- Is inflation always and everywhere a monetary phenomenon, as claimed by Milton Friedman? Or do real factors play a much bigger role than often assumed?
- Are we underestimating the influence that monetary policy has on real interest rates over longer horizons?
- If these two claims are true, does it then follow that central banks should place less emphasis on inflation in designing monetary policy, and more on the longer term effects of monetary policy on the real economy through its impact on financial stability?
In short, Borio's answer to these questions is broadly yes.
In the case of (1) he argues persuasively that the forces driving inflation are
increasingly global, rather than local, with technological change and the entry
of billions of new workers into the global workforce as a result of
globalisation being primary contributory factors. Ironically, the economics
profession generally believes that immigration has little impact on local wages
but that raising the global supply of labour impacts upon global wages. That is
a circle which needs to be properly squared.
With regard to (2), Borio uses a range of historical examples to indicate that the impact of monetary policy, via its influence on expectations, can have far longer-lasting implications on the real economy than is conventionally supposed. In other words the neutrality of money, which forms a key assumption underpinning much of modern macroeconomics, can be called into question. The logical conclusion is thus that a monetary policy purely focused on inflation can have dangerous side effects which cannot be ignored. Indeed, Borio argues for the "desirability of great tolerance for deviations of inflation from point targets while putting more weight on financial stability."
I find this set of arguments highly convincing. Indeed, it is difficult to dismiss the thought that QE, which reduces interest rates and prompts a bubble in the price of other assets, ultimately impacts upon decision making in the real economy. For example, it prompts indebted firms to issue additional debt to fund capital expansion – hence the boom in the high yield debt market – which may ultimately come to a sticky end if interest rates start to rise.
A further suspicion is that the current monetary policy model is merely the latest in a long line of fads which may well be junked when (or if) it proves not to work. This chimes with the view expressed by Charles Goodhart[1] who has pointed out that since the 1950s there have been broadly three fashions in policy. From the 1950s to the mid-1970s, monetary policy was focused on labour markets and the bargaining power of unions. As the economics profession increasingly realised that simple Phillips curve analysis was insufficient to explain the relationship between inflation and unemployment, policy between the late-1970s until the 1990s switched to looking at money and monetary aggregates. But as this approach also failed to deliver control of inflation, the thrust of central bank policy switched to the NAIRU and the influence of expectations. But if Borio is right, this may simply be another in the long line of transitory policy fashions if it proves to have adverse longer term consequences which require more rapid-than-desired policy adjustment.
Indeed, central bankers will readily agree in private that they do not know what are the long-term implications of the current monetary approach. In particular, the impact of low interest rates on depressing pension returns is a problem which will only become apparent over a multi-year horizon. In effect, society has been forced to choose between protecting employment and labour income today at the expense of lower pension returns tomorrow. The jury is out as to whether it is a worthwhile trade off.
The question of whether the BoE should raise interest rates in the near-term should be seen in this context. On the one hand, there is a strong case for suggesting that rates are too low given the overall macroeconomic picture which is helping to exacerbate asset price distortions. But it is less clear that inflation should be the trigger for higher rates. Admittedly, inflation is running well above the 2% target. But wages remain muted and given the backdrop of Brexit-related uncertainty, they are likely to remain so.
It is hard to avoid the suspicion that justifying a monetary tightening on the back of inflation is a convenience which the general public can readily understand. Whilst households may not like it, higher rates may in fact be in the best interests of the economy. Not because there is an inflation problem, but because it might be the first step on the road towards taking some of the air out of the asset bubble which has built up in recent years. It may also help to give us a little bit more retirement income too.
With regard to (2), Borio uses a range of historical examples to indicate that the impact of monetary policy, via its influence on expectations, can have far longer-lasting implications on the real economy than is conventionally supposed. In other words the neutrality of money, which forms a key assumption underpinning much of modern macroeconomics, can be called into question. The logical conclusion is thus that a monetary policy purely focused on inflation can have dangerous side effects which cannot be ignored. Indeed, Borio argues for the "desirability of great tolerance for deviations of inflation from point targets while putting more weight on financial stability."
I find this set of arguments highly convincing. Indeed, it is difficult to dismiss the thought that QE, which reduces interest rates and prompts a bubble in the price of other assets, ultimately impacts upon decision making in the real economy. For example, it prompts indebted firms to issue additional debt to fund capital expansion – hence the boom in the high yield debt market – which may ultimately come to a sticky end if interest rates start to rise.
A further suspicion is that the current monetary policy model is merely the latest in a long line of fads which may well be junked when (or if) it proves not to work. This chimes with the view expressed by Charles Goodhart[1] who has pointed out that since the 1950s there have been broadly three fashions in policy. From the 1950s to the mid-1970s, monetary policy was focused on labour markets and the bargaining power of unions. As the economics profession increasingly realised that simple Phillips curve analysis was insufficient to explain the relationship between inflation and unemployment, policy between the late-1970s until the 1990s switched to looking at money and monetary aggregates. But as this approach also failed to deliver control of inflation, the thrust of central bank policy switched to the NAIRU and the influence of expectations. But if Borio is right, this may simply be another in the long line of transitory policy fashions if it proves to have adverse longer term consequences which require more rapid-than-desired policy adjustment.
Indeed, central bankers will readily agree in private that they do not know what are the long-term implications of the current monetary approach. In particular, the impact of low interest rates on depressing pension returns is a problem which will only become apparent over a multi-year horizon. In effect, society has been forced to choose between protecting employment and labour income today at the expense of lower pension returns tomorrow. The jury is out as to whether it is a worthwhile trade off.
The question of whether the BoE should raise interest rates in the near-term should be seen in this context. On the one hand, there is a strong case for suggesting that rates are too low given the overall macroeconomic picture which is helping to exacerbate asset price distortions. But it is less clear that inflation should be the trigger for higher rates. Admittedly, inflation is running well above the 2% target. But wages remain muted and given the backdrop of Brexit-related uncertainty, they are likely to remain so.
It is hard to avoid the suspicion that justifying a monetary tightening on the back of inflation is a convenience which the general public can readily understand. Whilst households may not like it, higher rates may in fact be in the best interests of the economy. Not because there is an inflation problem, but because it might be the first step on the road towards taking some of the air out of the asset bubble which has built up in recent years. It may also help to give us a little bit more retirement income too.
[1] Goodhart,
C. (2017) Comments on D Miles, U Panizza, R Reis and A Ubide , “And yet it
moves – inflation and the Great Recession: good luck or good policies?”, 19th
Geneva Conference on the World Economy
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