Imagine that US non-farm payrolls were growing by 400k/month (that is how strong the UK labour market is)

My Danske Bank colleague Anders Vestergård Fischer had a fun idea today – he wanted to “translate” the latest UK labour market numbers into something an US audience could understand.

Here is the result of Anders’ back of an envelop calculations – if the US non-farm payrolls were growing as fast as the latest UK employment growth (Q3 2013) then the US economy would be adding 380-400k jobs per month! We haven’t seen job growth like that in the US since the late 1990s. Over the past three months US payrolls have growing around 190k per month.

So what are the explanations for the the UK labour market improvement? The negative spin: Horrible British productive growth. The positive spin: A very healthy combination of monetary easing and fiscal consolidation.

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A five-step plan for Mark Carney

I am on the way to London – in fact I am writing this on the flight from Copenhagen – so I thought it would be fitting to write a piece on the challenges for the new Bank of England governor Mark Carney.

I fundamentally think that the UK economy is facing the same kind of problems as most other European economies – weak aggregate demand. However, I also believe that the UK economy is struggling with some serious supply side problems. Monetary policy can do something about the demand problem, but not much about the supply side problem.

Five things Carney should focus on

Bank of England’s legal mandate remains a flexible inflation targeting regime – however, in latest “update” of the mandate gives the Bank of England considerable leeway to be “flexible” – meaning it can allow for an overshoot on inflation in the short-run if needed to support growth. I am not happy with BoE’s updated mandate as I fear it opens the door for too much discretion in the conduct of monetary policy, but on the other hand it do also make it possible to put good policies in place. I therefore strongly believe that Mark Carney from day one at the BoE needs to be completely clear about the BoE’s policy objectives and on how to achieve this objective. I therefore suggest that Carney fast implement the following policy changes:

1)   Implement a temporary Nominal GDP level target: The BoE should announce that it over the coming two years will bring back the level of NGDP to the pre-crisis level defined as a 4% trend path from the 2008 peak. This would be fairly aggressive as it would require 8-10% NGDP growth over the coming two years. That, however, is also pretty telling about how deep the crisis is in the UK economy. Furthermore, the BoE should make it clear that it will do whatever it takes to reach this target and that it will step up these efforts if it looks like it is falling behind on reaching this target. It should similarly be made clear that the BoE is targeting the forecasted level of NGDP and not the present level. Finally, it should be made clear that once the temporary NGDP target is hit then the BoE will revert to flexible inflation targeting, but with a watchful eye on the level of NGDP as an indicator for inflationary/deflationary pressures. I would love to see a permanent NGDP targeting regime put in place, but I doubt that that is within the BoE’s present legal mandate.

NGDP UK Carney

 

2)   Institutionalise the Sumner Critique: According to the Sumner Critique the fiscal multiplier is zero is the central bank targets the NGDP level, the price level or inflation. I believe it would greatly enhance monetary policy predictability and transparency if the BoE so to speak institutionalized the Sumner Critique by announcing that the BoE in it conduct of monetary policy will offset significant demand shocks that threaten it’s NGDP target. Hence, the BoE would announce that if the UK government where to step up fiscal consolidation then the BoE will act to fully offset the impact of these measures on aggregate demand. Similarly the BoE should announce that any change in financial regulation that impacts aggregate demand will be offset by monetary policy. And finally any shocks to aggregate demand from the global economy will be fully offset. The “offset rule” should of course be symmetrical. Negative demand shocks will be lead to a stepping up of monetary easing, while positive demand shocks will be offset by tighter monetary policy. However, as long as NGDP is below the targeted level positive shocks to demand – for example if financial regulation is eased or fiscal policy is eased – then these shocks will not be offset as they “help” achieve the monetary policy target. This offset rule would to a large extent move the burden of adjusting monetary conditions to the financial markets as the markets “automatically” will pre-empt any policy changes. Hence, it for example British exports are hit by a negative shock then investors would expect the BoE to offset this and as a consequence the pound would weaken in advance, which in itself would provide stimulus to aggregate demand reducing the need for actually changes to monetary policy.

3)   Introduce a new policy instrument – the money base – and get rid of interest rates targeting: There is considerable confusion about what monetary policy instrument the BoE is using. Hence, the BoE has over the past five years both changed interest rates, done quantitative easing and implement different forms of credit policies. The BoE needs to focus on one instrument and one instrument only. To be able to ease monetary policy at the Zero Lower Bound the BoE needs to stop communicating about monetary policy in terms of interest rates and instead use the money base as it’s primary monetary policy instrument. The annual targeted money base growth rate should be announced every month at the BoE Monetary Policy Committee meetings. For transparency the BoE could announce that it will be controlling the growth of the money base by it buying or selling 2-year Treasury bonds from risk and GDP weighted basket of G7 countries. The money base will hence be the operational target of the BoE, while the level of NGDP will be the ultimate target. The targeted growth rate of the money base should always be set to hit the targeted level of NGDP.

4)   Reform the Lender of Last Resort (LoLR): Since the outbreak of the crisis in 2008 the BoE has introduced numerous more or less transparent lending facilities. The BoE should get rid of all these measures and instead introduce only one scheme that has the purpose of providing pound liquidity to the market against proper collateral. Access to pound liquidity should be open for everyone – bank or not, UK based or not. The important thing is that proper collateral is provided. In traditional Bagehotian fashion a penalty fee should obviously be paid on this lending. Needless to say the BoE should immediately stop the funding for lending program as it is likely to create moral hazard problems and it unlikely to be of any significantly value in terms of achieving BoE’s primary policy objectives. If the UK government – for some odd reason – wants to subsidies lending then it should not be a matter for the BoE to get involved in.  My suggestion for LoLR is similar to what George Selgin has suggested for the US.

