What do we really know about monetary policy?

Much of the talk in macroeconomic circles is whether central banks are likely to raise interest rates further, having tightened policy considerably over the past 18 months. Indeed, the ECB this week raised the depo rate to 4.0% - its highest since the ECB took over responsibility for monetary policy in 1999. Whether this is a wise move we will only be able to judge with the benefit of hindsight. But there are signs that the economy is struggling, with Germany not having grown at all in the first half of 2023 and the euro area as a whole posting meagre growth of 0.1% since 2022Q3.

The academic economics view

Central banks have, of course, prioritised curbing inflation over supporting growth in recent months with fiscal policy having done much of the heavy lifting to support households through the worst of the energy crisis. However, there remains a fundamental question about how much we really know about the linkages between interest rates and inflation – a topic tackled by John Cochrane in an excellent series of blog posts (here) and a subject I looked at in 2022. Rates are a blunt instrument to tackle inflation and Cochrane points out that the standard model in which higher rates slow the economy and bring inflation under control, albeit with a lag, is much less well founded than is often assumed.

Cochrane argues persuasively that the standard view is based primarily on the Fed’s experience in the early-1980s and that it has not been replicated since. Moreover, even this experience did not conform to what much of modern macro suggests because there was no lag between the tightening of monetary policy and the decline in inflation – it was an instantaneous process. This ought to raise a red flag for it suggests that something else was going on. He also calls into question the results from vector autoregression (VAR) models, which are the standard means of assessing the impacts of monetary policy on the economy. Much of the literature is based on the question of how the economy responds to unanticipated monetary shocks. But monetary shocks are not unanticipated – central banks are always reacting to something. If we could endogenise this process into the model, by knowing what factors trigger monetary actions, we would have a better approximation to the central bank reaction function. However, in doing so the process becomes far too cumbersome, and parsimonious reduced form VAR models may not be the appropriate method. Bottom line: I suspect much of the empirical literature operates with omitted variables which, as any econometrician will tell you, leads to biased results.

In another strange twist, the predominant macro paradigm currently in operation at central banks does not support the standard story. Standard new Keynesian models produce an instantaneous fall in inflation in response to monetary tightening, and then drifts higher over the medium-term (chart above). This is primarily due to the adoption of rational expectations in which policymakers adjust interest rates on the basis of expected inflation. If the model uses adaptive expectations, in which central banks react to past inflation, the new-Keynesian model can replicate the standard story.

Academics such as Cochrane argue that resorting to such expectations formation is sub-optimal because it results in unstable ad-hoc models from which economics has been trying to escape for the past 50 years. He then goes on to examine a number of tweaks which may add additional insight and allow the models to get closer to reality. However, I cannot help thinking that this is to miss the point. The economy is a complicated mechanism, perhaps more akin to a biosphere than a deterministic physical system, and the pursuit of simple solutions is an essentially fruitless exercise. In any case, as a practitioner rather than an academic, I am not averse to ad hocery. One of the lessons drummed into me at an early stage of my training was to consistently test whether the models we use match the data. If they do not, then it is likely that your model is wrong and you should find a better one. This is not to say I don’t admire the elegance of what academic economists produce, but if it produces outcomes at variance with how we think the economy works, we really need to go back to the drawing board.

And another thing …

I recently came across a neat paper published by the San Francisco Fed which questioned the long-run neutrality of monetary policy (summary here). The standard view is that monetary quantities do not impact real quantities in anything other than the short-run because they do not impact on the economy’s productive capacity, and as the economy adjusts to a stable equilibrium in the long-run so the monetary factors wash out. This is engrained in modern economics to the point that it is barely questioned. However, the authors of the paper took a look at more than a century of data across a wide range of economies, and found that “unanticipated” policy tightening (that word again) has impacts on output more than a decade later via its influence on total factor productivity and the capital stock. Interestingly, their results show asymmetric responses, with policy loosening having almost no long-term impact (chart below, taken from the San Francisco Fed blog).

