Monetary Policy in an Era of Political Uncertainty
The following is the transcript of Jagjit’s keynote address at LBMA Conference in Barcelona on 16 October, 2017.
Thank you for inviting me to this very stimulating conference. I have had a number of interesting conversations with people already this morning and what is particularly encouraging is how carefully people are listening to us economists at the moment, which is reassuring in these uncertain times. We had an event in the UK that some of you know may know about called a ‘Referendum’ last year, where it was not entirely clear that everyone was listening to economistsat that time. So, it is an absolute pleasure to come here and enter a world in which you might be heard.
What I am also reminded about in my opening remarks is the famous Chinese curse ‘May you live in interesting times’. It is clear to me that since I took over Directorship of the institute last year, I and the rest of the world seem to be living in quite extraordinary times. It is a world that I think not many of us fully understand, and that also goes for central banks around the world. We charge these “superheroes” to maintain some equilibrium between aggregate demand and supply in the various countries and regions of the world. What we have seen, however, is the emergence of global imbalances where naturally, in aggregate, demand equals supply, but there are pockets of excess supply and excess demand in different parts of the world. That is one of the problems that I am going to address today.
Advanced versus Emerging Economies
Let me go on with a rather downbeat note about the state of the world as it is seen from the advanced economies, quite distinct to the emerging economies. In the past few days, I have been lucky enough to go to the Far East, where the robustness of growth in those economies is starkly different to the other places, I visited last week, which included Berlin and Dublin. One way of characterising the advanced economies is what we might call a “bad state of nature” – and I do not just mean the storm that is currently hovering over Ireland. It is one in which we have low wages, low productivity levels, low interest rates and, surprisingly enough, alongside that, low levels of unemployment, of which the flip side is high levels of employment at those relatively low wages that I have just suggested.
That is a common characteristic in advanced economies in the 10 years since the start of the global financial crisis. I think it is a constellation of observations with which central banks and fiscal policymakers are struggling to deal. In that world, they go to their rulebook and think that we have to respond to low growth by lowering interest rates and injecting demand into the system. But we now had 10 years of that, and it has not quite had the impact that we might have envisaged prior to the start of the financial crisis. Yes, there has been an increase in output, but income per head in the advanced economies has mostly moved sideways in this period. Compare that to the long period of growth since the start of the Industrial Revolution and the creation of sustained economic growth, after which people began to expect income-per-head growth rates of some 2% a year, under which circumstances every generation could expect to be twice as well off as its previous generation. This process simply has not continued in the large part of the advanced economic world over the past 10 years.
We charge these “superheroes” to maintain some equilibrium between aggregate demand and supply in the various countries and regions of the world.
The monetary policy debate to which I have contributed and worked on, both in academia and at the policy level has talked about ultra-accommodative interest rates. The idea here was to help economies that had high levels of private debt adjust to lower levels of private debt without falling off – to use a phrase that is common in Westminster at the moment – a cliff-edge. That was the idea of low interest rates. It was always supposed to be temporary. Indeed, the initial quantitative easing (QE) was, itself, supposed to be temporary measure rather than a new regime in itself.
Let me go back to the basic trade-off that any central banker faces. For those of you familiar with British history, Gillray was a famous cartoonist working out of Fleet Street. In his depiction of the Bank of England in 1797 was an image of Midas inverting the traditional mythology. The original idea was that anything he touched turned to gold. In 1797, the Bank of England left the gold standard, which had been adopted by accident by Newton in 1717 by getting the relative price of silver and gold a little array, so I am sure he would not have been eligible to be chairman of the London Bullion Market Association for making that pricing mistake.
For the following 80 years or so, sterling was fixed in terms of gold, but following theshocks of poor harvests and the demands of Napoleonic and revolutionary wars, the Bank of England was forced off the gold standard. The common concern was that all the gold in the vault would then spew out as paper, as the Bank of England would issue too much paper, leading to a sustained inflation, the idea of which we would become familiar in the end. In fact, this idea of the need to have flexibility to respond to shocks and yet adhere to rules is an idea that we see time and time again in monetary policy debates. It is almost endemic. It permeates every debate that we have.
