Stumbling and Mumbling

Inflation targets & credibility

Should the UK abandon its inflation target? The case for doing so is that inflation targeting works badly when an economy is hit by supply shocks, as it is now, with food and oil prices soaring. Such shocks depress economic activity anyway, so attempts to control inflation by raising interest rates exacerbate the downturn.
Inflation targeting works best when inflation is the result of demand fluctuations. When this happens, the Bank can both control inflation and stabilize demand by cutting rates in a downturn and raising them in a boom.
So, what's the case for keeping the inflation target now? This chart shows it. It shows that when we've had a credible monetary policy - inflation targeting recently or Bretton Woods in the 60s - inflation has been lowly or negatively serially correlated. By contrast, when we had no such credible policy in the 70s and 80s, inflation was positively correlated.
Back then, people reacted to high inflation by thinking: "Our costs are going up. We need to raise our prices or wages to cover them." So inflation fed on itself. By contrast, a credible anti-inflation policy makes folks think: "The Bank is going to raise interest rates. So if we raise prices or wages, demand for our services will fall."  Rises in inflation are then only temporary. 
Better still, because inflation stays low because people keep prices and wages down voluntarily, the Bank doesn't actually need to raise interest rates  to control inflation. We therefore don't get policy-induced recessions as we saw in 1980 and 1990.
It's no coincidence that a low serial correlation of inflation - recently and in the 60s - was accompanied by stable growth, whilst positive serial correlation was associated with output volatility. For this reason, some believe more credible monetary policy has been a major cause of recent macroeconomic stability.
Herein lies the case for retaining the inflation target. Abandoning it will change wage and price-setters' expectations, causing them to expect high inflation to persist. The result will not just be higher inflation, but greater economic volatility as - eventually - bigger rises in interest rates will be needed to bring inflation down.
Luckily, though, we don't need to formally abandon the inflation target anyway. The Bank of England's remit (pdf) acknowledges that inflation can depart from its target as a result of "shocks and disturbances", and that rigid targeting in such circumstances "may cause undesireable volatility in output." This is why the penalties the Bank must pay for such deviations - a mere letter of explanation - are so small.
I would expect Mervyn King to draw attention to this clause.
His problem is two-fold. First, it might be that the negative serial correlation of inflation might have been due less to credibility than to dumb luck (pdf) - shocks to prices happen to have been short-lived since the mid-90s - which is running out. Second, policy credibility might be diminishing anyway; the eight-year breakeven inflation rate is 3.45%, implying that the gilt market expects the inflation target to be consistently breached.
Mr King's dilemma, therefore, is that if he relieves the economic pain now by cutting interest rates, he faces a much bigger job in future, because inflation will be harder to bring under control.
There's no simple solution to this.

Markets versus capitalists

Imagine the scene. An idiot gets drunk, goes for a swim and gets into difficulties. I refuse to swim out to help him, as it's slightly dangerous for me to do so. Do I then have a right to be angry at another man who later, and reluctantly, swims out to the rescue?
Surely not.
So why are bankers reportedly angry at Mervyn King for not being quicker to rescue Northern Rock? After all, it was their refusal to lend to it through interbank markets that triggered its troubles.
What we're seeing here, though, is more than mere hypocrisy. This episode shows that many bosses don't really believe in free markets.   Instead, they are like the slaggiest single parent. They pretend to be victims, and expect the state to save people from the consequences of their own stupidity and promiscuity. Indeed, they are worse, as the single parents at least often have the excuse of bad education and upbringing.
This shows that there's an enormous difference between free markets and capitalism. And when the two collide, it's capitalism that wins, even at the price of humiliating a good man.

Greenspan, welfare states & inflation

Alan Greenspan, perhaps the world's most over-rated person, is warning of higher inflation. Why?
Here's what he says (pdf):

In the type of welfare economies that we all have, which required the abandonment of the gold standard, there has been a certain amount of inflation, which people have largely been willing to accept for the benefits of the economic safety nets which have been constructed.
But the problem is that the number is not 2%. Historically it's obviously been more than that.

