Carney risks communication breakdown
The push by incoming Bank of England governor Mark Carney for a flexible inflation-targeting regime and the promotion of forward rate-guidance, in particular, risks sowing the seeds of price instability. The ‘expectations hypothesis’ has weak academic roots and has been rarely implemented in practice, argues Finn Poschmann, economist at the CD Howe Institute, a public policy think tank in Toronto.
By global standards, certainly by British ones, Canada had a good crisis, and so did its central bank governor Mark Carney. Even jaded City watchers, if only fleetingly, sometimes seem to wonder if some of that economic charm, or luck, might rub off on the pound or the gilts market, or unemployment, or really anything. Expectations are high, and appearing before the Treasury Select Committee on Thursday, Carney sought to manage them – to live up to them to be sure, but not to allow expectations to inflate, either.
|Finn Poschmann is vice-president, research, at the CD Howe Institute|
Good thing, too. The UK’s CPI inflation rate has sat on the top side of 2% for most of the past five years, and in 39 of those 60 months turned in numbers above 3%. The GDP numbers are unprintable, not least in the wake of double-dippish Q4 preliminary data, and it would kind to say nothing about export trade numbers. The unemployment rate sits where it has sat since the crisis set in, and so too does the claimant count. A market-stifling one-in-five Britons works for the state, and the number would be higher had not the Office for National Statistics last spring reclassified 200,000 teachers from the public to the private sector.
Now, Canada’s year-on-year economic growth has hardly been stellar, but standing next to British, EU or US data, Canada’s numbers are pretty shiny, and goods and services trade numbers have held up well under exchange rate pressure.
Some of this is to do with Canada’s pre-recession fiscal stance, some too to do with its conservative financial sector and its regulation, and its floating exchange rate and 2% inflation target, which mostly the country has hit, unlike the UK.
In Canada, the inflation target is indeed well anchored, so much so that macro modelers rarely spend much time forecasting the CPI beyond a few quarters. The same cannot be said in the UK, where markets, and Threadneedle, have in the past five years spent rather much more time looking at a distant target from above, rather than from near it, where sometimes there is less haze.
With those features, and a banking system that has not recently endured a housing market collapse, Canada has done well. And it has been lucky. Or as Mary Poppins's Bert sang:
Chim chim-in-ey, chim chim-in-ey
Chim chim cher-oo!
Good luck will rub off when I shakes hands with you
Or blow me a kiss and that’s lucky too
The Treasury Committee had asked Carney to discuss the UK’s future monetary policy framework, which in the main he addressed by reference to Canada’s strikingly similar model. The inflation target always gets top billing, but in rhetoric and in formal addresses, particularly since the government and the Bank of Canada renewed their targeting agreement in late 2011, the inflation target has always been “flexible”.
Hence, in Carney’s committee remarks, the merits of being flexible about the time it takes to hit an inflation target got plenty of space. After all, if timely delivery on a target is not the proximate target, a central bank can pay attention to other things, such as financial excesses, credit crunches and rising fuel prices’ economic impact. Or, as now is US Federal Reserve Board policy, getting the unemployment rate below some threshold, such as 6.5% – a tougher stretch in the US than in the UK or Canada – or even throwing the inflation target fully overboard, and pursuing a nominal national income target, the current bloggers’ and editorialists’ favourite.
To achieve these goals, however, even if one is to drop attention to inflation, the market must understand what the central bank is seeking to achieve, believe fully that the bank will stick to its guns until it does, and make long-term investment decisions accordingly.
From the central bank’s perspective, as Carney emphasized, this takes clear communication and plenty of “guidance”.
The concept of guidance, the new central banking buzzword, draws heavily on Professor Michael Woodford, of Columbia University, and his Jackson Hole, Wyoming, presentation of August 2012. That drew, in turn, on a 2003 Woodford co-authored paper, which took lessons from Japan’s experience through the end of the 1990s, when the zero lower bound on administered overnight rates and liquidity traps began to figure anew in monetary theorizing.
With suitably clear and committed guidance, and market expectations anchored firmly to it, investors would know, and act on the belief, that accommodative policy would stay in place after growth and inflation pick up.
And, because markets would necessarily have placed full credibility in the received guidance, and understood the monetary framework within which the medicine was to be delivered, inflation expectations would nonetheless remain firmly anchored, owing to the belief that interest rates would go up before inflation got legs.
That, of course, is a lot to ask of guidance and clarity of communications, owing to the weight that it places on their complete credibility and markets’ forming expectations around them. This is problematic because the idea of forward guidance depends crucially on the “expectations hypothesis” – meaning that the term structure of interest rates will respond predictably and accurately to guidance.
And as Daniel Thornton, of the St Louis Federal Reserve Board, recently wrote, the empirical evidence that the term structure does so is thin. In fact, Thornton’s words were less kind, in that he referred to the expectations hypothesis’ “massive empirical failure”.
On this view, it would be wise not to let expectations about guidance’s infallibility rise too high. Of course, with clear and credible communications, and plenty of luck, the programme might work. And Carney, by the time of the less newsworthy exit he said he seeks in 2018, will have swept away traces of any market doubts about the power of monetary policy.
Chim chim cher-ee!
When you’re with a sweep you’re in glad company
Nowhere is there a more happier crew
Than them what sings, “Chim chim cher-ee, chim cher-oo!”
Finn Poschmann is vice-president, research, at the CD Howe Institute, a public policy think tank in Toronto.