Time the MPC abandoned activism
Monday 06 September 1999
Consider the contrast between the US Federal Reserve's interest rate policy and the Bank of England's during the past three years. The chart shows that US rates have been dramatically more stable. The Fed has cut rates four times since the start of 1996, three of those in response to the global financial crisis in the summer of 1998, and raised them three times. The Bank, meanwhile, has announced 12 rate cuts and 7 increases during the same period.
Some of the MPC's members have made a virtue of this activism. Both Charles Goodhart and Willem Buiter have argued that economic theory suggests most central banks alter interest rates too infrequently, and are too reluctant to change direction. After all, on the "stitch in time" principle, acting pre-emptively as soon as there is evidence of a need to do so ought to prevent big variations in the level of rates. And once the cost of loans is at about the right level, it should only need to be adjusted in response to unexpected news. That could go either way, so in principle there ought to be lots of policy reversals.
In practice, no central bank in the world behaves like this, and certainly not the Fed. But does this mean that the MPC is outclassing Alan Greenspan on economic theory? Not necessarily. One possible reason is uncertainty, not just about the kind of shocks that will rock the economy, but also about the structure of the economy. How will events today shape inflation next year? In other words, how far might future inflation deviate from target? How do interest rates actually affect consumer spending and investment (or, as an economist would put it, what is the transmission mechanism)? Nobody knows. But without firm answers there has to be a lot of uncertainty about the right policy. Taking account of uncertainty about the structure of the economy means theory can catch part-way up to central banking practice.
But not all the way. Research by the Fed shows that US rates are still less variable than it looks as though they ought to be. A new Bank of England working paper has repeated the work for the UK and concludes that even with our greater interest rate variability, there are fewer rate changes and far fewer reversals of direction than suggested even by the uncertainty augmented theory.
Mervyn King, the Bank of England's deputy governor, pointed out in a recent paper that there is yet another kind of uncertainty, concerning the long-run productive potential of the economy. The MPC can be thought of as following a rule whereby interest rates respond to deviations of forecast inflation from target and deviations of expected GDP from its long-term trend. This "Taylor rule" (after its author) captures both the fact that policy targets inflation and the fact that central banks try not to hit the target at the expense of big variations in growth.
Yet in addition to the kind of uncertainty about how big the size of the interest rate response ought to be to each kind of deviation, and uncertainty in the forecast of future inflation and output, the level and growth of potential GDP are also unknown. Often economists disagree over even the sign of the output gap (is GDP above or below potential?), never mind its size.
He concludes: "A keen appreciation of how limited is our present knowledge of the economy should be central to the policy-making process." In practice, this points to the conclusion that the MPC knows too little to fine-tune the volatility of growth as well as hitting the inflation target.
Certainly, estimates of the Taylor rule for the US suggest that since 1979, under Paul Volcker and Alan Greenspan, the Fed actually has not responded to variations in GDP, but only to divergences in inflation from its target.
The US has nevertheless enjoyed during the past 15 years its two longest peacetime expansions, earning the Fed an enviable reputation for boosting growth at the same time as keeping inflation low. In his paper Mr King points out that a genuinely pre-emptive policy could actually end up producing more stable interest rates and output than a wait-and-see policy. For if policy-makers react swiftly to shocks there will be less danger of inflation moving further away from target and therefore less need for a big policy reaction. So as long as the central bank moves fast it can end up moving little.
The Fed's relative inaction might therefore reflect a longer and more credible track record than any other central bank at nipping inflation in the bud.
A further tantalising possibility, raised in a discussion paper published by the Centre for Economic Policy Research, is that the Fed is better at manipulating long-term interest rates without having to shift its short- term policy rate. This possibility would help it achieve the central banker's nirvana of low inflation combined with high and stable growth.
Estimated Taylor rules for the US show the Federal Funds rate depending on inflation deviations and the previous level of the Fed Funds rate. This is another way of saying there are very few policy reversals.
But if this is the policy reaction, whenever there is an inflationary shock, short-term interest rates will rise, and they will stay at a higher level than they would if past interest rates did not influence the present. Under this rule, rising expected short rates mean long-term interest rates will climb further than the initial jump in the policy rate. The bond market reaction to a small shift in policy can turn it into a more powerful policy, so that the markets do a lot of the Fed's job for it. To the extent that consumer demand and investment depend more on long-term rates anyway, this kind of rule amplifies the effect of small moves in the interest rate set by policy-makers.
It used to be said that the merest twitch of the eyebrow from the Governor of the Bank of England could galvanise the City. Perhaps the MPC can learn to use its eyebrows collectively to similar effect in order to influence the economy. For the lesson from Alan Greenspan is abandon activism: do nothing and do it often.
"Challenges for Monetary Policy, New and Old" by Mervyn King, August 1999; "Should Uncertain Monetary Policy Makers Do Less" by Ben Martin and Chris Salmon, Bank of England Working Paper, August 1999; "The Science of Monetary Policy" by Richard Clarida , Jordi Gali and Mark Gertler, CEPR Working Paper 2139, May 1999.
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