Tag: inflation targeting

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The approach to monetary and fiscal policy

The following blog is inspired by my teaching of macroeconomic issues to my final year students at Aston University. In the classes we’ve been discussing important aspects of monetary and fiscal policy design. What has become clear to me and my students is that the trade-offs which characterise the discipline of economics are certainly alive and well in the current environment in which monetary and fiscal policy choices are being made.

To demonstrate this we consider here some of the discussions we’ve had in class around central bank independence and monetary policy mandates. We’ve also looked at fiscal policy. Here we’ve examined the state of the public finances and the importance that seems to be attached to debt stabilisation and the imposition of debt rules.

Delegation and central bank mandates

My teaching this term began by introducing my students to one of the most important and influential monetary policy models. This is the model of Kydland and Prescott. Their model, published in the Journal of Political Economy in 1977 has become the theoretical bedrock for the modern-day operational independence of central banks.1

The model explores how systemically high inflation can become established in economies when policymakers have the political incentive to lower unemployment or increase output above its long-run equilibrium value. This may be the case if governments operate monetary policy rather than the central bank (of if the central bank operates monetary policy but follows government objectives). By adopting expansionary monetary policy, governments can increase their popularity.

But this is likely to be short-lived, as any increased economic activity will only be temporary (assuming that the natural-rate hypothesis holds). Soon, inflation will rise.

But, if an election is on the horizon, there may be enough time to boost output and employment before inflation rises. In other words, an expectations-augmented Phillips curve may present governments with an incentive to loosen monetary policy and worry about the inflation consequences after the election.

However, the resulting ‘inflation surprise’ through the loosening of monetary policy means a fall in real pay and therefore in purchasing power. If people suspect that governments will be tempted to loosen policy, they will keep their expectations of inflation higher than the socially optimal inflation rate. Consequently, low-inflation targets lack credibility when governments have the temptation to loosen monetary policy. Such targets are time-inconsistent because governments have an incentive to renege and deliver higher inflation through a looser monetary policy. The result is an inflation bias.

Central bank independence
To prevent this inflationary bias arising, many central banks around the world have been given some form of operational independence with a mandate centred around an inflation-rate target. By delegating monetary policy to a more conservative central bank, the problem of inflationary bias can be addressed.

Yet central bank independence is not without its own issues and this has been an important part of the discussions with my students. Today, many economies are continuing to experience the effects of the inflationary shocks that began in 2021 (see Chart 1 for the UK CPI inflation rate: click here for a PowerPoint). The question is whether the appointment of a conservative or hard-nosed hawkish central banker trades off the stabilisation of inflation for greater volatility in output or unemployment.

The inflation–output stabilisation trade-off is closely associated with the works of Kenneth Rogoff2 and John Taylor3. The latter is known for his monetary policy rule, which has become known as the ‘Taylor rule’. This advocates that a rules-based central bank ought to place weight on both inflation and output stabilisation.

This is not without its own issues, however, since, by also placing weight on output stabilisation, we are again introducing the possibility of greater inflationary bias in policy making. Hence, while the act of delegation and a rules- or target-based approach may mitigate the extent of the bias relative to that in the Kydland and Prescott model, there nonetheless still remain issues around the design of the optimal framework for the conduct of monetary policy.

Indeed, the announcement that the UK had moved into recession in the last two quarters of 2023 can be seen as evidence that an otherwise abstract theoretical trade-off between inflation and output stabilisation is actually very real.

My classroom discussions have also shown how economic theory struggles to identify an optimal inflation-rate target. Beyond accepting that a low and stable inflation rate is desirable, it is difficult to address fully the student who asks what is so special about a 2% inflation target. Would not a 3% target, for example, be preferable, they might ask?

Whilst this may sound somewhat trivial, it has real-world consequences. In a world that now seems to be characterised by greater supply-side volatility and by more frequent inflation shocks than we were used to in recent history, might a higher inflation rate target be preferable? Certainly, one could argue that, with an inflation–output stabilisation trade-off, there is the possibility that monetary policy could be unduly restrictive in our potential new macroeconomic reality. Hence, we might come to see governments and central banks in the near future revisiting the mandates that frame the operation of their monetary policy. Time will tell.

