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.

Seven years on

It has been rather quiet on the blogging front these past few months as other projects impinge on my time, but every year around this point I take a look at where we stand on the Brexit issue, and given what has happened in recent weeks it would be a shame to break with tradition.

Johnson disappears and so does a lot of support for Brexit

The most noteworthy event was Boris Johnson’s resignation as an MP – an action precipitated by a report from the Parliamentary Committee of Privileges which would otherwise have recommended a suspension from the House of Commons. Never one to accept personal responsibility, Johnson flounced out of parliament, blaming everyone but himself for the circumstances of his departure. His exit nonetheless raised a whole raft of questions surrounding his toxic legacy and the circumstances that allowed him to thrive.

Both of these issues have been well documented on this blog over the past seven years and have their roots in the poisoned well of public debate triggered by Brexit. Quite simply, Brexit was a strategy designed to further the ends of those populist nationalists who largely happened to be members of, or associated with, the Conservative Party. This is not to say that the parliamentary Tory party of 2016 was rabidly pro-Brexit but it became so when the tone of public debate shifted in the wake of the referendum such that those who questioned the wisdom of the strategy were denounced as enemies of the people. It was in this environment that Johnson was enabled to rise to the top, promising his oven-ready Brexit deal despite the fact it was known in 2019 to be a far less economically attractive proposition than that negotiated by his predecessor, Theresa May. The same supporters egged him on to prorogue parliament in 2019, as he sought to subvert due parliamentary process. In so doing, Johnson kicked 21 Tory MPs out of the party who had the temerity to oppose his strategy. Perhaps it was that point that the Conservative Party became spectacularly unmoored.

Admittedly Johnson did win a handsome electoral majority in December 2019, although this was due in large part to the quality of an opposition led by Jeremy Corbyn. Not long afterwards, a combination of the Covid pandemic and apparent lack of interest in the business of governing caused the government to rapidly lose its way. Indeed one of my biggest concerns in recent years has been the lack of effective governance.

As many of those who agitated in favour of Brexit gradually leave the stage, they leave behind a toxic legacy. Following Johnson’s ousting from Downing Street last year and the implosion of the Truss premiership, the gilt has been slowly peeling from the Brexit crown. Since autumn 2022 the survey evidence points to a lead of 20 points for those who believe that voting to leave the EU in 2016 was a mistake. That does not exactly scream “will of the people.”

It's not just Project Fear

Many of the fears of those who pointed out the economic consequences of Brexit are now being realised (I include myself in that camp). It is simply more difficult to conduct cross-border trade in a world where barriers have been erected where once there were none. As of Q123 the volume of UK goods exports was 9.1% below the average levels in 2019 whilst import volumes were down 8.1% (admittedly the figures are volatile on a quarterly basis so we should not over-interpret them). But the OBR has pointed out that the UK’s trade intensity (trade as a share of GDP) has fallen below that in other G7 economies.

The fall in immigration from the EU has also contributed to the UK’s economic difficulties in a material way. Since 2020, there has been net outward migration of EU nationals: no longer can the UK rely on skilled labour from continental Europe to fill gaps in the domestic labour market. Although this has been more than offset by a net inflow of non-EU nationals (+606k in the year-ending December 2022), only 30% of them came to work, with almost as many being granted leave to remain on humanitarian grounds and therefore not immediately eligible to work (most of the remainder came to study - chart above). Labour shortages have contributed to second round inflation effects, following Covid-related supply bottlenecks and an energy price spike, which are making life harder for many. This is not to say that Brexit is wholly responsible for the cost of living crisis but its role cannot be denied.

However, to get a wider picture I have updated my estimate of the hit to UK GDP based on synthetic control analysis which attempts to measure the performance of the UK economy relative to a panel of 23 similar economies that did not experience the disruption of Brexit (chart above). Last year, I estimated that by Q122 the UK had underperformed the control group by 3.5%. This year my estimate suggests that the underperformance gap widened to around 6.5% by Q123 (admittedly better than the double digit figures recorded in 2020 and 2021 but still alarming). The figures are distorted by the pandemic period when differences in the way non-market services were recorded across economies made cross-country comparisons very difficult. Nonetheless, rebasing the figures at mid-2021 (by which time many of the pandemic restrictions were being eased) actual GDP still underperforms the control total by around 2.5%.

These figures have to be treated with caution. Nonetheless they do suggest that Brexit has imposed a sizeable hit to the UK economy. This should come as no surprise: The way that the UK trades with Europe has changed and it is no longer as easy to cross borders as it was prior to 2021. Eurostar services between London and Amsterdam, for example, have been suspended for a time as construction work means there is no space to perform passport and baggage checks in Amsterdam (ironically well reported in the Brexit-supporting Daily Telegraph).

What happens now?

Nobody really knows. Labour has ruled out returning to the European single market and the customs union, promising instead a “pragmatic” relationship with the EU. Obviously it is trying to win back voters in its core seats where it lost out to Boris Johnson’s promise of an oven-ready deal. But the polling evidence suggests that closer relationships with the EU would not be a vote loser.

Brexit remains an emotive subject. Economically, it poses additional costs at a time when global inflationary pressures are rising, along with interest rates; productivity growth remains sluggish; the fiscal position is less than ideal and the demographic profile is not supportive of a decent medium-term economic rebound. Some of its strongest proponents continue to claim that a “true” Brexit has not yet been tried so it is no surprise that it has failed to yield any benefits yet. Such people are the equivalent of flat-earthers who would not recognise facts if they were presented in a gift-wrapped box. They are, however, increasingly a minority who will probably be left howling at the moon as the political pendulum swings back towards the centre while the likes of Nigel Farage represent a no-trick pony.

