Viv Davies interviews David Miles for Vox

February 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/6154]

Viv Davies:  Hello and welcome to Vox Talks. I'm Viv Davies from the Centre for Economic Policy Research. It's the 23rd of February 2011 and I'm talking to Professor David Miles, member of the Bank of England's monetary policy committee, on the subject of a talk he is giving this evening titled "Monetary Policy and Financial Stability in Extraordinary Times". The event is being hosted jointly by the Centre for Economic Policy Research and the London Business School. I began by asking Professor Miles to explain the principal factors that have given rise to what he refers to as “the extraordinary times in which we live.”

Professor David Miles:  Yes, well people use that phrase very frequently, they say, "We're living in extraordinary times" and of course by definition most of the time it's not true. I think in terms of what's happened in the economy right across the Western world, certainly here in the UK, it really is true at the moment. I mean, just in the last few years we've seen a series of really extraordinary events that I think few people could have predicted.

Toward the end of 2008 the banking system in the UK came pretty close to almost complete gridlock and if the banking system had stopped working, and I think it came close to stopping working, it would have been about as serious as the supply of electricity being cut off. And I think in the aftermath of that crisis there was a period when confidence declined and the level of economic activity declined certainly in the UK, and not just in the UK, but certainly in the UK, declined for a period of three or four quarters which was comparable to the decline in output in the first six to twelve months of the Great Depression.

We've also seen an extraordinary roller coaster ride really for commodity prices between maybe the middle of 2008 and the middle of 2009. That is the period just before the near collapse of the banking system, the worst part of the financial crises at the end of 2008, between a few months before that and a few months after that, commodity prices, roughly speaking, halved, and in some cases, in oil prices, more than halved.

Now since then, since the middle of 2009 to now, prices more or less doubled. So they first of all halved and then they doubled so we've had something that has been close to a Great Depression-like trajectory for output in the UK. We've had a situation with the banking sector came pretty close to complete meltdown, and we've had a degree of volatility in commodity prices which is pretty extraordinary. We've also had a huge increase in the scale of the fiscal deficit, and again this is absolutely not unique to the UK, but it's been very serious in the UK, and an increase in the stock of government debt on a scale that's unprecedented outside of world wars.

We also on top of all that had a period in the first few months of 2009 where world trade declined in a way that we've never seen, outside of the outbreak of world wars. So I think this adds up to a truly extraordinary period and it's generated a situation where economic policy, monetary policy and fiscal policy is pretty difficult to set but we've got to try and get through it.

Viv:  The current rate of inflation in the UK is around 4% which is twice the Bank of England's official 2% target and according to the bank's quarterly inflation report, inflation is also likely to rise further in the coming months to 4.5% or even higher perhaps. There's also a widespread expectation that interest rates will go up as soon as May. Does this mean that we can expect rapid interest rate increases through 2011? And, if so, is there a danger that such increases could perhaps harm the economy given that it's still relatively fragile and facing further tax increases and public spending cuts, et cetera?

Professor David:  Well, I think it helps to sit back and try and understand as best as one can why inflation is as high as it is and in some ways it is a very unusual situation. We've had a very deep recession, unemployment has gone up a great deal. Other things equal you would expect that more likely than not that would take inflation lower and inflation might be sitting underneath the Bank of England's 2% target rather than rather uncomfortably above it. I think the reasons inflation is as high as it is are largely to do with the big exchange rate depreciation in 2007, 2008. Probably more important right now has been the enormous increase in commodity prices over the last year or so. Just in the last couple of weeks commodity prices have moved higher again. Over the last year in sterling terms on average commodity prices are up not far off 40%.

Viv:  So they are not where they were two years ago or 2008?

Professor David:  That's right. So commodity prices halved and then doubled and that's caused a great deal of variability in inflation. We've had an increase in VAT, in fact we've had two, one at the beginning of 2010 and another at the beginning of this year 2011. I think it's almost inevitable that when you have such big changes in the level of commodity prices and other imported goods prices and an increase in VAT, it's highly likely that's going to drive measured inflation up for a period after those increases in prices. I think the key thing for us in the monetary policy committee is to try and look through the temporary effects of those price changes and think about where the underlying inflation pressures in the UK are. I think if one focuses on the, what you might call the domestically-generated inflation pressures, you actually get a very different picture for the degree of inflation pressure than simply looking at the headline inflation rate right now. One of the, probably most important indicators of domestically-generated inflation pressure is what's happening to wages and the story there has been an unusual one.

