Monetary and fiscal policies after the financial crisis Malcolm Sawyer

Monetary and fiscal policies after the financial crisis Until recently, claims would generally be made for the success of policies based on independent Central Banks with some form of the targeting of inflation. The experience of the past year or so has cast major doubts on the general IT framework. Inflation has risen well above the target, widely seen to be cost inflation, and for which IT has no response. With the financial crisis interest rate policy is directed away from concern over inflation but more significantly the economy clearly does not resemble the stable one envisaged by the IT approach.

New consensus in macroeconomics The ‘new consensus in macroeconomics’ (NCM) framework which at least in the academic sphere (macroeconomic models at the Bank of England and some used within the ECB based on it) underpins Central Bank independence, inflation targeting and the link is based notoriously on an absence of banks ; it is based on an essentially stable view of the economy which diminishes the role for fiscal policy and for monetary policy with respect to stabilisation.

New consensus in macroeconomics The skeleton NCM model: Yg t = a0 + a1 Ygt-1 + a2 Et (Ygt+1) – a3 [Rt – Et (pt+1)] + s1 pt = b1Ygt + b2pt-1 + b3Et (pt+1) + s2 Rt = RR* + Et (pt+1) + c1Ygt-1 + c2 (pt-1 – pT)] + s3 with b2 + b3 = 1, where Yg is the output gap, R is nominal rate of interest, p is rate of inflation, pT is inflation rate target, RR* is the ‘equilibrium’ real rate of interest, consistent with zero output gap and constant rate of inflation, si (with i = 1, 2, 3) represents stochastic shocks, and Et refers to expectations held at time t.

New consensus in macroeconomics Equation (1) is the aggregate demand equation with the current output gap determined by past and expected future output gap and the real rate of interest. Equation (2) is a Phillips’ curve with inflation based on current output gap and past and future inflation. Equation (3) is an interest rate policy rule often referred to as Taylor’s rule.

New consensus in macroeconomics A key role in the NCM played by the ‘equilibrium rate of interest’, RR* = - a0/a3, but which may not exist, difficult to estimate and in this framework depends on the exogenous component of demand (including fiscal policy stance). Fiscal policy can be ruled out if it is assumed that Ricardian equivalence ‘rules’, and hence in terms of these equations a0 is constant no matter what the fiscal stance.

Inflation targeting There are some significant problems with inflation targeting (and also with dual mandates which include inflation). These include: The one instrument – one objective approach. Ignoring the potential role of fiscal policy; The inter-temporal budget constraint in the development of this model in effect imposes lifetime expenditure equals lifetime income and in effect rules any inadequacy of private aggregate demand. Ultra fine tuning: the frequent adjustment of interest rate runs into most of the problems which were raised against fiscal fine tuning.

Inflation targeting Lack of link from interest rate to inflation (theory) The Phillips’ curve type analysis has failed to establish the theoretical basis. A higher level of output/demand may lead to a higher price (relative to cost) – that would be the standard micro-economic position. It can, of course, be argued that unit costs and mark-up are roughly constant with respect to output over wide range. Higher demand may then lead to higher price, but that does not mean higher inflation (= persistent price increases).

Inflation targeting Two situations where this could lead to inflation : (i) a higher price level in the period in which it occurs provides a measure rate of inflation for that period; if expectations on inflation jump in line with that experience, then inflation may continue; (ii) wages (or similar) come into the picture and higher output involves both higher prices and higher wages ; the intended increase in at least one of price/wage or wage/price cannot occur.

Inflation targeting The argument presented by Wicksell rested on the effect of interest rate changes on asset prices. Lower interest rate raised asset prices, and stimulated acquisition of assets concerned and specifically production of those capital assets. This could be seen as changing relative price of interest-sensitive products. It can also fed into development of speculative bubbles in asset prices. It can though again be argued that the level of interest rates influences the level of prices, rather than the rate of increase of prices (inflation).

Inflation targeting Lack of link from interest rate to inflation : empirics There seems to be a consensus from the econometrics; and these are typically econometric estimation undertaken within Central Banks or by those closely associated with them. A 1 per cent hike in policy interest rate leads to a significant drop in output but reduction in inflation of the order of 0.1 to 0.2 per cent.

Inflation targeting Two words of caution : the interest rate change is applied for a year, but this may be because the nature of the model is such that a departure from the equilibrium interest rate within the model would eventually cause the model to explore Inflation in these models is tied down by expectations, and with assumption of some form of forward-looking ‘rational expectations’ and that the inflation target is met.

What should monetary policy do ? Is there any role for activist monetary policy ? Other uses of the interest rate Towards the rule: real interest rate equal to rate of growth. In present approach all attention is paid to 25 basis point variations in the interest rate on a monthly basis; little attention is paid to the average/equilibrium/natural rate. A number of arguments point to the average rate being around the rate of growth.

What should monetary policy do ? ‘The 2-percent “equilibrium” real rate is close to the assumed steady-state growth rate of 2.2 percent’, Taylor, 1993, p. 202). The ‘golden rule’ of accumulation. The distributional argument (real rate of interest = growth rate preserves relative position of savings)

Sustainable debt The sustainable debt position is given by b = d/g where g is nominal growth rate, b is debt/bonds, d is total deficit = primary deficit d’ + interest payments b.i Hence b.g = d = d’’ + i.b, and hence d’’ = 0 when i = g and deficit = interest payments.

Setting the interest rate Proposal coming from this is to set nominal rate at beginning of year, given expected inflation; and sit back for the rest of the year Some issues : the arguments above relate to ‘the’ rate of interest ; the relevant one is not necessarily the policy rate, e.g. post-tax rate on bonds relevant for the sustainable deficit argument: does policy rate in the end set all the relevant interest rates ? Exchange rate considerations ?

What should then be the role and objectives of monetary policy ? Objective of monetary policy shifts away from inflation more towards financial stability Development of monetary policy away from solely interest rates What about inflation ?

Fiscal policy ‘Functional finance’ approach sets a clear rule : set budget deficit to support aggregate demand at target level Fiscal policy : some form of ‘functional finance’ over the long haul with enhanced automatic stabilisers. The need to avoid arbitrary budget deficit rules – whether balanced budget in a year, over a cycle, or current budget balanced over the cycle.

Fiscal policy In ‘functional finance’ approach limit on budget deficit is the size of net private savings at target level of economic activity. Any total budget deficit is sustainable through the relationship b=d/g

Fiscal policy The need to deal with government’s capital account with assets and liabilities : implications for ‘bail-out’, and also for public-private partnerships, private finance initiative. The arguments for inter-temporal budget constraint etc. have idea that the limit of the discounted outstanding government debt as time tends to infinity is zero, alternatively expressed as sum of debt at time 0 plus discounted future budget deficits equals zero ; hence since debt at time 0 is positive, discounted future budget deficits negative. Is the outstanding debt the relevant figure ?

Fiscal policy Debt targets (or concerns) are set in liability terms : relevance of bail outs The role of the PPPs and PFIs akin to off-balance sheet activities. It could lead to the budget deficit being calculated in real terms rather than the nominal terms.

Concluding comments The financial crisis and the inflation ‘surge’ undermines current monetary policy arrangements. Drop focus of monetary policy on inflation Have argued here for setting interest rate = growth rate Monetary policy more broadly defined to focus on financial stability

Concluding comments Reinstatement of fiscal policy for stabilisation purposes and reassert ‘functional finance’. As long as budget position set in accordance with ‘functional finance’ principles it can always be funded, does not place pressure on interest rates and is not undermined by unsustainable debts.