However, nobody has the stomach to overturn the events of 2016 for fear of the bitterness it would unleash. It will take a new generation of politicians, untainted by events of the past decade, to find a rapprochement with the EU. By the time that happens, a future generation of historians will likely judge Johnson and his ilk as harshly as those of us who predicted much of the disaster he unleashed.

A slow-burning problem (if at all)

In the words of the great Yogi Berra, the shenanigans in global banking over the past two weeks are “like déjà vu all over again.” The failures of Silicon Valley Bank and Signature Bank in the US and the forced merger of Credit Suisse with UBS have given rise to fears of another bank-induced shock to the global system along the lines of 2008. My own view, for what it is worth, is that we are not on the cusp of a similar shock. But this does not mean that we will escape unscathed and there are lots of questions surrounding the current state of the banking landscape which will continue to reverberate and which may yet have far-reaching implications.

Balance sheet issues

The good news is that systemically important banks are adequately capitalised, at least according to the requirements laid down in the Basel III legislation implemented in the wake of the GFC (see table below). But as with all past crises, the introduction of new regulations is a response to the last war.

The academic evidence makes it clear that bank runs occur when depositors’ demand for liquidity is greater than banks’ ability to supply it. In an important 1983 paper by Douglas Diamond and Philip Dybvig[1] (for which they collected a Nobel Prize in economics last year, along with Ben Bernanke for significantly improving “our understanding of the role of banks in the economy”) the authors highlight that maturity mismatch, when banks’ assets are long-term but their liabilities are short-term in nature, results in an inherent instability in the event that depositors want their money back. This was precisely the problem faced by SVB where 43% of its assets were in the form of held-to-maturity securities marked at book value (significantly above their market value). It suggests that regulators may have to look more closely at the maturity structure of bank balance sheets in future.

Rising rates are the biggest problem

The reasons why banks are once again front and centre of the market debate are complex. But in large part the issues can be traced back to the sharp global monetary tightening that we have seen over the past year. Central banks have raised rates in response to inflation without really having a good understanding of how the monetary transmission process works. Indeed, so far any declines in inflation are due only to the impact of big oil price spikes dropping out of the calculations – nothing to do with tighter monetary policy – and there are real concerns that a sharp tightening of monetary policy will throw the European and US economies into recession. The pace of tightening in the US is the fastest since the late-1970s with the Fed funds rate having risen by 475bps in 13 months (an average of 0.36bps per month). The last time policy was tightened so aggressively was in 1978-79 and the result was recession.

Although in theory rising interest rates are good news for a banking sector that borrows short and lends long, higher rates also have adverse consequences. Aside from the fact that US banks are sitting on a bond portfolio whose market value is worth considerably less than they paid for it, there are mounting concerns about banks’ portfolio of commercial property. The dual impact of an economic slowdown and higher rates take the edge off property prices, reducing the value of the collateral against which loans are secured. Banks will be less willing to lend in these circumstances, potentially triggering further weakness in the commercial market. The fact that this sits on the balance sheet of regional US banks, which account for 70% of all commercial property lending, further amplifies the risks posed by the asset position of the US banking sector.

An additional problem is that banks have suffered from deposit outflows over the past year (chart above). The reason is that deposit rates tend to rise more slowly than lending rates with the result that depositors have an incentive to seek higher yielding alternatives, which goes a long way towards explaining why there has been a big inflow into US money market funds in recent weeks. According to Refinitiv Lipper data, US money market funds received a net $59.3bn of inflows in the week to March 29 bringing the monthly total to $273.3bn versus bank deposit outflows of $187bn over the first half of March.

Implications

The conditions which triggered the Lehman’s crisis of 2008 are not present today. Central banks have adhered to the Bagehot doctrine of providing ample liquidity against good collateral (whether they have done so at a penalty rate is moot). Although markets were spooked by the Credit Suisse issue and market concerns about Deutsche Bank were prevalent a week ago, if there are problems in the global banking system, they are more likely to emerge in the US than Europe.

By fully guaranteeing SVB depositors, despite the fact that many of them had deposits in excess of the $250k limit, the US authorities have sent a signal that there is no need for a rush to the exit which ought to limit the prospect of further bank runs. But whilst the kind of explosive shock which resulted from the Lehman’s bust is unlikely, there is still the prospect of a more slow-burn problem.

In some ways, the recent problems are reminiscent of the Savings and Loan crisis of the late-1980s/early-1990s. S&Ls were subject to limits on the interest rates they could offer to depositors, which consequently led to a major outflow of deposits to money market funds. Deregulation in the early 1980s encouraged them make risky loans in a bid to generate attractive returns, which went sour as the Fed tightened policy. S&Ls were encouraged to act in this way by taxpayer-funded guarantees provided by the Federal Savings and Loan Insurance Corporation which created an enormous moral hazard problem. Between 1986 and 1995 almost one-third of S&L institutions ceased to exist and although it was a slow burner, the demise of S&Ls was a contributory factor to the US recession of 1990-91.

This is not to say that history will necessarily repeat itself but it should act as a warning signal for central bankers who continue to believe that excess inflation is the main problem for them to worry about. Rapid monetary tightening will exacerbate weaknesses in the financial system and a prudent central banker might wish to hold fire on further rate hikes, especially given the magnitude of the tightening put in place over the last year.

---

[1] Diamond D. and P.  Dybvig (1983) ‘Bank runs, deposit insurance, and liquidity’, Journal of Political Economy, 91 (3), pp401–419