That being the case, it suggests that the recent dramatic tightening by the Fed and ECB (which has tightened at the fastest pace in its relatively short history) may yet have a significant economic impact. Moreover, with governments having relatively little fiscal space to accommodate any slowdown, following the hit to public finances resulting from the pandemic and the energy shock, none of this screams for a positive economic outlook in the near-term.

Last word

Just as economics was forced to rethink in the wake of the 1930s depression and again following the inflation surge of the 1970s, it may be time to start thinking more deeply about how the economy actually works. If I have any advice to the academic macro profession, it would be to stop trying to find ever more elegant ways to make microfoundations work: Understand how real world businesses operate and incorporate this into the models. So long as the theory and evidence do not match up, as much of this post has demonstrated, it is difficult to conclude that we know enough about how the economy really works.

Take it slow and steady

It has long been evident that we are heading for a bumpy economic landing but the BoE’s pessimistic outlook delivered in this week’s Monetary Policy Report nonetheless came as a shock. According to the BoE, CPI inflation is set for a peak of 13% by the fourth quarter of 2022 whilst real output growth more or less flatlines over 2023 and 2024 and unemployment is projected to rise. All this is taking place at the same time as the Conservative Party is set to choose a new leader – frankly, this would be a good contest to lose given that politicians are almost certain to be blamed for the cost of living crisis heading our way. 

It has become fashionable in recent months to lay the blame for the inflation surge on the BoE. Liz Truss, the current front runner to replace the hive of inactivity that is Boris Johnson, argued recently that “the best way of dealing with inflation is monetary policy and what I have said is I want to change the Bank of England’s mandate to make sure in the future it matches some of the most effective central banks in the world at controlling inflation.” I am not sure which central banks she is referring to. In the US, inflation is already above 9% and in the euro zone it is within a whisker of this rate (according to Eurostat, it is likely to have hit 8.9% in July). Admittedly Japanese inflation is at 2.2% but this is after years of disinflation with real GDP growth averaging just 0.5% per annum since the turn of the century. 

Prominent Tory politicians, such as current Attorney General Suella Braverman, have suggested that “interest rates should have been raised a long time ago and the Bank of England has been too slow in this regard.” But this is to conflate a number of issues in the monetary policy debate. In my view there are a number of questions which should be tackled separately: (i) did central banks become complacent in the wake of the GFC by holding rates too low for too long; (ii) was the policy response around the time of the Covid outbreak appropriate and (iii) would higher interest rates have prevented the current inflation spike? 

The answer to (i) is undoubtedly yes. The decline in inflation in the years prior to 2008 buttressed central bank credibility and their actions to inject liquidity in the wake of the GFC without triggering a surge in consumer prices gave rise to the view that they really had conquered inflation. Modern macroeconomics also has a lot to answer for, with the dominant paradigm in academia and central banks having little to say about the inflation process (I touch on this below but a more detailed look is a topic for another day). Thus the recent spike in prices blindsided central bankers who had, frankly, grown complacent. 

With regard to (ii) there is a valid argument to suggest that the Covid-induced collapse in output was a supply side shock to which central banks responded by stimulating demand, which was inevitably going to lead to inflation as demand outstripped supply. Admittedly, this view has only emerged with hindsight but there is a ring of truth to it (even if it is understandable why central banks reacted as they did in 2020). As to whether higher interest rates would have prevented the inflation spike, the answer is unequivocally no. Monetary policy cannot hope to impact on the type of supply shock posed by a huge rise in energy prices.

What does the empirical evidence suggest?

All of this raises an uncomfortable question for central banks which is far less clear cut than they think it is. The standard response to rising inflation is that the credibility of central bank policy requires higher interest rates to bear down on inflation expectations. The economist John Cochrane has been looking at this in a US context (a shorter overview of some of the key points can be found in this blog post). His starting point is the classic 1972 paper by Robert Lucas (even after 50 years it is still heavy going) which demonstrated that money is neutral with regard to the real economy. But as Cochrane pointed out, “our central banks set interest rates. The Fed does not even pretend to control money supply. There are no reserve requirements. We need a theory of inflation under interest rate targets.” At the current juncture, there isn’t one.

