What should we make of last week’s advice from the OECD that the Bank of England and the Federal Reserve Board should increase interest rates urgently and that the European Central Bank should start to raise interest rates at the end of this year?
The easy answer is “nothing”. Despite the OECD’s admonitions, short-term interest rates will almost certainly remain near zero until the spring of 2011 in all the leading economies — and once monetary policy does start being tightened, central banks will move extremely slowly, with interest rates unlikely to rise above 2 per cent before the second half of the decade.
The reason is illustrated by the chart, which comes from the OECD’s semi-annual Economic Outlook, published last week. The chart shows the OECD’s composite measure of monetary policy, incorporating short-term and long-term interest rates, availability of credit and the movements in the exchange rate. A rise of one point in this index of monetary conditions would result, on the basis of past experience, in an acceleration of 0.5 to 1 percentage point in GDP growth 12 to 18 months later. In Britain’s case, the improvement in monetary conditions since early last year should raise GDP by up to 5 per cent in 2011. Yet even with all this monetary stimulus, the OECD expects Britain to enjoy only 2.5 per cent growth in 2011. Imagine, then, what would happen if this monetary stimulus were reversed at the same time as the Government raised taxes and intensified its attacks on the public deficits and spending.
The ability and willingness of all big central banks to keep their interest rates near zero for most of the coming decade is the main reason to hope that a decent recovery will be possible in the world economy.
Yet the need for a long period of near-zero interest rates, if the world is to have any chance of pulling out of recession and restoring fiscal solvency, is a point many policymakers still refuse to acknowledge, as evidenced by the demand for rate rises from the OECD. The main reason for this reluctance is that near-zero rates create many anomalies and contradictions in the theoretical models on which most economists still rely. And instead of revising their models to fit reality, economists are reverting to their bad old habit of demanding that reality should be changed to fit their models.
Partly because of the refusal of official institutions such as the OECD to acknowledge the need for interest rates to remain extremely low for a very long period, market expectations about interest rates have remained high. In Britain, the Bank of England pointed out in its last Inflation Report that, while interest rate expectations have fallen by half a percentage point since February, long-term option prices still imply a base rate as high as 3.2 per cent in mid-2013.
A rate rise of three percentage points, as assumed by the markets, coming on top of planned tax increases and spending cuts, would almost certainly plunge Britain back into recession. Yet this drastic monetary tightening would still not be sufficient, in the view of the OECD: “The projected increase of core inflation to the Bank of England target warrants an increase of the policy rate to 3.5 per cent by end-2011.”
Even in America, where core inflation has recently fallen into negative territory for the first time in 50 years, “the start of monetary policy normalisation should not be delayed beyond the last quarter of 2010 and policy rates should be well above halfway to neutral by the end [of] 2011”, implying an interest rate of 2.4 per cent. And in the eurozone, where inflation has been far below the ECB’s 2 per cent target for two years, the OECD wants an increase of 1 to 1.5 percentage points in market rates in 2011, despite a need for unprecedented public spending cuts and the threat of a grave financial crisis.
Since central bankers themselves seem confident that they have the problem under control, and most of the figures, at least outside Britain, show that prices are falling, why is the OECD so worried about inflation?
The answer is that most conventional economic models developed since the monetarist intellectual revolution of the late 1970s simply assume that a loosening of monetary policy will always lead to inflation, regardless of what may be happening to unemployment, budget deficits or economic growth. Since the economic orthodoxy assumes that “inflation is always and everywhere a monetary phenomenon”, it follows that central banks should always and everywhere focus their efforts entirely on hitting a single inflation target such as the Bank of England’s 2 per cent. It is anathema, according to this monetarist doctrine, for central banks to use interest rates to reduce unemployment or promote economic growth or stabilise banking systems.
In reality, however, central banks have been forced to abandon their single-minded focus on inflation targets and instead have used monetary policy to pursue an ever-widening range of goals.
The latest, and now the most urgent, of these monetary objectives, especially in Britain and Europe, has been to support the efforts of governments to reduce public deficits and debts.
So far, of course, there have been almost no public admissions of this change in the objectives of monetary policy. The Bank of England, for example, still justifies all policy decisions in terms of their supposed effects on inflation prospects in two years’ time. But if central banks are judged by their actions, rather than their rhetoric, it is obvious that they are all now pursuing multiple mandates similar to the “triple mandate” that has always governed the actions of the US Federal Reserve — to achieve price stability, maximum employment and moderate long-term interest rates.
The gulf created by the crisis between monetarist theories and practical central banking, debated by the Institute for New Economic Thinking in April, and described in detail in my forthcoming book Capitalism, has traumatised defenders of the old doctrines and thrown academic economics into confusion. Hence the strange ex-cathedra pronouncements from defenders of the faith in orthodox institutions such as the European Central Bank and the OECD.
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