Cross-dressing in fiscal, monetary policy
“For what is a man profited, if he shall gain the whole world, and lose his own soul?” (Matthew 16:26)
Bank of England Governor Mervyn King and his colleagues on the Monetary Policy Committee (MPC) might be tempted to ask the same question.
For the governor has seized control of fiscal policy, only to lose control of monetary policy.
In the run-up to and the aftermath of the UK general election in May, King has acquired unprecedented sway over the broad outlines of the budget through his influence over the policies of the Conservative-Liberal Democratic coalition, and especially “Iron Chancellor” George Osborne.
King is credited with encouraging the coalition to opt for a front-loaded, aggressive deficit reduction strategy to ensure Europe’s sovereign debt crisis does not spread to Britain. His influence has been cited as decisive by senior Lib Dems in persuading their party to sign up for a coalition agreement committing them to deep, controversial spending cuts.
Not since Montagu Norman (1920-1944) has any governor wielded this type of influence. It is all a far cry from the 1970s, when the Bank was dismissively known as the East End branch of the Treasury.
But in becoming one of the inspirations and architects of the government’s deficit reduction strategy, King has increasingly tied his hands and those of his colleagues on monetary policy.
For the proposed cuts in public expenditure and public sector employment are so deep, especially in 2011 and 2012, that the Bank fears they will have a (modest) adverse impact on growth and a (larger) effect in reducing inflation.
Expected downward pressure on wages and prices from persistent spare capacity, as well as from fiscal consolidation, has encouraged the Bank to emphasize downside risks to forecast inflation at the two-year horizon, even though inflation has remained above the 2 percent target for 41 of the last 50 months and is likely to remain above target for much of the next 15-18 months.
Fiscal consolidation in the face of downside risks to growth and employment are the primary reason the Bank continues to keep interest rates ultra-low even though the United Kingdom, uniquely among the major economies, has seen inflation rise, rather than fall, since the onset of the banking crisis in 2007.
While the governor would stoutly deny the existence of an explicit pact, it is widely accepted that there is a bargain between the Bank and the Treasury to keep interest rates down and stimulative in return for rapid action to cut government spending and borrowing. The unspoken agreement is acknowledged by most senior officials and policymakers in both Whitehall and the City: low rates in return for fiscal consolidation.
But this is putting the Bank’s credibility on the line as never before, because it prevents the Bank from seriously contemplating any rise in interest rates despite persistently missing the inflation target.
In theory, senior officials continue to insist the Bank stands ready to respond to both upside and downside surprises on inflation. In practice, repeated upside surprises have not drawn any policy response in the last two to three years, and it is hard to see why that would change.
For as long as the government remains locked into its ambitious deficit reduction program, the Bank must support it by keeping interest rates low, in the hope that private sector spending, borrowing and job creation will pick up the slack created by a shrinking public sector.
The price of this is that very few people now believe the Bank has the will, or the ability, to drive down inflation to meet the target in either the short term (six to 12 months) or the medium term (one to two years).
Bank Chief Economist Spencer Dale tongue-lashed doubters in a speech last week for “dangerous talk” about the Bank going soft on inflation and seeking to resurrect the old British strategy of devaluing and inflating the economy out of trouble.
The Bank’s own inflation attitudes survey is worrying, however. While the Bank sees the risks to inflation as roughly balanced in the medium term (a two-year horizon), the public overwhelmingly sees inflation dangers in one direction: up .
In the August survey, 71 percent of respondents thought inflation over the next 12 months would be more than the Bank’s 2 percent target, and 52 percent thought inflation would be more than the 3 percent level that would require the governor to continue writing explanatory letters to the chancellor. In fact 15 percent though it would be over 4 percent, and 21 percent though it would be more than 5 percent.
Those figures represent a substantial deterioration from 53 percent who thought inflation would be above target, and 34 percent who thought it would be more than 1 percentage point over target, at the time of the February survey.
Now admittedly, there is a gap between the time horizon used in the survey (12 months) and that used by the Monetary Policy Committee (24 months) for guiding decisions. It is just possible to square public attitudes with those of the committee — if inflation were to remain very high for the next year (owing to the programmed increase in sales taxes, for example) and then tail off abruptly (when the tax rise drops out of the baseline).
But it is equally possible that the public is beginning to doubt the Bank of England’s willingness, or at least ability, to meet its target. Dale insisted the Bank of England’s focus was simply “inflation, inflation, inflation”. But the fact he had to reiterate this so vociferously is a sign of how far doubts have spread, and how desperate the Bank is to refute them.
MPC Member Adam Posen yesterday floated the idea of even more monetary stimulus to offset worsening downside risks, even though nearby inflation continues to overshoot the target.
Britain is not alone. Monetary policy and fiscal policy are being driven closer together around the world. For much of the 1980s and 1990s, the focus was on separating institutional control for monetary and fiscal strategies by giving central banks operational independence. The aim was for sound monetary policy to act as a “discipline” on populist politicians.
But the crisis has driven them together. In the United States, senior policymakers at the Federal Reserve have stressed that while fiscal policy needs a credible deficit reduction strategy in the medium term, they do not want tax rises and spending cuts in the near term lest it undermine an already shaky recovery. The Fed’s massive government bond purchases, as well as purchases of other assets, have already taken it deep into “quasi-fiscal” territory.
In this new world, monetary and fiscal policies are complements rather than substitutes, and monetary policymakers and politicians bedfellows rather than wary strangers.
In some ways it is a healthy growing-up of the monetary framework. One of the most profound insights in modern economics, Professor Jan Tinbergen’s Rule, says that if there are X independent targets (such as inflation and balanced trade) there need to be X independent policy instruments to have any hope of hitting all the objectives at the same time.
Fiscal policy and monetary policy have always needed to be coordinated to be truly effective – though it is only now that many economists are starting to acknowledge this fact.
The problem is that supposedly neutral and independent central bankers are put in an increasingly awkward position. The Fed finds itself pushed to defend deficit spending in the United States, even though such spending has become a subject of controversy between the two major parties and a central part of the mid-term election campaign.
And in the United Kingdom, the Bank of England finds itself relying on fiscal policy rather than monetary policy to bring inflation under control.
The idea of neutral and technocratic central banks setting monetary policy quite apart from the rough and tumble of the political debate is about to be challenged as never before.
While this might be right, it will not be comfortable.
Strange and perilous times indeed.