Modern macroeconomic models rely on the Phillips curve to propagate inflation dynamics (this postulates there is a negative relationship between unemployment and inflation). In Cochrane’s words, “the Phillips curve has been a disaster, especially lately” (a subject I looked at briefly here). Indeed, Roger Farmer has argued that we should replace the standard Phillips curve with a ‘belief’ function in which nominal output in the current period depends only on what happened in the previous period (see my blog post on this issue). Cochrane concludes on the basis of his analysis that there is no need for central banks to overreact to the surge in inflation: “If the Fed does nothing, inflation may surge for a while, but it will not explode. Inflation will eventually come back on its own, so long as fiscal policy does not create more inflation. The Fed’s inaction does not spur more inflation or set off an inflation spiral.”

I find this conclusion rather comforting since most of the models I have ever used demonstrated only a tenuous relationship between interest rates and inflation. The chart above illustrates the impact of a simulation exercise conducted using my structural macro model of the UK in which Bank Rate is raised by 100 bps relative to baseline and held there for four quarters. After 12 quarters, output is reduced by 1.4 percentage points relative to baseline but the level of consumer prices only declines by 0.1% (note that the impact on wages is far larger).

Another way of looking at the relationship between interest rates and the macroeconomy is to look at vector autoregression (VAR) models which capture the linear dependencies amongst time series by modelling each one in terms of past values of all series in the system. VARs are designed such that we do not need to know the structure of the economy but instead capture how changes in one variable affect other variables in the system. This makes them sub-optimal as forecasting models but very insightful as a method of assessing how shocks percolate through the economy. The model used here contains series for real GDP growth, CPI inflation, Bank Rate and the nominal sterling exchange rate index. The impulse response functions shown in the chart above suggest that the impact of higher BoE interest rates on UK inflation is limited (purists will quibble about the specification of the model and the analysis may come across as a bit back-of the-envelope).

Key takeaway

Based on the evidence, those who argue that the BoE is too far behind the curve (the same applies to other central banks) and that huge interest rate rises are needed to curb the current inflation spike are misguided. The most likely impact of such action will be to crimp economic activity thereby making life harder for those already being hit by the cost of living crisis.

As Cochrane notes: “Why do we not know answers to such basic questions? I think we have been a bit guilty of studying the world as we wish it to be rather than the world we are in.” He goes on to point out: “How is it that we’ve been playing with interest-rate based models for 50 years, yet such basic questions are still unanswered? … As I look at the effort to build monetary models based on interest rate targets, we have been guilty of playing with far too complex models that we don’t really understand.” This is not an argument for central banks taking their foot off the pedal. However, it is an argument for due care in the monetary tightening process. If the economic downturn is as nasty as the BoE predicts, the calls for rate cuts in a year’s time will start to become louder.

Not a pretty picture

This week’s decision by the BoE to raise interest rates another 25 bps to 1% takes Bank Rate to its highest since 2009 and in the process managed to please nobody. Consumers certainly do not welcome it, nor do the markets if pressure on the pound is any guide. Following on from the Fed’s 50 bps rise on Wednesday, central banks are now acting on their rhetoric to take action against the big rise in inflation which is running at 40-year highs in the US and 30-year highs in the UK. This puts the spotlight on the ECB which has yet to follow up its recent more hawkish message with action. But maybe the ECB, like many of us, has significant reservations about countering an adverse economic shock with a tightening of policy which in the short-term will squeeze the economy and make life harder for consumers and businesses which are already reeling under the strain.

The BoE’s economic forecast grabbed a lot of headlines with its prediction that CPI inflation will hit 10.2% by the fourth quarter of 2022, which would be the highest ever CPI inflation reading on data back to 1989 (the RPI series, by contrast, can be extended back to 1914). It also forecast that GDP will contract slightly in 2023, though the quarterly profile suggests that the technical definition of recession, in which there are two consecutive quarterly contractions, is not fulfilled. Looking out over the next three years, the forecast is consistent with annual average growth of just 0.3% which is a grim picture and not one in which a central bank would normally be expected to raise interest rates. So why do it? Aside from the surge in headline CPI inflation, the minutes of the MPC meeting made it clear that the Committee is concerned about the tightness of the labour market and the potential for a spillover to wages. We should thus view this week’s rate increase as a precautionary measure.