Fiscal policy and debt stabilisation

The second topic area that I have been discussing in my final-year macroeconomics classes has centred around fiscal policy and the state of the public finances. The context for this is that we have seen a significant increase in public debt-to-GDP ratios over the past couple of decades as the public sector has attempted to absorb significant economic shocks. These include the global financial crisis of 2007–8, the COVID-19 pandemic and the cost-of-living crisis. These interventions in the case of the UK have seen its public debt-to-GDP ratio more than triple since the early 2000s to close to 100% (see Chart 2: click here for a PowerPoint).

Understandably, given the stresses placed on the public finances, economists have increasingly debated issues around debt sustainability. These debates have been mirrored by politicians and policymakers. A key question is whether to have a public debt rule. The UK has in recent years adopted such a rule. The arguments for a rule centre on ensuring sound public finances and maintaining the confidence of investors to purchases public debt. A debt rule therefore places a discipline on fiscal policy, with implications for taxation and spending.

How easy it is to stick to a debt rule depends on three key factors. It will be harder to stick to the rule:

  • The higher the current debt-to-GDP ratio and hence the more it needs to be reduced to meet the rule.
  • The higher the rate of interest and hence the greater the cost of servicing the public debt.
  • The lower the rate of economic growth and hence the less quickly will tax revenues rise.

With a given debt-to-GDP ratio, a given average interest rate payable on its debt, and a given rate of economic growth, we can determine the primary fiscal balance relative to GDP a government would need to meet for the debt-to-GDP ratio to remain stable. This is known as the ‘debt-stabilising primary balance’. The primary balance is the difference between a government’s receipts and its expenditures less the interest payments on its debt.

This fiscal arithmetic is important in determining a government’s fiscal choices. It shows the implications for spending and taxation. These implications become ever more important and impactful on people, businesses, and society when the fiscal arithmetic becomes less favourable. This is a situation that appears to be increasingly the case for many countries, including the UK, as the rate of interest on public debt rises relative to a country’s rate of economic growth. As this happens, governments are increasingly required to run healthier primary balances. This of course implies a tightening of their fiscal stance.

Hence, the fiscal conversations with my students have focused on both the benefits and the costs of debt-stabilisation. In respect of the costs, a few issues have arisen.

First, as with the inflation-rate target, it is hard to identify an optimal public debt-to-GDP ratio number. While the fiscal arithmetic may offer some clue, it is not straightforward to address the question as to whether a debt-to-GDP ratio of say 100% or 120% would be excessive for the UK.

Second, it is possible that the debt stabilisation itself can make the fiscal arithmetic of debt stabilisation more difficult. This occurs if fiscal consolidation itself hinders long-term economic growth, which then makes the fiscal arithmetic more difficult. This again points to the difficulties in designing policy frameworks, whether they be for monetary or fiscal policy.

Third, a focus on debt stabilisation alone ignores the fact that there are two sides to any sector’s balance sheet. It would be very unusual when assessing the well-being of businesses or households if we were to ignore the asset side of their balance sheet. Yet, this is precisely the danger of focusing on public debt at the exclusion of what fiscal choices can mean for public-sector assets, from which we all can potentially benefit. Hence, some would suggest a more balanced approach to assessing the soundness of the public finances might involve a net worth (assets less liabilities) measure. This has parallels with the debates around whether mandates of central banks should be broader.

Applications in macroeconomics

What my teaching of a topics-based macroeconomics module this term has vividly demonstrated is that concepts, theories, and models come alive, and are capable of being understood better, when they are used to shine a light on real-world issues. The light being shone on monetary and fiscal policy in today’s turbulent macroeconomic environment is perhaps understandably very bright.

Indeed, the light being shone on fiscal policy in the UK and some other countries facing an upcoming election, is intensified further with the state of the public finances shaping much of the public discourse on fiscal choices. Hopefully, my students will continue to debate these important issues beyond their graduation, stressing their importance for people’s lives and, in doing so, going beyond the abstract.

