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It is time for BoE to make the 4% NGDP target official

While I do not want to overestimate the effects of Brexit on the UK economy it is clear that last week’s Brexit vote has significantly increased “regime uncertainty” in the UK.

As I earlier have suggested such a spike in regime uncertainty is essentially a negative supply shock, which could turn into a negative demand shock if interest rates are close the the Zero Lower Bound and the central bank is reluctant to undertake quantitative easing.

In the near-term it seems like the biggest risk is not the increase in regime uncertainty itself, but rather the second order effect in the form of a monetary shock (increased money demand and a drop in the natural interest rate below the ZLB).

Furthermore, from a monetary policy perspective there is nothing the central bank – in the case of the UK the Bank of England – can do about a negative supply other than making sure that the nominal interest rate is equal to the natural interest rate.

Therefore, the monetary response to the ‘Brexit shock’ should basically be to ensure that there is not an additional shock from tightening monetary conditions.

So far the signals from the markets have been encouraging 

One of the reasons that I am not overly worried about near to medium-term effects on the UK economy is the signal we are getting from the financial markets – the UK stock markets (denominated in local currency) has fully recovered from the initial shock, market inflation expectations have actually increased and there are no signs of distress in the UK money markets.

That strongly indicates that the initial demand shock is likely to have been more than offset already by an expectation of monetary easing from the Bank of England. Something that BoE governor Mark Carney yesterday confirmed would be the case.

These expectations obviously are reflected in the fact that the pound has dropped sharply and the market now is price in deeper interest rate cuts than before the ‘Brexit shock’.

Looking at the sharp drop in the pound and the increase in the inflation expectations tells us that there has in fact been a negative supply shock. The opposite would have been the case if the shock primarily had been a negative monetary shock (tightening of monetary conditions) – then the pound should have strengthened and inflation should have dropped.

Well done Carney, but lets make it official – BoE should target 4% NGDP growth

So while there might be uncertainty about how big the negative supply shock will be, the market action over the past week strongly indicates that Bank of England is fairly credible and that the markets broadly speaking expect the BoE to ensuring nominal stability.

Hence, so far the Bank of England has done a good job – or rather because BoE was credible before the Brexit shock hit the nominal effects have been rather limited.

But it is not given that BoE automatically will maintain its credibility going forward and I therefore would suggest that the BoE should strengthen its credibility by introducing a 4% Nominal GDP level target (NGDPLT). It would of course be best if the UK government changed BoE’s mandate, but alternatively the BoE could just announce that such target also would ensure the 2% inflation target over the medium term.

In fact there would really not be anything revolutionary about a 4% NGDP level target given what the BoE already has been doing for sometime.

Just take a look at the graph below.

NGDP UK

I have earlier suggested that the Federal Reserve de facto since mid-2009 has followed a 4% NGDP level target (even though Yellen seems to have messed that up somewhat).

It seems like the BoE has followed exactly the same rule.  In fact from early 2010 it looks like the BoE – knowingly or unknowingly – has kept NGDP on a rather narrow 4% growth path. This is of course the kind of policy rule Market Monetarists like Scott Sumner, David Beckworth, Marcus Nunes and myself would have suggested.

In fact back in 2011 Scott authored a report – The Case for NGDP Targeting – for the Adam Smith Institute that recommend that the Bank of England should introduce a NGDP level target. Judging from the actual development in UK NGDP the BoE effectively already at that time had started targeting NGDP.

At that time there was also some debate that the UK government should change BoE’s mandate. That unfortunately never happened, but before he was appointed BoE governor expressed some sympathy for the idea.

This is what Mark Carney said in 2012 while he was still Bank of Canada governor:

“.. adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.

when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.

Shortly after making these remarks Mark Carney became Bank of England governor.

So once again – why not just do it? 1) The BoE has already effectively had a 4% NGDP level target since 2010, 2) Mark Carney already has expressed sympathy for the idea, 3) Interest rates are already close to the Zero Lower Bound in the UK.

Finally, a 4% NGDP target would be the best ‘insurance policy’ against an adverse supply shock causing a new negative demand shock – something particularly important given the heightened regime uncertainty on the back of the Brexit vote.

No matter the outcome of the referendum the BoE should ease monetary conditions 

If we use the 4% NGDP “target” as a benchmark for what the BoE should do in the present situation then it is clear that monetary easing is warranted and that would also have been the case even if the outcome for the referendum had been “Remain”.

