In light of the Fed’s 75 bps hike yesterday, the BoE had little choice but to raise rates by 25 bps today with the case for action strengthened by the fact that it now predicts inflation will reach 11% before the year is out. The markets were split 50-50 between a 25 bps and a 50 bps rise - either way they will still be at record lows in real terms - but the less aggressive option has left many dissatisfied. The hawkish camp believes that rates must rise more quickly to bear down on inflation – incremental hikes of 25 bps just do not cut the mustard. Conversely, the dovish element – admittedly a minority at present – believes that aggressive rate increases are misguided at a time when the economy is clearly slowing (the BoE predicts that Q2 GDP will contract by 0.3%).
This is a genuine conundrum and there are many question marks as to whether rate hikes are the right way to deal with inflation caused by a supply shock. Higher interest rates act on inflation by curbing demand: The magnitude of the contraction required to rebalance supply and demand in such circumstances is probably much bigger than politicians, and indeed central bankers, are prepared to accept. After all, higher rates are not going to result in more oil being pumped or an increase in Asian semiconductor supply. I was thus taken by the Tweet from the journalist Ryan Avent, who noted “I feel like there's a good chance we're reading macro papers in 20 years which are like ‘the recession of 22-3 was yet another case of Fed overreaction to energy-price shocks.’”
Moreover the linkages from the real economy to prices are highly imprecise. Given that it takes up to two years for tighter monetary policy to impact on the economy, it is likely that a host of other factors will swamp price trends in the interim. Clearly, central banks are using monetary policy to try and influence inflation expectations, particularly wages. However, this is a risky strategy. Faced with rising food and energy prices, the like of which we have not seen for 40 years, workers are not going to sit idly by whilst the prices of goods and services which they consume are going up. And when central bank actions impact on their interest costs, it is no surprise that trade unions respond with industrial action.
This is not to say that central banks should necessarily refrain from hiking rates. But it is an illustration of how the textbook models used by economists to describe the workings of the economy often fall apart when circumstances change. Just as the 1970s sounded the death knell for structural macro models which did not incorporate forward-looking expectations, it will be interesting to see whether the current vogue for forward-looking DSGE models emerges unscathed from today’s events. After all, one of the criticisms levelled at central banks is that they failed to foresee the inflationary shock.
As it happens, I have sympathy with central banks’ position. Random shocks are by their nature unexpected and although central banks did highlight that inflation would rise in the course of 2022, they could not reasonably have predicted the impact of the war in Ukraine. That said, the likes of the BoE probably should have curtailed their QE programmes once it became clear that the economy was recovering. However, even by summer 2021 they had already pumped significant amounts of liquidity into the system and the effect of calling a halt earlier than planned would have had a marginal effect on inflation at best.
The groupthink criticism
At least we cannot criticise the BoE for sitting on its hands. Rates have risen at five consecutive meetings for the first time since the MPC was established in 1997. It was not always this way: After unprecedented policy easing in the wake of the Lehman’s bankruptcy, the BoE (in common with most other central banks) kept interest rates at their 2009 emergency settings for the next nine years. This contributed to excessive asset price inflation, notably for housing, and gave rise to criticisms of groupthink as the MPC ignored all the concerns surrounding a prolonged ultra-loose monetary stance and focused purely on the near-term inflation outlook.
Former MPC member Danny Blanchflower has been one of the strongest critics of groupthink, pointing to the lack of intellectual diversity on the Committee and arguing that there are fewer independent thinkers who are drawn from an increasingly narrow talent pool. As he noted in a Tweet in May, “still nobody on the MPC lives or comes from north of the Watford gap so diversity means only London (8) & USA (1) are represented? No Birmingham Leeds Belfast Glasgow Newcastle Cardiff Liverpool Manchester representation? No representation of business?” Blanchflower may sometimes be overly critical of the BoE but he does have a point. For example, there has never, to my knowledge, been a Scottish representative on the Committee during its 25 year existence. Given that Scotland accounts for 8% of the UK population, one would have thought they deserve some representation. Indeed, there have been more representatives born in Argentina, Belgium, India and the United States than those born north of the border.
Assessing the evidence
To assess Blanchflower’s claim that the Committee is drawn from an overly narrow pool, it is instructive to examine the universities from which MPC members graduated. Taking their highest university degree as the relevant benchmark, 12 of the 46 past and present members obtained their highest qualification from Oxford whilst another 9 were graduates of the LSE and 7 were from Cambridge. Only thirteen universities are represented in the list, which will rise to 14 when Swati Dingra replaces Michael Saunders in August. Widening the list to include those who attended British universities as an undergraduate reveals that 16 MPC members attended Oxford (almost 35% of the total) whilst 12 have Cambridge connections (26%) and 5 have an LSE-only affiliation. The response to this is that these universities attract some of the brightest and the best. The fact that they have strict entry criteria means that those with the best academic performance are more likely to study there. But by any standards this is a small sample from which to draw and does nothing to refute Blanchflower’s suspicions of selection bias.
The old joke has it that if you ask a question of nine economists, you will get nine different opinions and another of Blanchflower’s criticisms is that there is simply not enough dissent from the majority view on the MPC. We are on more solid ground here. I have applied two ways to measure the independence of individual voting patterns: One is the proportion of times an individual votes for an option other than the committee consensus – for example, a person who votes for a 50 bps hike rather than the majority view of 25 bps is a dissenter on this measure. Another metric is the number of times an individual votes in the opposite direction to the majority, which is a stricter measure of dissent.
Based on 25 years of MPC voting, the dissent measure, which calculates the proportion of members voting for something other than the committee average, is recorded at 14.4% over the period 1997 to 2008 versus a post-2009 figure of 6.5%. Obviously times were different in the wake of the 2008 crash when there was a universal belief that an expansive monetary policy was required. But it is notable that this dissent measure recorded a figure of 16.5% during Eddie George’s term as Governor, falling to 9.3% under Mervyn King and just 6.9% under Mark Carney. Whisper it quietly, but under Andrew Bailey’s tenure the dissent measure has crept up to 7.8%. But the numbers do back up Blanchflower’s claim that there is a lot less dissent in the voting patterns.
On the stricter measure of directional dissent, a similar pattern applies. Pre-2009, on 12.9% of occasions MPC members pushed for directional rate moves which were out of line with the committee consensus versus 5.6% post-2009. The post-2009 figure is low and would appear to confirm the fact that MPC members were reluctant to stick their head above the parapet and call for rate hikes.
Last word
For all the criticism that the BoE kept rates too low for too long in the wake of the 2008 crash – a view with which I concur – and that it has been dominated by groupthink, the events of recent months appear to have shaken the MPC out of its complacency. Although there are those who believe that it should have been more aggressive today and hiked by 50 bps, my own view is that the 25 bps increase was the right move. Doing nothing was not an option but acting too aggressively would exacerbate recession concerns, which is the last thing beleaguered households need now.
No comments:
Post a Comment