According to "divine coincidence", the monetary policy that is best for stabilising inflation is also best for stabilising real output. Divine coincidence seems to be holding up fairly well in Canada. But the recent UK experience is a case where divine coincidence has failed.
The Bank of Canada's inflation target is up for renewal this year. Canadians spend too much time looking at the US. I think we could learn more by looking at the UK. The Bank of England, like the Bank of Canada, has been targeting inflation. And the UK, like Canada, is a more open economy than the US. Which is why I find the recent UK experience worrying.
What's worrying about the UK is that the inflation rate is above target, but the country is still deep in recession. That's not true in Canada. But it might have been. We ought to pay attention, because Canada might be in that same situation in future, if we are unlucky.
Scott Sumner argues that the UK experience shows the failure of inflation targeting. His own preference is for targeting the path of Nominal GDP. He's got a point. Does anyone really want to say that UK monetary policy has been too loose over the last two years? But if we look only at the inflation rate, which is above target, that is what we are forced to say. If we look at NGDP, we can say that monetary policy should have been looser, and needs to stay loose.
Thanks to Stephen for doing this graph for me: to compare Canada and the UK; CPI and Nominal GDP (both in levels):
Look at the dashed lines first.
For Canada you see a clear slowing of the CPI inflation rate beginning mid-2008, with even a slight fall in the price level. Inflation only recovers at the end of 2010. Clearly, in hindsight, monetary policy was too tight, because it allowed inflation to fall below target.
For the UK you see a very short dip in inflation in the second half of 2008, then it immediately recovers. Someone looking only at the CPI would see almost no sign of any lack of aggregate demand in the UK at all. Recession? What recession? Inflation rose above the 2% target, so UK monetary policy must have been too loose?
It's only when you look at the solid line for NGDP that you see the UK recession.
Both countries show divine coincidence before mid-2008. Both CPI and NGDP are growing smoothly. Canada continues to show divine coincidence throughout. You see the same recession in both CPI and NGDP. By either measure, monetary policy was, with hindsight, too tight. But divine coincidence fails in the UK.
I can think of four ways in which Canada has been different from the UK in the recession:
1. UK banks went bad; ours didn't.
2. The UK has had to tighten fiscal policy; Canada was able to loosen fiscal policy.
3. The pound depreciated; the Loonie didn't.
4. The UK has increased VAT (update: from 15% to 17.5% in January 2010 and to 20% in January 2011, thanks Matteo); Canada hasn't.
1 and 2 have meant that the Bank of England's monetary policy has had to be more aggressive than the Bank of Canada's.
3 and 4 are possible explanations for the high UK inflation, despite weak signs of any real recovery. They are possible explanations for the failure of divine coincidence. (But the second VAT increase only took effect in January 2011, so is not included in Stephen's graph).
I really don't like the thought of changing the Bank of Canada's inflation target. It has worked well. It ain't broke so don't fix it. Learning the 2% target was a big investment, by the Bank and by everyone else. A lot of people have made plans based on that 2% target. It has a quasi-constitutional status. We need a stable monetary order as part of the background people rely on. We can't change monetary policy to follow the latest academic fads.
But the UK experience is forcing me to reconsider.
The Bank of Canada has finessed the question of divine coincidence in the past. When the GST (VAT) was first introduced, they recognised it would cause a one-time increase in the CPI. But the Bank made no attempt to tighten monetary policy in anticipation. The Bank said it would allow the "first-round effects" of the GST, but would only try to ensure there were no "second round effects". It "looks through" one-time increases in the CPI. It invokes core CPI as its "operational guide". And we've been lucky too, because increases in oil prices tend to coincide with an appreciating exchange rate, which has an offsetting effect on the CPI. My guess is that this is the biggest reason why divine coincidence seems to work better in Canada than the UK.
The current failure of divine coincidence in the UK is getting too big for the Bank of England to finesse so easily. Eventually, unless our luck holds forever, Canada will also face a failure of divine coincidence too big for the Bank of Canada to finesse.