This echoes back to Greenspan's work for Ayn Rand, where he argued that welfare states required the abandonment of the gold standard and hence printing money and inflation.
There are two problems with this.
First, it's not welfare states as such that create inflation, but rather people's short-termism.
The argument that welfare states are inflationary is simple. The public want welfare spending, but not taxes. So governments have incentives to borrow money . And it's easier to finance that borrowing by printing money than by issuing bonds. So governments abandon the gold standard in favour of fiat money.
But the root cause here is not the welfare state, but rather the public's gullibility. If the public responded to a government that printed money by thinking: "this is going to lead to inflation, and inflation is bad for us" governments would have no incentive to leave the gold standard - especially as it's remarkably easy these days for them to borrow in bond markets.
The welfare state here is a sideshow. Imagine a democratic government in a minimal state facing election. It decides to bribe the voters by a one-off hand-out, financing the bribe by printing money, causing inflation later. There's no welfare state here in the sense we understand it, but inflation arises because the public are daft enough to elect a government that creates it.
The second problem is that political authorities don't just support ordinary people.
Right now, markets are worried by the possibility of inflation, despite today's numbers. Yields on index-linked gilts are low and break-even inflation rates are high; gold has risen above $700/oz; and the Baltic dry index (a neat short-term lead indicator of US producer prices) is near a record high.
But the market ain't worried because it fears more generous welfare for workers.  Markets fear that central banks (led by the Fed today) will cut interest rates even though the global economy is still so strong as to generate inflationary threats - in an effort to bail out bank bosses and fund managers who gambled, lost and are now whining like snotty-nosed five-year olds.
So, insofar as the welfare state generates inflation, it's welfare for capitalists that's the problem, not welfare for workers. Oddly, Mr Greenspan hasn't mentioned this.

Defending the Bank

I don't want to get into a habit of doing this, but I should defend the Bank of England from Jon Moulton's criticism:

Mr Moulton said that during a breakfast meeting with Bank officials “it became clear they did not know what a [collateralized loan obligation] was"...The power of the Bank to control debt markets had been significantly reduced by the proliferation of securitised debt, according to Mr Moulton, who is the senior partner of Alchemy, a mid-market buyout firm. He said the Bank had “no weapons to control CLOs”.

First, it's not the job of all Bank officials to know everything. Here's a hint, Mr Moulton. Look at a £20 note - you've got enough of them. That stuff on the back about the division of labour. They practice it at the Bank. Plenty of folk there know what a CLO is - the fact that you spoke to ones who didn't tells us nothing.
Second, knowing what a CLO is is in itself not terribly useful for the Bank. The question for the Bank is not: what is a CLO? It's: why should we give a damn about them? Why do they pose a threat to the economy? And two months ago, it would have been entirely reasonable not to worry. CLOs, in theory, were tools to help spread risk - not a source of risk. And, Bank officials might have figured; "the guys in the CLO market earn 10-20 times more than we do, so mightn't they have some clue what they are doing?" Detailed knowledge of CLOs, in itself, would not have helped the Bank avoid these forgivable errors.
Finally, it's not the job of the Bank to control CLOs or debt markets. The Bank should not run after traders wiping their noses like a mother with a snotty five-year-old. It's the Bank's job to ensure that the macroeconomy remains stable, whatever damn fools throw at it. And it's been better at its job in recent years than many hedge funds who were just gamblers who got lucky, and are now whining that they've been caught out.

The Fed, and rationality

Should the Fed respond to fears of a "credit crunch" by cutting rates (or hinting at a cut) next month? This is not merely a question of narrow mechnical economics, but about the nature of rationality.
Imagine the Fed were to (surprisingly) cut rates. Equity investors could respond to the move in one of two ways:
1. "Easier money is good for shares and the economy, so I'll buy."
2. "Yikes. Things must be even worse than I thought if Bernanke's so scared of a credit crunch that he's been panicked into cutting rates. I'll sell."
Reaction (1) is plain causal expected utility. Reaction (2) is what Robert Nozick called evidential expected utility.
And the thing is, both are plausible principles of rationality. That's why Newcomb's problem is so vexing.
Becuase we can't use logic to tell which principle will dominate investors' thinking, we can't tell whether  a rate cut really would calm their nerves. Traders make their money not by anticipating economic news, but by anticipating reactions to it, which is a different thing altogether.
But things aren't so simple as this. Lets' suppose investors know that the Fed knows all this. Then they could react to a rate cut by thinking: "If the Fed's easing despite fears that we'll react by principle  (2), things must be catastrophically bad. I'll sell."
I suspect it's the fear of this meta-reaction that will (or should) stop the Fed moving next month; we're into the higher moments of reflexivity.
But the implications are wider than a single rate move. This paper (pdf) discusses how it complicates monetary policy. More generally, the fact that rationality is ambiguous means that predicting human behaviour is just far trickier than the so-called experts would have us believe.