When looking ahead it is important to be aware of the interest rate assumptions underpinning the forecast. The baseline (modal) forecast is conditional on market interest rate expectations in which Bank Rate is expected to hit around 2½% by mid-2023 before falling to 2% by mid-2025. Under this assumption, GDP contracts by around 0.25% next year and the output gap widens to 1¼% on a twelve month horizon which under normal circumstances would be considered disinflationary. The central case projection also foresees rising unemployment, with the jobless rate rising by two percentage points to 5.5% on a three year view. These forces combine to produce a sharp slowdown in CPI inflation over the forecast horizon, with inflation close to target on a two year view (2.1%) and well below it by Q2  2025 (1.3%). In the alternative scenario, in which interest rates hold at 1%, the fall in output is less dramatic, with GDP growth next year averaging +0.8%. The rise in unemployment (jobless rate at 4.2% by mid-2025) and fall in inflation (still above target at 2.2% by mid-2025) are correspondingly slower. On the basis of these two forecast paths one conclusion we might draw is that in order to hit the inflation target on a three year view, rates will rise further but perhaps by less than the market is currently pricing in.

Any forecast relies on assumptions about the future, and those regarding energy prices are particularly uncertain but will have major implications for the inflation projection. As it currently stands, the BoE assumes household energy bills will rise by another 40% in October when the domestic price cap is up for its biannual review, following the 54% rise in April (5 percentage points of which were accounted for by the costs resulting from those suppliers that went bust in recent months). Yet the BoE admits that if energy prices “fall back to the levels implied by futures curves …  the level of GDP would be nearly 1% higher by the end of the forecast period and excess supply and unemployment around ¾ percentage points lower. CPI inflation would fall back towards the target more rapidly than in the central projection and would be around ½ and over 1 percentage points below the target in two and three years’ time respectively.” Bottom line: Things may not turn out quite as bad as this forecast suggests.

There are some other elements of the forecast which don’t necessarily stack up. First, if energy prices do rise by 40% in the fourth quarter, the slowdown in inflation in 2023 looks quite ambitious – the BoE estimates that energy will add only 0.25 percentage points to inflation versus 4 points in 2022. Average earnings inflation is expected to slow from 5¾% this year to 4¾% in 2023 despite the fact that if the labour market is as tight as the BoE believes, surely there will be greater upward pressure on wages rather than less as workers try to recoup some of the real wage losses suffered in 2022. This would point to upside risks to the inflation forecast and it is noteworthy that the BoE sees risks to the inflation outlook as tilted marginally to the upside.

If inflation does turn out higher, should the BoE be more aggressive in raising rates compared to current market expectations? In my view, no. Higher inflation will continue to act as a brake on real incomes and activity rates, and in an environment where the UK is struggling to come to terms with a post-Brexit world the headwinds are strong enough without an additional monetary burden (the BoE’s forecast looks for net trade to subtract 1.5 percentage points from growth next year).

Not everyone agrees. Former MPC member Adam Posen is quoted as saying that “The central bank has no choice but to cause a recession when a broad range of prices are rising at such a strong pace … It is duty bound to bring inflation down after more than a year when it has been more than 2 percentage points above its 2% target level during a period of full employment.” This is both irresponsible and wrong from an economist whose work I admire and is the kind of thinking which gets economists a bad name. It also ignores the fact that the BoE’s mandate is to maintain price stability subject to “the Government’s economic policy, including its objectives on growth and employment.” Given the Conservatives’ poor showing in this week’s local elections, I cannot imagine anyone in government believes that exacerbating the cost of living crisis is going to make them any more popular at the ballot box.