My colleagues Chris Ragan(pdf) and Angelo Melino(pdf) on the CD Howe Monetary Policy Council want the Bank of Canada to lower its inflation target. Some economists believe that monetary policy is impotent when it hits the zero lower bound, and so would be strongly against lowering the inflation target. I don't believe monetary policy is impotent at the zero lower bound. But I really don't want to test whether I am right on that question more than once a century.
If we do change the Bank of Canada's 2% inflation target, there has to be a very good reason for doing so. Swapping 2% for 1% inflation, just seems like tempting fate for minimal gains. Swapping inflation targeting for NGDP level targeting might be worth thinking about. But I think it's not even on the agenda.
The best policy might be some kind of NGDP targeting in the short run, but with a slowly adjustable "bias" which ensures that the overall price level grows on a predictable path, thus satisfying the mandate of overall price stability.
I think the Taylor Rule is supposed to work similarly, but I'm not really sure. Does this policy have any issues compared to simple NGDP or price level targeting?
Posted by: anon | February 23, 2011 at 01:34 PM
Apart from looser fiscal policy in Canada relative to the UK, we also had more robust household spending throughout the recession. I would therefore expand on Point #1 in your list of differences between the UK and Canada during this recession by adding:
1a. UK banks went bad, ours didn't, so Canadian banks were still willing to extend credit;
1b. UK house prices tanked in 2008, Canadian house prices did not, so Canadians still retained a lot of their home equity (and, therefore, had lots of collateral);
1c. By having access to credit, and by taking advantage of historically-low interest rates, Canadian households spent their way through the recession.
The most striking feature of this recession is that households in this country behaved as if it never happened (see Chart 13 in the BoC’s Jan 2011 Monetary Policy Report). The brunt of the recession was felt by net exports (not surprising, considering the economy of our largest trading partner went AWOL), and business investment (with tales of Great Depression II dominating headlines, risk premia on corporate bonds went through the roof in 2008-09, so lower policy rates had little impact on corporate borrowing rates).
Meanwhile, Table 2.A in the Feb 2011 Bank of England Inflation Report shows that virtually all GDP components in the UK were falling in the first half of 2009.
In short: Canadian GDP recovered more quickly than the UK thanks to higher G and C, which can be traced to healthier banks and the lack of a housing bubble. I think, in this instance, this has more to do with our regulatory framework rather than the choice of monetary policy target.
Posted by: Greg Tkacz | February 23, 2011 at 02:28 PM
Nick,
VAT increased twice in the UK in the last 2 years, from 15% to 17.5% in Jan 2010 and from 17.5% to 20% in Jan 2011.
Matteo
Posted by: Matteo | February 23, 2011 at 03:20 PM
"The UK has had to tighten fiscal policy"
They did. They didn't have to.
Posted by: crf | February 23, 2011 at 06:44 PM
UK experience a reflection of what happens when you run pro-cyclical fiscal and monetary policy for a decade leading to real estate bubbles, excessive aggregate debt (and government). Despite a 25% depreciation in the currency, the UK still has a current account deficit telling something about how uncompetitive it became. Also, UK had bigger QE program as % of GDP then USA so inflation should be a problem ... payback time for years of loose policy.
Canada should keep its 2% target but policy makers should now be very wary of aggregate Canadian debt getting to USA levels per capita.
As for Sumner, folks have a tendency to think that just because the US economy is more closed that policy ramifications isolated to domestic economy. This is most definitely not true as it omits the impact of the numeraire in the pricing of all products for which markets are global i.e. commodities.
Posted by: bertusmaximus | February 23, 2011 at 07:11 PM
anon: yes, suppose we wanted (say) 2% inflation on average in the long run. If we forecast (say) 3% LR GDP growth, we could target 5% NGDP. And if the forecast fell to 2% LR GDP growth, we could change the target to 4% NGDP. But: our ability to forecast LR GDP is not that great; it puts a bit too much discretion in the rule.