5)   Reform macroeconomic forecasting: To avoid politicized and biased forecasts the BoE needs to serious reform it macroeconomic forecasting process by outsourcing forecasting. My suggestion would be that macroeconomic forecasts focusing on BoE’s policy objectives should come from three sources. First, there should be set up a prediction market for key policy variables. There is a major UK betting industry and there is every reason to believe that a prediction market easily could be set up. Second, the BoE should survey professional forecasters on a monthly basis. Third, the BoE could maintain an in-house macroeconomic forecast, but it would then be important to give full independence to such forecasting unit and organizationally keep it fully independent from the daily operations of the BoE and the Monetary Policy Committee. Finally, it would be very helpful if the British government started to issue NGDP-linked government bonds in the same way it today issues inflation-linked bonds.  These different forecasts should be given equal weight in the policy making process and it should be made clear that the BoE will adjust policy (money base growth) if the forecasts diverge from the stated policy objective. This is basically a forward-looking McCallum rule.

This is my five-step program for Mark Carney. I very much doubt that we will see much of my suggestions being implemented, but I strongly believe that it would greatly benefit the UK economy and dramatically improve monetary and financial stability if these measures where implemented. However, my flight is soon landing – so over and out from here…

PS it takes considerably longer to fly from Canada to the UK and from Denmark to the UK so Carney have more than two hours to put in place his program so maybe he can come up with something better than me.

Mr. Osborne: “There is a lot of innovative stuff happening around the world”

It is hard not getting just a bit excited about the discussions getting under way in the UK after the coming Bank of England governor Mark Carney basically has endorsed NGDP level targeting. So far the UK government has not given its view on the matter, but it is pretty clear that UK policy makers are aware of the issues. That is good news and today we got a “reply” from the UK government to Carney’s (near) endorsement of NGDP targeting in the form of comments from UK Chancellor George Osborne.

This is from the Daily Telegraph:

The Chancellor said he was “glad” that Mark Carney, the next Governor of the Bank, had raised the prospect of ending central banks’ inflation targets to concentrate more on gross domestic product.

Mr Osborne described the suggestion (NGDP level targeting) as “innovative” and said he was pleased Mr Carney was discussing such ideas.

“There is a debate about the future of monetary policy — not exclusively in the UK, but in many countries. There is a lot of innovative stuff happening around the world,” he said.

“There is a debate going on. I am glad that the future central bank governor of the UK is part of that debate.”

Asked if he was considering making the change suggested by Mr Carney, Mr Osborne said: “There is a debate going on. Any decisions, any future decisions are a matter for government.”

He added: “I have no plans to change the framework. There is a debate going on. I think it’s right there is a debate.”

Mr Osborne said he had had “lots of discussions” with Mr Carney about monetary policy before appointing the Canadian to the Bank of England. But he declined to confirm they had discussed the inflation target, sating the conversations were “private”.

Although he signalled he was open to changing the target, he said that the current inflation target has “served us well” and he would have to be persuaded to changing it.

…A similar debate about nominal GDP targets has been underway for some time, Mr Osborne noted, adding: “It would be a good thing for academia to lead the debate and government to follow.”

This is certainly uplifting. Osborne signals that he don’t necessarily think that NGDP level targeting is a bad idea (it is a great idea!). Obviously for those of us who think NGDP targeting is a great idea it is natural to cheer and scream on Mr. Osborne to get to work on changing the BoE’s mandate immediately. However, for once I will be cautious. I think it makes very good sense for Mr. Osborne to encourage discussion about this issue. Changing a countries monetary regime is an extremely serious matter. Yes, I strongly believe that an NGDP level targeting regime would be preferable to the UK compared to today’s regime, but I also think that the “institutional infrastructure” needs to be sorted out before completely changing the regime.

That said as far as I understand the legal framework (and I am certainly no specialist on this) the Chancellor actually can change the BoE’s mandate simply by sending a letter to the Bank of England governor. So with the stroke of his pen Mr. Osborne could make the  UK first country in the world that had an NGDP targeting regime. I would compare such a policy move to the decision in 1931 that took the UK of the gold standard. That saved the country from deflation and depression. Mr. Osborne could write himself in to the economic history books by showing the same kind of resolve as the UK government did in 1931.

Mr. Osborne deserves a lot of credit for encouraging debate

While I do not agree that the UK’s inflation targeting regime has “served the UK well” I would also say that the UK could have had much worse regimes – just think of monetary policy in the UK in the 1970s or the failed experiment with pegging the pound with with the ERM in the early 1990s.  The is no doubt that an inflation targeting regime is preferable to both alternatives – discretionary inflationary madness or a misaligned fixed exchange rate regime.

However, the inflation targeting regime in the UK likely added to fueling the UK housing bubble (sorry Scott – there was a UK housing bubble) and it has certainly made the crisis much deeper since 2008. An NGDP level targeting regime would have meant that UK monetary policy would have been tighter in the “boom year” just prior to 2008, but also easier over the past four years (but maybe with much less QE!). That would have led to more conservative fiscal policies, more prudent lending policies from the commercial banks and a small housing bubble prior to 2008 and most defiantly much stronger public finances and less unemployment after 2008. Who would seriously oppose such a monetary policy regime?

So I certainly think that an NGDP level targeting regime would have served the UK better than the inflation targeting regime. But Osborne is right – there need to be a debate about this and think the Mr. Osborne deserves a lot of credit for calling for such a debate instead of just declaring that nothing can ever be changed. That is wonderfully refreshing compared to the horrors of the (lack of) debate about monetary policy in Continental Europe (the euro zone…)

 

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