References

  1. Rules rather than discretion: The inconsistency of optimal plans
    The Journal of Political Economy, Finn E Kydland and Edward C. Prescott (1977, 85(3), pp 473–92)

  2. The optimal degree of commitment to an intermediate monetary target
    Quarterly Journal of Economics, Kenneth Rogoff (November 1985, 100(4), pp 1169–89)

  3. Discretion versus policy rules in practice
    Carnegie-Rochester Conference Series on Public Policy, John B Taylor (December 1993, 39, pp 195–214)

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Questions

  1. What is meant by time-inconsistent monetary policy announcements? How has this concept been important for the way in which many central banks now conduct monetary policy?
  2. What is meant by a ‘conservative’ central banker? Why is the appointment of this type of central banker thought to be important in affecting inflation?
  3. What is the contemporary macroeconomic relevance of the inflation–output (or inflation–unemployment) stabilisation trade-off?
  4. How is the primary balance different from the actual budget balance?
  5. What do you understand by the concept of ‘the fiscal arithmetic’. Explain how each element of the fiscal arithmetic affects the debt-stabilising primary balance?
  6. Analyse the costs of benefits of a debt-based fiscal rule.
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Why raise interest rates to tackle cost-push inflation?

We have examined inflation in several blogs in recent months. With inflation at levels not seen for 40 years, this is hardly surprising. One question we’ve examined is whether the policy response has been correct. For example, in July, we asked whether the Bank of England had raised interest rates too much, too late. In judging policy, one useful distinction is between demand-pull inflation and cost-push inflation. Do they require the same policy response? Is raising interest rates to get inflation down to the target rate equally applicable to inflation caused by excessive demand and inflation caused by rising costs, where those rising costs are not caused by rising demand?

In terms of aggregate demand and supply, demand-pull inflation is shown by continuing rightward shifts in aggregate demand (AD); cost-push inflation is shown by continuing leftward/upward shifts in short-run aggregate supply (SRAS). This is illustrated in the following diagram, which shows a single shift in aggregate demand or short-run aggregate supply. For inflation to continue, rather than being a single rise in prices, the curves must continue to shift.

As you can see, the effects on real GDP (Y) are quite different. A rise in aggregate demand will tend to increase GDP (as long as capacity constraints allow). A rise in costs, and hence an upward shift in short-run aggregate supply, will lead to a fall in GDP as firms cut output in the face of rising costs and as consumers consume less as the cost of living rises.

The inflation experienced by the UK and other countries in recent months has been largely of the cost-push variety. Causes include: supply-chain bottlenecks as economies opened up after COVID-19; the war in Ukraine and its effects on oil and gas supplies and various grains; and avian flu and poor harvests from droughts and floods associated with global warming resulting in a fall in food supplies. These all led to a rise in prices. In the UK’s case, this was compounded by Brexit, which added to firms’ administrative costs and, according to the Bank of England, was estimated to cause a long-term fall in productivity of around 3 to 4 per cent.

The rise in costs had the effect of shifting short-run aggregate supply upwards to the left. As well as leading to a rise in prices and a cost-of-living squeeze, the rising costs dampened expenditure.

This was compounded by a tightening of fiscal policy as governments attempted to tackle public-sector deficits and debt, which had soared with the support measures during the pandemic. It was also compounded by rising interest rates as central banks attempted to bring inflation back to target.

Monetary policy response

Central banks are generally charged with keeping inflation in the medium term at a target rate set by the government or the central bank itself. For most developed countries, this is 2% (see table in the blog, Should central bank targets be changed?). So is raising interest rates the correct policy response to cost-push inflation?

One argument is that monetary policy is inappropriate in the face of supply shocks. The supply shocks themselves have the effect of dampening demand. Raising interest rates will compound this effect, resulting in lower growth or even a recession. If the supply shocks are temporary, such as supply-chain disruptions caused by lockdowns during the pandemic, then it might be better to ride out the problem and not raise interest rates or raise them by only a small amount. Already cost pressures are easing in some areas as supplies have risen.

If, however, the fall in aggregate supply is more persistent, such as from climate-related declines in harvests or the Ukraine war dragging on, or new disruptions to supply associated with the Israel–Gaza war, or, in the UK’s case, with Brexit, then real aggregate demand may need to be reduced in order to match the lower aggregate supply. Or, at the very least, the growth in aggregate demand may need to be slowed to match the slower growth in aggregate supply.

