Monetary policy used to be a simple job – so much so that economic consultant Paul Ormerod once said that membership of the Monetary Policy Committee (MPC) should be seen as a sinecure. Central bankers assumed that trend or potential growth was stable, so if demand was high relative to this potential growth they raised rates and if it was low they cut them. This job was summarised by John Taylor’s rule, which said interest rates should be a simple function of inflation and the output gap, the difference between actual output and its potential.
Now, though, things are not so easy – if indeed they ever were. One problem is that potential growth is not stable. Which poses the question: how should monetary policy respond to falls in it?
On the one hand, such shocks reduce growth and so should require rates to fall. But, on the other hand, they reduce the speed at which demand can grow without sparking inflation and this requires an inflation-targeting central bank to raise rates.
The Federal Reserve has faced this dilemma because the trade war with China is just such an adverse supply shock. But the Bank of England might also face it if Boris Johnson is re-elected prime minister and delivers on his promise to take us out of the EU by January. To the extent that this throws sand into the wheels of international trade, it will depress exports and productivity. We don’t know the size of these effects, but we can be tolerably confident of the direction.
So, what should be the monetary policy response to this? Should the Bank raise rates to choke off inflation, or cut them to promote growth?
One reason for doing the latter is that we are in fact some way off the point at which the economy is strong enough to cause inflation: the large amount of underemployment will hold wages and prices down. Also, it’s possible that even the reality of Brexit will prolong uncertainty and continue to hold down capital spending, if companies fear a no-deal at the end of the transition period.
Both of these responses, however, only postpone facing the dilemma. They do not resolve it.
So, can it be resolved? Possibly. One origin of the dilemma is the traditional belief that there’s a sharp distinction between trend and cycle. This view says that central banks can affect the cycle insofar as looser monetary policy can stimulate consumer spending, but they cannot affect trend growth as this is determined by things such as technology and trading rules. As Fed chairman Jerome Powell has said: “While monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rulebook for international trade.”
Perhaps, though, this distinction between trend and cycle is too sharp. It’s possible that sustained loose monetary policy can boost trend growth insofar as it boosts capital spending, company start-ups and innovation and so could raise productivity growth and hence longer-term growth.
But can it? History tells an ambiguous story. On the one hand, ultra-low interest rates were one factor behind the strong non-inflationary growth of the 1950s and early 1960s, which suggests they can contribute to boosting long-term growth. But, on the other hand, forward guidance after 2009 – the promise of continued low rates – seems to have done almost nothing to raise capital spending or productivity.
For me, this suggests the job of boosting trend growth should be done by governments as these have many more levers than central banks: infrastructure spending, competition policy, tax, and so on. Even with all these, however, it’s hard to raise long-term growth, as economists John Landon-Lane and Peter Robertson pointed out. But this is a reason for governments to try all the harder. It is not, however, wholly obvious that all the main political parties are willing to make such an effort.
