With his rock star good looks and his PR brilliance Carney has already shown he is a smooth operator. On his first day he arrived at Threadneedle Street by public transport rather than the chauffeured car. He announced that Jane Austen is to be the female face on a Bank of England ten pound note. He has turned a split MPC into agreement on QE. And in an interview on the prestigious Today programme on Thursday he said he wanted women on the rate setting Committee (currently there are none). Carney is clearly courting the media.
But Fleet Street is notorious for its hostility. Newspaper headlines after Wednesday’s Inflation Report concentrated on the pain to savers of his lower and longer interest rate policy (but newspaper readers tend to be older people who have bank savings). If Carney wishes to fly high, then most British journalists would warn that he has further to fall. There are those waiting to write the sobriquet Carney Carnage and already I have received in my inbox Mark (et) Carn (age) and he has only been in the job for a month!
But let’s concentrate on what he had to say, looking at Carney’s opening paragraph:
“A renewed recovery is now underway in the United Kingdom, and it appears to be broadening. While that is certainly welcome, the legacy of the financial crisis means that the recovery remains weak by historical standards, and there is still a significant margin of spare capacity in the economy.”
The first thing I would note is that the recovery up till now has been weak. But that was expected after a global financial crisis. But from here on, the recovery may surprise in its strength. Recent data has been very good and economic data tends to underestimate the strength of the upturn. The Bank increased its forecasts for GDP substantially from 1.2% to 1.5% for this year and from 1.9% to 2.7% for 2014. Once upward revisions start, they often continue. That is because it can take a year of two of revisions to show the real economic picture.
The second worry I have is Carney’s reliance on “spare capacity” in the UK economy – his speech and answers were littered with it. This is the idea that an economy has spare or slack capacity that can be used up without incurring any inflationary pressures. So in chart form:
Economists assume a trend rate of growth (for example 2-2.5%) and the plot that against real GDP. The gap between the two lines is described as the “output gap”. However there are some serious problems with this analysis: What is trend growth? When is the economy operating at full capacity (when do the two lines on the chart above cross)? And a prolonged period of below trend growth can reduce productive capacity, but how much is that loss? In fact the Bank of England itself is highly sceptical of any analysis of a theoretical output gap – In a report dated 10th October 2012, (External MPC Unit Discussion Paper No. 36: Did output gap measurement improve over time?) the bank admits “A large body of research has shown that real-time estimates of the output gap tend to be unreliable.” Give an economist a few drinks and almost all will admit that calculating such a figure is guesswork.
And yet Carney is relying on this output gap to ensure that future growth does not deliver inflation and he is also basing the path of future interest rates on this gap: “The MPC intends, at a minimum, to maintain the currently exceptionally accommodative stance of monetary policy until economic slack has been substantially reduced.” But when is “slack” reduced if we don’t know how much slack there is at the beginning?
In the real world an example of “slack” is people operating below their skilled level. I take a lot of minicabs in London and driving is a quick way to earn cash for both immigrants and the unemployed. Recently two of my drivers were highly educated professionals. One was a building services engineer, with two degrees, who had been laid off in the property price collapse. The other had a degree in IT, ten years experience in the NHS, but had been made redundant in the first round of public sector cuts. Both thought that already after three years out of their chosen profession, they could never return to their old highly productive careers. This is the loss of productive capacity previously referred to and estimating it almost impossible.
Now onto Carney’s desire to link monetary policy to one economic variable – the unemployment rate, “…the MPC intends not to raise Bank Rate above its current level of 0.5% at least until the Labour Force Survey headline measure of unemployment has fallen to a threshold of 7%.” I have concerns with targeting one economic variable. In the 1980s Thatcher’s chancellors thought that targeting Money Supply was a key monetary goal. That failed. More recently the central banker target of choice has been consumer price inflation. That failed too in America and the UK – the benefit of cheap Chinese goods ensured RPI and CPI stayed low even whilst a property price boom was created from the resultant low interest rates.
Goodhart’s Law is named after a former advisor to the Bank of England, Charles Goodhart which also cautions against choosing one target variable. It is best summed up by “when a measure becomes a target, it ceases to be a good measure”. In Goodhart’s own words “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”. Goodhart first described it in 1975 but it was subsequently used to criticise Thatcher’s targeting of money supply. Similar is Campbell’s Law (“when test scores become the goal of the teaching process, they both lose their value as indicators of educational status and distort the educational process in undesirable ways” ).
From an economics perspective one variable targets are poor. But from a communications viewpoint, he is sending a clear message to UK people and businesses – no rate rise until unemployment falls below 7%. When he was Governor of the Bank of Canada, he is quoted as saying how important it was to communicate rate policy directly to ordinary Canadians. Clearly he is trying to replicate that in the UK. And in order to do so, he needs to get the media onside – he needs them to get his message out. (Although the FT’s front page on Friday ran “Carney rate vow set to fuel buy-to-let mortgage boom” which I do not imagine was his aim).
Carney is targeting unemployment because it is a proxy for the output gap. Again this makes me nervous. It may not be socially acceptable to say but some British people are unemployable. And others do not want the jobs on offer. Some unemployed live in the wrong part of the country (and will not move to work) or have the wrong skills (or none at all). No amount of economic growth will ensure these people are in work. So what percentage of the unemployed does this constitute? That is very difficult to guess.
The lowest recent rate of unemployment was 4.6% in 2005. At the start of the crisis in 2009 it rose to 7.9%. But one of the features of the last three and a half years has been that even with no growth and many thousands of public sector job cuts, unemployment is only 7.7%. There is little consensus on why unemployment has stayed relatively low (as say compared to previous recessions when it got up to over 11% in the 80s and 10.4% in early 1993). So Carney is targeting a variable that no one quite understands at this moment.
And now inflation. Already for the most part of five years, CPI has been over target. Carney admitted on Wednesday it will continue to do so for the next two years (at least). So for seven years – the best part of a decade – inflation has been and will be over target. And Carney admitted that he would only seek to reassess policy if inflation was forecast to be over 2.5% 18-24months into the future. The Inflation target may as well be ripped up and flushed down the toilet.
But do Britons care? The country has a history of inflation acceptance. Britons are not like the Germans, we tolerate inflation (many do not even understand its destruction of wealth). In fact given our obsession with property ownership it makes us feel wealthier (even if we aren’t). In the same way, when critics complain about rebalancing (which I have written about before), I am also a little bewildered. Britons like to spend, we are not German savers, 60-70% of our economy is consumption. To try and reduce Britons from consuming and getting indebted seems an almost Herculaen task. Also given how indebted the UK is, I don’t care where the growth comes from, just that we have some.
In Nate Silverman’s excellent book “The Signal and the Noise”, he highlights just how complex an economy is and how impossible it is to predict. An economy is always changing, cause and effect is unknown and economic data is generally of very low quality. Even given this warning, I will commit to a forecast (however unlike most economists I am not overconfident). My scenario is that the beginnings of the recovery will be from consumer spending and then companies will rush to spend. After years of a lack of investment, this could prove to be a real jolt in the arm. The recovery will be much stronger than expected and inflation will eventually come back with a vengeance. And I fear Carney will not raise rates soon enough. In my opinion, the Bank of England under Carney is rebalancing its goals away from inflation towards growth just when the UK is about to boom – a delicious irony.
One of the most successful financial books in the last few years has been Liaquat Ahamed’s Lords of Finance that analysed the performance of the great central bankers of the 1930s. It is the nature of the role of central banker that their actions are judged by the passage of time. Alan Greenspan was considered the God Central Banker when in office but his actions now are mostly criticised. It is history that will judge Carney.