Huw Pill, the Chief Economist at the Bank of England, in a podcast from the Columbia Law School (see links below), argued that people should recognise that the rise in costs has made them poorer. If they respond to the rising costs by seeking higher wages, or in the case of businesses, by putting up prices, this will simply stoke inflation. In these circumstances, raising interest rates to cool aggregate demand may reduce people’s ability to gain higher wages or put up prices.

Another argument for raising interest rates in the face of cost-push inflation is when those cost increases are felt more than in other countries. The USA has suffered less from cost pressures than the UK. On the other hand, its growth rate is higher, suggesting that its inflation, albeit lower than in the UK, is more of the demand-pull variety. Despite its inflation rate being lower than in the UK, the problem of excess demand has led the Fed to adopt an aggressive interest rate policy. Its target rate is 5.25% to 5.50%, while the Bank of England’s is 5.25%. In order to prevent short-term capital outflows and a resulting depreciation in the pound, further stoking inflation, the Bank of England has been under pressure to mirror interest rate rises in the USA, the eurozone and elsewhere.

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Blogs on this site

Information and data

Questions

  1. How may monetary policy affect inflationary expectations?
  2. If cost-push inflation makes people generally poorer, what role does the government have in making the distribution of a cut in real income a fair one?
  3. In the context of cost-push inflation, how might the authorities prevent a wage–price spiral?
  4. With reference to the second article above, explain the ‘monetary policy conundrum’ faced by the Bank of Japan.
  5. If central banks have a single policy instrument, namely changes in interest rates, how may conflicts arise when there is more than one macroeconomic objective?
  6. Is Russia’s rise in inflation the result of cost or demand pressures, or a mixture of the two (see articles above)?
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Should central bank targets be changed?

Central bankers, policymakers, academics and economists met at the Economic Symposium at Jackson Hole, Wyoming from August 24–26. This annual conference, hosted by Kansas City Fed, gives them a chance to discuss current economic issues and the best policy responses. The theme this year was ‘Structural Shifts in the Global Economy’ and one of the issues discussed was whether, in the light of such shifts, central banks’ 2 per cent inflation targets are still appropriate.

Inflation has been slowing in most countries, but is still above the 2 peer cent target. In the USA, CPI inflation came down from a peak of 9.1% in June 2022 to 3.2% in July 2023. Core inflation, however, which excludes food and energy was 4.7%. At the symposium, in his keynote address the Fed Chair, Jay Powell, warned that despite 11 rises in interest rates since April 2022 (from 0%–0.25% to 5%–5.25%) having helped to bring inflation down, inflation was still too high and that further rises in interest rates could not be ruled out.

We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.

However, he did recognise the need to move cautiously in terms of any further rises in interest rates as “Doing too much could also do unnecessary harm to the economy.” But, despite the rises in interest rates, growth has remained strong in the USA. The annual growth rate in real GDP was 2.4% in the second quarter of 2023. Unemployment, at 3.5%, is low by historical standards and similar to the rate before the Fed began raising interest rates.

Raising the target rate of inflation?

Some economists and politicians have advocated raising the target rate of inflation from 2 per cent to, perhaps, 3 per cent. Jason Furman, an economic policy professor at Harvard and formerly chief economic advisor to President Barack Obama, argues that a higher target has the benefit of helping cushion the economy against severe recessions, especially important when such there have been adverse supply shocks, such as the supply-chain issues following the COVID lockdowns and then the war in Ukraine. A higher inflation rate may encourage more borrowing for investment as the real capital sum will be eroded more quickly. Some countries do indeed have higher inflation targets, as the table shows.

Powell emphatically ruled out any adjustment to the target rate. His views were expanded upon by Christine Lagarde, the head of the European Central Bank. She argued that in a world of greater supply shocks (such as from climate change), greater frictions in markets and greater inelasticity in supply, and hence greater price fluctuations, it is important for wage increases not to chase price increases. Increasing the target rate of inflation would anchor inflationary expectations at a higher level and hence would be self-defeating. Inflation in the eurozone, as in the USA, is falling – it halved from a peak of 10.6% in 2022 to 5.3% in July this year. Given this and worries about recession, the ECB may not raise interest rates at its September meeting. However, Lagarde argued that interest rates needed to remain high enough to bring inflation back to target.

