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.

More on the McCallum-Christensen rule (and something on Selgin and the IMF)

I have just printed three papers to (re)read when the rest of the family will be sleeping tonight. You might want to have a look at the same papers.

The two first are connected. It is Lastrapes’s and Selgin’s 1995 paper “Gold Price Targeting by the Fed” and McCallum’s 2006 paper “Policy-Rule Retrospective on the Greenspan Era”. Both papers are basically about how the Greenspan conducted monetary policy.

The hypothesis in the first paper is that the Greenspan Fed used gold prices as an indicator for inflationary pressures, while the other is a restatement and an empirical test of the so-called McCallum rule. The McCallum rule basically saying that the Fed is targeting nominal GDP growth at 5% by controlling the money base.

As both papers confirm their hypothesis why not combine the results from the two papers? The Fed reserve controls the money base to ensure 5% NGDP growth and use the the gold price to see whether it is on track or not. Okay, lets be a little more open-minded and lets include other asset prices and lets look at more commodity prices than just gold. Then we have rule, which I have earlier called a McCallum-Christensen (yes, yes I have a ego problem…).

The McCallum-Christensen rule can be estimated in the following form:


d is %-quarterly growth, B is the money base (or rather I use MZM), V is the 4-year moving average of MZM-velocity and NGDPMI is a composite index of asset prices that all are leading indicators of NGDPMI.

In my constructed NGDPMI I use the following variables: S&P500, the yield curve (10y-2y UST), the CRB index (Commodity prices) and an index for the nominal effective dollar rate. I have de-trended the variables with a four-year moving average (thats simple), but one could also use a HP-filter. I have then standardized each of the variable so they get an average of 0 and a standard deviation of 1 – and then taken the average of the four sub-indicators.

And guess what? It works really well. I can be shown that during the 1990ties the Fed moved MZM up and down to track market expectations of NGDP captured by my NGDPMI indicator. This is the time where Manley Johnson and Bob Keleher played an important role in the conduct and formulation of monetary policy in the US. As I have earlier blogged about I fundamentally think that the Johnson-Keleher view of monetary policy is closely connected to the Market Monetarist view.

The McCallum-Christensen rule also fit relatively well in the following period from 2000 to 2007/8, but it is clear that monetary policy is becoming more erratic during this period – probably due to Y2K, 911, Enron etc. Hence, there is indications that the influence of Johnson and Keleher has been faithing in that period, but overall the McCallum-Christensen rule still fits pretty well.

Then the Great Recession hits and it is here it becomes interesting. Initially the Fed reacts in accordance with the McCallum-Christensen rule, but then in 2009-2010 it becomes clear that MZM growth far too slow compared to what the MC rule is telling you. Hence, this confirms the Sumnerian hypothesis that monetary policy turned far to negative in 2009-10.

So why is it that I am not writing a Working Paper about these results? Well, I might, but I just think the result are so extremely interesting that I need to share them with you. And I need more people to get involved with the econometrics. So this is an invitation. Who out there want to write this paper with me? And we still need some more number crunching!

But for now the results are extremely promising.

Okay, on to the third paper “Reserve Accumulation and International Monetary Stability”. Its an IMF working paper. I have a theory that the sharp rise in the accumulation of FX Reserves after the outbreak of the Great Recession has prolonged the crisis…but more on that another day…

PS I promised something on Selgin and this was not really enough…but hey the guy is great and you are all cheating yourselves of great inside into monetary theory if you don’t read everything George ever wrote.


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