Another issue which perhaps did not get as much prominence as it deserved was that in lifting Bank Rate to 1%, the BoE has reached the threshold at which it will consider actively running down its balance sheet. We can expect more guidance as to how this might happen in the August Monetary Policy Report. Suffice to say that if the BoE is raising interest rates whilst simultaneously engaging in quantitative tightening, it is likely to make a bad situation worse.

Getting a grip on inflation

There is an old joke about a man who gets lost in the countryside and asks a local for directions to the nearest town. The local responds: “if it’s the town you’re going to, I wouldn’t start from here.” In many ways that perfectly sums up the position central bankers find themselves in today. Inflation has ramped up in a way that was unforeseen just six months ago and as a consequence interest rates are currently too low for prevailing inflation conditions. It is a very uncomfortable place to be because it opens up central banks to the charge that they are behind the curve on policy.

Onwards and upwards

It is very easy to make the case that central banks missed the inflation surge and have maintained a lax monetary stance for too long. On a literal interpretation this is true. There again, the consensus forecasts did not anticipate the inflation surge either so the noisy brigade perhaps ought to dial down some of the criticism about how slow central banks have been to react. We can see this very clearly in UK data using consensus forecasts for CPI inflation in Q4 2021 against the BoE’s projections (chart below). If anything, the central bank anticipated the inflation surge slightly quicker than most forecasters.

Perhaps the criticism is rooted in the fact that central banks were tardy in tightening policy as the economy normalised following the GFC of 2008-09. I have a lot more sympathy with this view. There was no justification for maintaining the lax stance adopted in 2009 once the economy started to normalise and those criticising central banks today perhaps feared a repeat of the policy mistakes of the 2010s which promoted significant inflation in financial asset prices.

At least the BoE has begun the process of raising interest rates, having increased them by a total of 40 bps over the last two months with more to come. Last month the Fed passed up the opportunity to raise rates and instead signalled a March rate hike whilst continuing its asset purchase programme for another six weeks rather than bringing it to an immediate end. As for the ECB, the depo rate has not been above zero since 2012 and has been stuck in negative territory since 2014. Negative rates may be an acceptable policy option for a limited period but eight years is way too long. At least this week’s press conference provided some indication that the ECB acknowledges “inflation is likely to remain elevated for longer than previously expected [and] risks to the inflation outlook are tilted to the upside, particularly in the near term. The situation has indeed changed." Suggestions from some analysts that this marked a “hawkish” stance from the ECB is rather to miss the point. Moving rates from negative territory to zero is not “hawkish” – it reflects the start of a long-overdue normalisation of the policy stance.

Given the nature of the supply-generated inflation shock it is clear that a rise in interest rates is not going to resolve the problem. But in one sense central banks have no choice but to react. By claiming credit for the fall in inflation during the 1990s they have created a paradigm in which they appear to have control over the inflation process. Under current institutional arrangements, in which central banks maintain responsibility for controlling inflation, their whole credibility is bound up in taking action to curb it which in turn requires tightening policy. However, there may be something of the emperor’s new clothes about this argument. A hugely simplified view of using monetary policy to control inflation is the assumption that it is (to use Milton Friedman’s phrase) “always and everywhere a monetary phenomenon.” As recent events have shown, that is not the case. How do we act then upon inflation?

Dealing with the energy shock

One of the problems facing consumers around the globe is the sharp rise in energy prices. European gas production has declined in recent years and to the extent that this was used largely to smooth out demand patterns during the winter, this has had a significant impact on the market. Last summer European countries were also unable to boost storage to levels that might prevent shortages from emerging during the coldest periods and the resultant scramble for gas has pushed up global prices.

This is making its presence felt in household fuel bills. UK domestic gas and electricity prices rose by 19% and 17% respectively in October and will rise again in April following the Ofgem announcement that the energy price cap will rise by 54% which is likely to push inflation to 7% or above in Q2. Whilst the problem of rising energy costs is not a uniquely British phenomenon, it has taken a different approach to other European countries. In the UK Chancellor Rishi Sunak announced that households would receive a discount of £200 on domestic energy costs in 2022 (around 10% of an average bill) which would be repaid over the following five years. The full impact of the price hike will therefore be borne by consumers.

