TVHE is now international

While Matt was busy lounging around in Colombia I packed my bags and moved to London. With agnitio in Auckland, that leaves Matt as the only remaining Wellington resident still blogging, although he makes up for that by writing 80% of the posts!

To celebrate my move to the UK it seems appropriate to reference football with this quote from the BoE governor, Mervyn King, in which he explains his ‘Maradona theory of interest rates’:

The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.

Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those expectations were sufficient – at times – to stabilise private spending while official interest rates in fact moved very little
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That pattern is sometimes described as “the market doing the work for us”. I prefer a different description. It is the framework of monetary policy doing the work for us. Because inflation expectations matter to the behaviour of households and firms, the critical aspect of monetary policy is how the decisions of the central bank influence those expectations. As Michael Woodford has put it, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. Indeed, one can argue that the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations. The precise “rule” which central banks follow is less important than their ability to condition expectations. That is a fundamental point on which my later argument will rest.