Hence, particularly over the past year actual NGDP have fallen somewhat short of the 4% target path indicating that monetary conditions have become too tight.

I see two main reasons for this.

First of all, the BoE has failed to offset the deflationary/contractionary impact from the tightening of monetary conditions in the US on the back of the Federal Reserve becoming increasingly hawkish. This is by the way also what have led the pound to become somewhat overvalued (which also helps add some flavour the why the pound has dropped so much over the past week).

Second, the BoE seems to have postponed taking any significant monetary action ahead of the EU referendum and as a consequence the BoE has fallen behind the curve.

As a consequence it is clear that the BoE needs to cut its key policy to zero and likely also would need to re-start quantitative easing. However, the need for QE would be reduced significantly if a NGDP level target was introduced now.

Furthermore, it should be noted that given the sharp drop in the value of the pound over the past week we are likely to see some pickup in headline inflation over the next couple of month and even though the BoE should not react to this – even under the present flexible inflation target – it could nonetheless create some confusion regarding the outlook for monetary easing. Such confusion and potential mis-communication would be less likely under a NGDP level targeting regime.

Just do it Carney!

There is massive uncertainty about how UK-EU negotiations will turn out and the two major political parties in the UK have seen a total leadership collapse so there is enough to worry about in regard to economic policy in the UK so at least monetary policy should be the force that provides certainty and stability.

A 4% NGDP level target would ensure such stability so I dare you Mark Carney – just do it. The new Chancellor of the Exchequer can always put it into law later. After all it is just making what the Bank of England has been doing since 2010 official!

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Another argument for Open Borders: It is good for the quality for football!

There is no doubt that I strongly favour a policy of removing restrictions on immigrations. Nathan Smith in his recent guest post on my blog showed that a policy of global Open Borders would significantly boost global GDP. However, there might be even better arguments for Open Borders.

My friend Ben Southwood, Head of Policy at the Adam Smith Institute, in a new paper argues that the “crackdown on foreign players hurts English football”. You might not buy Nathan’s arguments, but you should certainly buy Ben’s arguments for Open Borders in international football (to my American readers: Soccer).

This is the abstract from Ben’s paper:

It is a very common view that “importing” foreign football players into the UK to play in the Premier League leads to less opportunity for English players to play for these teams. This means that English players get less high-level experience, and consequently aren’t as good as the players of Spain, France, Italy or Ger- man, who make up a larger fraction of the players playing in their home leagues. This, the argument runs, is an important factor in explaining the English national team’s perceived underperformance in international competitions. I review the literature and present novel data establishing a negative relationship between current performance (as measured by FIFA ranking) and the current amount of football played in a league by native players (across Spain, England, Germany and Italy). Further, I find no relationship between minutes played by English players in the Premier League five or ten years ago and current performance. Finally, I find strong evidence that a league’s overall strength (as measured by its UEFA coefficient) is predicted by the current amount of foreigners playing in it. To restrict foreign players would not directly benefit the English national team, but it would risk substantially curtailing the overall quality of the world’s most popular football league.

PS in my favourite team FC Copenhagen there are very few Danish players and the best “Danish” players have immigrant background. Thank god for immigration and free trade in footballers!

PPS this is my son’s favourite (now former) FC Copenhagen player Igor Vetokele.

Igor

Scott Sumner’s Adam Smith Lecture

Last week Scott Sumner gave a lecture in London on the causes of the Great Recession and Market Monetarism. I had the honour of introducing Scott and you might me hear interrupting Scott near the end of the presentation. Scott made a lot more sense than I did.

Watch Scott’s Adam Smith lecture here.

Enjoy.

HT Sam Bowman

Scott Sumner will be in London next week

This is from the Adam Smith Institute:

Adam Smith Lecture with Scott Sumner

Speaker: Scott Sumner

Date: Tuesday 17 June 2014

Time: 07:00pm – 07:00pm

RSVP: events@adamsmith.org

Location: 10-11 Carlton House Terrace

Map: find us!

Scott Sumner is an American economist who shot to fame between 2009 and 2013 as a result of his blog, themoneyillusion.com, and was in 2012 named the world’s 15th top thinker by Foreign Policy—the same rank as then-Federal Reserve Governor Ben Bernanke.

Prof. Sumner is the father of market monetarism, a macroeconomic school of thought centred on markets and money. Though it takes its foundations from academic work, including that of Robert Lucas, Eugene Fama and of course Milton Friedman, it arose largely on the blogosphere. The Atlantic named Sumner “the blogger who saved the US economy” after his ideas were seen as part of the intellectual support that convinced the Fed to implement QE3. And his view that central banks should target total spending—nominal GDP—rather than consumer price inflation has provoked comment from, among others, Mark Carney.

