Not dead yet: the future of monetary policy

I recently read, with great interest, the Resolution Foundation’s “Recession ready? Assessing the UK’s macroeconomic framework”. Written by James Smith and three co authors, I was in the mood for a broad and solution-led survey of how monetary, fiscal, and structural policy might be reformed. But it shouldn’t take 113 pages to say “when monetary policy becomes ineffective use fiscal policy instead”. I know that I’m being a little harsh to suggest that’s all they do, but I can’t help but feel that the Keynesian conclusion can be readily anticipated from the Keynesian premise, which is “what tools do we need to escape a future recession?” The alternative approach would be to ask “what macroeconomic framework will prevent recessions from occurring” - a deeper question, and one which may well lead to different answers.

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I totally accept that low interest rates have caused a major problem for the Bank of England, but only to the prevailing approach of inflation targeting. An attack on the status quo isn’t an effective criticism of monetary policy more generally. The report pays lip service to a higher inflation target, and more systematic QE (something I approve of), but seems keen to dismiss those as minor tweaks to an approach that didn’t adequately draw attention to fiscal policy. But demonstrating that different fiscal policy improves on current monetary policy is not a fair fight.

(As an indication of the pernickety way in which I read the report, Figure 3 reveals that “Recessions always result in falling GDP and rising unemployment”, but a recession is falling GDP. Also, Figure 32 claims to show that “tax receipts have fallen since the financial crisis”, but given that it shows receipts as a proportion of GDP, it could also label this as “GDP has risen”.)

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To consider how to fix monetary policy, such that we’re not left with fiscal policy as a last resort, I recommend “Facts, Fears and Functionality of NGDP Level Targeting: A Guide to a Popular Framework for Monetary Policy”, written by David Beckworth and published by the Mercatus Center. This is the paper I’d been hoping he’d write for some time, covering the basic idea behind a nominal GDP target, as well as dealing with some common criticisms.

The first criticism he deals with is how to respond to changes in the potential real GDP growth (Y*). If we set an NGDP target of 4% (let’s say we want ~2% inflation and believe the long term growth rate of real GDP is 2%), then what happens if a productivity slowdown reduces Y* to 1%? Beckworth points out that there’s two options. The first is to recalibrate the NGDP target, e.g. by bringing it down to 3%. But he also mentions George Selgin’s preference, which is to allow the trend inflation rate to change instead. I see three main reasons to favour the latter: (i) by permitting inflation to rise to 3% you are utilising the price systems ability to signal information, rather than be used as an arbitrary means to shape expectations; (ii) a little inflation volatility is tolerable given that by adopting an NGDP target you’ve already decided that nominal income stability is more importance than price stability; and (iii) in this situation you’d need to adjust an inflation target anyway.

The second criticism is that data revisions make NGDP targets impractical. I think this is a valid concern - CPI data is more immediate and reliable than GDP figures - and I don’t find Beckworth’s reassurances totally convincing. His first counterpoint is that a Taylor rule also requires an estimate of GDP (and potential GDP to boot), but this is precisely why many policymakers avoid using it. Certainly in a UK context I believe MPC members place much more weight on the latest CPI figures than on their impression of the output gap. Beckworth’s second counterpoint is that there are ways to improve our real-time estimates. He suggests using income data, or high-frequency nowcasting (such as that used by the Atlanta Fed), or credit card companies payments systems. I’m intrigued by this, and looked into payment data in my book on alternative monetary indicators (see chart below). But whenever I read people getting excited by the possibilities of big data my Austrian instincts kick in and I question whether a lack of data, or computing power, has ever been the constraint on central planning? And even if big data would help, it isn’t ready yet. And I want an NGDP target now! His third counterpoint is my favoured approach, which is using markets rather than computing power - in particular Scott Sumner’s proposal for an NGDP futures market. But it’s never been clear to me how such a futures market would deal with revisions to past GDP figures. (It seems to open the door to policy changes in response to revisions to past data, but this may just be a downside of any level target.)

UK payments growth (% change on previous year)

UK payments growth (% change on previous year)

The third criticism that Beckworth responds to is that the public won’t understand NGDP targets, and I like Beckworth’s framing of a “dollar income growth” as the improvement over a “cost of living index”. But this does cut against the political difficulty of having to wind back an overshoot. In the same way that it’s difficult to sell a need for higher prices to the public during a downturn, it would not be popular to put the breaks on wage growth when the economy is strong.