I think of the Taylor Rule as a way to implement inflation targeting, rather than an alternative to inflation targeting.
Greg: Yep. Good points on the differences between Canada and the UK. But, will we always be this lucky? Could it ever happen here? I think it could.
Matteo. Thanks. I've changed the post. I didn't Google deeply enough.
crf: Perhaps a better way of putting it would be like this: Canada went into the recession in better fiscal shape than the UK. So Canada was under less pressure to tighten fiscal policy.
Posted by: Nick Rowe | February 23, 2011 at 07:24 PM
Nick, the ONS publishes a constant indirect taxation cpi series. Latest YoY print was 2.3%. The BoE is nearly right on target.
Posted by: Adam P | February 24, 2011 at 02:35 AM
"But: our ability to forecast LR GDP is not that great; it puts a bit too much discretion in the rule."
Assuming that NGDP- and inflation-indexed securities exist, wouldn't asset markets be doing the forecasting? This would not be "discretionary" in any real sense.
Posted by: anon | February 24, 2011 at 05:40 AM
Adam: thanks. ONS= Office of National Statistics? I'm so out of touch with the UK. If I were the Bank of England, that is exactly the sort of thing I would be pointing to. But it's still what I've been calling a "finesse". If we exclude indirect taxes from the CPI, why? And why stop there? I could maybe sketch out an answer (I think I did sketch out an answer, back in my old post http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/09/targeting-the-stickiest-price.html ). But one of the main arguments in favour of inflation targeting is transparency, and if we keep fudging over what we do and do not include in the CPI, that transparency is lost.
anon: OK, assume those futures markets exist. And that we target market forecasts of NGDP over the "short run" and market forecasts of CPI over the "long run". We still need some formula to tell us how long is the long run, and how much we adjust the short run to the long run.
Posted by: Nick Rowe | February 24, 2011 at 07:28 AM
I don't think the current UK experience is a good example of the failure of divine coincidence. Think about it: Would you rather have had the UK experience with inflation or that of the US over the last two years? The Bank of England isn't facing a conflict between different objectives--it should admit that it is not upset but in fact should take credit for generating higher inflation in the current environment. At the zero lower bound for the policy rate, there are good arguments for raising expectations of inflation (and hence realizations of inflation) above the usual target. This lowers the real rate at short maturities and should help the UK exit the recession more quickly.
Unfortunately, by apologizing rather than taking credit for the higher inflation, it looks like the BoE has lost control of inflation and that hit to its credibility is going to make a return to a lower inflation target more costly.
Posted by: Angelo Melino | February 24, 2011 at 07:40 AM
Canada's CPI includes GST: see this technical note.
Canadian GST was cut by one percent in Jan 1, 2008. July 1 2010 provincial sales taxes were replaced with harmonized sales taxes in Ontario, which probably bumped up CPI a little bit.
Nick, is this good for your story or bad for your story?
Posted by: Frances Woolley | February 24, 2011 at 09:01 AM
The UK is in a similar situation as Spain and Ireland. Bad loans, property bubbles etc etc...
Rather than re-balance nominal wages down through austerity attrition, inflation is doing the heavy lifting on real wages. Now it's just a balancing act between expectations and observed, making sure the former doesn't become unhinged. Watch King spend the next year or two with meticulously worded speeches while inflation creeps higher.
In 2009 the BoE pension board moved 70 pc of it's fund into inflation-indexed bonds. As Mr. Jerry Macguire once said...
Posted by: Mark | February 24, 2011 at 09:47 AM
On nominal GDP - I'm an adept of the glorious system of national accounts. But it does not tell us the whole economic story, when it comes to money, inflation and MV = PT.