Prof Sumner teaches at Bentley University, a small, well-regarded private college in Massachusetts. His academic papers—which tackle subjects ranging from whether the US should privatise its mint to the causes of business cycles and recessions—have been featured in prestigious journals including the Journal of Money, Credit & Banking and the Journal of Political Economy.

Please let me (ben@adamsmith.org) know if you’re a journalist and you’d like to arrange an interview with Prof. Sumner.

 

Sam Bowman calls for nominal spending targeting in the euro zone

My friend Sam Bowman, Research Director at the Adam Smith Institute, has written a letter to the Financial Times calling for the introduction of a nominal spending target in the euro zone. This is from Sam’s letter:

…While supply-side reforms are usually helpful and fiscal integration may help some eurozone states, Europe’s main problem is monetary.

Nominal spending has collapsed in the eurozone since 2008 and is still well below its pre-crisis trend level. As a result, Europe’s unemployed face a problem of musical chairs: too many jobseekers chasing too little money.

The eurozone’s best hope is for the European Central Bank to pursue a more expansionary monetary policy to raise nominal spending in the eurozone to its pre-crisis trend level, and commit to a nominal spending target thereafter.

Monetary chaos is the source of Europe’s woes: only monetary stability will overcome them.

I fully agree. The ECB can end the European crisis tomorrow by introducing a nominal spending target. Even a very modest proposal of 4% nominal GDP growth targeting would do the trick. Unfortunately nobody in Frankfurt or Brussels seems to be listening.

Prediction markets and UK monetary policy

I have long argued that central banks should utilise prediction markets for macroeconomic forecasting and for the implementation of monetary policy.

In today’s edition of the UK business daily City AM I have an oped on this topic and about how the Bank of England should have a closer look at prediction markets. See here:

IN HIS first major speech since becoming governor of the Bank of England, Mark Carney is today likely to defend a policy that has come to be described as the “Carney rule”. Also known as forward guidance, the rule effectively promises that interest rates will stay at present levels until unemployment drops below 7 per cent, so long as the Bank’s inflation forecast does not top 2.5 per cent.
 
This kind of forward guidance is welcome news for the financial markets. We will now at least have some sort of map to navigate monetary policy, instead of relying on insinuations from the lips of the wise men on the Monetary Policy Committee (MPC).
 
But this still leaves markets at the mercy of the Bank of England’s internal forecasters, whose credibility can certainly be questioned. The Bank doesn’t need to be biased to consistently predict that it will hit its inflation target, for example (though what institution would forecast that it will fail?). Even with the best incentives, it cannot possibly bring together all the private knowledge spread across investors, firms and households.
 
It is this inability of elite central planners to gather such a wide source of information that led even committed Marxist GA Cohen to agree that markets may be necessary for a rational economic system. No individual, however intelligent, can know enough about the economy to make a really reliable prediction about it.
 
And it’s not just the dragging-together of information from thousands of different sources that makes market predictions more accurate than those made by small elite groups. Investors betting in markets have skin in the game; they have an extremely strong incentive to get their bets right, since they will lose money for bad (inaccurate) bets and win money for good (accurate) ones.
Read the rest of the piece here.
 
And Mark Carney is lucky that he now in fact has a prediction market to look at. This is from a press release from the Adam Smith Institute:

Today we’ve launched two betting markets to try to use the ‘wisdom of crowds’ to beat government economic forecasters….The Bank of England’s economic forecasts have been wrong again and again. To counter this, the free market Adam Smith Institute is today (Wednesday 28th August) launching two betting markets where members of the public can bet on UK inflation and unemployment rates, taking the government’s experts on at their own game. The markets are designed to aggregate individual predictions about the economy’s prospects to use the ‘wisdom of crowds’ to beat the predictions of government experts.

The launch coincides with Mark Carney’s first major speech as governor of the Bank of England and follows his announcement earlier this month that the Bank will consider both inflation and unemployment when deciding monetary policy.
Read more here.
 
It will extremely interesting to follow how this prediction market will work and it will obviously be very interesting to see how it will impact the monetary policy debate in the UK. My hope certainly is that it will help the case for market-driven monetary policy implementation and also help “police” the Bank of England’s forecasts.
 
 
 
 
 
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