The UK position

The Bank of England, too, is committed to a 2 per cent inflation target, even though the inflationary problems for the UK economy are greater that for many other countries. Greater shortfalls in wage growth have been more concentrated amongst lower-paid workers and especially in the public health, safety and transport sectors. Making up these shortfalls will slow the rate of inflationary decline; resisting doing so could lead to protracted industrial action with adverse effects on aggregate supply.

Then there is Brexit, which has added costs and bureaucratic procedures to many businesses. As Adam Posen (former member of the MPC) points out in the article linked below:

Even if this government continues to move towards more pragmatic relations with the EU, divergences in standards and regulation will increase costs and decrease availability of various imports, as will the end of various temporary exemptions. The base run rate of inflation will remain higher for some time as a result.

Then there is a persistent problem of low investment and productivity growth in the UK. This restriction on the supply side will make it difficult to bring inflation down, especially if workers attempt to achieve pay increases that match cost-of-living increases.

Sticking to the status quo

There seems little appetite among central bankers to adjust inflation targets. Squeezing inflation out of their respective economies is painful when inflation originates largely on the supply side and hence the problem is how to reduce demand and real incomes below what they would otherwise have been.

Raising inflation targets, they argue, would not address this fundamental problem and would probably simply anchor inflationary expectations at the higher level, leaving real incomes unchanged. Only if such policies led to a rise in investment would a higher target be justified and central bankers do not believe that it would.

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Data

Questions

  1. Use an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate inflation since the opening up of economies after the COVID lockdowns. Use another one to illustrate the the effects of central banks raising interest rates?
  2. Why is the world likely to continue experiencing bigger supply shocks and greater price volatility than before the pandemic?
  3. With hindsight, was increasing narrow money after the financial crisis and then during the pandemic excessive? Would it have been better to have used the extra money to fund government spending on infrastructure rather than purchasing assets such as bonds in the secondary market?
  4. What are the arguments for and against increasing the target rate of inflation?
  5. How do inflationary expectations influence the actual rate of inflation?
  6. Consider the arguments for and against the government matching pay increases for public-sector workers to the cost of living.
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Global inflation: looking ahead

Inflation has surged worldwide as countries have come out of their COVID-19 lockdowns. The increases in prices combined with supply-chain problems has raised questions of what will happen to future prices and whether it will feed further inflation cycles.

Inflation targeting

Inflation is a key contributor to instability in an economy. It measures the rate of increases in prices over a given period of time and indicates what will happen to the cost of living for households. Because of its importance, many central banks aim to keep inflation low and steady by setting a target. The Bank of England, the Federal Reserve, and the European Central Bank all aim to keep inflation low at a target rate of 2 per cent.

Inflation-rate targeting has been successfully practised in a growing number of countries over the past few decades. However, measures to combat rising inflation typically contract the economy through reducing real aggregate demand (or at least its rate of growth). This is a concern when the economy is not experiencing a strong economic performance.

Current outlook

Globally, rising inflation is causing concern as a surge in demand has been confronted by supply bottlenecks and rising prices of energy and raw materials. As the world emerges from the COVID-19 lockdowns, global financial markets have been affected in recent months by concerns around inflation. They have also been affected by the prospect of major central banks around the world being forced into the early removal of pandemic support measures, such as quantitative easing, before the economic recovery from the coronavirus is complete.

The Chief Economist at the Bank of England has warned that UK inflation is likely to rise ‘close to or even slightly above 5 per cent’ early next year, as he said the central bank would have a ‘live’ decision on whether to raise interest rates at its November meeting. Although consumer price inflation dipped to 3.1 per cent in September, the Bank of England has forecast it to exceed 4 per cent by the end of the year, 2 percentage points higher than its target. UK banks and building societies have already started to increase mortgage rates in response to rising inflation, signalling an end to the era of ultra-low borrowing costs and piling further pressure on household finances.

In the USA, shortages throughout the supply chains on which corporate America depends are also causing concern. These issues are translating into widespread inflationary pressure, disrupting operations and forcing companies to raise prices for customers. Pressure on every link in the supply chain, from factory closures triggered by COVID-19 outbreaks to trouble finding enough staff to unload trucks, is rippling across sectors, intensifying questions about the threat that inflation poses to robust consumer spending and rebounding corporate earnings. Reflecting concern over weaker levels of global economic growth despite rising inflationary pressures, US figures published at the end of October showed the world’s largest economy added just 194 000 jobs in September, far fewer than expected.

