July 15, 2008
When the going gets tough, central banks hope for a miracle
This past year has been the first time since the Bank of England was made operationally independent in May 1997, that monetary policy has been politically difficult. From a technical point of view, designing the right monetary policy has also been slightly more complicated than usual, but nothing that a bunch of moderately intelligent graduate students in economics wouldn’t be able to handle. The same applies to the ECB, which started functioning as the central bank of the euro area on January 1, 1999. The Fed has not gone through any institutional transformation since the Humphrey-Hawkins act of 1978, but it too has not been in the current painful policy position since the early 1980s.
So far, these three leading central banks have failed the test. They have looked inflation in the face, blinked and hoped for a better tomorrow.
There are two reasons things are slightly more difficult today from a technical perspective. First, a massive global liquidity crunch has forced all the leading central banks into lender of last resort and market maker of last resort mode, supplying the markets with unprecedented amounts and kinds of liquidity. The financial system and especially the banks, are fragile. Many banks will have to shrink the scale of their operations and balance sheets or go out of business altogether. Many financial markets remain closed for business. The monetary transmission mechanism is therefore likely to be working rather differently from the way it has been for the past twenty or so years.
Second, the global increase in food and fuel costs manifests itself to individual food and fuel importing countries as a one-off increase in the general price level and an increase in the relative price of imported non-core goods to domestically produced core goods and services. This is a double adverse supply shock, the first temporary, the second permanent.
This double supply shock is uncommon rather than hard to handle: you don’t try to reverse the one-off increase in the general price level. You watch out carefully for second-round effects and tighten when they show up. You tighten monetary policy in response to the permanent increase in the relative price of food and fuel because this causes the path of potential output to be lower.
The Bank of England appears to ignore the reduction in potential output represented by the increase in the relative price of non-core goods to core goods and services. It also ignores (chooses to ignore) the evidence of strong second-round effects from recent increases in the general price level. Instead of responding to the clear evidence of higher inflation expectations, short-term and long-term, the Bank takes comfort from the fact that earnings growth or unit labour cost growth has not increased much. That may be a false source of comfort if, as I suspect is the case, the equilibrium share of labour in national income is still falling under the combined influences of globalisation and technical change. In that case there can be full translation of higher expected inflation into earnings growth and unit labour cost growth but no commensurate effect on recorded earnings growth and unit labour cost from one period to the next. Higher expected inflation does get translated into higher actual inflation (on the GDP deflator measure) , however, because the mark-up of prices on unit labour costs is rising - the other side of labour’s declining income share.
The Bank of England continues to sit on its hands, with CPI inflation now at 3.8 percent. At least real short policy rates are still likely to be positive in the UK. In the euro area, where the ECB is far behind the curve despite raising its official policy rate to 4.25 percent this month, forward-looking real policy rates may well turn out to be negative. In the US, the Fed is so far behind the curve that it is likely to look itself in the back sometime soon.
Central banks that raise rates to fight high, rising and above-target inflation at the same time that real output growth (and perhaps even the level of real output) is falling and unemployment is rising are unpopular institutions. Much more unpopular than when rates are raised at a time when inflation is high, rising and above-target but output and employment too are high and still rising. Ministers of Finance, parliaments and other political figures and entities are all over them. But these are exactly the times that independent central banks were made for. Apparently, formal operational independence is not enough. It is true that the Fed, with its dual mandate and its lack of formal independence has turned out to be the softest of touches for those who cry for help whenever a downturn or recession looms. But the Bank of England too appears to lack the courage of its convictions and the ECB is all talk and very little action.
This is your time, guys & gals. This is why central banks were made operationally independent. If you don’t use the political space created by the laws that granted you operational independence to keep the lid on inflation when this is difficult - as it is today - there is no point in granting central banks operational independence. Only determined action by central banks can put the inflation genie back in the bottle. Praying for a miracle won’t do.
I would go further than Willem; this is an opportunity for the BoE. Now, when the monetary constraint is binding for the first time since independence, demonstrating a willingness to let it tighten when it is costly and unpopular can instil a culture of financial rigour (eg in house purchase decisions) that can serve the UK economy well for years, as the Bundesbank did for Germany. I expect that a modest rise in interest rates beginning from the next MPC meeting would be sufficient to achieve this.
Posted by: Tim Young | July 15th, 2008 at 12:41 pm | Report this commentI am not an economist but I studied economics and management and I understand the interest rates’ mechanism. This however does not imply that all my statements will be correct.
It’s true that by increasing interest rates, inflation can be maintained at low levels, but this it’s not always the truth or the way to go.