Finally, Beckworth made a strong case in favour of the financial stability angle of NGDP targets. As he says,

the countercyclical inflation created by an NGDP level target will cause real debt burdens to change in a procyclical manner

This is a big improvement on the status quo. Currently, a recession means that prices fall and the real debt burden on debtors is increased. Under NGDP targets a downturn will lower the real debt burden and share some of those losses with the creditor. Beckworth points to empirical literature showing this risk sharing is useful in a world of incomplete financial markets.

Two bold papers, both worth reading.

Getting the Measure of Money

The IEA have recently published my book on UK monetary policy, called "Getting the Measure of Money".

Throughout the last century or so, economic theory and history have marched together. At certain times, in certain places, new ideas (and the new packaging of old ideas) have captured the attention of the public and policymakers, and been adopted. At other times, and in other places, experiences have prompted an appetite for something different. Arguably, for much of the twentieth century we have seen the latter – the perceived failure of the existing system has required something new. The experience of the 1930s led to the rise of Keynesianism. The experience of the 1970s led to the rise of monetarism. I believe that the experience of the 2008 financial crisis has led to an ongoing revival in Austrian economics. Whilst I do not anticipate the Austrians matching the scale the Keynesian and Monetarist revolutions, the book is my modest attempt to help, by applying some specific Austrian insights to a UK context.

2012 saw the centenary of the original publication of Ludwig von Mises’ The Theory of Money and Credit. I wrote an article (co-authored with Robert Thorpe) that was published in the Review of Austrian Economics, justifying Mises’ position as a quantity theorist. We argued that Mises’ understanding of the equation of exchange differs from both of the conventional textbook versions, and warrants recognition as being a distinct contribution. Most importantly, the equation of exchange can be utilized for distinctly Austrian analysis.

Austrians might argue that you can’t show the business cycle in an aggregated way, but I would argue that the equation of exchange is still the best way to approach it. Indeed according to Ludwig Lachmann, “Austrian aversion does not pertain to these aggregates as such… It pertains to the construction of an economic model in which these aggregates move, undergo change, and influence each other in accordance with laws which are devoid of any visible reference to individual choice” (1978, p.8). It therefore isn’t non-Austrian to utilize economic aggregates, provided they have adequate microfoundations. As Cachanosky (2009) has pointed out, Mises rejected the use of price indices for pure theory. However,

“Their application is appropriate for history and politics. Catallactics is free to resort to them only when applying its theorems to the interpretation of events of economic history and of political programs. Moreover, it is very expedient even in rigid catallactic disquisitions to make use of these two terms whenever no misrepresentation can possibly result and pedantic heaviness of expression can be avoided” (Mises 1949 [1996], p.423).

According to Egger (1995), Athur Marget was a neglected economist because he became known purely as a historian of the “Quantity Equation”, and this focus on aggregate variables was at odds with claims of being attentive towards methodological individualism and subjectivism. However Egger goes on to argue that Marget helped show that the “conceptual organisation” of the “Quantity Equation”, is “capable of the disaggregated, individualistic, and subjective analysis of temporal process that has always identified the Austrian method (Egger, 1995, p.20)”.

Finally, the aim isn’t to provide a definite “Austrian” account of the crisis, because that is simply too ambitious. Indeed as Opper (2002) says an intention to provide one would be falling into the same trap as the mainstream of the profession,

“it appears that the wholesale rejection of Austrian ideas in the post-war era went too far. This rejection reflected a drive by the economics profession to develop a detailed theoretical macroeconomic framework that applied to all business cycles, a goal that is now recognized as overly ambitious”

Rather, if you are engaged in UK monetary policy debate, but are worried that our standard indicators are misleading, this book shows what the Austrian school can add. Data and appendices are available on my personal website.

The defence lines for the war on cash

The Cato Institute has recently published a paper by Jeff Hummel, called “Should Governments Restrict Cash?” As you should expect it’s an excellent overview of the topic and contains multiple astute insights. Hummel considers the two main cases for abolishing cash - (1) to crackdown on criminal activities; and (2) as a means to conduct monetary policy. He notes that some economists stress the former (Larry Summers) and some the latter (Willem Buiter) and his central target is someone who advocates both - Kenneth Rogoff.

Hummel persuasively argues that the burden of proof should fall on those who want to abolish cash to demonstrate that the benefits of doing so would outweigh the costs. And I think he’s right to point out that thus far they’ve neglected a number of important insights. Such as:

  • Actual welfare analysis needs to take place which distinguishes between wealth creating black market activity and wealth destroying illegal activity.

