Does the BoE’s view on uncertainty make sense?

Uncertainty is an unavoidable element of policy decisions. In the words of the great Donald Rumsfeld, we must confront the unknown unknowns. In this appearance the BoE’s chief economist, Spencer Dale, discusses his approach to dealing with uncertainty in the context of forward guidance. Essentially, he says that the Bank doesn’t know how big the output gap is so it has been cautious with forward guidance. He suggests that any other course of action would risk pushing up inflation expectations.

His view is understandable, given the Bank’s inflation target, but it is probably not optimal for the UK. The Bank’s primary obligation is to ensure that inflation remains at 2 per cent in the medium term so I can see why Dale would take the view that uncertainty should make them more cautious. However, if the true cost to the economy is a combination of both lost output and inflation, then it would be better if the Bank were less cautious.

First, uncertainty in the economy is likely to reduce the effectiveness of monetary policy. To be effective the Bank must be especially decisive in times of uncertainty, and that is the opposite of the cautious approach the Bank has taken.

The second reason is espoused by Alan Blinder. He points out that inflation can be effectively controlled by central banks through their standard tools, but lifting output has proven difficult at the ZLB. Consequently, the risks of being overly tight are far greater than the risks of being decisively easy. It is easier for a central bank to gain forgiveness for high inflation than to gain permission to lift output. That too militates in favour of decisive action when there is uncertainty about the output gap at the ZLB.

For both those reasons it would be better if the Bank had been bolder in its forward guidance. However, the MPC is merely executing its statutory duty. The responsibility for the cautious policy announcement lies with those who chose not to change the Bank’s mandate to explicitly include output in some fashion.

  • Matt Nolan

    Hmm, I’m not entirely following.

    Surely they are treating downside and upside risks to the inflation target symmetrically? If so, there is as much risk of them overstimulating activity as under-stimulating it – the need for “caution” is relatively unclear.

    Or by caution does the Bank mean they are not treating deviations symmetrically? In that case I wouldn’t be so quick as to say they are meeting their mandate ;)

    • jamesz

      I don’t think there is obviously a lack of symmetry here; the Bank doesn’t really face much downside risk at the moment. The real question for them is how to balance supporting nominal output growth against returning inflation to target when it’s been above target for five years! Persistently high inflation makes them understandably nervous about easing even though other measures of the output gap suggest it is still around 4%ish. Blinder’s point is that the Bank should be more worried about closing the output gap than about the possibility of pushing up inflation.

      • Matt Nolan

        Hmm, I wouldn’t paint the trade-off in quite that way.

        The BoE is targeting future inflation. Future inflation is a function of (output gap, current inflation). If current inflation had no impact on expectations of future inflation, then by definition a refusal to close the ‘output gap’ in the medium term is a failure to meet its inflation target.

        The BoE is uncertain about what the output gap actually is, but that doesn’t, in of itself, mean they should be cautious – it just tells us that if they follow their best expected monetary policy there is a wider range of (output gap, inflation) outcomes that may occur with some non-negligable probability.

        Now, they could say that the inflation rate has been above the target band, and that current inflation has a strong impact on future inflation (hence why it seems so sticky). In this case, and combined with the idea that the costs of deviations rise exponentially as we move away from target, they do not want to treat inflation symmetrically and have a downward bias towards inflation. But I would be nervous about them taking that argument a bit far!

        • jamesz

          Nobody seems to have a good explanation for why inflation in the UK has been so high recently, which is why the relationship between the output gap and inflation has been questioned. I should clarify that there are plenty of candidates but none that stand out above the others so much that you’d trust them as the primary causal channel. That is why they don’t talk as if hitting a medium term inflation target and closing the output gap are necessarily the same thing.

          It’s also worth remembering that their statutory duty is not defined as ‘medium-term inflation’. The wording is that ‘the inflation target applies at all times’, which could be interpreted as the medium term but certainly puts them under pressure when realised inflation remains persistently above target.