This is what happens right now in the eurozone where even if interest rates are high inflation keeps rising. It’s true that inflation might put at risk from some economical aspects the various economies, but from the moment that the countries are struggling to achieve high growth I always say “Let the people breathe”. Moreover, economic models do not apply for all situations.
This is exactly what the ECB is not doing in this moment, it increases the interest rates in a period where economies are suffering from low growth and obviously, investments suffer as well. I think that ECB calculates the Eurozone rates with an “average method”. This is not the best way because different countries have different needs especially the economies of the south which are different than those of the north.
I agree that the strong Euro and the fight against inflation is a way to reduce the effects of the credit crunch and the rising oil prices but, in this moment, it’s not what Europe wants entirely. Imagine if Mr. Jean-Claude Trichet would anounce a reduction in interest rates. This would immediately destroy the credibility, indipendence and the image not only of ECB but Mr. Trichet’s in particular. My opinion is that ECB had to take a decision in some way, and the only way to do that was by announcing a 0.25 increase accompanied by a hidden assurance that it would keep the rate there, in other words, no further increase. Why? This would have brought the Eurozone growth to unacceptable levels. At that point they could also have kept the rates where they were.
One more question. How can ECB ask for the wages to remain constant(to reduce inflationary pressures) while inflation is rising by itself, especially when the pressures come from external sources(oil, rice, corn, food etc.)? This implies same amount of money but lower purchasing power. This is highly contradictive. Wages should increase in order for the purchasing power to remain the same.
I cannot elaborate on the Fed because I don’t live in the US but I think that the Fed acts and was always acting like a real government, especially during the credit crunch. I cannot judge if it acted correctly or not, but it acted, as governments should do. ECB just stays there and observes. Immobility and observation is not the way to go in these cases.
Posted by: sm | July 15th, 2008 at 2:30 pm | Report this comment“From a technical point of view, designing the right monetary policy has also been slightly more complicated than usual, but nothing that a bunch of moderately intelligent graduate students in economics wouldn’t be able to handle.”
This is supposed to be a joke, right? Or have the technocrats and their cheerleaders in the chattering classes completely lost their grip on reality? Are the limits only political? Do economists really have so much faith in their own abilities and in their discipline? I’d like to argue the point further, but I wasn’t even a competent undergraduate economics student–although, trained in the Classics, I did learn a word immensely helpful in my later career trading derivatives: hubris.
Posted by: Melancholy Korean | July 15th, 2008 at 2:56 pm | Report this comment2 things:
Posted by: steve jennings | July 15th, 2008 at 3:00 pm | Report this comment1.The oil/food shock is only a one-time event if the price of oil and food doesn’t keep rising…which it probably will.
2. The FED raised rates in 1929 in order to reign in inflation, in fact just exactly what the good prof. suggests they do again now…
The case Prof. Buiter has made for BofE to show guts against political pressures and tighten monetary policy makes sense for a closed economy model. But a relevant question for central banks of major economies today is whether they can be effective in acting alone. Given the low interest rate stance of US Fed, how effective can BofE be in raising the policy rate and fight inflation in the UK alone?
A likely consequence is, if markets are convinced of high interest rates in the UK, that the sterling would appreciate too much to the liking of BofE and the accompanying capital inflow may offset the tightening of monetary policy in terms of credit quantity.
Given the lighly sceanrio that the UK monetary policy cannot do much to offset negative supply shocks, would not the policy-induced appreciation of the sterling aggravates the slowing down of the British economy?
Posted by: Yingfeng Xu | July 15th, 2008 at 4:23 pm | Report this commentA little while ago, Willem Buiter pointed out that there is a strong case in the interests of the British for joining the euro now. In an open economy, would not the best available policy be to join the euro on terms that raised the ECB’s interets rates a quarter point or so extra. That would have much more effect on world inflationery pressures than an isolated UK increase of less than a couple of percentage points; and would produce no economic pain whatever in the UK (politcal agonising is another matter).
Posted by: David Heigham | July 15th, 2008 at 5:25 pm | Report this commentProf Buiter makes many assertions: as to the probable effects of the rise in the relative price of non-core goods, the path of the relative weight of labour income in GDP etc. But as Melancholy Korean points out, how much do we know? Have any of these assertions been tested econometrically? Is it at all possible to test them?
Steve Jennings repeats what I too have asked on this blog: how do Prof Buiter’s policy recommendations differ from those implemented before the Great Depression? In a period of stagflation, which is the riskier: the stagnation or the inflation?