GDP accounting typically leaves out 'second hand trade', as this does not generate value added (aside from some fees). But do not underestimate the monetary importance of the second hand trade:
* the second hand car market is, in monetary terms, larger than the first hand market
* even more so for the housing market
* e-bay has gained some importance, during the last decade or so
* the old fahsioned yard sale has not disappeared
* the entire stock market is a second hand market, except for issues of shares
* ancient art and antiquities are also second hand
Value increases in these markets are (rightly) not seen as an increase in value added and available services and goods and therefore not included in GDP and neither are their prices. However - money is used to pay for these items. Monetary policy should not only take account of GDP-prices, but also of second hand prices. The PT part of MV = PT does include second hand trade. Targeting nominal GDP is targeting only the sunny side of the mountain, the shadowy side has to be included to.
P.S. - its, alas, nevessary to state that I'm convinced that al the MVPT items can 'prime-move' somewhat independent from each other. The housing market is a fine example. In the upward moving phase of a housing cycle, more money (read: cheaper and easier mortgages) leads to price rises, which are sometimes, but not always, followed by an increase in the number of transactions. In the present, downward phase, less money (more expensive and more difficult to become mortgages have a different consequence: loss aversion however leads to sticky prices and to a decline of the number of transactions, instead of prices, which only follow with a sometimes considerabe lag (a staple of Georgist economics, this one, by the way).
Posted by: Merijn Knibbe | February 24, 2011 at 01:28 PM
Merijn - and if people are abandoning geolocal life for Second Life, World of Warcraft, etc., nominal GDP is an even worse measure of economic well-being.
Posted by: Frances Woolley | February 24, 2011 at 02:08 PM
It seems likely that U.K. inflation is largely due to rises in import costs. It seems unwise to try to reduce such inflation by tight monetary policy. Perhaps we should target an inflation rate that ignores such import effects. Perhaps targeting wage inflation would be better.
Are figures on wage inflation or other measures that take out imports published?
Posted by: Paul Friesen | February 24, 2011 at 02:19 PM
Nick
I believe inflation in Britain is "overstated". A few days ago I did a post arguing in that direction:
http://thefaintofheart.wordpress.com/2011/02/17/what%c2%b4s-going-on-on-the-inflation-front/
Posted by: Marcus Nunes | February 24, 2011 at 02:42 PM
Merjin Knibbe, the second-hand market has more price flexibility than the primary market, so it is less sensitive (if at all) to business cycle fluctuations and shifts in monetary policy. The only exception I can think of is housing, and we can use sector-specific indicators for that.
Posted by: anon | February 24, 2011 at 02:55 PM
Nick, Very good post. A few comments:
1. I have an open mind regarding NGDP targeting for smaller open economies. I've always that that nominal wage rate targeting was optimal, but for all sorts of reason was not feasible. Hence NGDP targeting was a sort of second best. For small open economies, NGDP and average nominal wages might occasionally diverge quite sharply.
2. I think there is an argument for excluding VAT from the CPI, for monetary policy purposes. Faster CPI growth is supposed to signal an overheating economy, and too much hiring. But that's only true if the companies are actually receiving higher prices, in net terms. But if the CPI only rises due to higher VAT, then companies aren't actually receiving any additional net revenue.
Posted by: Scott Sumner | February 24, 2011 at 03:48 PM
Angelo: I agree that the BoE has done well to prevent expected inflation falling. Yes, it could have done worse. But it has totally failed to stop NGDP (and RGDP) from falling. I don't want to say that AD was growing strongly enough over the last 3 years. But if I judge it according to inflation targeting, that's what I am forced to say.
Frances: the Canadian GST cut, contrasted to the UK VAT increases, adds to the explanation of the divergence between the Canadian and UK experiences. But, we can imagine the situations were reversed, where Canada were the one which was experiencing GST increases and a depreciating exchange rate during a recession, so that the BoC would face a conflict between keeping inflation on target and fighting the recession.
Mark: I don't know what's been happening to nominal wages in the UK. But I agree that the BoE's communication strategy will be very difficult, if it wants to keep expected inflation anchored.
Merijn: you lost me there. Sure, we can complain about NGDP in a number of ways. But, in this case, it does seem to be telling us something more reasonable than CPI. NGDP says the UK had a recession. CPI says it didn't.
