Paul Tucker: Monetary strategy and prospects
Speech by Mr Paul Tucker, Deputy Governor Financial Stability at the Bank of England,
Member of the Monetary Policy Committee, Member of the Financial Policy Committee and
Member of the Prudential Regulation Authority Board, at the Association for Financial
Markets in Europe flagship conference on "Financing growth", London, 24 September 2013.
* * *
Around the western world monetary policy is at a critical juncture. As differences in the
relative pace of recovery in different economies become apparent, each central bank is
having to articulate how it sees the particular conditions it faces. Contrast that with early
2009, when we were all simply priming the monetary pumps to prevent our economies
slipping into depression and deflation. Indeed, contrast it with 2011 and 2012 when, again,
central banks acted more or less in unison to contain, as best we could, the spillovers from
the crisis in the euro area periphery. Today, although normality is hardly restored, we are
back to circumstances where differences in local economic conditions matter to domestic
monetary prospects and to exchange rates.
The big policy trade off
In the UK, the core challenge lies in balancing two medium-term risks - to the economy's
productive capacity and to price stability.1 Concretely, the longer the weakness in activity, the
greater the erosion of the economy's capital resources and the damage to the skills and
capabilities of our labour force. The Monetary Policy Committee has needed to provide
monetary stimulus not only to contain the short-term economic weakness but, even more
important, to reduce its longer-run costs - social and economic. But we cannot do that at the
expense of price stability - or, more technically, of allowing medium-term inflation
expectations to drift away from the target of 2%. Were the anchor to slip, our ability to
support recovery would be undermined. It is sometimes suggested that independent central
bankers are more averse to inflation than to periods of low growth and increased
unemployment. I hope the past few years have demonstrated that, in fact, it is the credibility
of the Bank of England's commitment to price stability that enabled us to provide such
exceptional monetary support to help the recovery. It is unimaginable that, prior to Bank
independence in 1997, any government would have been able to hold the policy rate at
effectively zero and make a further monetary injection of £375bn without inflationary
expectations - and government financing costs - spiralling out of control.
But credibility is not to be taken for granted. Even we cannot provide stimulus without limit,
without a wary eye to inflation expectations.
Nor has it been at all easy to judge just how much stimulus has been needed to secure
recovery given the extraordinary uncertainties about what is going on in the real economy.
On the one hand, the rise in unemployment, while inflicting a terrible cost on those directly
affected, has been a lot smaller than anyone would have expected given the weakness in
output. On the other hand, this means that productivity has fallen over recent years, leaving it
some 15% below current estimates of its pre-crisis trend path - in sharp contrast to the US.
Let's be clear: we do not understand why productivity has been so weak. And that means
that we are highly uncertain about the amount of slack in the economy currently and
prospectively; uncertain about the extent of the consequent downward pressure on
domestically-generated inflation; and, thus, uncertain about the path of output and
employment consistent with non-inflationary growth. That sums up the background to my
approach to policy settings over the past couple of years. Provide stimulus; pause to see
whether inflation expectations remain anchored; if, but only if, they are and more stimulus is
needed, provide it etc. A "probing" approach.
The MPC's framework of forward guidance
And, as I see it, that is broadly consistent with the Committee's new framework of Forward
Guidance. The government having revised its Remit to the MPC, the Committee has, in
effect, formally clarified that it is adopting a probing approach to policy in order to strike the
right balance between risks to stability and the risks of sclerosis.
To be clear, I do not see the Forward Guidance - and personally would not favour -
committing the Committee to knowingly keeping policy loose beyond the point that would be
prudent. I say that because, in parts of academia and the commentariat, the expression "low
for long" is used in a rather special way to mean just that: that policy should be loose beyond
the period that, ex post, would warrant special stimulus, in order actively to deliver a
persistent rise in inflation and inflation expectations above target, thereby pushing down
prevailing real rates of interest and so accelerating recovery.2 While not without insight on the
mechanics of monetary stimulus, that stream of economic modelling makes the absolutely
critical assumption that even as the monetary authority deliberately generates a persistent
rise in inflation, its anti-inflation credibility remains 100% intact; later, the central bank simply
announces that things are back to normal. That is utterly unrealistic.
To re-iterate: the MPC's forward guidance provides an articulated framework for a probing
approach to policy, without a change in our preferences on inflation.3
Saying more about the Committee's approach to policy in this way might be particularly
valuable during a period when signs of recovery have become more apparent. These are
conditions in which it would be very easy for the financial markets, businesses and
households to jump to the mistaken conclusion that monetary stimulus will soon begin to be
withdrawn. Given the slack in the economy, the Committee is not in a rush.
Assuming anchored inflation expectations, an orthodox central bank would not contemplate
beginning to withdraw stimulus until the economy had reached "escape velocity", which I
have defined to mean "the economy growing, and being set to continue to grow, at a pace
that gradually absorbs the slack in the labour market and within firms".4 And at that point the
central bank would assess the erosion of slack in the economy and thus the extent to which
downward pressures on inflation were dissipating.
Since my own policy deliberations have been framed in terms of "escape velocity", I saw real
merit in any MPC Forward Guidance being cast in terms of a threshold for real growth.
Manifestly, this could not be a measure of slack in the economy; it would be clear what it was
and was not. Once passed, it would prompt a rich assessment of slack and inflationary
pressures, drawing on the widest possible range of indicators. The Committee decided on a
threshold specified in terms of unemployment.
The MPC's threshold is what it says: a threshold for assessing inflationary pressures,
although the Committee must maintain that broader assessment month-by-month, quarter-
by-quarter. The threshold is not a target. Indeed, a monetary authority cannot have a target
for unemployment; it can have a target only for price stability, as Paul Volcker recently
stressed.5 That is why the Committee's Forward Guidance incorporates, crucially, a
"knockout" for inflation expectations, where individual members will have to judge whether
they are "sufficiently well anchored".
