Knockouts, cutoffs and consensus at the Bank of England

The most interesting thing that happened yesterday was the description of the knockouts which would cause the Bank of England to reconsider its monetary stance. Surprise! We’re screwed.

There are a number of knockouts that would cause the Bank to consider discussing raising interest rates and tightening their already tight monetary policy. The knockouts are defined not as automatic cutoffs for action, but as thresholds when a change in behaviour will be discussed. They are:

  • A 7 % unemployment knockout
  • An 18-24 month out prediction of 2.5% CPI inflation
  • Financial instability

There are a number of problems with each of these. I’ll end with unemployment because it’s the most important.

These knockouts are meant to ensure that monetary policy doesn’t damage the economy by trying to help it. The Bank of England is worried that if inflation gets too high inflation expectations will get to high and we’ll have to undergo an extend period of unemployment to force them back down…looks down at dole queue…no I don’t get it either.

The problem with looking at inflation is that it is an unreliable indicator. Britmouse has done the leg work (thanks!) and has pointed out that the 18-24 month out prediction of 2.5% CPI came closest to being triggered in early mid-late 2008 and early 2013. If your indicator is telling you to tighten at the beginning and middle of a depression you might want a new indicator. As Britmouse suggests and shows, NGDP was a better predictor.

The financial stability point is irritating. I’ve been following FT alphaville and they’re all much cleverer than me. This means I have to concede that low interest rates and the purchase of massive amounts of safe assets by central banks has made life hard for some banks and money market funds. In some ways low interest rates have spread financial instability.

But raising interest rates would crush the real economy and crushing the real economy will crash the markets. As we saw in mid-2008 when all these shenanigans started, in mid-2011 when the ECB decided it fancied a sovereign debt crisis and in the US earlier this year tapering or tightening or loosening less than expected is the real cause of financial instability.

Lastly, unemployment. There are few things more debilitating or awful than unemployment and study after study underline this. Unfortunately, you can’t push unemployment too low because people have to find the right jobs. In a recession a lack of demand raises unemployment above this minimum level…looks down at dole queue…you might have noticed.

This natural rate of unemployment (ugly phrase, but useful) will change and vary depending on how easy it is to find a job. Before the recession the UK’s recession the unemployment rate was about 5.5% and seems to be bobbing along for a decade or so nicely in the circa-5% region. There is little evidence that this natural rate has changed to 7% and yet this has been selected as the threshold.

We can see in each of these forward guidance knockouts elements of compromise with the inflation hawks, the structuralists and the finance obsessed. There are people who care more about inflation, don’t properly understand financial stability and don’t care enough about the unemployed. They are holding back the economy and people’s lives and, it seems, probably Mark Carney.

We got weak forward guidance yesterday and you can see in each of the thresholds the same dead hand of indifference and ignorance holding back the economy. Things are better than six months ago. But remember six months ago things were shit. There’s a new consensus and the Bank of England that things should be a bit less shit and people seem excited.


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