Interest rates since independence

John Redwood's complaints about Brown's policy towards the Bank of England are, as Matt says, strange. And they miss what for me is a curious point - that it's not clear that interest rates have been much different as a result of Brown's decision to give the Bank independence in 1997.
The chart shows what I mean. It compares actual three month rates to those predicted by a simple Taylor rule, of the form:
     Rates = (1.5 x RPIX) + (0.5 x output gap) + 1.5
I've used the Treasury's own estimate of the output gap, and set the constant term so that if RPIX inflation were 2.5% and the output gap zero, rates would be 5.25%, giving a real rate equal to trend GDP growth.
The chart shows that, for the first five years of independence, the Bank tracked the rule closely. Rates were lower than the rule forecast in 2003-04 - as the Bank took out insurance against the risks of US deflation and a recession caused by weak stock markets. And they are lower now, because the Bank anticipates a slump (pdf) in inflation as utility bill rises drop out of the annual comparison soon.
I suspect that, if the Treasury were still setting rates, there'd be a similar pattern.
This suggests that independence might not have changed the way the Bank responds to growth and inflation.
Instead, perhaps the big change is that inflation expectations are lower as a result of Bank independence, which allows rates to be lower than they otherwise would be.
This is one area where Brown shouldn't be criticized.

Expertise: King's red herring

Why should the Bank of England have operational indepdendence? I fear that in his Adam Smith lecture (pdf) on Sunday, Mervyn King may have mis-stated the argument. He said:

Responsibility for setting interest rates has been delegated to a group of people - the Monetary Policy Committee - with the appropriate technical competence...Expert judgment is needed because changes in the way the world works mean that monetary policy cannot be run on auto-pilot.

I've got two problems with this.
1. In theory, the Chancellor could set interest rates by drawing on as much expert advice as the MPC has. The MPC doesn't, in principle, have an advantage in expertise. It has an advantage in credibility. Markets trust the MPC more than it trusts politicians to hold inflation down. Indeed, it's quite possible - as Paul Ormerod argues here (pdf) - that no feasible amount of expertise would allow us to predict and control inflation.
2. In practice, monetary policy does seem to have been run on auto-pilot for most of the time since 1997. The chart shows that interest rates have closely followed a Taylor rule (more here) since then*. The two main deviations were in 1997-98, when policy was tighter than the rule warranted, and in 2002-03, when it was looser, possibly because the Bank took out insurance against a protracted US downturn and US deflation - just as the Fed did. It's not obvious that it required great expertise to follow this path, or that a Chancellor would have done much different; coincidentally, the excess tightness came straight after the general election.
* The rule I used is (0.5 x output gap) + (1.5 x RPIX inflation) + 1.6. This means rates should be 5.4% when output is at its potential level and RPIX inflation is 2.5%. I'm using the Treasury's estimate of the output gap.

Radical thinking on the MPC

Brown's appointment of Tim Besley to the Monetary Policy Committee looks like a nice vindication of Alan Blinder's saying - that economists have the least influence on policy where they know the most and have the most influence on policy where they know the least.
Besley's done little work on macro and monetary policy; this isn't a criticism - just a sign that these fields don't attract many of the best minds these days. But he has written this (pdf):

In a representative democracy, the bundling of issues together with the fact that citizens have only one vote, means that policy outcomes on specific issues may diverge far from what the majority of citizens want. In such circumstances, allowing citizens to out legislation directly on the ballot permits the 'unbundling' of these issues, which forces a closer relationship between policy outcomes and popular preferences.

The chances of Brown heeding this are zero. He probably reckons it's better that Tim fiddles around with quarter-point moves on interest rates than actually comes up with ways of fixing our broken democratic institutions.
Not all of Tim's views are so dangerous for Brown, though. In this study of MPs expenses (pdf), he estimated that "each vote attended by a Conservative MP cost the taxpayer about £58 more than a vote attended by a Labour or Lib Dem MP."

