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.
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!