There are also fears raised over high levels of corporate debt, including in China at the embattled property developer Evergrande, where worries over its ability to keep up with debt payments have rippled through global markets. There are major concerns that Evergrande could pose risks to the wider property sector, with potential spill-overs internationally. However, it is argued that the British banking system has been shown in stress tests to be resilient to a severe economic downturn in China and Hong Kong.

Central bank responses

The sharpest consumer-price increases in years have evoked different responses from central banks. Many have raised interest rates, but two that haven’t are the most prominent in the global economy: the Federal Reserve and the European Central Bank. These differences in responses reflect differing opinions as to whether current price increases will feed further inflation cycles or simply peter out. For those large central banks, they are somewhat relying on households keeping faith in their track record of keeping inflation low. There is also an expectation that there are enough underutilised workers to ensure that wage inflation is kept low.

However, other monetary authorities worry that they have not yet earned the record of keeping inflation low and are concerned about the risk of wage inflation. In addition, in poorer countries there is a larger share of spending that goes on essentials such as food and energy. These have seen some of the highest price increases, so policy makers are going to be keen to stamp down on the inflation.

The Federal Reserve is expected to announce that it will start phasing out its $120bn monthly bond-buying programme (quantitative easing) as it confronts more pronounced price pressures and predictions that interest rates will be lifted next year. However, no adjustments are expected to be made to the Fed’s main policy rate, which is tethered near zero. Whilst financial markets are betting on an rise in Bank Rate by the Bank of England as early as next month, spurred by comments from Governor Andrew Bailey in mid-October that the central bank would ‘have to act’ to keep a lid on inflation.

Outlook for the UK

The Bank of England’s Chief Economist, Huw Pill, has warned that high rates of inflation could last longer than expected, due to severe supply shortages and rising household energy bills. He said inflationary pressures were still likely to prove temporary and would fall back over time as the economy adjusted after disruption caused by COVID and Brexit. However, he warned there were growing risks that elevated levels of inflation could persist next year.

The looming rise in borrowing costs for homeowners will add further pressure to family finances already stretched by higher energy bills and surging inflation. According to the Institute for Fiscal Studies, it is expected that households will face years of stagnating living standards, with predictions showing that households would on average be paying £3000 more each year in taxes by 2024/25, with the biggest impact felt by higher earners.

Investors are also reacting to concerns and have pulled $9.4bn out of UK-focused equity funds this year after hopes that a COVID-19 vaccination drive will fuel a vigorous economic recovery were overshadowed by questions about slow growth and high inflation. It is suggested that there is a general sense of caution about the UK when it comes to investing globally, driven by monetary, fiscal and trade uncertainties.

Given all the elements contributing to this outlook, The IMF has forecast that the UK will recover more slowly from the shocks of coronavirus than other G7 nations, with economic output in 2024 still 3 per cent below its pre-pandemic levels. Financial markets are predicting the Bank of England will lift interest rates as soon as the next MPC meeting. And while supply-chain bottlenecks and rising commodity prices are a global trend, the Bank’s hawkish stance has increased the possibility of a sharper slowdown in Britain than other developed markets, some analysts have said.

What next?

Some of the major central banks are poised to take centre stage when announcing their next monetary action, as it will reveal if they share the alarm about surging inflation that has gripped investors. Markets are betting that the Bank of England will begin raising interest rates, with Bank Rate expected to rise to around 1.25 per cent by the end of next year (from the current 0.1 per cent).

It is thought that the Fed will not raise interest rates just yet but will do so in the near future. Markets, businesses, and households globally will be waiting on the monetary decisions of all countries, as these decisions will shape the trajectory of the global economy over the next few years.

