The Bank of England's Credibility Dilemma
"The fault, dear Brutus, is not in our stars, But in ourselves" - William Shakespeare, Julius Caesar (I, ii, 140-141)
In his article yesterday Azad Zangana warned against the Bank of England following the Federal Reserve in linking monetary policy moves to key economic thresholds – the so-called “Evans rule”. While I am sympathetic to the argument that an unemployment target may not be optimal policy in the UK, the idea that policymakers should fear wage inflation does not seem to be supported by recent evidence.
Since the financial crisis real wages have been far from a concern for inflation hawks on the Monetary Policy Committee, as the chart below shows:
That wage growth has been so restrained while headline inflation has consistently overshot the Bank’s 2% target tells us something about how worried policymakers need be about the threat of a wage/inflation spiral. Indeed if you looked only at core inflation policymakers could well be forgiven for thinking that the deflation monster is much more of an immediate threat than the inflation beast.
Yet it is undeniable that the Bank has dented its own credibility over the crisis by suggesting that inflation would quickly fall back to target in order to pay lip service to their mandate. As Zangana diplomatically says: “I don’t believe that they’ve been entirely truthful in the inflation forecasts.”
Following this logic, the shift in the Bank’s remit announced by the Chancellor in this year’s Budget should be broadly positive for restoring the institution's credibility. However, while George Osborne made explicit the ability of the MPC to temporarily depart from its inflation target during periods of economic stress, it does not tie them to any particular output indicators.
For many, therefore, the new remit might seem rather too vague:
“The remit recognises that inflation will on occasion depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the target in these circumstances may cause undesirable volatility in output. This reflects the short-term trade-offs that must be made between inflation and output variability in setting monetary policy.”
So here is my problem. If central bank credibility (and independence) is achieved through having a fixed target and sticking to it, a mandate that allows prolonged drifts from its single target has little hope of maintaining its reputation.
Zangana says the addition of forward guidance to the mandate will tie the Bank’s hands to some extent as “if they miss their interim forecasts now they will have to act”. But if it has to continue to balance a stagnating economy against above-target inflation for longer than they anticipate at what point would it be prudent to force them into raising rates?
It seems to me that there is a strong argument for a Fed-style dual mandate. That said, as I mentioned at the start of the piece, I am not convinced that headline unemployment figures are necessarily the right indicator to target for the UK.
This is predominantly because of what the productivity puzzle suggests about the changing nature of the labour market. As Frances Coppola has discussed, labour's falling share of output could be indicative of structural changes in the country’s labour market that the Great Moderation had helped conceal. Under her thesis far from pointing to economic health, rising temporary employment could be a symptom of an unwillingness by corporates to invest in long-term projects and assets (including staff) – that is, it could be a sign of further weakness to come.
Yet there are a variety of metrics that policymakers could pick. Market monetarists, for example, would strongly advocate an NGDP level target while others suggest a central bank could target a price index that gives substantial weight to the level of nominal wages. All of these ideas should be given due consideration by Mark Carney when he takes over at the Bank.
Common to all of these, however, is a focus on an optimal target with little consideration given the tools available to achieve them. The big underlying assumption, of course, is that monetary policy can efficiently influence output. This should not be taken as a given. As John Aziz and I considered in a recent post, it does not seem unreasonable to suggest that, after a financial crisis, the transmission mechanisms of monetary policy can become ineffective (or even counterproductive) when interest rates are stuck around zero.
To my mind we need to re-examine the interrelationship between monetary and fiscal policy, particularly with regard to the distributional effects of the former, if we are to fully understand the dynamics of our current situation. Without this we are asking an extraordinary amount of central bankers, who are already experimenting with tools that we are yet to fully understand. Given the lack of consensus among academics and policymakers on this point it seems somewhat extraordinary that politicians appear so blasé about the risks they are taking.After all, it is not the theoretical threat of rising wages on inflation we should be concerned about but the very real problem of falling incomes due to deteriorating conditions in the labour market.