Paul: there is published data on wage inflation. And, if you believe that wages are the stickies price, there's a lot to be said for targeting that stickiest price. Politically though, you can imagine the howls from the ill-informed "The Bank of Canada is trying to stop us getting wage increases!"
Marcus: good post! Everyone: if you follow the link in Marcus' post above, he does some good graphs comparing UK and US inflation, and explains the disconnect as due to the UK VAT increase plus the depreciation of Sterling. Confirms my hunch.
Scott: thanks! As you see, I'm still sitting on the fence between CPI and NGDP. This is the nearest I have come towards your position. The other big difference between Canada and the US is that the US doesn't have an existing formal target, so is not biased towards the status quo in the way Canada is. It is easier to advocate NGDP ex nihilo, than to advocate a switch from CPI to NGDP, especially since CPI has served Canada quite well so far.
Posted by: Nick Rowe | February 24, 2011 at 05:53 PM
The graph would be more helpful if it were plotted on a log scale.
Posted by: Michael Kelly | February 24, 2011 at 06:13 PM
So go ahead and make one, and give us a link. Jeez.
Posted by: Stephen Gordon | February 24, 2011 at 06:18 PM
On the one hand, one reason given for Australia's weathering the storm so well is that it had almost 4% inflation in 2007, which gave it a cushion, so that it never approached the dreaded zero bound. As against that, there are people in Canada recommending a 1% inflation target?
Tilt!!!!!
What gives, Nick?
Thanks. :)
Posted by: Min | February 24, 2011 at 11:23 PM
If someone is getting raises then it ain't me or any of the proletarians I rub elbows with. In more than a decade of working I have never once had a raise. The only way I ever got a pay rise was to change jobs. Now that may say more about me and my abilities than anything else (or perhaps my profession) ... nonetheless, given my experience I would happily hand over wage inflation control to the BoC - if only to witness the spectacle of hedge fund managers, hockey players and CEO's (to name a few) having their bonus squashed by Mark Carney. I can see it now: NO SOUP FOR YOU!
Posted by: Patrick | February 24, 2011 at 11:46 PM
@M Kelly
I did the graph in log scale. There is no visually detectable difference. The range of the data is too small to make it noticeable. The info Nick wanted to show is well represented in the linear scale graph.
Posted by: Marcus Nunes | February 24, 2011 at 11:46 PM
At the risk of appearing a moron, could someone please explain Angelo's comment to me?
"I don't think the current UK experience is a good example of the failure of divine coincidence."
As I read Nick, "Divine Coincidence" is the coincidence of an inflation target being a pretty good policy for real growth.
As I read Angelo, he's claiming that that a third coincidence, the zero-lower bound, means that missing the inflation target is good for growth just now.
Angelo is a pretty smart guy and I'm reading this at 6:30 am. What am I missing here?
Posted by: Simon van Norden | February 25, 2011 at 12:41 AM
It's a matter of balancing growth in demand with growth in supply. Inflation is a form of sharing of real profits, where the real profits of business are shared with labor.
Inflation is, among other things, a redistributionalist tax on business profits. It distributes demand, money, to the rest of the economy, where otherwise business would retain the entire real profit, and all the increase in demand. 'Taming' inflation would then result in businesses then growing, but demand in the rest of the economy would not, leading to an excess of productive capacity, and the woes that accompany this. So rather than seeking to decrease the inflation rate, the BOC would do better to increase the rate slightly, to say 3% if the average of nominal business profits is 6%, 4% if the average of nominal business profits is 8%, etc.
Seeking to balance the growth of demand with supply, it would seek an inflation rate roughly half of the average rate of nominal business profits. That is it would seek a growth of the money supply a few percent more than the real rate of growth of GDP, so each sector grows at the same rate.
Excess inflation, of course, is disruptive to business profits, and leads to an excess of demand over supply. These considerations indicate how adjusting the inflation rate can be used to regulate an economy.