Questions for Bernanke

US monetary policy is getting interesting. Mark Thoma says:

If expectations are overwhelmingly for 5.25%, I don't think the Fed will be willing to surprise markets and pause anyway.

This raises some questions:
1. What if market expectations are irrational - say because herding or information cascades are causing everyone to worry too much about inflation? Should the Fed follow an irrational herd?
2. Is there a danger that higher rates might actually validate high inflation expectations? The private sector might regard a rate rise not as a sign that the Fed is willing to reduce inflation, but rather as confirmation that inflation is indeed a big risk. If higher interest rates lead to higher inflation expectations,  they lose much of their power to reduce actual inflation.
3. Whatever happened to Brainard conservatism? This is the idea that interest rate moves should be modest because central banks need to learn about their effect upon the economy. Doesn't this argue for the Fed pausing?
4. Contrarily, there can be a case for the Fed taking very aggressive action. This paper (pdf) argues that gradual interest rate moves can fail because they do indeed validate private sector expectations. Policy,  say Andrew Caplin and John Leahy "needs to be more aggressive than the reaction it seeks to elicit."
5. Given these uncertainties, could it be that the case for the Fed doing what the market expects is not that this is the right thing to do, but simply that - from the Fed's point of view - it  is the least expensive mistake to make?  As every forecaster knows, if you're going to be wrong, make sure you're wrong in a crowd.

Lay off Bernanke

Anatole Kaletsky accuses Ben Bernanke of being "too clever by half". This is, to my country's shame, a characteristically English insult. And Kaletsky fails to justify it.

Soon after taking the helm at the Fed three months ago, Mr Bernanke decided he would improve on Mr Greenspan’s notoriously convoluted and Delphic statements on monetary policy...Mr Bernanke, by contrast, has tried to dispense with such obfuscation and offer clear guidance on the future direction of interest rates.

However, there's a strong case for greater transparency in monetary policy. In reducing unnecessary uncertainty about monetary policy, risk premia on bonds and shares should be lower. That should benefit everyone. It's hard to see an offsetting cost of greater transparency - though this paper tries to find one.

By adding the single word “yet” to the previous communiqué — “some further tightening may yet be needed” — Mr Bernanke seemed to think he could convey the dual message that the Fed would pause in its rate rises to avoid any danger of an economic slowdown, but simultaneously that it would do whatever was needed to keep inflation under control. In the event, this approach achieved exactly the opposite result — undermining confidence in the dollar and US financial markets.

But markets have suspected for ages that there might be a rate pause at 5% from May onwards; it's pretty much what was in options prices back in March. To any rational person, there should have been little surprise in the statement.

US inflation is now at its highest level for a generation and is creeping steadily upwards.

Insofar as this is the result of monetary policy, it's because policy was too loose under Greenspan. The lags between interest rates and inflation are such that Bernanke's governorship cannot be to blame at all.

If Mr Bernanke decides to stop tightening while inflation is still moving upwards, we could well see financial markets decide to test the new Fed Chairman’s mettle.

But there'll have to come a time when the Fed stops tightening as inflation is rising. This is simply because it takes at least a year for monetary policy to affect inflation*. If you keep raising interest rates while inflation is rising, you'll raise them too high.
Second, financial markets cannot decide anything. They are simply the aggregation of individual actions. And of the countless reasons why an individual might sell bonds or stocks, not one includes a desire to test the Fed's mettle. It's simply wrong to assume to attribute intentionality to groups of atomic actors.
I suspect Kaletsky's argument will be the first of many which compares Bernanke unfavourably to Greenspan. Such comparisons, though, will owe a lot to two biases.
One is the fundamental attribitution error (yes, Bryan, it is sometimes an error). Greenspan had the good fortune to be Fed governor at a time of positive supply shocks, such as the US productivity breakthrough and the supply of  cheap goods from China, and macro stability (which is only very partly (pdf) due to monetary policy itself). It's easy to be a good policy-maker in such benign times.
Second, Greenspan erred on the side of easy policy - which might be why inflation's rising now. And cheap money makes lots of friends.
* Sometimes, inflation rises soon after tighter monetary - this is Chris Sims' price puzzle (pdf). I once raised this  in a job interview at the Bank of England.  I never got the job.