Right now, the debate is very much between those who would like to see interest rates normalised, if that is the appropriate expression, because interest rates have been low for a very long time, and there is a sense in which there may be asset bubbles being blown. On the other hand, there are those who argue for more flexibility and to not repeat the mistakes that we possibly saw in Japan in the 1990s with attempts to normalise too quickly. When we understand the context, I think we can understand very clearly debates then and now, because we can always frame the monetary policy question with a debate between flexibility and rules, going back to Gillray’s cartoon.
East Asian economies relative size now 60% rest of world.
During the long period of the gold standard up to about 1914, the price of gold was relatively constant in terms of goods and services. As soon as we left the gold standard in the UK in 1931– and Bretton Woods was linked to gold until 1971 – we saw tremendous volatility in gold prices, which I will come back to a little later for those interested in gold prices, who might want to know what the drivers may be. There may be various types of demand for gold, either for industrial use or for jewellery, but I am going to posit another idea right at the end, so bear with me.
Let us subscribe to the Fisher equation, which refers first to the natural rate of interest, which clears the global market for savings and investment. To that, we might add an expected inflation rate, which will give us the Fisher equation. In normal times, the policy function is one in which central banks raise interest rates by more than inflation increases or by cutting interest rates by more than inflation falls. What you see are very high-frequency but relatively small changes in interest rates as central banks are able to stabilise the economy in whatI call ‘good times’.
With a large enough negative shock, however, such as a global financial crisis that permeates the economy in an enduring and persistent manner, and possibly helpsbring down productivity growth rates for a variety of reasons, the economy will find itself stuck where we are currently – in the ‘interest-rate doldrums’. At this point, we still have a market-clearing level of savings and investment, but interest rates are stuck at a very low rate and central banks are unable to respond to shocks in the way that they could before, particularly if there are negative shocks.
Note that over any prolonged period, we should anticipate positive and negative shocks. If the central bank cannot respond to them, we are going to find ourselves absorbed into this low state or bad equilibrium. That is possibly to what we have stumbled, now 10 years on from the financial crisis. We were not able to move to stabilise the economy quickly enough, so the question is: how do we plot our way out? Bad Equilibrium.
Let me go a little deeper into the point about the bad equilibrium. Between 1950 and 2010, in real terms, average world GDP per capita rose from constant price USD2,000 to 8,000 – a fourfold increase in 60 years, which is a remarkable achievement. This is in constant terms. In 1950, the advanced economies – typically the G7 and the rest of Europe – had something like three times the level of income compated to that observed on average in the rest of the world.
The remarkable story, however, of the last 20 years is the increase in income of many emerging economies, particularly in East Asian. In the 1950s, 1960s and 1970s, they were at around 50% of the average level of income per head; however, in this current decade, they are at the average, which is a remarkable human achievement that has drawn some 60% of the world’s population to the average level of income in the world. You will be able to quickly work out, therefore, that these economies broadly approximate to some 60% of world GDP. Therefore, even though the income per head is only around the average of the world, their relative size is now considerably bigger. That means that, in aggregate, this bloc has an increasing impact on decisions made throughout the world and we have to think about those interactions.
I will give you one example before explaining why that is important. What it means is that these large economies, and their business models, have different preferences over savings and investment than the advanced economies. And what that has tended to do is reduce real interest rates. The institute has done an estimate of G20 long-term real interest rates using structural models and market prices, as well as uncertainty bands. Over time and on a secular basis, real interest rates have fallen, which means that we are discounting the future at a lower rate less than we did before. This is the direct impact of those growing economies that have grown and saved rather than necessarily through the more traditional route of domestic investment and capital formation.
This economic model leads to important consequences for the rest of the world. Lower real interest rates raise asset prices. They are very good things for people who already have assets and wealth, but they create inequality and tensions for those who do not. It is a form of initial condition that we talk about in economics. It is something that may be very hard for any generation to offset if they have not, at the start of this period, been holding wealth. Those outside the initial “lucky” set are going to find themselves, relatively speaking, immiserated, which is a phenomenon that we are seeing develop increasingly rapidly in the advanced world. This is, I think, very much at the root of some of the disturbances that we have seen.
