Fifty years have passed since Milton Friedman delivered his groundbreaking American Economic Association Presidential address on the role of monetary policy. Unfortunately, many of Friedman’s insights are neglected today. Friedman demolished the view that the Federal Reserve was powerless to prevent the Great Depression. In fact, he showed that the Federal Reserve’s deliberately deflationary policies were to blame for turning a crash into a depression. One of Friedman’s great insights was that you cannot infer whether money is easy or tight by looking at interest rates alone.
As Friedman wrote in 1997, “Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy… After the US experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”
Today’s conventional wisdom that monetary policy since the crisis has been expansionary and easy is mistaken. As no less of an authority than Ben Bernanke pointed out, nominal interest rates are unreliable indicators, and one should instead “check… by looking at macroeconomic indicators such as nominal GDP growth and inflation.”
But inflation, which the Bank of England targets, is an imperfect measure. It can be determined by both demand factors (which the Bank can control) and supply factors (which the bank can’t). For instance, an oil price shock can increase inflation in the short-term but a central bank shouldn’t raise rates in response. Policymakers on the MPC are trained to “look through” supply-shocks, and they did just that in 2015 when inflation fell due to oil prices collapsing.
Since the great recession, by being willing to look beyond inflation data and to Nominal GDP, the Bank has been able to weather the storm without creating mass unemployment. Over on the continent, the European Central Bank has been more rigid on sticking to inflation and inflation alone. In 2011, the ECB hiked rates when inflation rose above target due to higher VAT and rising oil prices, creating the Eurozone crisis.
We need a monetary policy that works in good times and bad. Under the status quo, we are too reliant on the wisdom and discretion of central bankers. We are in the perverse position that if central bankers stuck rigidly to the mandates they were set, then we would be worse off. This creates a climate of uncertainty and mutes the financial market response to policy changes. Market actors are forced to stress out over minor changes in central banker wording and phrasing.
Monetary policy is unusual in that the more you promise, the less you need to do. If a central bank is credible then it is much easier to meet its targets. Take the ECB. By failing to hit its inflation target and prematurely tightening policy, the market response to its QE packages is underwhelming. Investors anticipate the ECB tightening policy if QE is too successful and as a result bigger and bigger asset purchases are necessary to shift inflation expectations.
As Professor Anthony J. Evans sets out in an Adam Smith Institute report released today, the solution is a simple mandate that provides market actors with clear forward guidance. The Bank should scrap its 2 per cent CPI inflation target and move to a Nominal GDP target (5 per cent might be a good starting point). As Nominal GDP is GDP plus inflation, it would mean higher inflation during a recession, and lower inflation when productivity growth surges. Policymakers could put away the crystal ball.
Some argue that inflation targeting is important because the public understand it. But less than half the population can tell you who sets the base interest rate and the public’s estimates of inflation are woefully wrong. Nominal GDP targeting may even be easier to explain to the public. After all, Mark Carney would no longer have to send a letter to the Chancellor to explain that he’s failed to increase prices by 2 per cent.
Others worry that if the Bank already struggles to control inflation, then what luck will it have controlling Nominal GDP? One solution is to use prediction markets. We could set up a Nominal GDP futures market and allow bankers to trade on Nominal GDP expectations. If the policy were too tight and markets thought the Bank wouldn’t meet its target then they could bet against the Bank and short the market – prompting the Bank to change policy. This would provide an accurate real-time forecast of Nominal GDP.
Monetary policy matters. When policy is too loose, it can stoke unsustainable asset booms that eventually bust. But when the money supply abruptly contracts, financial crises can turn into depression with mass unemployment. Nominal GDP targeting gives us a monetary policy that works in good times and bad.