BoE needs more ammo to absorb next deflationary shock

When the Great Recession began in 2008/9, the Bank of England swiftly cut its interest rate to an all time low of 0.5%. Seven years later, and despite extensive quantitative easing, inflation is worryingly close to zero; monetary policy is running out of tools.

The macroeconomist Simon Wren-Lewis, and member of Labour’s Economic Advisory Council, has recently joined a small panel set up by the Shadow Chancellor to review the Bank of England’s mandate.

In an interview with PoliticsHome, Wren-Lewis explains how monetary policy could be updated to suit the new economic climate, and given more ammunition to absorb the next deflationary shock.

Why does the Bank of England need a new mandate?

I think it is a good idea in principle to periodically review the Bank's mandate. After all the Monetary Policy Committee (MPC) is still a relatively new creation, and rather a lot has happened over the last decade! I think a key question to ask is would a different mandate have improved its performance both before and since the financial crisis. In addition, there is the opportunity to learn from the performance of other independent central banks around the world , who may do things differently. Finally the science of monetary policy does not stand still, so there may be important new findings that could imply a change to the mandate.

Perhaps I can also give a more specific reason. Before the financial crisis, the MPC had a single instrument, which was changes to the short term interest rate. Few people can have anticipated that this rate would have remained at 0.5% for 7 years! For many of those 7 years, the MPC have used other policies to try and stimulate the economy. In a way it would be extraordinary not to revisit how monetary policy is done given that experience. George Osborne and the Treasury did conduct a review of the mandate in 2013, but suggested no major changes, and I think a lot of people thought at the time that this was an opportunity wasted.

In what ways could its mandate change?

I think we should separate this into various categories. The first concerns the basic target, which at present is 2% inflation. Some have advocated raising that target to 4%, so that the chances that interest rates would hit zero (or whatever their lower bound is) will be reduced. Others have suggested targeting the price level, or nominal GDP. This would mean that periods where the desired rate of inflation was undershot would have to be followed by periods where it was deliberately overshot. Although that might seem an odd thing to do, it could reduce the impact of a large shock like the financial crisis. Others have suggested that we move to a 'dual mandate', which the US Fed has, of targeting both inflation and output.

Then there is a question about the instruments the Bank uses. The Bank, in common with the Fed and now the ECB, has tried Quantitative Easing, which means creating money to buy long term assets like government debt. A year ago I wrote an article in the Guardian (with Eric Lonergan and Mark Blyth) arguing that it would be more effective if central banks gave this created money directly to the public, and idea that Adair Turner had championed before us. It is what economists call helicopter money. At the time it was thought to be a slightly mad idea, but since then it has become a hot topic in discussions about future monetary policy. Another issue is whether what is called 'forward guidance' is useful. Also should the Bank, as the Fed does, publish its own forecast of interest rates?

As you can see, there is plenty to talk about, and there are other issues I have not mentioned. At this stage I cannot predict which way the Blanchflower review will go, except to say that there is no desire among the members of the review to end central bank independence.

How much difference would this make?

These are potentially important issues. Let me give one example. One reason we have just an inflation target, while the Fed also targets output, is what macroeconomists call the divine coincidence. The divine coincidence is the idea that if you control inflation, you also control output. The trouble is, that idea has not looked too good since the financial crisis. If you ask an MPC member how good monetary policy had been since the crisis, they might say that inflation was too high around 2011, and too low right now, so overall not that bad. But if you looked at output or employment, we had 5 years where unemployment was persistently much too high. From that perspective, monetary policy has failed badly. Perhaps if the MPC had focused on unemployment as well as inflation, monetary policy might have been more expansionary and the recovery from the recession might have been quicker, although with the cost of higher short term inflation.

That is looking at the past. Looking at the future, the big worry in many countries right now is that if the economy is hit by another negative shock, monetary policy might 'run out of ammunition'. Anything that can be done to improve how well policy works could avoid another recession. 

What political process is necessary to make this change?

The Bank's mandate is determined by the Chancellor. The Blanchflower review, although commissioned by the Shadow Chancellor, is entirely independent. We have already talked to senior economists at the Bank, and I'm sure we will do so again. At the very least I hope our findings will spark a debate, but whether any suggested changes are implemented is up to whoever is Chancellor.  

Where does the resistance come from?

There is of course a natural conservatism within central banks, but I think it would be wrong to exaggerate this. The MPC and the Bank also know that their mandate and how it works is the Chancellor's decision.

My biggest fear is that some people may try and put their political spin on anything we recommend, even when those recommendations come from an analysis of the technical academic literature. When I accepted an invitation to be on Labour's Economic Advisory Council, one or two people did suggest that this would damage my reputation as an economist. Given that being a member placed no restrictions on what I could do or say in public, or any obligation to support party policy, I thought it was an extraordinary accusation to make. Can you imagine a medic being told that they had damaged their reputation by advising policy makers about medical research?

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