Wage settlements in the UK now, certainly in the private sector, have been running at somewhere around 1.5 ‑ 2% for much of the last few years. In fact for many companies there has been a wage freeze for most of the last couple of years. Now wage settlements are picking up a little bit, but it's plausible that they remain, at least in the near term, at a level far beneath the actual rate of inflation and probably beneath a level consistent with domestically-generated inflation pressures being above the target.

So once we get through, I think, the aftermath of a big increase in commodity prices and a substantial increase in VAT, I think it's more likely than not, I wouldn't put it any stronger than that, but more likely than not, that inflation will move back down toward the target level. Now who knows how things will play out, there's plenty of risks that inflation maybe stays above the target level a bit longer then our best guess, an educated best guess that the monetary policy committee makes, but I think there's plenty of chances that actually inflation moves back to the target level even more quickly than the central forecast that the monetary policy committee came up with just a few weeks ago.

Viv:  This is the 14th month in a row that inflation has exceeded the bank's 2% target. In light of this do you think that criticism of the bank in failing to meet its target is justified and more broadly do you think it has implications for the effectiveness of inflation targeting as a monetary policy framework?

Professor David:  I mean it's certainly true that inflation has been above the target level for an uncomfortably long period of time and indeed for longer than the monetary policy committee had thought likely. I think some of the reasons for that are the very sharp further increases in commodity prices over the last six to twelve months. And we've had increases in the VAT rate that almost inevitably would keep the inflation rate high for a period, maybe not permanently, I don't think permanently, but for a period. Some of those things are easy to see in retrospect but if you go back a year or two it wasn't at all clear that one's best guess 18 months ago would have been that commodity prices would have risen as fast as they actually have risen.

Now, that’s an explanation for why the MPC's own past forecasts have been lower than what's actually happened to inflation. I don't think it's an excuse. I hope it doesn't come across as an excuse. I think it is just the inevitable consequence of things happening that are easy to see in retrospect but difficult to forecast in advance.

The key policy question for the Monetary Policy Committee is, given where we are now, given that inflation has been and for a few more months is likely to stay rather significantly above the target level, what's the best policy to bring it back down to the target level? I don't think it makes a great deal of sense to take the 2% target level and say, we must try by any means possible to bring inflation back to that target over the course of three or four months, because in order to do that, one would need to tighten monetary policy on such a scale as to make it likely that you'd push the economy back into a recession.

So the question, I think, is, what's the right way of balancing the risks of inflation staying above the target for sufficiently long that people get used to it and think that's the new normal against, balance that against the risks of tightening monetary policy so rapidly to bring inflation down very quickly, but that causing the rather fragile recovery we've seen already being essentially knocked on the head and the economy going back into a recession.

I think that's a tricky judgment. It's a judgment that it’s my job as being a member of the Monetary Policy Committee to make, and it's a judgment that I wouldn't want to try and forecast in advance what the best thing to do is. The reason we meet every month rather than meet every six months or 12 months is precisely because you get a lot of information from one month to the next which is relevant to judging what the right setting in monetary policy is.

Viv:  Given the UK government's policy of fiscal tightening, do you anticipate any potential tensions between undertaking that whilst at the same time implementing a tighter monetary policy? Could the two together perhaps serve to hinder an economic recovery?

Professor David:  I think, given what had happened to the size of the deficit and the trajectory of the debt result, it's absolutely essential that there be a period of fiscal consolidation. What we do at Monetary Policy Committee is take the fiscal stance that the government has decided on as a given, we'll assume that that's how fiscal policy will be set, and we set monetary policy in the light of that to bring inflation back toward the target level and try and keep it there. I wouldn't say that there was a tension with those things or that was problematic, it's just the natural, if you like, division of labor, if you will, between a government that sets fiscal policy and an independent Monetary Policy Committee that uses monetary policy to hedge an inflation target. I think there are lots of advantages in doing things that way, and I wouldn't say that that caused enormous tensions or difficulties.

