to 90% of GDP – almost four times that of the Fed, ECB or BoE – inflation has only exceeded the BoJ’s 2% target for three months during this century (once we strip out the distortionary effects of consumption taxes, see chart).
The narrowness of the BoE vote came as a surprise with the dissenters concerned that inflation had overshot relative to expectations, reaching a four year high last month, at the same time as the margin of spare capacity in the economy has clearly diminished. My initial reaction to this reasoning was that it was flawed: Inflation has surged largely because of the impact of currency depreciation and so long as this does not impact markedly on inflation expectations, which leads to faster wage growth, the BoE may simply have to swallow the problem. Indeed, with wage growth slower today than before the EU referendum, higher interest rates at a time of falling real wages will not do anyone any favours. That said, with the unemployment rate close to the BoE’s estimate of the NAIRU, such concerns are understandable.
My own view is that the uncertainties surrounding Brexit will suffice to keep UK inflation expectations in check for some time to come. Indeed, across much of the industrialised world, it is proving difficult to drive up inflation: In both the US and euro zone inflation is struggling to reach the central bank’s 2% target – a trend which will not be helped by the recent decline in oil prices which has supported headline inflation in the past year. Although central banks have a mandate to control inflation, and in many cases have to meet particular targets, it is difficult to explain to the wider public that there is no automatic link between price growth and interest rates – just as there is not, and never has been, one between inflation and money supply growth, despite the best efforts of many politicians and (some) economists to convince us otherwise. As if we needed proof, consider the case of Japan where despite running a balance sheet equivalent to 90% of GDP – almost four times that of the Fed, ECB or BoE – inflation has only exceeded the BoJ’s 2% target for three months during this century (once we strip out the distortionary effects of consumption taxes, see chart).
There are numerous reasons why inflation today is much lower
than during previous periods when prevailing economic circumstances were
similar. A much more globalised economy, in which value chains stretch across
international borders has been one of the key factors holding down price
inflation over the past decade. This has been accompanied by technological
change which has depressed wage expectations. In effect, the pricing power of
labour has been reduced as wages are increasingly set according to
international conditions rather than those in local labour markets. Moreover,
as the BIS reminds us in a message that too many economists often overlook, “wage growth is not necessarily inflationary: whenever it is supported
by productivity gains, it will not lead to rising production costs.” And as
I never tire of pointing out, although the UK’s productivity record has been
dismal since the great financial crisis, it has still been stronger than real wage
growth.
In an environment where the link between the domestic economy and wages has weakened, this makes it difficult for central banks to justify raising rates based on the threat of more rapid potential wage growth. But low interest rates have contributed to the asset bubble which has forced – or perhaps facilitated – investors to take risks in order to generate faster rates of return. Some form of monetary tightening is thus desirable. It is for this reason that the BoE today announced that it will raise banks’ countercyclical capital buffer – a measure of mandatory additional capital holdings – from zero to 0.5%, with a view to raising it to 1% in November in a bid to curb excess credit growth.
I must confess to some mixed feelings on the situation we now find ourselves in. On the one hand, central banks are concerned about the impacts of low interest rates on credit and asset price growth. Yet on the other, they wish to ensure financial stability which appears to be at odds with the current loose monetary stance. The case for higher rates based on price inflation or wage growth is weak. But there is an argument to suggest that the wider impacts of running a loose monetary policy require some tightening. For the moment, the likes of Norges Bank and the ECB can get away with merely talking about it. The BoE fiddles around the edges by adjusting macroprudential measures. But before long, they may all be forced to follow the Fed – everyone does in the end.
In an environment where the link between the domestic economy and wages has weakened, this makes it difficult for central banks to justify raising rates based on the threat of more rapid potential wage growth. But low interest rates have contributed to the asset bubble which has forced – or perhaps facilitated – investors to take risks in order to generate faster rates of return. Some form of monetary tightening is thus desirable. It is for this reason that the BoE today announced that it will raise banks’ countercyclical capital buffer – a measure of mandatory additional capital holdings – from zero to 0.5%, with a view to raising it to 1% in November in a bid to curb excess credit growth.
I must confess to some mixed feelings on the situation we now find ourselves in. On the one hand, central banks are concerned about the impacts of low interest rates on credit and asset price growth. Yet on the other, they wish to ensure financial stability which appears to be at odds with the current loose monetary stance. The case for higher rates based on price inflation or wage growth is weak. But there is an argument to suggest that the wider impacts of running a loose monetary policy require some tightening. For the moment, the likes of Norges Bank and the ECB can get away with merely talking about it. The BoE fiddles around the edges by adjusting macroprudential measures. But before long, they may all be forced to follow the Fed – everyone does in the end.
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