Posted by: Greg | February 25, 2011 at 02:42 AM
Greg, inflation is defined as a relative change in the price level, although some people use the word to mean a change in money supply. Why would these have anything to do with real labor income? If anything, the consensus among economists is that low or negative inflation may raise real wages to an excessive level, and unemployment may result.
Posted by: anon | February 25, 2011 at 06:26 AM
Min: That was my reaction. The ZLB used to be a theoretical possibility. Now we experienced it first hand. OK, Canada has survived this recession fairly well, but all the same. I'm trying to think of the right metaphor. "That big truck just missed us, so we can drive nearer the white line".
Patrick: now, you know it wouldn't mean the BoC setting individual wages!
Marcus: thanks. Yep, at that range, it shouldn't matter. 102/100 = 110/108.
Simon: 6.30=12.41? You must be in Germany? I was a bit puzzled by Angelo's comment too. Like the rest of us, he was probably worried to distraction by the fear of expected deflation. So any central bank that avoids that has done well.
Greg: you lost me there. I can't think of any economic model that would generate those effects of inflation.
Posted by: Nick Rowe | February 25, 2011 at 06:59 AM
Yeah... but wouldn't they need to some lever to pull to cap wage increases? Off the top of my head, the only thing I can think of is to limit/mandate pay rises.
Posted by: Patrick | February 25, 2011 at 08:34 AM
@Min
Yes, Australia had high headline inflation in 2007, but so did New Zealand. I did this post to show that MP in Australia is consistently better than New Zealand´s. And this is true both in the present crisis and in the Asian crisis of 1997-98!
http://thefaintofheart.wordpress.com/
Posted by: Marcus Nunes | February 25, 2011 at 09:28 AM
Patrick: no. In principle targeting wage inflation is no harder than targeting price inflation. If average wages (prices) start to rise more quickly than the target, just tighten monetary policy.
Marcus: I enjoyed reading your post on Australia and NZ. Here's my old post on a similar subject: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/canada-australia-and-new-zealand.html
Posted by: Nick Rowe | February 25, 2011 at 09:45 AM
Of course. Stupid of me. Brain not working. Same machinery, different gauge. I guess I had the same early morning syndrome as Simon.
Posted by: Patrick | February 25, 2011 at 10:07 AM
Nick: I was waking up (or trying to) in Zurich, but I'm writing this from Luxembourg. Same time zone, different currency.
Posted by: Simon van Norden | February 25, 2011 at 10:46 AM
Nick
I remembered readind your post back in the day. I was always fascinated by the "natural experiment" regarding MP that NZ and Australia provide. Back in 99 I had done that comparison and its interesting to see that Australia "beats" NZ everytime! But over the last 12 years it seems NZ has learned something...
On a related topic, at present many are very concerned about the inflationary impact of oil and CB reactions.
I got hold of this 1997 piece by Bernanke and al.
http://econ.as.nyu.edu/docs/IO/9382/RR97-25.PDF
The abstract reads:
Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se.
I´m not too optimistic. In the past he showed that he understood Japan´s problem (lack of AD), but when his turn to act came along in 2008, he "failed" miserably!
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.172.4467&rep=rep1&type=pdf
Posted by: Marcus Nunes | February 25, 2011 at 11:06 AM
Nick Rowe: "That big truck just missed us, so we can drive nearer the white line".
Thanks, Nick. :)
Posted by: Min | February 25, 2011 at 11:43 AM
I can't understand Angelo's comments also. the divine coincidence has nothing to do with the fact that the BOE is allowing inflation expectations and realized inflation to increase so that real rates keep falling, thereby stimulating the economy. But as Nick pointed out NGDP and RGDP have both been falling in the UK.
What about all the work that has pointed out that NGDP targeting like Price level targeting is bad when inflation expectations are backward-looking? Moreover, how easy is it to communicate that you are targeting NGDP?
Posted by: Anon17809 | March 01, 2011 at 12:05 PM