  • Inflation is a tax on real money balances and therefore is currently used as a tax on illegal activity. Therefore going cashless would alter the tax rate facing criminals.

  • The highest denominated banknotes provide the highest amounts of seigniorage. Abolishing them would therefore impact public finances.

  • The US Dollar is a global public good and affects welfare in dollarised countries as well as non-dollarised countries. There’s no evidence to say that restricting the ability of Russian criminal gangs to use US banknotes would compensate for depriving normal Russian families of diversifying from Ruble holdings.

I’m open minded about the so called “war on cash” and conscious of the fact that my instinctive support for anonymous forms of payment cuts against the potential for central banks to solve coordination problems in systems where they are in fact the monopoly provider or currency. However Hummel nicely presents where the defense lines are and since they’re yet to be breached it seems clear that monetary economists have an obligation to protect people’s rights to use cash.

Why r* matters

In an interesting post, Eric Lonergen provides a nihilistic reflection on the relevance of r*. He points out that there's "no simple link between growth and real policy rates" when you look at cross-sectional global data, and that the habit of assuming the long run equilibrium real interest is 2% is lazy. I agree with his claim that the determination of r is "strikingly vague" and that the yield curve, the cost of equity, the term premium and credit spreads are important indicators that shouldn't all be subsumed into r*. But that is because r* is unique and important. 

He writes,

As a practitioner, and a global investor, I gradually came to the conclusion that demographic factors (notably youth dependency), GDP per capita, and changing risk properties were the most important variables in determining the centre of gravity for policy rates and government bond yields.

However consider the Beckworth/Selgin estimate of r*. They use a Ramsey growth model to define the real natural rate as the sum of productivity growth, population growth, and the household rate of time preference. Such factors are indeed the important determinants of "the centre of gravity", but that's exactly what r* is

Shadow banks

“Shadow Banks” permit credit intermediation outside of the conventional banking system. Typical examples include

  • Insurance companies
  • Pension funds

While shadow banks are not part of the central bank regulatory system (and therefore eligible for  liquidity provision) they are still regulated depending on their specific functions.

As the chart below shows shadow banking really took off prior to the global financial crisis. Since then commercial banks have continued on trend whilst shadow banks have leveled out


The growth in shadow banking is likely driven by:

  • Regulatory arbitrage (as a result of harsher regulatory requirements on conventional banks)
  • Search for yield (money being funneled into riskier investment funds)

Quick thoughts on balance sheet recessions

The basic "balance sheet recession" (Koo 2011) story begins with a debt-fuelled asset price bubble, for example:

  • Japan housing 1992
  • US housing 2007

The main argument is that when the bubble bursts the value of people’s assets collapses, but the value of their liabilities remain. Their balance sheets are “under water”.

In this situation, people need to engage in balance sheet repair. This involves private sector deleveraging (increase savings, pay off debt); or firms trying to reduce debt rather than maximise profit. Collectively, this reduces AD and generates a prolonged slump.

The problem is that the central bank can’t do much, for three reasons:

  1. People don’t want to borrow because they are focused on balance sheet repair (therefore low interest rates aren’t enticing)
  2. People draw down bank deposits to pay debt (money supply contracts and the money multiplier becomes 0)
  3. Lenders themselves (i.e. banks) have their own balance sheet problems

Reinhart and Rogoff provided empirical support, showing that recoveries following financial crises are inherently weaker. However this has been challenged by Nelson and Lopez-Salido (2009):

“We find that the regularity that recoveries are systematically slower in the aftermath of financial crises does not hold for the postwar United States. The pace of the expansion after recessions seems to reflect deliberate aggregate demand policy. A weak lending outlook does not appear to pose an insurmountable obstacle to the functioning of stimulative aggregate demand policies”

Scott Sumner provides an alternative (simple) explanation to balance sheet recessions:

  • Recession caused by tight money
  • Tight money reduces nominal income (one might ask why recipients of debt repayments don’t spend it, but this implies there’s an excess money demand problem)
  • Since most debts are nominal, this implies bigger declines in spending in more highly indebted areas

In other words, weak NGDP growth explains things perfectly well

  • “the weak economic recovery is a failure of policy to fully restore aggregate demand, nothing more” (David Beckworth)
  • “increase in government deficits may introduce the uncertainty that causes deleveraging to occur” (Vuk Vukovic)

And even Allan Meltzer (1995, p.67)

  • A further reason to doubt the importance of bank lending as an independent channel propagating the Great Depression is that the decline in bank lending can be readily explained as a response to the decline in nominal GDP… there is no need for any separate explanation of the decline in bank lending

To conclude, we should factor in the structural problems at the onset of the crisis (i.e. not simply an AD shock out of nowhere) and the regime uncertainty caused by big players (government and central bank).