Posted by: RCS | July 15th, 2008 at 8:18 pm | Report this commentOne does not have to be either an economics graduate or a derivatives trader but one has to possess some iota of common sense to understand that inflation impacts unfavourably on the lower and middle classes’ welfare and purchasing power.
Posted by: ttsing | July 15th, 2008 at 9:15 pm | Report this commentCentral bankers are remunerated lavishly and do not feel the pinch at month ends when disposable income is calculated to meet the expenses of the
ensuing month.So what would be the appropriate step to be taken? Increasing interest rates will further penalise the lower income group;increasing wages to maintain purchasing
power will be of short duration as this fuels additional inflation with the higher level value
of money in circulation.Keeping the status quo is not an option but as the Government and the supposedly independent Central Bank(as staunch socialists!) are bailing out financial institutions that are mostly responsible for causing the chaotic and messy state of the economy why not introduce good old-fashioned price controls?? We are no longer in market economies and the Government has to intervene
as a first resort to protect its citizens.
ttsing is very correct.
It is easy for an ordinary person to understand that some forms of price controls are needed nowadays. The general idea is not to destroy the free market but to set boundaries that can help the correct functioning. Of course many people will argue that price controls will produce imbalances and inequilibrium but from the moment that sometimes heavy and ruthless speculation is under way in the stock markets and in our ordinary life in general best example being the coffee that we drink in the local caffes or the milk that we buy in the super market (excluding the impact of biofuels and world crop reduction) why not use this measurements in a cautioned way?
Posted by: sm | July 16th, 2008 at 7:40 am | Report this commentOf course this does not apply for all categories of trading since new changes in the structure of supply(e.g.biofuels etc.) create a new reality.
sm asked: “One more question. How can ECB ask for the wages to remain constant(to reduce inflationary pressures) while inflation is rising by itself, especially when the pressures come from external sources(oil, rice, corn, food etc.)? This implies same amount of money but lower purchasing power. This is highly contradictive. Wages should increase in order for the purchasing power to remain the same.”
The supply of oil, many raw materials and food is limited (or at least inelastic in response to demand increases). Since (for example) Chindia can afford to import more of these resources, because we are buying their goods and services, there is less for the developed countries. So it is not contradictive. The market is telling us we will have to buy less, at least until new supplies or substitutes can be found.
Various policy responses are possible in response to the underlying crisis in supply of essential commodities. First and worst, if wages are allowed to rise (second order inflation) we will simply enter an inflationary spiral. Allowing wages to increase will not alter the basic fact that the UK’s “share” of the world’s oil (for example) based on the goods and services we create is declining. Such an inflationary spiral would be highly destructive.
Second, a small amount of first-order inflation could be allowed, in the hope that wages will not increase. This (it is hoped) will lead to a one-off reduction in spending power, fairly evenly distributed.
Third, inflation could be kept within target, by raising interest rates. This would reduce economic activity and is likely to lead to more unemployment compared to the second option. Note that the main effect at present of lower interest rates on the man or SME in the street has been to weaken the pound, since retail (e.g. mortgage) interest rates are right now being set by supply of and demand for money rather than in response to MPC decisions. But the UK (unlike the US perhaps) is not in a position to export (or import substitute) its way out of trouble by a “competitive devaluation” resulting from a lower exchange rate.
So it is a political decision whether we accept higher unemployment or a general reduction in living standards. Since the start of the crisis last summer, Mervyn King has so far chosen (since the inflation was predictable) to try to spread the pain, and allow more inflation by lowering interest rates (and hence reducing the value of the pound and the cost of imports). This also risks an inflationary spiral. I suggest this was not King’s decision to make and that he should have stuck to his mandate and focussed purely on the inflation target.
Posted by: Tim Joslin | July 16th, 2008 at 9:28 am | Report this commentProfessor Buiter: “You tighten monetary policy in response to the permanent increase in the relative price of food and fuel because this causes the path of potential output to be lower.”
But isn’t any lower output already offset by lower disposable income caused by the same increase in the price of food and fuel? Isn’t there therefore a risk that tighter monetary policy would contract growth to below potential output?
Professor Buiter: “I suspect [that] the equilibrium share of labour in national income is still falling under the combined influences of globalisation and technical change.”
It is interesting that Buiter sees also globalisation as reducing labour’s share in national income. That is often disputed by trade economists. Also, an increase in labour productivity offsets a lasting increase in food and fuel. So, in that case it should be possible to maintain real wages.
