The Bank of England’s chief economist, Andy Haldane, just released another fascinating speech on the state of the British (and global) economy, and what the role of monetary policy is.
Known as the most dovish person on the Monetary Policy Committee (MPC), he’s concerned about the threat of deflation and is much more worried about the economy generally than other policymakers
He’s even suggesting the possibility of revising the UK’s 2% inflation target upwards, to something more like 4%.
After the inflation scare of the 1970s and early 1980s, that disinflationary trajectory has been hugely beneficial. Nonetheless, the ratchet down in inflation, alongside falls in global real interest rates, has not been costless. Taming inflation through tight monetary policies came at an output cost, albeit probably a temporary one. More fundamentally, by lowering steady-state levels of nominal interest rates, lower inflation targets will have increased the probability of the ZLB constraint binding.
That being so, one option for loosening this constraint would simply be to revise upwards inflation targets. For example, raising inflation targets to 4% from 2% would provide 2 extra percentage points of interest rate wiggle room.
That’s an argument that finds some agreement from mainstream economists, but Haldane notes rightly that the public perception of inflation is extremely negative. If anything, the average person in the UK would like the inflation target to be lower, not higher.
Haldane notes that in the 1990s, real interest rates (the interest rate once inflation is stripped out) ran to about 4% around the world. Combined with inflation at 2%, that left nominal interest rates at about 6% and allowed the Bank a lot of “wiggle room” to cut them if there was a recession. Now, with global real interest rates floating at something near zero, even with 2% inflation, nominal interest rates would be just 2%.
When it wants to cut interest rates to stimulate the economy, that means the Bank only has 2 percentage points to cut before it hits zero and has to start doing more unconventional things, like quantitative easing.
Haldane reckons that a higher inflation target would give the Bank more wiggle room when downturns appear, given that they’re much more constrained than they were before.
Much like the Federal Open Market Committee’s Naranya Kocherlakota, Haldane isn’t swimming in the same direction as the other policymakers at his central bank. He doesn’t think there’s a good case for an interest rate hike any time soon, and actually thinks if anything, the next move should be a cut. Here’s the kicker from the speech:
Over the past few months, debate on the global economy has been dominated by news from Greece and China. In my view, these should not been seen as independent events, as lightning bolts from the blue. Rather, they are part of a connected sequence of financial disturbances that have hit the global economic and financial system over the past decade.
While the UK’s recovery remains on track, there are straws in the wind to suggest slowing growth into the second half of the year. Employment is softening, with a fall in employment in the second quarter and surveys suggesting slowing growth rates. Surveys of output growth, in manufacturing, construction and possibly services, have also recently weakened. All of these data were taken prior to recent EME wobbles.
In my view, the balance of risks to UK growth, and to UK inflation at the two-year horizon, is skewed squarely and significantly to the downside. Against that backdrop, the case for raising UK interest rates in the current environment is, for me, some way from being made. One reason not to do so is that, were the downside risks I have discussed to materialise, there could be a need to loosen rather than tighten the monetary reins as a next step to support UK growth and return inflation to target.
That puts him completely at odds not only with the minority of hawks on the Bank’s monetary policy committee, but with governor Mark Carney and most of the rest of the rate-setters, who agree the next step will be an interest rate hike.
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