          • Matt Nolan

            “which is why the relationship between the output gap and inflation has been questioned”

            This makes no sense to me – the output gap, by definition, translates into future inflation. Just because there have been other exogenous shocks, and their form is uncertain, doesn’t change that. There isn’t a trade-off between these estimates, they are the same concept.

            This sounds to me like the BoE believes their best estimate of the output gap is small – uncertainty is a red herring, and more a potential (and potentially fair in this circumstance) excuse for when things don’t turn out the way they expect.

            • jamesz

              Sorry, I didn’t mean ‘inflation’, I meant ‘the CPI’, which is the target index. Yes, the output gap determines future inflation but the question is what current price indices tell us about the current output gap. Productivity has crashed and even the core CPI has been kinda high so you can see why they’d think the output gap is small. However, other price indices, such as the GDP deflator and wages, have been really low, which supports the idea of a large output gap. What I meant is that the CPI may not presently reflect ‘true’ inflation.

              • Matt Nolan

                Ahhh indeed. But I still don’t understand how this implies why “uncertainty” would make them “do too little” ex ante.

                If the CPI is mismeasuring true inflation, but they are mandated to chase CPI, that is a institutional failure – it is not a result of uncertainty having an impact on the central banks reaction function.

                • jamesz

                  The second bit I agree with. The first bit is just about the symmetry of the Bank’s loss function around optimal policy. Obviously they don’t know what is optimal and I’m saying that their loss function might be asymmetric. Well, Alan Blinder was saying that and that’s an oracle I’m happy to believe in ;)

  • Alfred

    The link you provide regarding the effectiveness of MP under uncertainty regards standard interest rate shocks, I’m not sure that this result can easily be carried over into other MP tools such as forward guidance.

    The main channel through which uncertainty affects MP effectiveness is the covariance wedge in the agents’ Euler condition—precautionary savings. A second important channel is through the financial friction, where aggregate nominal uncertainty can make if difficult for entrepreneurs to write external finance contracts. It is clear to see why IR shocks would not be so effective when these wedges are large.

    In English, households will save more if they don’t know what the future holds.

    Stimulative monetary policy encourages people to save less, bringing forward spending from tomorrow to today.

    Some Delphic forward guidance may in some circumstances reduce these uncertainty wedges—bringing forward spending. It is not clear that more aggressive, or Odyssian forward guidance, “The MPC is going on holiday and turning their phones off until unemployment is below 5% or inflation is above 4%” would reduce these wedges.

    Surely if the MPC had completely changed course to the whims of HM Treasury that would have introduced more policy uncertainty? The UK does not have a long tradition of independent MP. Does following Osborne’s call for growth right before the election mean that immediately after the election the MPC will bow to the hard-money wing of the Tories and lift rates?

    Note that these same uncertainty wedges also affect price and wage markups in a New Keynesian model, as these too are fixed nominal contracts—keeping inflation up.

    But the best ways to reduce these wedges are to ensure that MP remains independent, and that the future tax burden and pensions are predictable. IMF: It’s Mostly Fiscal.

    • jamesz

      You’re right, I lazily conflated Delphic guidance where the Bank is concerned that people are misreading its reaction function with Odyssian guidance. To be more specific, the Bank is apparently providing only Delphic guidance at the moment but in a very cautious fashion. The employment threshold is very high relative to the likely NAIRU and they have provided no signal about their RF below the threshold. Nor have they provided guidance on their likely course of action if growth remains weak. In terms of using Delphic guidance to reduce uncertainty I think they could have done a lot more.

      More broadly, the series of supply-side price shocks have proven a real challenge to the MPC through the recession. I would have preferred that HMT changed the target in its recent review to explicitly include some output measure. That may have avoided the tangle of mixed messages that the Bank has been sending lately, eg. “Guidance isn’t an easing of policy but it should support growth by making policy more effective.” I’ve heard Dale do a very good job of explaining what that means but it is a really difficult message to sell.

      • Alfred

        I agree that forward guidance is worded very conservatively. I mean who in their right mind *would* increase the policy rate when unemployment is above 7% and *no* risk to inflation or financial stability!