Even with an independent central bank, there needs to be implicit or explicit concerted action between the main economic actors. They need to know the trade-offs between monetary policy, fiscal policy and wage settlements, and the impact of different policy mixes on prices, growth and employment. To be sustainable, inflation targets need to be supported by a social consensus, however much economists may detest such a concept. If sacrifices need to be made, they need to be fair and seen to be fair. The Bundesbank’s success was based on such a social consensus.
Posted by: Edward S | July 16th, 2008 at 11:41 am | Report this commentWhy is it that economists spend all of their time describing human behavior according to models based on rational profit-seeking individuals, and yet never use those models to understand their own actions? How many millions of dollars has Alan Greenspan accepted from Wall Street through speaking and consulting fees since he left the Fed? How many millions will Bernanke receive? And people wonder why the Fed continually makes decisions that harm the majority of Americans but make large profits for the banks.
Posted by: RichB | July 16th, 2008 at 12:44 pm | Report this commentRichB,
Because, as rational individuals themselves, they have more to gain by not spreading this information.
Posted by: NC | July 16th, 2008 at 2:57 pm | Report this commentProf. Buiter,
what do you make of Nouriel Roubini’s assessment?
“But over time inflation will be the last problem that the Fed will have to face as a severe US recession and global slowdown will lead to a sharp reduction in inflationary pressures in the U.S.: slack in goods markets with demand falling below supply will reduce pricing power of firms; slack in labor markets with unemployment rising will reduce wage pressures and labor costs pressures; a fall in commodity prices of the order of 20-30% will further reduce inflationary pressure.”
Do you part with Roubini (and Joe Stiglitz, and a few others) because you do not believe that this will be “the worst recession since the great depression” ?
Posted by: pat toche | July 16th, 2008 at 9:44 pm | Report this commentQualitatively, what Roubini says is correct. I believe that Roubini c.s. overestimate the likely severity of the coming recession. Ironically, the only way we would get a severe global slowdown is through a determined anti-inflationary policy effort in the emerging markets. With the exception of Brazil, all EMs have let inflation get out of hand to varying degrees. Because I consider that a severe across-the-board tightening of monetary policy in the EMs is unlikely, I believe the global downturn will be fairly mild (and will not amount to a global recession). In that case there will be a recession in the overdeveloped world (US, UK, euro area, possibly Japan), but not a severe one.
Posted by: Willem Buiter | July 16th, 2008 at 11:54 pm | Report this comment[…] the going gets tough, central banks hope for a miracle” 17 07 2008 Great article here: (ht Bayesian […]
Posted by: “When the going gets tough, central banks hope for a miracle” « The visible hand in economics | July 17th, 2008 at 6:01 am | Report this commentThank you Prof. Buiter for your reply.
I imagine that the developed and overdeveloped economies that will soon be fighting inflation at home will be quick to complain about imported inflation from emerging markets (that would be China and India) — judging by the way they usually blame foreigners for trade deficits, restructuring and other perceived economic woes — and use the usual threats (textile quotas and the like) to get them to tighten their monies (with a little help from the IMF perhaps). You would also expect China to want to establish a certain reputation for their central bank, while at the same time (as it is their President’s main concern) fight poverty and inequality in rural areas (neither high inflation nor a recession would help, so the tradeoff is unclear)… so on balance I find it difficult to imagine what the emerging economies’ central banks will be doing next January!
Thanks for your thought-provoking posts.
Patrick.
Posted by: pat toche | July 17th, 2008 at 7:48 am | Report this commentProf. Buiter: I am surprised to see you arguing on several occasion like an “inflation nutter”. Your recommendation for higher interest rates is basically based on a decline of the output gap following higher prices of oil. 1. Will labor supply decrease as the purchasing power of wages declines with higher prices of gasoline? Do you really believe in this strange story? The opposite seems to me more convincing. 2. The fact that consumption does not decline in terms of domestic production does not proof that demand for domestic production remains unchanged. With unchanged savings rate higher prices for imported consumer goods necessitate lower real demand for domestically produced goods. This points more in direction of a larger output gap than the opposite. The claim for tightening monetary policy seems to me not convincing.
Posted by: Richard | July 17th, 2008 at 12:18 pm | Report this commentJuly 19th 2008, and stil there is not a British in the Executive Board of the European Central Bank.
There is a British in the G8, a British in the IMF, a British in the World Bank, a British in the European System of Central Banks (ESCB)…but there is not a single British in the Executive Board of the ECB which is taking decissions which affect the United Kingdom.
Posted by: Enrique | July 19th, 2008 at 5:21 am | Report this comment