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. …..it 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.