Or, what keeps Britain’s central bankers up at night.
The Bank of England and the Centre for Economic Policy Research hosted their fourth monetary policy roundtable on July 14, the summary report of which has only just been published.
The events follow the Chatham House Rule – which means none of the opinions or discussions are attributed to any individuals. Plus, the whole thing carries a big caveat about how it doesn’t represent the views of the BoE or the CEPR, blah blah blah. Still though, it’s an enticing read.
Here’s what caught our eye.
First up, that sticky UK inflation and the nebulous output gap:
Most agreed that the exchange rate depreciation had been a key factor accounting for the relative resilience of UK inflation. It was suggested by one speaker that lags between changes in the exchange rate and consumer prices could potentially be quite long: history indicated that it took some time for prices to adjust to the levels charged by overseas competitors following major shifts in the exchange rate. Others argued that the lags from the exchange rate to CPI inflation were variable and would depend on the circumstances that applied at the time. Ultimately, the impact on inflation would depend on the reason for the change in the exchange rate.
It was also noted that the level of spare capacity might be lower than many currently judged. In particular, the financial crisis might have impaired potential supply by more than had been expected. Furthermore, the effect of a given level of spare capacity on inflation might have changed. Alternatively, inflation expectations may have risen.
And some quantifying of quantitative easing:
There was, however, a range of views among discussants about the exact impact of QE on gilt yields. In a recent Bank of England Working Paper that had examined the reaction of market prices over a relatively short interval around each QE announcement, the authors had concluded that QE might have depressed gilt yields by around 100 basis points.2 There was a range of uncertainty around these calculations, as estimated effects of QE from event studies were inevitably sensitive to the chosen interval for evaluating the policy. Some participants thought that this estimate might have been too large, and that the impact of QE had been confined to temporary flow effects. Gilt yields and gilt-OIS spreads had edged up since autumn 2009 which lent some support to that argument. Others believed that the true impact of QE had been larger than the Bank’s estimate, as UK gilt yields had been lower than those in other countries with similarly high projected government debt issuance. Some remarked that QE could have caused interest rates first to fall and then to rise, if it had served to increase growth prospects or had led to higher inflation expectations . . . Some participants thought that QE had boosted the supply of money as broad money growth had not decreased by as much as might have been expected given how much nominal spending had fallen. There was some evidence that those who had sold gilts to the Bank of England may have been buying banks’ equities and long-term debt with the proceeds. This would have reduced deposits, but would have been beneficial for the economy as it would have increased banks’ capital and so lessened the pressure on banks to shed assets. Other participants expressed some concerns about the fact that broad money growth had still fallen after QE.
And the future:
Participants discussed the potential future impacts of withdrawing the current level of monetary stimulus. Participants welcomed clarification on the approach to exit given during the Governor’s Mansion House speech. It was likely that the MPC would use Bank Rate as the active instrument, raising it first, before conducting asset sales in an orderly programme over a period of time. A reasonable benchmark for the impact of asset sales was that they would be the mirror of QE asset purchases, but several arguments were advanced by participants as to why this might not be the case. First, the extent of banking sector impairment, which might have diminished the effect of QE, might be lower in future. Second, markets might interpret the announcement of any programme of sales as a signal about future Bank Rate tightening. And third, the sales might coincide with a period of strong gilt issuance by the Debt Management Office. Overall, there was broad agreement that QE would continue to be a valid monetary policy instrument if it had to be used again, even if the circumstances were different.
Those contagious eurozone difficulties — and potential debt restructuring:
In the euro area, sovereign bond spreads over German Bunds had picked up for a number of countries, as market participants’ concerns over the sustainability of debt positions had risen. One participant pointed out that this had to be seen in the context of the remarkable compression of spreads that had occurred in the previous ten years. But any debt restructuring could give rise to a new source of solvency risk for banks. The uncertainty surrounding which banks were exposed to these problems had raised interbank rates. And one participant noted that economists did not yet fully understand issues of contagion – the degree of interconnectedness had meant that even problems in small entities could spill over and affect the entire financial system. It was essential that these problems were resolved rapidly to prevent a further slowing in growth.
And finally a little monetary policy existentialism, and a slight intergenerational hiccup:
Participants discussed the academic literature on the optimal design of fiscal policy. This literature identified several factors that policymakers needed to weigh up. On the one hand, there was the motive to ensure that taxes were not volatile from one period to the next, because such volatility was costly for the private sector. This motive led to the optimal fiscal policy being one that did not attempt to correct for past shocks that had driven debt up. On the other hand, there were likely to be limits to either the willingness or the ability of governments to levy taxes to service ever higher stocks of debt, and so there was a motive to correct shocks to debt to prevent it from becoming unboundedly large. A third force pulling on the optimal fiscal policy was the concern that not acting to reduce government debt might crowd out private investment. Furthermore, there was the question of intergenerational equity. One perspective on this was that risk should be shared out across generations: a single generation should not be expected to bear all the costs of having the bad luck to experience a war or a financial crisis directly. Finally, the design of the optimal fiscal policy was bound up with the debate about optimal monetary policy. A very high stock of (nominal) debt might increase the perceived temptation for the government to force the central bank to reduce its real burden with a burst of inflation, a perception which could lead to rising inflation expectations.
What’s it all about, eh economists?
Related links:
Economists question Bank stance on spending cuts – FT
Bank of England Skiving* Paper No. 393 – FT Alphaville
The existential QE - FT Alphaville