In the UK, we have had the referendum with the result that we will leave the European Union. We have had other kinds of elections in other parts of the world – and you probably do not need me to list them as you will know which ones I am referring to, and one not a million miles away from here in this very city – that all, in some sense, reflect this increasing inequality of wealth or opportunity that might be developing is happening in the West.
x4 increase GDP per capita rose from 2,000 to 8,000 a fourfold increase between 1950 to 2010
Just to drive the point home, what I want you to think about is global savings and investment. A downward-sloping investment function tells you how much you will invest at a given interest rate. As interest rates fall, you will invest more as less profitable ventures can now be make sense. The ‘upward-sloping savings schedule suggests that at higher interest rates we will have an incentive to save more. In a world before the emerging and developing countries (EDCs) came along, the real interest rate was at some point that cleared the savings market for the advanced economies. at relatively high interest rates. However, 60% of world GDP is from economies that have a different savings schedule and a different investment schedule, and they would clear the global savings- investment markets at lower interest rates. And this means that the world interest rate is driven down and we will see current-account deficits in the advanced economies as they borrow those excess savings from the rest of the world, the EDCs.
The key point, however, is that this transition lowers real interest rates, which has profound consequences for the operation of monetary policy and for public debt. Monetary policy gets harder because you are going to bump against the lower zero band in a world in which real interest rates are falling. It is also harder to understand fiscal policy because, in some sense, fiscal constraints are relaxed: real rates are lower, and it should be easier to run deficits and invest. But often in advanced economies, however, it is not exactly clear in what we should invest. It is not very clear how you can find infrastructure projects very quickly in economies that are already hugely developed, so it leads to a problem for fiscal policy as well. The danger is that the low interest rates are used up by government consumption: expenditure on things that do not increase productive capacity. And that might be something that we have seen in many advanced economies.
It is new and different, and not what we would anticipate from the history of gold’s purpose in the international monetary system.
A Negative Relationship
What does this all mean? I have made a story today about things having changed: we have gone into this bad equilibrium. I want to summarise a thought related to gold at the end, and this is part of the story and part of the point of departure for where we go to next. If we look at the period since before QE started and subsequently in the US; the risk-neutral forward curve that we use to calculate the risk premia embedded in US bonds; and the gold-bullion price in US dollars per troy ounce. In normal times, what we see is what you would expect for a commodity such as gold. When US risk premia increase, US bond prices fall, and gold prices tend to go up. This is a positive correlation, as you might expect in normal times.
What has happened in this new world in which central banks and fiscal policy authorities have had to do new types of operations, however, is that a negative relationship has developed, which we think is something to do with the operation of QE. Central banks have bought bonds, which has tended to reduce risk premia embedded in fixed income instruments in advanced economies, and this excess liquidity is finding its way into other markets and helping to support the gold price. That is why we think we are seeing a negative relationship. It is new and different, and not what we would anticipate from the history of gold’s purpose in the international monetary system.
It is clear that recent income growth has frustrated large fractions of the advanced world population. Clearly, the greater growth in emergent economies, is a great achievement but it has thrown open complications for the operation of policy that I do not think our policymakers have fully understood.
The impact on real rates has jacked up asset prices and played an important role in setting off momentum for populist policies. I am not saying that such policies are right or wrong. I am simply saying that it is a root cause of the momentum that we have observed.
Normalising policy, which I think should continue, is very hard, because the absorbing equilibrium that I talked about is a tough one from which to escape. There are large numbers of academic papers that have described this problem. One solution is to think about policies that increase investment demand and increase future capacity. But I do not necessarily trust the public sector to find a way, and the private sector cannot, without confidence, implement these investment strategies alone.
And so, for that, we might need some form of relationships that bind countries and strategies together. Unfortunately, some of the paths we have taken in the last year seem to be about unbinding those very long- run relationships that have been so key to world growth in the last 60 years or so.
Jagjit Chadha is Director of the National Institute of Economic and Social Research, Professor of Economics at the University of Kent, and also part-time Professor of Economics at Cambridge. He was previously Professor of Economics at the University of St Andrews and Fellow at Clare College, Cambridge. He has worked at the Bank of England as an Ofﬁcial working on Monetary Policy and as Chief Quantitative Economist at BNP Paribas, and has served as Chair of the Money, Macro, Finance Study Group. He has acted as Specialist Adviser to the House of Commons Treasury Committee and academic adviser to both the Bank of England and HM Treasury, and to many central banks as well as the Bank for International Settlements and is the current Gresham Professor of Commerce.