Another step towards the BOE getting asked the right questions - More from John Hearn
The chase for the truth is on for guest economist John Hearn 6 Jan
Further to my posting JBH's last piece "Questions that the UK's TSC enquiry should be asking the Old Lady" we've had a couple of conversations about getting to the Treasury Select Committee to make sure they ask Governor Carney & Co the right questions.
Well here's the next stage in a joint JBH/MSP/FXL initiative to see if we can get some honest (nowhere to hide) answers by asking those questions as John submits his thoughts to a TSC template. The final para turns the tables nicely. We'll keep you posted on our progress.
As always we welcome your comments/questions too.
Please find below my submission to the Treasury Select Committee on Monetary Policy. In order to keep my response concise, and where I feel it is necessary, I refer to explanatory articles written for my undergraduates
The effectiveness of monetary policy in meeting the inflation target
- The effectiveness of holding Bank rate near zero and whether extremely low rates can encourage more, rather than less, saving
Holding Bank Rate near zero has been ineffective. It has distorted the structure of interest rates. Unsecured rates on borrowing are still as high as they were before the crisis and it is mainly secured mortgage rates that have fallen significantly. Low rates have not had the expected effect of reducing borrowing and increasing spending on new products, and even more worrying is the fact that as you approach ZIRP or negative interest rates so there will be an increase in hoarding which takes money out of circulation and is exactly the opposite of the desired effect.
"A reappraisal of interest rates and market interest rates"
- The effectiveness of quantitative easing and whether it has met with diminishing returns
QE was successful in avoiding deflation immediately after the Financial Crisis, although as I predicted at the time it was overdone and caused inflation to rise to just under 6%. The problem with QE is that it is a transparent policy that has been, and is, significantly misunderstood. In fact it is the expansionary half of Open Market Operations (OMOs) which were used prior to the crisis to manage liquidity in the UK banking system. In the near future we may have to use quantitative tightening (QT) to control inflation and this will be very difficult to explain to the public. My advice is to return to using OMOs and avoid making announcements about QE/QT.
"Understanding and misunderstanding QE"
- The scope for further expansion of "qualitative easing" (e.g. corporate bond purchases)
I would not advise using QE for anything other than government debt repurchase and resale under the OMOs policy mentioned above. In fact it is not necessary to use interest rate policy at all to manage monetary demand. OMOs are all you need to achieve the inflation target. This was used in the `50s and 60s, discussed and dismissed in the `80s and I would like it reintroduced as explained below.
"Understanding monetary policy: a synthesis of the old and new"
"The best way to complete monetary reform with maximum impact and minimum change"
- Whether forward guidance effectively binds the Bank to a policy course, and the desirability of doing so
No it does not. FG became ineffective the moment that the unemployment rate fell below 7%. Even worse is the fact that it is now adding to volatility on FOREX markets.
"The mystery of exchange rate determination solved"
The unintended consequences of monetary policy
- The impact on asset-price inflation, the housing market and financial stability
This is the most damaging unintended consequence of a low interest rate policy. As explained earlier a low Bank Rate has distorted the structure of interest rates and led to an unintentional focus on secured low mortgage rates. This has caused a housing bubble which will only be seen clearly when rates rise and, even if they do not rise the bubble will still burst causing even greater problems.
Exceptionally low savings rates have forced inexperienced investors to risk their savings on stock and derivatives markets where they will eventually lose money when markets reset or when their lack of knowledge is exposed. Altogether low interest rates have caused an increase in unproductive investment in second hand assets and a decrease in productive investment as firms are still waiting for emergency rates to be adjusted back to a sustainable level.
"The bubble will burst (just don`t ask me when)"
- The implications for the long-term sustainability of pensions and savings income
Low interest rates on savings has created an unsustainable black hole in pension funds and almost eliminated savings income. This is a crisis that is still unfolding as more people will have to rely on the state for retirement incomes as the only other source of low risk returns has dried up. There is also a lesser known problem which is that index linked pensions will fall in value each year if they have been linked to CPI. This is why the Bank of England has refused to change to CPI and is staying with RPI linking for its pension. CPI undervalues inflation by about 1% a year and compounded over the life of a pension it will reduce its real value year after year. The reason for this is that RPI is an arithmetic average and a truer measure of changes in the value of money. CPI is a geometric average that undervalues these changes. This is explained in more detail:
"Which is the best measure of inflation and changes in the value of money"
- The distributional impact
At the top end of the income spectrum current monetary policy has created a significantly rich group of people who have speculated in second-hand assets, traded in derivatives with the advantage of asymmetric information and the automatic hedging of risk that occurs with proprietary trading in large financial institutions. There have been few other sectors that have gained as private businesses are treading water and savers are seeing their capital fixed or being eroded. At the bottom end the hardest hit will continue to be the hardest hit. Trading, arbitrage and speculation in second-hand assets is a zero sum game that has made the distribution of wealth more uneven especially by location.
