Why irresponsible? Well, the Chancellor told the Bank of England’s MPC to hit a 2% target. How could it be good news that the Bank undershot it by 1.5 percentage points? Are we to believe that the Chancellor, if he had time to get far enough down into his in-box, would lower the target, to try to ensure more ‘good news’?
A common gripe with Eurozone policy is that the ECB defined its own target somewhat asymmetrically. It ‘clarified’ the treaty set mandate to achieve ‘price stability’ as obligating it to achieve inflation ‘close to, but below’ 2 per cent. I doubt that these words mean much any more, since former Chief Economist Ottmar Issing’s departure [this clarification happened on his watch]. But their effect has been quite pernicious, and many people disagree with my assessment that they don’t weigh on policy now and think that the current difficulties reflect the ECB’s deflationary bias. George Osborne should be more careful about what he says that could colour interpretations of the Bank’s remit.
Why inconsistent with modern monetary macroeconomics? The suggestion is that if we had prices falling 20% that would be even better. 50%, better still. No. The inflation target was set at 2% for a good reason. The view that monetary policy can’t improve living standards by generating falling prices, or, if we return to the old 70s fallacy, neither can we buy lower unemployment with higher inflation. The best monetary policy can do is to keep inflation stable and low, additionally weighing inflation stability with real activity stability in the short run. It’s possible that some future generation of macro theory will overturn this wisdom. But right now, this is what we understand, and this is what informs the remit HMT gave to the MPC, as you will see from the March 2013 remit review.
Another thing that the Osborne-Sentance tweets do is mangle all the important subtleties of the conjuncture. Falling oil prices, other things equal, will impove real incomes, and boost demand, spending, and help return inflation itself to target, allowing policy to escape the zero bound. But other things are probably not equal. It may be that the fall is extra information not already factored in about weak global demand, now and in the future, and that will put downward pressure on general inflation. To the extent that falling oil prices is an increase in potential output, this could – indeed is in the Bank of England’s own New Keynesian model – deflationary. And further, a fall in oil prices that a rational forecast would suggest should be temporary could lower inflation expectations that are formed more adaptively and increase real interest rates [nominal rates minus inflation expectations] which would also depress demand, and therefore be deflationary. The most likely case might well be the benign one. But, with no proven instrument to loosen, the risks weigh very much on the downside.
For me, ‘good news’ would be inflation and real activity rising greatly, signalling that we can soon lift interest rates off their zero floor, and a return to a time when we will have the ability to use monetary policy to counter the next recessionary shock. In fact, ‘even better news’ would be to hear that the authorities had heeded calls to raise the inflation target at a time when policy had the means to achieve it, so that in the future there was less chance of interest rates being trapped at their zero floor.
Perhaps the Sentance-Osborne tweets are clever, politically astute interventions to talk up the economy and boost demand. But they are not economics.
Let us not forget, too, that CPI overstates true inflation, and probably by quite some amount. I won’t go into this again in this post – I wrote about it here – but it’s important to bear in mind when you read the next contribution wondering whether we will tip into deflation, that we probably already have. So, Andrew/George: things are even better than you thought!