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Forecasts and commentary

Questions

  1. What is the definition of inflation?
  2. How is inflation measured?
  3. Using a diagram to aid your answers, discuss the difference between cost-push and demand-pull inflation.
  4. What are the demand-side and cost-side causes of the current rising inflation?
  5. Explain the impact an increase in interest rates has on the economy.
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Testing the Fed’s independence

Donald Trump has suggested that the Fed should cut interest rates by 1 percentage point and engage in a further round of quantitative easing. He wants to see monetary policy used to give a substantial boost to US economic growth at a time when inflation is below target. In a pair of tweets just before the meeting of the Fed to decide on interest rates, he said:

China is adding great stimulus to its economy while at the same time keeping interest rates low. Our Federal Reserve has incessantly lifted interest rates, even though inflation is very low, and instituted a very big dose of quantitative tightening. We have the potential to go up like a rocket if we did some lowering of rates, like one point, and some quantitative easing. Yes, we are doing very well at 3.2% GDP, but with our wonderfully low inflation, we could be setting major records &, at the same time, make our National Debt start to look small!

But would this be an appropriate policy? The first issue concerns the independence of the Fed.

It is supposed to take decisions removed from the political arena. This means sticking to its inflation target of 2 per cent over the medium term – the target it has officially had since January 2012. To do this, it adjusts the federal funds interest rate and the magnitude of any bond buying programme (quantitative easing) or bond selling programme (quantitative tightening).

The Fed is supposed to assess the evidence concerning the pressures on inflation (e.g. changes in aggregate demand) and what inflation is likely to be over the medium term in the absence of any changes in monetary policy. If the Federal Open Market Committee (FOMC) expects inflation to exceed 2 per cent over the medium term, it will probably raise the federal funds rate; if it expects inflation to be below the target it will probably lower the federal funds rate.

In the case of the economy being in recession, and thus probably considerably undershooting the target, it may also engage in quantitative easing (QE). If the economy is growing strongly, it may sell some of its portfolio of bonds and thus engage in quantitative tightening (QT).

Since December 2015 the Fed has been raising interest rates by 0.25 percentage points at a time in a series of steps, so that the federal funds rate stands at between 2.25% and 2.5% (see chart). And since October 2017, it has also been engaged in quantitative tightening. In recent months it has been selling up to $50 billion of assets per month from its holdings of around $4000 billion and so far has reduced them by around £500 billion. It has, however, announced that the programme of QT will end in the second half of 2019.

This does raise the question of whether the FOMC is succumbing to political pressure to cease QT and put interest rate rises on hold. If so, it is going against its remit to base its policy purely on evidence. The Fed, however, maintains that its caution reflects uncertainty about the global economy.

The second issue is whether Trump’s proposed policy is a wise one.

Caution about further rises in interest rates and further QT is very different from the strongly expansionary monetary policy that President Trump proposes. The economy is already growing at 3.2%, which is above the rate of growth in potential output, of around 1.8% to 2.0%. The output gap (the percentage amount that actual GDP exceeds potential GDP) is positive. The IMF forecasts that the gap will be 1.4% in 2019 and 1.3% in 2020 and 2021. This means that the economy is operating at above normal capacity working and this will eventually start to drive up inflation. Any further stimulus will exacerbate the problem of excess demand. And a large stimulus, as proposed by Donald Trump, will cause serious overheating in the medium term, even if it does stimulate growth in the short term.

For these reasons, the Fed resisted calls for a large cut in interest rates and a return to quantitative easing. Instead it chose to keep interest rates on hold at its meeting on 1 May 2019.

But if the Fed had done as Donald Trump would have liked, the economy would probably be growing very strongly at the time of the next US election in November next year. It would be a good example of the start of a political business cycle – something that is rarer nowadays with the independence of central banks.

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FOMC meeting

Questions

  1. What are the arguments for central bank independence?
  2. Are there any arguments against central bank independence?
  3. Explain what is meant by an ‘output gap’? Why is it important to be clear on what is meant by ‘potential output’?
  4. Would there be any supply-side effects of a strong monetary stimulus to the US economy at the current time? If so, what are they?
  5. Explain what is meant by the ‘political business’ cycle? Are governments in the UK, USA or the eurozone using macroeconomic policy to take advantage of the electoral cycle?
  6. The Fed seems to be ending its programme of quantitative tightening (QT). Why might that be so and is it a good idea?
  7. If inflation is caused by cost-push pressures, should central banks stick rigidly to inflation targets? Explain.
  8. How are expectations likely to affect the success of a monetary stimulus?