Viv:  OK. The second part of your talk deals more directly with banking and regulation. You say that one way to make the banking sector more robust is to have banks use more equity and less debt to finance their activities. Could you expand on this perhaps?

Professor David:  Yes. One of the unusual things, it certainly looks exceptional and extraordinary, and unusual , in retrospect,...one of the unusual things about the position major banks have got themselves into before we ran into the financial crisis that began in 2007 and got very bad in 2008, was the degree to which they had very high leverage. In other words, many banks were in a situation where they had a huge balance sheet, a very large stock of assets, a very large amount of debt financing that and very little equity. What that means is that, if people become nervous for whatever reason, good reasons or bad reasons, about the value of the assets, since there's very little equity capital in the institution, it doesn't take much of a fall in the value of the assets or, indeed, a perception that there's a risk of a fall in the value of the assets, for the institution to simply run out of capital and to become insolvent. We had let banks get into that situation.

I think in retrospect that was a mistake. Had banks had far more equity, had their leverage been lower, they would have been far more robust institutions and, even if people had become much more nervous about the true value of assets, if the equity buffer had been very much larger, it wouldn't have led people to believe there was a risk about them not getting their money back if they lent money to a bank.

So I think the primary way, to my mind, of having the banks become much more robust so we don't get in a situation again, is that they have a lot more equity. The reason I think that's the natural response is that having banks hold a lot more equity is probably not really that costly a thing to have them do.

Viv:  It's been suggested that extra equity financing and increased capital requirements means that there's actually less money available for lending, but you maintain that the opposite is, in fact, the case.

Professor David:  Yeah, I think there's a bit of confusion here. There's a view that some people have which is that if you have banks use more equity, have higher capital, that somehow this reduces their ability to lend. I don't think that makes much economic sense, to be honest with you. If a bank goes out and raises more equity capital, and it could do that by issuing some new shares or maybe paying out slightly less of its profits in the form of dividends and retaining it, that would be a form of equity financing, if a bank does that, it's got more money to lend, not less money to lend. That's why I think there's a degree of confusion in the vocabulary people sometimes use here, where they give the impression that having banks hold more capital is somehow tying the money up and there's less money available to lend. Actually, I think that pretty much the opposite to the truth.

Viv:  Finally returning to the theme of extraordinary times, you refer several times in your talk to the idea that what we are currently experiencing is clearly not a standard textbook economic cycle. In your view, does this mean that micro‑economic textbooks probably need to be rewritten?

Professor David:  That's a good question, because with my co‑author, Andrew Scott, I'm actually rewriting a micro‑economics textbook that we wrote a few years ago. I think my point there about this being not a standard economic cycle is merely a way of making the following point: That there are occasions where economies go through a natural downswing and growth is a little bit less than average for a while, and then there's an upswing and there's a period where growth is a bit above average, and it sort of evens out. You could call that a textbook economic cycle. There are plenty of occasions in history where that is a perfectly reasonable description of what economies have gone through.

I do not think it is in any way a good description of what we're going through at the moment. Just to come back to the prototypical example of the UK, output fell by around about 6%, GDP fell 6%, in 2009. The level of output is probably now in the UK about 10% below where you might have expected it to be at the beginning of 2007 if you just thought the next three or four years would be typical, average years of growth. So in some sense we've lost 10% of our growth.

I don't think it's particularly likely, I don't think it's likely at all, to be honest with you, that we over the next three or four years have a period of such strong growth that we get back onto the same trajectory where we were on. And if that's right, then you wouldn't be able to describe what we've gone through as a textbook economic cycle. Now, I'm not saying that there aren't such things as textbook economic cycles, my point is merely the simple one that this isn't one of those things.

Viv:  So we've experienced more than just a blip on the landscape?

Professor David:  I think we have experienced more than a blip on the landscape and I think that if you just look at a picture showing the trajectory of GDP, not just in the UKbut for many economies, this doesn't look like just a blip.

Viv:  David Miles, thanks very much for talking to us today.

Professor David:  Thank you very much. 

