BOE chief economist on policy reversals

The Bank of England’s chief economist Andy Haldane had a stimulating speech out overnight.  I find almost everything Haldane writes is worth reading –  he stimulates thought, and sends me off chasing down references, even if I often end up not quite convinced by a particular argument he makes.

This speech, titled simply “Stuck”, explores some of the reasons why interest rates, around the advanced world, have been so low for so long.   Much of his story uses insights from psychology literature to try to explain behavioural responses across the advanced world in the years since the 2008/09 crisis.  I don’t find the application of the psychology literature entirely compelling, partly because Haldane does not attempt to differentiate between countries that did, and did not, directly experience a financial crisis.  For example, I would have expected different behavioural responses in places such as Ireland or the United States, on the one hand, and countries like New Zealand and Australia on the other.  For New Zealanders, I’d assert, the experience of 1987 to 1991 was much more frightening, and prone to have induced behavioural change, than anything we directly experienced in 2008/09.  And yet within 2.5 years of the trough of the 1991 recession, interest rates needed to rise here.  By contrast, in mid 2015, we are six years on from the trough of the recession, with no sign that the OCR needs to be higher than it was in 2009.

As it happens, New Zealand gets a mention in Haldane’s speech, in somewhat unflattering company. I did a post a few weeks ago on Policy interest rate reversals since 2009 looking at the 10 OECD countries/areas that had raised their raised their policy rates and then lowered them again.  Writing about the New Zealand policy reversal I commented:

it is difficult not to put this episode –  the increases last year, now needing to be reversed – in the category of a mistake.  It is harder to evaluate other countries’ policies, but I would group it with the Swedish and ECB mistakes.    Monetary policy mistakes do happen, and they can happen on either side (too tight or too loose).  But since 2009 it has been those central banks too eager to anticipate future inflation pressures that have made the mistakes and had to reverse themselves.  … should be a little troubling that our central bank appears to be the only one to have made the same mistake twice.  It brings to mind the line from The Importance of Being Earnest:

“To lose one parent may be regarded as a misfortune; to lose both looks like carelessness.”

Haldane includes in his speech a table with an “illustrative list of countries which have pursued the latter strategy – tightening during the post-crisis recovery and then course-correcting”.  New Zealand’s 2014/15 experience makes the list, as do the Swedish and ECB reversals noted in my quote above.  Somewhat provocatively, Haldane includes in the same list the US experience in 1937/38, where some combination of  fiscal and monetary policy tightenings (the role of active monetary policy is much debated) badly derailed the US recovery from the Great Depression, generating another severe recession.
Haldane uses this illustrative material (and not all of the cases seem overly well chosen) to argue a case for an alternative monetary policy strategy:

The argument here is that it is better to err on the side of over-stimulating, then course-correcting if need be, than risk derailing recovery by tightening and being unable then to course-correct.  I have considerable sympathy with this risk management approach.

He goes on to say

Chart 19 shows the average path of output either side of the tightening. Most of these countries experienced several years of robust growth prior to the tightening, suggesting the economy was primed for lift-off. Yet when lift-off came, annual output growth weakened by around 2 percentage points in the following year, in the US by much more. Lift-off was quickly aborted as the economy came back to earth with a bump. In trying to spring the interest rate trap, countries found themselves being caught by it.

Why did this happen? One plausible explanation is the asymmetric behavioural response of the economy during periods of insecurity. Dread risk means that good news – such as oil windfalls – is banked. But it also means that bad news – 9/11, the Great Depression – induces a hunkering down. It risks shattering that half-empty glass. A rate tightening, however modest, however pre-meditated, is an example of bad news. Its psychological impact on still-cautious consumers and businesses may be greater, perhaps much greater, than responses in the past. Or that, at least, is what historical experience, including monetary policy experience, suggests is possible.

Another way of illustrating this point is to imagine you were concerned with the low path of the yield curve and the limited monetary policy space this implied. And let’s say you were able to lift the yield curve to a level which, for the sake of illustration, equalised the probabilities of recession striking and interest rates being at a level at which they could be cut sufficiently to cushion a recession.

With monetary policy space to play with, this might seem like a preferred interest rate trajectory. But it comes at a cost, potentially a heavy one. The act of raising the yield curve would itself increase the probability of recession. If we calibrate that using multipliers from the Bank’s model, cumulative  recession probabilities would rise from around 45% to around 65% at a 3-year horizon. These ready-reckoners are, if anything, likely to understate the behavioural impact of a tightening in a nerve-frazzled environment.

This suggests that a policy of early lift-off could be self-defeating. It would risk generating the very recession today it was seeking to insure against tomorrow. In that sense, the low current levels of interest rates are a self-sustaining equilibrium: moving them higher today would run the risk of a reversal tomorrow. These self-reinforcing tendencies explain why the glue sticking interest rates to their floor has been so powerful.

Haldane concludes that, in his view, current very low UK policy interest rates are still needed, to secure “the on-going recovery and the insure against potential downside risks to demand and inflation”.  Even at such a low policy rate, Haldane observes that he has no bias –  the next move the policy rate could be up or down, and might well be a long time away.

It is certainly refreshing to have a speech of this depth and quality from a senior policymaker, just one among many of those on the Bank of England’s Monetary Policy Committee.

But how convincing is his argument?  I’m not entirely convinced about the mechanism he proposes, but in practical terms, experience is on his side.  Almost all the advanced countries that have raised rates since 2009 have had to lower them again, in New Zealand’s case twice.  Personally, I’m inclined to think that psychology might offer more insights into the behaviour of central banks  and markets –  which, as Haldane notes, repeatedly expected early lift-offs and were repeatedly proved wrong.  In addition, as a nice piece on the Bank of England’s new blog recently illustrated, the “probability of deflation is raised further, and the likely duration of any deflation increased, if one thinks that there are limits on how far the Monetary Policy Committee (MPC) could loosen policy in the face of new shocks.” (ie as policy rates get near zero).