Beyond that, I am glad that in its "financial stability knockout", the Committee has in effect
recognised that monetary policy influences risk-taking behaviour in the financial system.6 This
does not mean that the MPC will suddenly lurch towards a supplementary goal of trying to
control excesses in markets. The UK's new architecture gives the Financial Policy
Committee some tools to do that where there is a threat to the stability of the financial
system. But in the limit monetary policy can be a backstop - as booms and busts increase
the likelihood that inflation will be volatile in the future.
Overall, the Committee's Forward Guidance can forestall avoidable uncertainty about its
"reaction function", about how policy will be set. But it does not affect the greater uncertainty
about the evolution of the recovery.
Uncertainties about the economic outlook
Of course, financial markets inevitably transform the Committee's state-contingent guidance
into predictions of when the Committee will begin to withdraw monetary stimulus; the markets
trade instruments with different maturities, ie with time-contingent features not with
statecontingent contractual triggers. But the MPC provided state-contingent guidance for a
reason. We cannot wave away the uncertainties surrounding the performance of the real
economy. If we only understood why productivity growth has been so weak, we could be
more confident about whether or not it will recover in tandem with a recovery in spending. If
that does happen, the fall in unemployment could be slow, and monetary stimulus might not
need to be withdrawn for some time. If, on the other hand, productivity growth remains weak,
job creation as the economy recovers could be strong, as it has been on average over the
past couple of years. That is why there is a wide band of uncertainty around the MPC's
August forecast for unemployment. My own probability distribution for unemployment is
broadly "flat" in the sense that I do not regard one of those scenarios as materially more
likely than the other. As data comes in, the Bank's projections for unemployment are far
more likely to change, in one direction or the other, than the Committee's forward guidance.
Probabilistically, that could explain part of the rise in the money market curve given the signs
of recovery. All this underlines the need for the Committee to keep under review, month by
month, a wide range of indictors of slack in the labour market and in firms. For example, if
participation in the workforce develops in unexpected ways, the degree of slack implied by
any rate of unemployment might change.7
That recovery is, I trust, finally underway should not be a complete surprise. The MPC has
provided a massive amount of monetary stimulus over recent years. Its effects were arrested
for an extended period by the threat of severe turmoil in the euro area, coming on top of an
erosion of spending power from rising commodity prices. Monetary policy (and credit policy
for that matter) works partly by incentivising households and firms to bring forward future
spending. They were not likely to do so when the risks and uncertainties on our Continental
doorstep were so great and so unusual. As those immediate risks and uncertainties receded,
it was as if UK monetary policy was being switched back on.8 With monetary stimulus
maintained, now within the framework provided by the Committee's Forward Guidance,
recovery will continue to be underpinned - although of course the road will be bumpy.
That is a key element of what, in our internal discussions, I have called the Keynesian part of
the Bank's policy response to the crisis. The Funding for Lending Scheme; the liberalisation
of our liquidity insurance to the banking system - through the Extended Collateral Term
Repo scheme and the liberalised Discount Window Facility; and the Financial Policy
Committee's related Recommendation to the Prudential Regulation Authority to relax liquidity
requirements on banks - all these fell under the same broad heading. "Keynesian" because
we are supporting demand in order to help smooth the adjustment the economy is going
through.
But a central bank's monetary and liquidity interventions cannot remove the need for
adjustment. The UK economy entered the crisis with too much debt in banking, in the
household sector, in government and, for the nation as a whole, externally. And the UK
entered the crisis with the composition of demand imbalanced - too much public and private
consumption, too little net trade. Indeed, aggregate demand had been unbalanced for so
long that the economy's productive capacity was (and probably still is) unbalanced,
investment in capital having followed the pattern of demand. For prosperity to be put on a
secure footing for the longer term, adjustment is still needed.
With one vital exception, engineering structural change in the economy is not the
responsibility of the central bank.
The exception of course is the safety and soundness of the banking system, which is a
precondition for broader monetary stability. An undercapitalised banking system would not be
able smoothly to supply sufficient credit to aid recovery as demand picks up, enabling
investment in innovations and efficiency. Nor has it been able to do so as much as needed to
help capital shift to firms and sectors that are beneficiaries of the new pattern of global and
domestic demand. In my view, that may explain some of the weaknesses in productivity
growth.9 The Financial Policy Committee required recapitalisation of the UK's big banks and
building societies not simply because that is needed to underpin stability, which it is, but also
because a resilient banking system is a precondition for sustained and better balanced
recovery. New entrant banks can do a bit, but the big incumbent banks need to be healthy
too.
Their repair is now underway. That has required, and will continue to require, realism about
asset values, expected losses and risks - not pretending, taking the medicine. In that sense,
it is a policy in the spirit of Hayek.10
So the overall policy package has combined Keynes and
Hayek.
Conclusion
In the wake of such a massive crisis, recovery has needed active monetary, liquidity and
banking policy. Beyond the realm of central banking, it needs supply-side reform - to create
optimism about higher incomes and better investment opportunities in the future.
If recovery does gain traction, the MPC will need to avoid misperceptions about the likely
course of policy. The MPC is using Forward Guidance to help avoid those possible
misconceptions. The Committee cannot make the uncertainty about the supply side of the
economy and, thus, about the degree of slack go away. But by adopting a probing approach
and maintaining an eclectic approach to its assessment of the outlook, the MPC has the
wherewithal to provide broadly the right degree of stimulus without risking, or diluting its
commitment to, price stability.