Romesh Vaitilingam interviews Andrew Levin for Vox

November 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5848]

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Andrew Levin from the Federal Reserve. Andrew and I met in August 2010 at the European Economic Association's annual meetings in Glasgow, where he had presented a paper called "Limitations on the Effectiveness of Forward Guidance at the Zero Lower Bound." He began by explaining the background to his study, in research over the past 10 years, on optimal monetary policy at the zero bound.

Andrew Levin: The consensus of the literature that was started about 10 years ago, various papers looking at optimal policy at the zero lower bound, including some very nice work at the Bank of Japan and a very well known paper by Gauti Eggertsson and Mike Woodford in the Brookings papers. And the consensus from that literature seemed to be that, regardless of the size of the shock or the persistence of the shock, that monetary policy could be very effective in stabilizing the economy, even with a constraint of the zero bound, by providing forward guidance about the future path of policy.

In effect, committing to providing more stimulus in the future when the fund's rate or the policy rate's no longer constrained by the zero bound, that stimulus has a contemporaneous effect by lowering current long term real interest rates. And in effect, in these papers, the ability of those expectations about the future policy path could largely offset the current adverse effects on aggregate demand and keep the economy very close to its potential output level and keep inflation very close to the target level.

So that raises a couple of questions. One, this Great Recession episode that we've had that started a couple of years ago has had very severe consequences on many industrial economies. We see the estimates are that the output gaps in Britain, the Euro Area, Canada, Japan, and the United States have all been five or six percent, in some cases, even more than that, much, much larger than anything experienced during the Great Moderation era.

In fact, in our paper, we tabulate that the standard deviation of the output gap from the early '90s through 2006 or '07 was typically around one percentage point for most of these countries. So output gaps of five or six percent, you're out into the tails of the distribution.

And these shocks all seem to be very persistent. The levels of the output gap in 2010 are generally very similar to what they were in 2009, because GDP growth in most of these countries has continued to be fairly moderate over the last year, so not really making much headway in bringing the output back to our potential. And the projections of professional forecasters are that unemployment's going to remain high for years to come.

So, in contrast to the results of that earlier literature, it seems like, even with the efforts of monetary and fiscal policies over the last couple years in these industrial countries, that still the shocks had very severe adverse effects on economic activity that are expected to last for a long time.

And so one aspect of our research in this paper I presented this morning was to try to understand why. Is it because monetary policy was far from optimal and, in some sense, didn't follow the prescriptions given in this consensus literature? Or are there some limitations? Which, in fact, is what we found. There are significant limitations on the ability of monetary policy, even with expectations about the future path of policy, to offset an adverse shock when you're constrained by the zero bound.

What turns out to be crucial is, if it's a large enough shock that is expected to depress aggregate demand for a relatively long time, and if the economy is relatively interest sensitive in a sense of empirically plausible parameter specifications, then it turns out that forward guidance is still helpful, but it's not a panacea, and you can still get very large and persistent effects on the real economy, similar to the kind that we've seen in many countries in the last few years. Again, that points to the idea that it's not necessarily a failure of monetary policy. It's just reflecting the constraints and limitations on monetary policy.

Another key question that we were interested in is why many central banks, including the Bank of England, the ECB, the Bank of Japan, and the Federal Reserve, have been using non-traditional forms of monetary policy. The Bank of Japan refer to it as quantitative easing, Chairman Bernanke typically refers to it as credit easing. Each central bank has its own nomenclature for referring to these.

In the case of the Federal Reserve, it was large scale purchases of mortgage backed securities and treasuries. In the case of the ECB, it was covered bonds. In the case of the Bank of England, it's gilts. But in each case, aimed at providing additional stimulus to private credit markets through these large scale asset purchases.
And in this earlier literature, there's no clear rationale for why a central bank would want to do that. In effect, in the earlier literature, you can accomplish everything through the forward guidance, the promises about the future path of policy. There's really no need for quantitative easing or credit easing.

But once you recognize that, again, for large and persistent adverse shocks to aggregate demand that put you at the zero bound for a relatively long time, the ability of forward guidance to offset that shock is limited, and therefore the rationale for non conventional policy tools becomes much more compelling.

We don't analyze the non-traditional tools in this paper, but we do think that analysis like this is helpful in playing the direction for further analysis that's really needed to incorporate those kind of non-traditional policy tools into macro models, and to think about what's the optimal combination of forward guidance, non-traditional policy tools, and possibly fiscal policy, all working together to try to provide the best possible stabilization outcomes, which still might not be ideal but at least constrained optimal outcomes.