Koo, Richard, C., 2011, “The world in balance sheet recession: causes, cure and politics” Real-World Economics Review, Issue 58

Austrian economics and the yield curve

Two quick views on Austrian economics and the yield curve...

According to Sean Corrigan*, a primary cause of the inverted yield curve is what Hayek referred to as “investment that raises the demand for capital” 

Interestingly, Cowen (1997, p.92-94) argued that the existence of the yield curve negates ABC – he assumes that the long term rate signifies the amount of real savings. In his dissertation (which provides a capital-based macroeconomic model to explain why yield curves tend to inverse one year before a recession), Cwik attempted to refute Cowen (see p.98)**.

* Corrigan, S., “The ABC(T) of the Crisis” Tangible Ideas, Sept/Oct 2010

** Cwik, P.F. “An investigation of inverted yield curves and economic downturns

The mortgage burden

I was reading Bernanke & Gertler's (1995) classic, "Inside the Black Box: The Credit Channel of Monetary Policy Transmission" and was interested in their treatment of the "mortgage burden". Following Boldin (1994) they define it thus: "the ratio of mortgage payments to income for the median new home buyer." I've tried to track down the Boldin article to see this in more detail, but can't find a link

Anyway, I wondered what it would look like for the UK in the lead up to the global financial crisis and asked on Twitter. Neal Hudson kindly shared this chart:




Annual monetary thoughts, 2017

I've not been paying close attention to monetary policy this year - I felt that arguments about the pros and cons of interest rate rises had been done to death, so when the MPC raised to 0.5% in November it barely registered.

But with uncertainty surrounding Brexit likely to dominate macro policy over the next year, I wanted to present an overview of the monetary foundations. 

CPI has recently gone above the 3% letter writing threshold, and it's trajectory is a concern. 


The RPI tells a similar story, although the CPIH seems to show that the main inflation pressures might have already passed through. 

The December Inflation Attitudes Survey has revealed an uptick in inflation expectations, with the median response for 5 years time reaching 3.5%. It will be important to monitor whether policy decisions curtail this view. However other key indicators suggest policy may be too tight.


As the chart above shows broad money (M4ex) growth has steadily fallen since last summer, and current growth of 4.2% is probably too low. Divisia measures have fallen from 12.5% this time last year, to 9.8% now.

Industrial production was at 3.5% in October, stronger than the US but weaker than the Euro area. 

NGDP growth is currently 3.4%, suggesting that the back end of 2016 wasn't a return to consistent ~4% growth but more of a blip. This is a big concern and if it falls below 3 the Bank of England should take note. 


So what's the implication for interest rates? My rough estimate of the natural rate is currently 2.1%, whilst a classic Taylor rule suggests rates should be 4.6%. So policy rates still feel artificially low. But if inflation is passing through, and AD continues to fall, choppy waters may lie ahead. 

The natural rate and EMH

I've just read an interesting paper by Philip Pilkington (then of Kingston University, now of GMO), called "Endogenous Money and the Natural Rate of Interest: The Reemergence of Liquidity Preference and Animal Spirits in the Post-Keynesian Theory of Capital Markets". In it, he argues that the concept of "a" natural rate of interest implicitly assumes that the EMH holds.

This is a post Keynesian perspective, resting on Keynes' view that there was no single rate of interest that would bring the loanable funds market to equilbrium. Rather, there's a multitude of interest rates that exist throughout the market. One might think that the risk-free rate serves as a benchmark upon which other rates relate, however these rates require a risk adjustment. Pilkington's point is that in order for savings and investment to be equal, "every lender is pricing in the risk of the borrower correctly - i.e. they are lending to the borrower at the "correct" or "natural" rate of interest given this specific borrower's risk". He goes on to argue that this requires an assumption that lenders are perfectly rational and have perfect information. If this isn't the case, he says, there's no reason to expect the natural rate to "channel investment in a manner that ensures a stable equilibrium growth path".