Elsewhere in Europe, governments have taken a more aggressive approach. With one eye on the election, the French government has forced state-owned EDF to sell nuclear power to rivals at below the current market price, costing it €8.4bn in revenue, whilst limiting the rise in household bills to 4%. The German government plans to reduce the green energy surcharge by 46% and introduce subsidies for lower income households (one person households would receive €135 and a two person household would receive €175) whilst the Irish government has planned a €113 energy rebate to every household.

Calls for wage restraint are missing the point

BoE Governor Andrew Bailey came under fire for suggesting that this week’s 25 bps rate hike was implicitly designed to deter workers from demanding big pay rises. But as many people pointed out, nothing screams wage restraint like a big rise in basic living costs. In any event workers real wages have lagged productivity growth in the decade since the GFC (chart below). Even though there has been a narrowing of the gap since 2018, workers have not been compensated for such productivity growth as has been achieved since 2009. That said, the ratio is currently in line with its long-term average. But this implies that even in a zero productivity growth economy, workers are entitled to flat real wage growth and with inflation set to average close to 6% this year, a nominal wage rise of 6% could be justified on economic grounds.

The governor’s comments were (to be polite) somewhat insensitive. It would have been far better to suggest that the BoE is raising rates to keep down inflation in order that the pay packet can stretch a little further. The FT journalist Martin Sandbu also posed the question “why does the governor of the Bank of England encourage restraint in wage demands but not call for restraint in businesses’ attempts to protect their profit margins?” With BP set to announce a huge rise in profits at a time when energy customers are struggling to find the means to pay their bills, calls for wage restraint are not a good look.

None of this is to say that central banks should not raise interest rates further. But we have to recognise that this will do little to tackle the underlying problems and that a tightening of the monetary stance maybe should be accompanied by fiscal measures to offset some of the pain, especially since rapid inflation will also boost the government’s fiscal revenues. At a time when the government is struggling to remain credible, and when many prominent Brexiteers promised that prices would go down once the UK left the EU, they need to get a grip on the inflation problem soon or voters may be tempted to take their revenge at the ballot box.

A little less conversation (a little more action please)

The investor community was distinctly unimpressed with the BoE’s decision to leave interest rates on hold yesterday with accusations that it had raised expectations ahead of the MPC meeting, only to dash them again. I have a lot of sympathy with those who were caught out, having spent years trying to discern the messages from central banks, and it is always immensely galling when policymakers drop hints only to act contrary to these messages. But it is equally important to understand that central bank messaging is always ever conditional and this subtlety is often overlooked during the media frenzy. However, this episode calls into question the usefulness of forward guidance as a policy tool and the BoE will clearly have to work on its communication strategy. There is also a question of whether a rate hike to counter a supply-side boost to inflation was ever the right approach in the first place.

Communication breakdown

Starting first with the communications, Governor Andrew Bailey told an online panel discussion organised by the G30 group on 17 October that "monetary policy cannot solve supply-side problems - but it will have to act and must do so if we see a risk, particularly to medium-term inflation and to medium-term inflation expectations … And that's why we at the Bank of England have signalled, and this is another such signal, that we will have to act." There were mutterings at the time that such a strong statement, made on a Sunday when markets were closed, should not have been made unless it signalled a shift in policy communications. A few days later the BoE’s new chief economist, Huw Pill, said in an FT interview that “I think November is live” and went on to add “the big picture is, I think, there are reasons that we don’t need the emergency settings of policy that we saw after the intensification of the pandemic” (a view I would endorse). But Pill also tried to take some heat out of the debate by noting “maybe there’s a bit too much excitement in the focus on rates right now.”

The latter point is the bit that was overlooked in the media commentary that followed. The BoE really ought to know better by now that markets simply do not do subtlety. Interest rate decisions are viewed as binary and markets are very poor at determining the distribution of risks unless they are spoon fed. There were also a couple of exogenous factors to take into consideration. Central banks are generally wary of moving ahead of the Fed, and with the FOMC having kept rates on hold the previous evening, the BoE may well have been sensitive to the prospect of acting unilaterally. Moreover, the MPC was not helped by the timing of the tax-raising Budget, released at the start of the MPC ‘purdah period’, which allowed the BoE no time to nudge expectations.

