UK monetary policy

Adam Posen, external member of the Bank of England, has just given a speech arguing that the current fuss about inflation is misplaced. When MPC members fret about good output data or the latest signs of rising household inflation expectations, they should get a grip and look at longer term trends. It is a cogent argument, welcome in reminding everyone to be wary of data blips, and will certainly go down badly with some on the MPC.

Why? Well, in his typical robust style Mr Posen pulls few punches. He suggests that Andrew Sentance, the Committee hawk, is akin to a US climate change-denier who feels the cold chill of one winter’s day and declares all climate scientists wrong. Others on the Committee are rather like a naive foreigners who see a good run of results from Newcastle United and think the team will win the premiership.

“Yes, it is possible that UK supply capacity disappeared despite relatively low increases in unemployment and liquidations, that a large and ambitious fiscal consolidation undertaken at a time of already low interest rates will not be a drag on consumption, that declining unit labor costs do not presage a meaningful decline in inflation, and so on. It is also possible that our recent snows mean that global warming is not happening, and recent performance in matches mean that Newcastle will win the Premiership. Possible, but I would not bet on it, and I certainly would not make policy on the basis of such a forecast.”

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The recent battle of words on the MPC translated into a 1-7-1 vote at the October meeting with Adam Posen voting to increase quantitative easing by £50bn over an unspecified period and Andrew Sentance continuing to vote for a rise in interest rates to 0.75 per cent.

Between these two now entrenched positions, the rest sit in no-man’s-land, unsure whether the risk that high inflation will dislodge expectations is greater than the risk that significant spare capacity will bring medium-term inflation sharply lower.

The bias of this mushy middle was slightly dovish:

“Some of those members felt the likelihood that further monetary stimulus would become necessary in order to meet the inflation target in the medium term had increased in recent months. But, for them, the evidence was not sufficiently compelling to imply that such a course of action was necessary at present.”

What will be fascinating is Read more

At today’s Monetary Policy Committee meeting, Andrew Sentance goes head-to-head with Adam Posen in a bid to sway the mushy middle of the Bank of England’s MPC to his point of view. Like most analysts, the betting is that neither will succeed and the Bank will leave policy unchanged with interest rates at 0.5 per cent and a stock of £200bn of assets purchased under the programme of quantitative easing.

As a paid-up member of the mushy crowd, I share Mr Posen’s theoretical concern that deficient demand will have permanent effects, but also Mr Sentance’s observation that the evidence for these worries is lacking.

So, following Robin’s good practice and the wise words of Fed chairman Ben Bernanke from January, I wondered whether the use of a simple rule of thumb – a Taylor Rule – could help guide us where UK interest rates should be going.

The short answer is no. Read more

The general reaction to Adam Posen’s speech on Tuesday has been to predict a 1-7-1 vote at next week’s Monetary Policy Committee with Mr Posen voting for a resumption in quantitative easing and Andrew Sentance voting for higher interest rates. I have no idea how the MPC will vote. But I do know that Mr Posen is not necessarily alone on the Committee in his central view that if demand is too weak, the risk is not just a temporary double dip but a persistent loss of output which can blight lives and an entire economy.

In fact, Mervyn King, the Bank of England governor made the same point at the February inflation report.

“I think if anything we’re more uncertain about how much spare capacity there is. It’s an extraordinarily difficult judgement to make, and I think the Committee – we had a long discussion of this – we were more inclined to think that this is a reduction in effective supply in the short run that could be reversed. So I don’t think we are confident that this reduction in supply capacity will necessarily persist. And indeed we are in a position where, if growth in demand were to be rapid, I suspect that much of the capacity which has been, quote, “lost”, would come back and be able to be used again, whether in the labour market or on capital stock.

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Martin Weale, Gordon Brown’s least favourite economist, has finally become a member of the Monetary Policy Committee. Having been director of the National Institute of Economic and Social Research for 15 years, he has long been an obvious choice for the Committee but never before got the nod.

With the arrival of the new government, the black mark against his name has been removed and, I am told, he was a natural choice for the Treasury panel and the chancellor.