What caught my eye was a footnote where Pilkington points out a perceived contradiction amongst Austrians:

One might note the superficial similarities between what we have just described and the boom-bust cycle of the Austrian Business Cycle Theory (ABCT). The key difference, however, is that the ABCT assumes that only central bank action can affect the money rate on interest. As we have seen, however, unless we assume perfect foresight on the part of savers/investors there is no logical reason to assume that they will set the money rate of interest in line with the natural rate. It would be interesting to consider how Austrian theorists, who generally recognize Knightian uncertainty as being operative in capital markets, would respond on this point. The only viable response to this so far as we can see is to advocate some form of the EMH and rational agents, but if Austrians were to do so it would no longer be clear what would distinguish them from, for example, New Classicals.

The Austrian point is that expectations don't need to be rational (in a RatEx sense) for there to be a tendancy towards equilibrium. The Austrian point is that the "saving" in the loanable funds market is - to paraphrase Roger Garrison's terminology - "saving for something". It thus bridges short run and long run models.

Keynesians emphasise the capacity for saving to not find its way into investment (i.e. the paradox of thrift can occur), whereas classical growth theorists argue that all unconsumed resources are necessarily channelled into investment uses. However the  critical difference between these views is simply the time scale: in the short run Keynesians are right, in the long run the classicals are. But the Austrian approach finds a convenient middle ground. Higher saving (because it's driven by a purposeful reason) means greater future consumption and therefore greater profits for entrepreneurs that ready those resources. Rather than implicitly rely on an assumption of Rational Expectations, this fully captures the radical uncertainty that characterises entrepreneurial decision making. Indeed this is precisely why disruptions to the natural rate (i.e. signal extraction problems) matter. I think the Austrian position is robust on this. The middle ground is solid.

For more on my take on the differences (but also similarities) between Austrians and the New Classicals, see here.

Taylor rule calculator: UK rates should be 4%

When I teach introductory classes on monetary economics, I follow Fernando Nechio's simplified version of the Taylor Rule:

Target rate = 1 + 1.5 x Inflation – 1 x Unemployment gap.

It is easy to remember and provides a decent back of the envelope. I've been looking for a decent online applet, and came across a script from Don't Quit Your Day Job. It nicely integrates with current data, allows you to adjust the coefficients, and shows everything on a chart (recent monetary difficulties are clearly expressed by the fact that the Taylor rule never drops below zero).

A recent WSJ article by Michael Derby (h/t Mike Bird) uses a tool from the Atlanta Fed to claim that rates for the US should now be 2.5% - 3% under a Taylor Rule. A very nice aspect of this is the ability to tweak the estimate of the natural rate (conventionally, but arbitrarily, set to 2%). Using a Laubach-Williams model this reduces the Taylor rule to just 0.72%, which is below the current Fed Funds target (see chart).

The classic version of the Taylor Rule (the one I use in my textbook) is as follows:

i=r+PT +a(PPT)+b(YY)

Using that, a current estimate for the UK is 4%:

You can download the spreadsheet here.

Visualising the price swarm

In his 1994 RAE homage to Arthur Marget, John Egger invokes the image of a price "swarm", as opposed to an overall level.

[t]here is no logical reason why a picture of changes in the height of a given "swarm" could not be obtained by simply plotting the individual prices in such a "swarm", and then generalising concerning the movements of the "swarm" on the basis of the picture of the movement of individuak prices thus obtained (1942, p.333)

I'd hoped that the Billion Prices Project would utilise some awesome Gapminder style visualisation tools to bring the swarm to life, but so far I've not seen any attempts. I was looking at the April CPI data though and figured I'd plot the breakdown. The chart below shows the all 12 inflation sub indices from Feb 2016-March 2017 (2015=100). The overall CPI level is shown as a line:

It's a start.

MA vs. M1

MA has been a work in progress for some time, and so the usefulness in terms of telling a distinct story to other, alternative monetary aggregates, also changes. When I present the current version (but using data as of December 2013) I point out that it's roughly the size to M1. And indeed from 2009-2013 the growth rates have been pretty much the same. Which begs the question as to whether it has any additional explanatory power.

The chart below shows MA vs M1 growth going back even further though, and you can see some major differences. In particular in early 2008 MA started to contract however M1 growth skyrockets.

Given that my motivation for pursuing MA was that traditional aggregates weren't demonstrating a monetary tightening during the 2008 credit "crunch", this is an important point of difference. The trouble with narrow measures are that they are susceptible to reclassifications and data adjustments. That's probably what we're seeing here, but it's also evidence that MA and M1 tell different stories.