So that's the gist of what we've been doing.

Romesh: Is it partly an issue that this crisis has given a whole new testing ground for these ideas that started 10 years ago, when before that it was only really Japan that had gotten into this position of actually facing the zero bound, and now all the developed economies are in this position?

Andrew: Yeah, that's a great question. I think there's two aspects to it. One is that we need to give a lot of credit to economists at the Bank of Japan and other Japanese universities who were thinking hard and doing a lot of really valuable research about policy at the zero bound back 10 years ago when there wasn't a lot of interest in it among economists in other industrial countries. And now we recognize it's not just a Japanese problem. It's potentially an issue for many industrial countries. I think another interesting point about this is that the work that was done in the US 10 years ago, some of it was using the FRBUS model, work that Dave Reifschneider and John Williams did that's been published in a JMCB paper, and work that people did with small scale DGE models, there's a nice paper by Klaus Adam and Roberto Billi where they do this.

The typical findings in that literature was that with a steady state real interest rate of two percent and an inflation target of two percent, which meant that the policy rate would typically be around four percent in normal times, that you needed very large shocks to hit the zero bound at all, and when you did, you'd only be constrained by it for a couple of quarters, something more or less like what happened in 2003 and 2004 in the United States.

Romesh: And in that kind of situation, forward guidance would be fine, because you were just saying they're a few months ahead.

Andrew: Yeah. And the shocks just aren't that bad and the outcomes aren't that bad, and the need to resort to non-traditional policies or some unusual fiscal policies would really be minimal. So I think that sense of what the Great Moderation era looks like did also have a big influence on this literature. All the models were calibrated to Great Moderation type shocks. Well, now we know. The financial crisis can be much worse than any type of shock that you'd see during a Great Moderation. And therefore, again, the potential implications for policy could be quite different.

Going forward, I guess I hope that we don't have another financial crisis for a long, long time. And so there's some scenario where, five or 10 years from now, people forget about the zero bound again and resort to methods that are well designed for a Great Moderation period.

But I also have a lot of sympathy for the analysis that Robert Lucas gave in a lecture called "Understanding Business Cycles." Part of his analysis was emphasizing that small shocks to the economy and small movements in aggregate consumption probably weren't that important for welfare. I think that's still an open question. There's been a lot of interesting work, 25 years since his lectures, about why even moderate business cycles may, in fact, be more costly.

But the other part of his lecture was emphasizing that these rare events like the Great Depression are clearly very costly for welfare and that economists ought to, basically, be doing more risk management, I think, of trying to anticipate what can go wrong and how to minimize those risks and how to ensure that the economy makes it through if you do have a large shock like that.

And so, in that sense, I hope that even 10 years from now, even if things go back to normal and we get back into a Great Moderation, that macroeconomists and monetary economists will be more risk oriented than they might have been five or 10 years ago. Because, again, as Lucas said, those are the very costly events that, if economists can help try to figure out how to avoid them, there might be big payoffs in terms of welfare.

Romesh: At this point, where you saw we're at the zero bound and we have these non-standard, non-traditional policies in place, when it comes to tightening, monetary policymakers have two things they can do different from their normal one thing of shifting the interest rate. How should we start thinking about those kinds of issues, about whether you withdraw the credit easing first or whether you raise the interest rate first?

Andrew: These are all active questions, so this is where I can just emphasize that I'm only giving my own views. There have been a number of speeches of Federal Reserve policymakers on this question of what's often referred to as the exit strategy. So, for example, earlier this spring, Chairman Bernanke gave a couple of speeches about the exit strategy. I think the view that he expressed there was that once the central bank has the ability to pay interest on reserves, it's also the case that that has significant implications for the mix of policy tools because, in principle, a central bank can maintain a larger balance sheet even after it tightens the stance of policy through the short term interest rate. There's a cost, of course, to maintain a large balance sheet, in the sense that the central bank may be paying less seigniorage to the fiscal authorities.

