Monetary policy at the limit

As the global economy recovered in the wake of the 2008-09 bust, many economists noted that central banks would have to raise interest rates as a precautionary measure in order to give monetary policy some headroom when the next downturn struck. That downturn appears to be here and central banks do not have much conventional ammunition left in their locker, even though markets are increasingly pricing a BoE rate cut this month having dismissed such a prospect at the start of last week (chart). Central bankers continue to sound confident about their ability to cope. Is this simply a case of them trying to underpin market sentiment or are there grounds for confidence?

A speech last week by outgoing BoE Governor Mark Carney was a case in point. In summary, Carney emphasised that further asset purchases and additional forward guidance mean that central banks have more scope than is commonly supposed. But the speech had a valedictory air about it, highlighting the successes of the BoE’s monetary policy during Carney’s near-seven years in office without touching on the downsides, and we have to look through some of the spin in order to assess whether some of the policy prescriptions still stand up. That said, central banks have had more policy successes than failures over the past decade so we should cut them some slack. After all, if the likes of the ECB had not done “whatever it takes” to hold the euro zone together in 2012, the economic history of the past decade could have been very different (and not in a good  way).

Turning first to the issue of forward guidance, this was one of Carney’s big ideas when taking office in 2013 through which the BoE would indicate how it would set monetary policy contingent on economic conditions. Despite the Governor’s claims for its success today, the reality in 2013-14 was very different. Recall that the BoE made it clear it would not raise interest rates so long as the unemployment rate remained above 7%. In the event unemployment fell much more quickly than anticipated, yet rates were kept on hold. Clearly, a commitment not to raise rates so long as unemployment is above a threshold level is not the same as a commitment to raise them when it falls below it. But there was a significant degree of confusion surrounding the policy and it is more than a stretch to claim, as Carney does now, that “people understood the conditionality of guidance.”

One of my retrospective criticisms of the BoE’s forward guidance policy is that it quickly abandoned the published unemployment rate as a target variable in favour of the output gap, giving rise to the suspicion (whether justified or not) that it no longer suited the BoE’s purposes. As I noted in written evidence to a parliamentary committee in 2017, “since the measure of spare capacity was determined by the BoE, this meant that outside observers became increasingly reliant on the information feed from the MPC to determine the future policy stance. The clarity of rule-based forward guidance policy was lost.”

Is there a future for forward guidance? Despite my reservations about the way in which it has been implemented in the past, I believe it does have a role to play – although maybe a less important one than Carney believes. In my view, forward guidance has a much more prosaic role. By communicating its objectives to as wide an audience as possible on a regular basis, it should be possible to remind people of the things that the central bank focuses on and thereby encourage the public to observe a particular set of variables, thereby giving it a better idea of how the central bank is likely to react. I am not sure that the message is getting through, however. Despite numerous BoE communications regarding the current below-target rate of inflation, the most recent Bank of England/TNS Inflation Attitudes Survey, conducted in November, suggested respondents believed the current rate of inflation was 2.9% (it was actually 1.4%) and the 12-month ahead forecast was for a rate of 3.1% (the BoE expects it to be significantly below 2%).

Carney also made the case for additional QE. On the basis of his calculations, further asset purchases of around £120bn (0.5% of GDP) is equivalent to 100 bps of interest rate cuts. Adding in the near 75 bps of conventional rate reductions, which would take Bank Rate to near zero, and the (unspecified) impact of forward guidance he reckons the BoE would be able to deliver monetary easing equivalent to 250 bps of rate cuts, which just happens to be the average in pre-2008 monetary easing cycles. However, it is what he did not say that is telling. It may be possible to deliver a one-off monetary boost of the magnitude that Carney suggests, though that is questionable since it is acknowledged that the marginal impact of QE diminishes as central banks buy more assets. But it is not possible to deliver it on a repeated basis without taking away some of the initial stimulus when the economic picture improves (which is, of course, what European central banks have not done in the past decade).

Another issue that Carney did not address are the long-term consequences of lower for longer. Savers have foregone a significant amount of interest income over the past decade. The response to that is savers should have taken cash out of the bank and bunged it into equities, but that does not seem to be a prudent policy which central bankers should endorse. Indeed, Carney argued that “the vast majority of savers who might lose some interest income from lower policy rates stand to gain from increases in asset prices that result from monetary policy stimulus.” But that is not very helpful when the asset in question happens to be your home as it is not so easy to realise the capital gain (unless you plan to significantly downsize). As for pensions, central bankers are aware that keeping rates low has a major impact on future pension returns but they do not talk about it much in public. However, annuity rates continue to fall which means that the future value of our pension pots is a lot less than it used to be. I thus continue to believe that the long-term consequences of a prolonged low interest rate policy will only be felt in the very long-term, by which time it will be too late to do anything about it, and today’s generation of central bankers will be long gone.

For all central bankers continue to tell us that they have more ammunition in the face of a downturn, the ECB under Christine Lagarde is no longer as gung-ho about a lax monetary stance as it was under Mario Draghi, since it realises that negative rates have significant side effects. Although the likes of Carney and Draghi can, with some justification, argue that their loose policy prescriptions were the right choice at the time the real problem is that rates remained low for much longer than was necessary on the basis of prevailing economic conditions. The problems associated with this are becoming increasingly evident and sooner or later I fear we will all pay a price.