The rate debate
Willem Buiter says the Bank of England should raise interest rates. Gavyn Davies reckons rates are about correct. It looks like the jokes about economists always disagreeing are right.
But they’re not.
Let the Taylor rule adjudicate. This says Bank Rate should be a function simply of the output gap and inflation. One simple such rule is:
Now, the Treasury reckons (pdf) output was slightly above trend in Q4 2007, which allowing for the recent slowdown suggests the output gap now is teeny. With CPI inflation at 3.3%, this means the Taylor rule says Bank Rate should be well over 7%. Even market rates are well below this.
It looks like Buiter’s right.
But let’s scroll forward to the end of 2009. Economists expect (pdf) that CPI inflation will be almost on target by then (2.1%), and that an output gap of around 2% will have opened up; they expect GDP growth of 1.7% in 2008 and 1.6% in 2009; the Treasury reckons trend growth is 2.7%.
The Taylor rule says this implies a Bank Rate of 4.65%: (0.5 x -2) + (1.5 x 2.1) + 2.5.
So rates will have to come down a tad. It looks like Davies’ right - rates are on the right path.
This raises two issues. One is: how far should policy rely upon forecasts rather than rules? Rules say rates should rise; forecasts say they shouldn’t.
The case for trusting rules is obvious; forecasts are unreliable. Buiter wants rates to rise because he doesn’t trust the forecast that inflation will hit target.
But there’s a case against raising rates. It’s that if rates go up and the forecasts are even roughly right, they’ll merely have to come down sharply later. Raising rates therefore increases interest rate volatility. And the more volatile are interest rates, the more volatile - ceteris paribus - will be demand and inflation in the future. That makes the job of targeting inflation even harder, and increases the likelihood of deviations from target.
I say all this not to come down on the side of Buiter or Davies. Instead, it’s just to show that the jokes about macroeconomists always disagreeing miss the point. Disagreement is embedded in the very nature of the subject, and the demand for certainty is unreasonable. As Wittgenstein said, a clear picture of a fuzzy thing is itself fuzzy.
But they’re not.
Let the Taylor rule adjudicate. This says Bank Rate should be a function simply of the output gap and inflation. One simple such rule is:
This implies that if output is on trend and inflation on target, Bank Rate should be 5.5%.Bank Rate = (0.5 x output gap) + (1.5 x CPI) + 2.5.
Now, the Treasury reckons (pdf) output was slightly above trend in Q4 2007, which allowing for the recent slowdown suggests the output gap now is teeny. With CPI inflation at 3.3%, this means the Taylor rule says Bank Rate should be well over 7%. Even market rates are well below this.
It looks like Buiter’s right.
But let’s scroll forward to the end of 2009. Economists expect (pdf) that CPI inflation will be almost on target by then (2.1%), and that an output gap of around 2% will have opened up; they expect GDP growth of 1.7% in 2008 and 1.6% in 2009; the Treasury reckons trend growth is 2.7%.
The Taylor rule says this implies a Bank Rate of 4.65%: (0.5 x -2) + (1.5 x 2.1) + 2.5.
So rates will have to come down a tad. It looks like Davies’ right - rates are on the right path.
This raises two issues. One is: how far should policy rely upon forecasts rather than rules? Rules say rates should rise; forecasts say they shouldn’t.
The case for trusting rules is obvious; forecasts are unreliable. Buiter wants rates to rise because he doesn’t trust the forecast that inflation will hit target.
But there’s a case against raising rates. It’s that if rates go up and the forecasts are even roughly right, they’ll merely have to come down sharply later. Raising rates therefore increases interest rate volatility. And the more volatile are interest rates, the more volatile - ceteris paribus - will be demand and inflation in the future. That makes the job of targeting inflation even harder, and increases the likelihood of deviations from target.
I say all this not to come down on the side of Buiter or Davies. Instead, it’s just to show that the jokes about macroeconomists always disagreeing miss the point. Disagreement is embedded in the very nature of the subject, and the demand for certainty is unreasonable. As Wittgenstein said, a clear picture of a fuzzy thing is itself fuzzy.
How did Taylor come up with this formula? What is the extra 2.5% for?
Is it to allow for the City to thrive on hot money?
Why are our interest rates always about 2.5% higher than the Eurozone?
As inflation is being caused by international oil prices, isn't dampening down demand here pointless? (and it may move us into recession).
I don't know the answers, just want to know what you think.
Posted by: Neil Harding | June 18, 2008 at 12:16 PM
The 2.5 is to ensure that real interest rates are normally positive. In the UK, since the early 80s, high real rates have been needed to restrain credit demand. Which is one reason why rates have been higher here than in Europe: with credit so freely avaiable, rationing has to be done by price.
It's not pointless to damp down demand in response to higher oil prices. Quite the opposite.
Higher oil prices mean that our productive capacity will fall, as energy-intensive factories shut down. If demand stays the same in the fact of this, inflation will rise, as demand exceeds supply. So demand must be dampened down.
I suspect your scepticism here is founded upon egalitarian concerns. Traditionally, the most most obvious losers from recession have been workers, whilst the obvious winners from lower inflation have been richer folk.
For me, though, this is not an argument for being soft on inflation, but rather for greater insurance for workers (Shiller-type macro markets or unemployment insurance) and greater redistribution.
Posted by: chris | June 18, 2008 at 02:04 PM