His appointment is obviously a loss to the public commentary on economics, but we must be able to hope he will still be vocal in his views, challenging authority in the constructive way he has shown in recent years. An example of this was in the FT less than 2 weeks ago when he wrote on Budget day that the chancellor’s “budgetary  target is not ambitious enough” and sought a further tightening of 1 to 2 percent of national income. Many people will disagree, but these views deserve to be aired. Read more

Adam Posen has just finished speaking at the Society of Business Economists’ annual conference. He repeated regularly he was speaking for himself not the Bank of England or the Monetary Policy Committee. And his remarks were a breath of fresh air because he didn’t duck difficult issues nor assume them away. Two things stood out:

  • Mr Posen’s conclusion that British inflation expectations are drifting up and neither one-off effects such as sterling’s depreciation nor higher commodity prices can fully explain the drift of inflation higher.
  • British monetary policy is again walking on a tightrope, suspended above higher inflation on one side and a renewed downturn on the other, making monetary policy very difficult to set. This is likely to make it reactive not proactive and liable to large errors.

Rising inflation expectations Although many in the audience disagreed, Mr Posen’s argument on inflation expectations rested on the argument that Britain’s recovery has been broadly similar to other countries, but its inflation performance has been very different. This he argued was easiest to explain, not by sterling’s depreciation, but by persistent inflation overshoot and mildly adaptive inflation expectations the public hold, as the chart shows.

“The most logical and empirically reasonable explanation for inflation creep is some unanchoring of inflation expectations, caused by the series of above-target outcomes for UK inflation in recent years.”

In a welcome display of transparency, Read more

Yesterday, the Office for Budget Responsibility made it clear that it did not think fiscal tightening would tip the British economy over the edge, partly because “it would be normal to expect some monetary policy response to additional fiscal tightenin.” Some on the MPC think otherwise. Andrew Sentance, an external MPC member, voted to raise interest rates by a quarter of a percentage point. His reason, published in the minutes this morning was as follows:

“For one member, developments over the past month were consistent with a pattern which had been developing over the past year. Inflation had proved resilient in the aftermath of the recession, casting doubt on the future dampening impact of spare capacity on inflation. Demand had recovered at home and abroad, and the average growth of the main measures of UK nominal demand in recent quarters had been above typical pre-recession rates. Despite current uncertainties, for this member, it was appropriate to begin to withdraw gradually some of the exceptional monetary stimulus provided by the easing in policy in late 2008 and 2009.”

If this view gains ground on the Committee, the idea that monetary policy will offset fiscal tightening – if it can – disappears. So far, it seems Mr Sentance does not have much support for his views. Read more

One of the minor obsessions of the new British government is the desire to include housing in the measure of the inflation target given to the Bank of England. In his reply to Mervyn King’s letter explaining why inflation was too high, George Osborne brought the subject up on Tuesday. He wrote:

“As we have discussed, over the longer term I would welcome your views on how we might accelerate the process of including housing costs in the CPI inflation target.”

Of course, housing is included in the CPI already for those who rent property, but not for owner-occupiers. This was followed by the commitment in yesterday’s coalition agreement and programme for government:

“We will work with the Bank of England to investigate how the process of including housing costs in the CPI measure of inflation can be accelerated.”

This ambition is often championed by the Eurosceptic wing of the Conservative Party because it would replace the use of a nasty harmonised European inflation measure as the Bank of England’s inflation target with a measure designed here in Blighty.

The Eurosceptics have a point – not because Britain might ditch something European – but because it is widely recognised that the Harmonised Index of Consumer Prices (the UK CPI) includes rents but nothing for the housing costs of owner occupiers. And that is crackers.

Eurostat is well aware of the shortcoming and is looking Read more

As expected, the Bank of England has just kept interest rates on hold at 0.5 per cent and left the target of asset purchases at £200bn.

There was no statement from the Monetary Policy Committee. This was as everyone expected – the first of many boring rates meetings at the start of 2010 (with the possible exception of next month).