The rising popularity of monetary policy in the UK

A James Alexander post

I think this post by Eric Lonergan  may be an attempt at a response to this post here a week ago.

Rather incredibly, rather wonderfully, monetary policy is becoming a subject of popular debate in the UK as Jeremy Corbyn looks favourite to win the nomination for Labour Party leader. One of his policies is a “People’s QE”

This idea can be discussed later, but appears to be an attempt to get monetary and fiscal policy aligned by getting the Bank of England to buy bonds issued by a National Investment Bank, and thus directly finance additional government spending, even if labelled “public investment”. It would probably lead to higher inflation, but the negative multiplier from government investment controlled by Corbyn and his trade union supporters would mean real GDP would not grow much.

However, in the reply to my post Lonergan completely misunderstands the call to change the target of monetary policy. Market Monetarists do not call for raising the inflation target. We call for not trying to target something as flaky and hard to measure as inflation, but something much easier: nominal GDP, or aggregate demand (as defined in economics textbooks), measured by one of the three standard methods of nominal income, expenditure or output. As a distant second or third best, raising the inflation target would be better than sticking to a rigid target for inflation. Many successful central banks operate with this policy right now. Lonergan should read up on Canadian, Australian and Swedish monetary policy, at least in the Svensson era.

Lonergan sets out five premises for his argument:

1. Inflation falls if there is significant spare capacity.
2. If the central bank can consistently hit its inflation target there is no spare capacity.
3. If there is no spare capacity, there is no policy problem.
4. There is only a problem if inflation is below target AND the central bank cannot raise the inflation rate.
5. If the central bank cannot raise the inflation rate, and inflation is below target, it cannot hit a higher inflation target.

The premises start badly and get worse. “Spare Capacity” is a red herring for a good monetary economist. The spare capacity (or gap) theory of inflation is not true. You can have high inflation unemployment and low inflation unemployment. Inflation is a monetary phenomenon in the long run, not a real one. The Phillips curve has been discredited for a long time now. It is surprising to still hear it from such an expert on money – although not surprising given many central bankers seem to share this illusion too.

The second premise is confusing. The central bank can hit its inflation target if it wants to, but has to convince the market that it wants to through credible action or threats of it. Constant fears of tightening every time the target is approached means the target will not be hit. Many modern central banks consistently defeat themselves, see the Fed or the UK nowadays, or Japan for many years until recently.

The third premise is problematic. Spare capacity is almost impossible to measure. We can see it obviously when unemployment is high, but when it is low and the participation rate is low (the US now) – who knows? Probably there is spare capacity, and a lot of it. Is there spare capacity when you have low unemployment, decent participation levels, but lots of low paid gigs, many with tax credits attached, zero hours contracts and a constantly growing labour force size due to inward migration, like the UK? Who knows, probably yes.

The fourth premise does raise a problem. If central bankers are just not doing their job properly then we need to sack them and get in ones who will do the job – just like any employee who constantly misses their targets. The Japanese government has shown it can be done without causing instability and has had decent success following the change – as unemployment has fallen and inflation ticked up. Japan needs to do more, but they have shown good determination.

The fifth premise is just a truism.

The “sort of” opposition of Lonergan and other left wing bloggers (Wren-Lewis, Coppola, De Long and Yates) have to changing the inflation target or moving to nominal GDP targeting remains mysterious to me. Sometimes, they write in sympathy, even Longeran, sometimes not. I think mostly this is because they want to see more government, they are left-wing after all, whereas Market Monetarism is politically neutral – even if I am a self-admitted supply-sider. Either way, we need good strong real GDP growth to pay for those less successful via welfare or via offering them decent jobs.

NB The “market” in Market Monetarism is for market expectations of NGDP growth to be the target of monetary policy. Constant, predictable, nominal growth should be the object of central bank policy.