In the current climate, the safest approach for monetary policymakers is to hold off on the rate increases until there is hard evidence that actual measures of core inflation have risen to some considerable extent.  And if you have a central bank that made the mistake of moving too soon, hope that they recognise it quickly, own up quickly, and quickly act to reverse the mistake.  With data like the ANZBO survey results out this afternoon, those wishes seem increasingly apposite in the New Zealand case.

A few thoughts on Greece

It is a pretty difficult period for the world economy. The new BIS Annual Report (on which more later) keeps repeating that world growth has been back at around long-run averages.  But a quick glance down the headline stories on MacroDigest this morning (and it is much the same on the FT or the WSJ) reveals this collection:

Puerto Rico “can’t pay $72bn of debt”

Greece threatens top court action to block Grexit

Double bubble trouble in China

A failed euro would define Merkel’s legacy

BOE’s Haldane: Record-low rates necessary for continued recovery

My 12 year old has asked me to start teaching him economics, and we are bombarded with stories to discuss. This morning, at least, there are no good-news stories.

Of course, most focus is on Greece.  I’ve recently lost a long-running wager on Grexit.  Three years ago I bet a senior official who was much closer to the politics of the euro area that at least one country would have left the euro by mid-June 2015.   His story was, essentially, that the European authorities would do whatever it took to hold the euro together and make it viable for the long run, partly because the alternative was so awful.  My story was that the economic stresses were sufficiently severe, and choices would ultimately be made in individual nation states, that euro was most unlikely to hold together, at least with anything like the number of countries it had then.

In 2012 I certainly underestimated the political determination, and probably also the extent to which Greek public opinion would want to stay in the euro, no matter how bad the economy got.  Getting into the euro seems to have been a mark of a successful transition to a modern democratic state.  This was, recall, a country that had been ruled by the colonels as late as 1974, and had had a civil war only thirty years prior to that.  Even now, there is no certainty that a “no” vote this Sunday –  in respect of a package which is no longer even on the table –  will lead to Greece quickly leaving the euro.  With tight enough capital controls, and the rudiments of a parallel currency, perhaps they will limp on for a while yet.  The political imperative still seems to be that if Greece is going to leave, the narrative has to be one in which “other countries forced us out”.   Greece doesn’t seem to be ready to positively embrace exit –  political dimensions aside, the path through the first year or two beyond exit is pretty difficult and unclear.  For those of you who have read Pilgrim’s Progress, it is perhaps reminiscent of Christian’s fear as the river rises around him –  the river he must cross to enter the celestial city.  Grexit is no path to nirvana, but it does promise something better.

Because if exit looks frightening, going on as things have been in the last few years shouldn’t be remotely attractive either.  The simple mention of 27 per cent unemployment should really be enough.  Add in no sign of any sustained growth in the external sector of the economy, and it is a picture of any economy that has made no progress at all in reversing one of the very deepest recessions of modern times.  None of that is to deny that there have been useful reforms. But, as I’ve said before, there is no sign of any politically acceptable deal (politically acceptable to creditor countries and to the Greeks) that in consistent both with Greece staying in the euro, and with securing a strong rebound in economic activity and employment in Greece.  “Tragedy” is an over-used word, but surely this is one?

Part of the sheer awfulness of the situation is realising the part that other countries played in bringing this about.  And here I include even remote countries like New Zealand, which did not speak out –  or even speak quietly – against the IMF involvement in the deal.  Without the bailout package in 2010, this crisis would have come to a head five years ago.  It is now hardly controversial to suggest that the case for the 2010 bailout package, rather than a widespread Greek sovereign default, was mostly about the French and German banking systems, and concern with the possible ramifications for the wider world economy and financial system.    None of this absolves the Greeks of some responsibility.  Technically, no one forced them to take the deal.   But as the Irish and Italian authorities also found, it can be very difficult to resist the pressure to accede to the wishes of the ECB and core euro-area governments.

Where to from here?  As Gideon Rachman put it in his FT column today

If the Greek people vote to accept the demands of their EU creditors — demands that their government has just rejected — Greece may yet stay inside both the euro and the EU. But it will be a decision by a cowed and sullen nation. Greece would still be a member of the EU. But its European dream will have died.

And if Greece does leave, who will be next, and when?  It might take some time, but with no sign of a strong or sustained rebound in European growth, it is difficult to see the euro surviving in anything like its current form.  It probably isn’t a risk in the next few months –  the ECB and the Commission can deploy support mechanisms to manage any resurgence of external market pressures.  The threat is more from public opinion –  of realising, a year or two from now, that there is viable life outside the euro.  Places as badly managed as Argentina didn’t lapse into permanent economic depression after default and the abandonment of a fixed exchange rate.

The euro has not delivered the promises of its advocates and founders.  Further integration of national policies seems increasingly unlikely to happen.  Breaking up is hard to do, and in this case could be very disruptive to the wider world economy (with so little policy firepower left anywhere)  But the end of the euro, one of the more hubristic policy experiments in the modern West, would probably be good for the longer-run health of the member countries, and especially for their ability to respond to future shocks.  What it might mean for the future of the EU itself is a bigger question.  One could envisage very bad outcomes – a reversion to the controls of 1957, before the EEC was first negotiated.  That doesn’t seem very likely –  trade barriers are much lower now than then around the world.  Perhaps over time what might emerge is something more like a free-trade area without the overlay of other controls and bureaucratic apparatus of Brussels.  For citizens, even if not necessarily for officials, politicians, and lawyers, that might be rather a good thing. It might even make membership of a much more modest EU attractive in the UK.