And so, over time, this becomes a fiscal issue that's relevant for the elected officials, and ultimately to the public: what responsibilities should the central bank have, and what are the implications of those responsibilities for the balance sheet? In the United States, there are some policymakers who feel strongly that the central bank should not engage in activities that are directed towards specific private credit markets. Those policymakers would be opposed to getting involved in mortgage markets, for example, and don't think those should be on a central bank's balance sheet. But there are other policymakers who have different views.

And so I think these are areas where there is a need for more research and, over time, some more public debate about, again, what central bank responsibilities should be delegated and so forth.

Romesh: And what about the interactions with fiscal policy? Because, certainly, in Europe, you have the exit strategy in place from the fiscal stimulus, very strongly in some countries, including my own in the UK but also in many Euro Area countries. And I guess the hope is there that the Central Bank keeps the interest rates low, they keep the quantitative easing programs, the "enhanced credit support" programs as they call them in Europe, in place. But there's interesting issues there about the interactions of these two because they're governed by a different authority: you have the public authority in terms of the government on one hand and independent central banks on the other.

Andrew: I think a clear lesson from past experience is that there is a need for fiscal authorities and monetary authorities to coordinate their policies and to communicate with each other and not work at counter purposes. There's a fascinating debate going on right now about how alternative fiscal approaches affect the macroeconomy. And it's not a settled debate. There are some people who think that moving in the direction of reducing the expected future path of fiscal deficits and providing greater fiscal stability can actually provide stimulus in the near term. And obviously, there are others who think that that reduces aggregated demand and puts the economy in a worse position that might need to be offset by monetary policy.

These different views, oftentimes, are using the same model and very similar methods. So that's why I say I don't think it's settled right now. Maybe the UK, the measures that are being taken actually will stimulate aggregate demand relative to otherwise. There's fascinating empirical research that suggests that could be the case.

There is a question on my mind, again, thinking in terms of risk management. What if the economy weakens again? What can policymakers do to make sure that we do not get into another Great Depression, that we make sure that prices don't start falling?

I still subscribe to Friedman's saying that, 'inflation's everywhere and always a monetary phenomenon', which means that central banks really have to take responsibility for making sure that inflation remains as close as possible to their stated objective. They can't necessarily control the real economy perfectly. There can be structural changes that influence economic growth and unemployment over time. But in the case of an aggregate demand shock, there's no trade off between stabilizing economic activity and stabilizing inflation.

And so, if you're in a situation where inflation is trending downward and resource slack seems to be very high, both of those signals are pointing in the same direction, which is that it's ultimately the central bank's responsibility to maintain price stability. When you're constrained by the zero bound, what are the non-traditional tools that the central bank can use to make sure that you don't fall into a deflationary spiral?

So, again, I think these are very important questions. They're interesting questions. I hope a lot of academics will continue to do research on them. But I think we're not out of the woods yet. We're not ready to relax and go back to Great Moderation types of research yet, either.

Romesh: Can I ask you one final question, Andy, about central bank communication and central bank transparency? That's something that's evolved very much in the recent couple of decades, I guess. And I guess that informed that literature you mentioned at the beginning of our conversation about the zero bound, about the Fed being able to provide forward guidance, or other Central Banks being able to provide forward guidance. Do you think that issue changes somewhat when you're at the zero bound and you're using these non-standard, non-traditional policies? Do you think the same emphasis on communication and transparency is as essential, or perhaps you might want to rein back on that a bit?

Andrew: Well, I think of Franklin Roosevelt. When he came into office, he said, "We have nothing to fear but fear itself." And I think what that captures is the sense that uncertainty and lack of security are the enemy. When you're in a difficult situation, those factors make things worse. So I think that in a situation where the economy's been hit by some severe, adverse shocks, and it could be a financial crisis, it could be other types of geopolitical shocks, that's the time that the central bank needs to be as clear as possible in its strategy and its communication so that it contributes to reducing uncertainty on the part of financial markets, reducing uncertainty on the part of people who are setting wages and prices, and a sense of security on the parts of households and firms in making their spending decisions.

So I think, if anything, the case for central bank transparency and clarity of communication is strongest when you're facing a crisis or when you're recovering from a crisis, to try to help minimize the uncertainty, or at least make sure the central bank's not adding to it.

Romesh: Andrew Levin, thank you very much.

Andrew: OK, thank you.