Better ways to communicate

A couple of years ago, former MPC member Gertjan Vlieghe gave a speech in which he suggested there were better ways of communicating monetary policy than the BoE does now. The speech was somewhat overlooked but in my view was a very thoughtful contribution to the policy debate that deserved more consideration. Vlieghe argued that there was a case for the MPC to communicate end-year forecasts for the policy rate. In his view this would take some heat out of the debate by reducing the focus on the very near term (though it may occasionally make life difficult at the final MPC meeting of the year). He reported that central banks in Sweden, Norway and New Zealand, which publish explicit forecasts, were satisfied that this method improved transparency. However, I have reservations that such an approach would work in the UK. Although Vlieghe noted that “it would be important to communicate the degree of uncertainty around this path”, my concern is that the commentariat would not necessarily understand the distinction between a conditional and an unconditional forecast. We are thus likely to end up in a situation where failure to deliver on the central case would be seen as a policy error.

If the BoE were to change its communication strategy, my own preference would be for it to adopt something akin to the Fed dot plot in which individual committee members give their own (anonymised) views on how they believe rates will develop. Here, too, there are many arguments against. For one thing, a dot plot does not identify how interest rate forecasts are linked to growth and inflation forecasts. Moreover the markets would likely focus on the diversity of views rather than the median outcome thus missing the point of the communication.

If we do not like this idea there is always the radical option of not trying to appease markets in the first place. Indeed, explicit monetary policy communication is a relatively recent phenomenon with the Fed switching to this strategy only in 1994. It is not as if the forward guidance policy espoused by former Governor Mark Carney has been a great success. If one of the objectives of monetary policy communication is to increase transparency, the outcome in the wake of yesterday’s decision, when sterling fell by 1.5% against the dollar and bond yields declined by 14 bps, is the sort of transparency that investors could probably live without.

Should interest rates be raised at all?

The issue of whether central banks should raise interest rates is one which I will undoubtedly look at in more detail in future. However, a couple of quick thoughts are in order. I have long taken the view espoused by Huw Pill that central banks have been too slow in taking back the emergency monetary easing put in place to cope with exceptional circumstances. In my view, one of the BoE’s errors in recent years has been the asymmetric nature of its reaction function. It has rightly cut interest rates during times of stress to provide support to the economy. But once the emergency is over, it has justified the decision to keep rates on hold by an absence of inflationary pressures rather than referring to a normalisation of economic conditions. This asymmetry has resulted in real interest rates remaining in negative territory for much of the past decade, with all the attendant distortions that have resulted.

Furthermore, with the BoE expecting inflation to get close to 5% next year, it is difficult to understand why a central bank which talks so much about hitting its inflation mandate continues to sit on its hands. Obviously the inflation spike is being driven by energy trends and supply bottlenecks in the wake of the pandemic, neither of which are amenable to monetary policy actions. But if the central bank does not want to raise rates at a time when inflation is heading towards its highest in 14 years, when will it ever?

Matters were undoubtedly complicated by the release of the budget last week, in which the main takeaway was the ongoing squeeze on household incomes. A rate hike would clearly have played badly in those circumstances. But what the episode demonstrates is that the BoE will have to think a lot more clearly about how it communicates its message, and perhaps equally importantly who it is communicating with? The decision to keep rates on hold sends a positive message to households that the BoE does not intend to make their lives harder but rattled markets which got carried away with the central bank’s message (obviously a rate hike would have reversed the two situations).

There are no easy answers to the conundrum of market communication, but clarity and consistency are the watchwords and arguably the BoE has fallen a bit short on both. Perhaps the problem can best be summed up in Alan Greenspan’s famous quote: “I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant.” It is easy to be critical of both the BoE for its mixed messages and investors for reading too much into its pronouncements. But if ever there was a sign that communications need to be rethought, this week's events provided it.