- The impact on competition, "zombie companies" and productivity
Zombie companies rely on artificially low interest rates and will have to liquidate when loan rates increase. The good news is that higher interest rates will reduce unproductive investment in second-hand assets and increase productive investment which is the necessary requirement for economic growth
- The effects on the structure of relative prices in capital and commodity markets and the consequences for capital allocation, productivity and the trade cycle
Monetary policy, particularly low interest rate policy has distorted the structure of interest rates and the price of assets and commodities that are traded for speculative gains. It has reduced the allocation of funds to capital investment and therefore had a significant effect on economic growth and will have increased the amplitude of cyclical events.
- The implications of a large balance sheet and the Treasury indemnity for Bank accountability and its relationship with the government and other agencies
The QE enlarged balance sheet at the Bank of England is relatively easy to control, but should only be used to achieve the inflation target. It is a fallacy to think that expanding the Bank's balance sheet can achieve more employment and growth or be used to relieve the debt problems of government.
"The four fallacies of the coming economic apocalypse"
- The use of macro-prudential, fiscal and other policy to counterbalance any unintended consequences of monetary policy
The unintended consequences of monetary policy are the result of the incorrect and damaging use of current policy. It is therefore counter-productive to think of offsetting these mistakes using other policies. The only solution is to correct monetary policy. This means using OMOs to manage aggregate monetary demand and achieve the inflation target and allowing interest rates to rise and rebalance the economy.
To get interest rates back to a productive level will probably require a concerted effort on the part of all the main Central Banks. This will avoid unnecessary volatilty on FOREX markets. I would go one step further and require all CBs to establish a rule that Central Bank rates cannot fall below 3% although they can still rise above that rate.
Macro prudential policy is something different and I would require rules which take proprietary trading out of banks with a retail sector. Also I would require Central Banks to deal with liquidity only, and the Bank of International Settlements to set international capital adequcy rules. A further explanation of this is below:
The many meanings of liquidity"
"The vital difference between capital adequacy and liquidity"
The prospects for monetary policy
- The drivers behind and prospects for low real interest rates in the UK and globally
Low real interest rates are a function of inflation. I would target the lowest rate of real interest at 2% meaning that if we are achieving the 2% inflation target then nominal interest rates will be at 4%. This is achievable if Central Banks understand their limitations and do the one thing they can do which is hit an inflation target.
- What is the significance for monetary policy of rises in bond yields since the US election?
It is monetary policy that has driven the increase in bond yields. American talk is of a rise in Fed Funds Rate. There is a simple inverse relationship between bond prices and interest rates and therefore, in anticipation of rate rises, bond prices are falling and yields are increasing.
- The impact and trade-offs of tightening monetary policy in the near-term.
It is possible to tighten monetary policy by raising interest rates and loosen monetary policy by increasing liquidity (OMOs & QE). Done together this will help rebalance the rewards from savings and the search for productive returns and help the Bank to achieve its inflation target. A rise of 3% in Bank Rate will have a short sharp shock on asset prices, but little effect on the rates for busuness loans and other unsecured forms of borrowing.
- Whether monetary policy is currently out of ammunition for the next crisis
Yes it is out of ammunition which is the reason why a rise in Bank Rate is both essential and urgent. Without this we are taking a slower walk into recession and the really damaging consideration of a move to negative interest rates which will leave us in a Japanese style continuing recession and an even harder climb to get out.
- Options for raising the "natural rate" of interest (e.g. fiscal policy, promoting investment)
There are two options. Firstly the Bank can start with quarter point moves upward every few months to a target of 3% Bank Rate. If Mark Carney and Janet Yellen get together I have no doubt this is achievable. Secondly it would be for the Bank to abandon interest rate targeting, allow rates to float up under market forces, improve the regulatory envirnment and control monetary demand through base money controls. This would require the Bank to recognise that its powers are limited to inflation targeting only.
As you ask I need to point out that fiscal policy is not a solution to our current problems and has never been so as the evidence shows. I suggest you read what is itemised below and prepare yourselves for another Treasury Select Committee investigation, but this time, of the Treasury.
"Are demand management policies the solution or a mass delusion?"
"Money, money supply, money creation and monetary demand"