Warwick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer between 1989 and 1992
Harriett Baldwin, chair of the Treasury Select Committee, was recently interviewed by the BBC following the publication of Ben Bernanke‘s report on the Bank of England’s economic modelling and inflation forecast. Asked whether she thought that the British central bank suffered from groupthink – with the implication there should be a review of its policy and the ideas that inform it – she offered a cautious answer.
Baldwin commented that all central banks had had problems with inflation after COVID-19, but that the Bank of England had had particular problems. She thought that rather than a wider change in the Bank’s modus operandi, she wanted the Bank to address the inflation forecast and concentrate on improving its forecast model in the manner suggested by Bernanke’s report.
The difficulty of this is that some technical improvements in the central Bank’s econometrics will not resolve the flaws of the inflation-targeting regime that central banks have developed since the 1990s. Inflation is a lagging indicator. As Alan Greenspan said, it is like driving the car and looking in the rear-view mirror. An economic model that generates an inflation forecast will not overcome this.
Central banks have run discretionary monetary policies guided by economic models that expressly exclude money. There is no formal scope for an inflation target to take account of asset changes, such as property and equity prices, which are important parts of a monetary transmission mechanism that leads to general price inflation.
As both John Maynard Keynes and Milton Friedman explained, mathematical models do not yield reliable guidance. As Friedman wrote often, they “are simply tautological reformulations of selected data”. Moreover, over the last thirty years, as Paul Romer, the World Bank’s former chief economist powerfully argued in his lecture The Trouble with Economics: “For more than three decades, macroeconomics has gone backward. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque.”
Economists constructed models that dismissed real-world facts, often modelling their work on physics. Central banks have been too readily guided by it – for example, in constructing inflation models without a monetary sector.
Baldwin was right: the Bank of England had made a major error in monetary policy, in common with many central banks in advanced economies post-COVID. Central banks, led by the Federal Reserve in the US, mistook a general inflationary problem for a transient, short-term increase in inflation resulting from a series of relative price shocks arising from supply disruptions and specific changes in demand resulting from the public health COVID-19 pandemic emergency.
They persevered with this error of judgment. Their mistakes were buttressed by economic forecasts based on erroneous models. In the process, central banks exposed the central flaws of an inflation targeting paradigm, based in practice on central banks making wholly discretionary judgements about the conduct of policy, without any intermediate targets or rules, but supported by an economic model that justified their decisions.
The central problem is that inflation is a lagging indicator. Given the leads and lags involved in transmitting the impact of monetary conditions on an economy, the time that inflation is rising it is already too late to avoid an episode of unacceptable rapid price change. In the inflation-targeting regime developed in the 1990s, the central defect was supposed to be overcome by an inflation forecast generated by a central bank model that would prevent mistakes.
Britain in the second half of the 1980s provides a classic example of the problems involved. Nigel Lawson and the Treasury got egg on their face, because the monetarist agenda, laid out in the Medium Financial Term Strategy in 1980, had not worked out as planned. High real interest rates created a tight monetary squeeze. Inflation fell, but the money supply expanded much faster than the targets laid out in the MTFS.
There was no mechanical connection between M3 and the Retail Prices Index (RPI). There was a portfolio effect that raised the demand for money because the real return on it had risen. This meant there was no mechanistic connection between reported growth in M3 and the fall in inflation.
At the time of this embarrassment, Harold Lever, the former Labour Cabinet minister who had been financial adviser to both Harold Wilson and James Callaghan, quipped he was confident that Lawson had been clever enough to get himself into monetarism, and will be clever enough to get himself out of it.
In the Mansion House speech of 1985, Nigel Lawson abandoned monetary targets, explaining that the demand for money was unstable and said the “inflation rate is judge and jury” of policy success. Between 1985 and 1988, monetary conditions became progressively looser – rapid growth in bank lending, mortgage borrowing, and monetary growth matched by asset price bubbles in the housing market and equity prices.
Yet the inflation did not begin to present itself properly until 1989, when it was too late to prevent inflation from rising to over 10 per cent. Lawson then took the necessary decisions to disinflate the economy, tightening domestic monetary conditions and raising interest rates to 15 per cent in October 1989.
Lawson’s explanation was that the Treasury forecast was wrong and underreported the strength of economic activity. Following his resignation, here was a discussion about what monetary policy the Treasury could pursue. An inflation target was considered but its lagging character was identified as a central weakness. Moreover, while low inflation may be the objective of policy, merely setting a target for it begs the question of how it will be achieved.
British politicians should be interrogating the difficult questions as to what makes monetary policy, in a fiat monetary system, such a challenge. They include the role of money in the economy; what account should be taken of asset prices; what part should the exchange rate should play either as a source of information or as a conduit for policy; should policy instruments solely focus on influence the demand for money through interest rates or should there be consideration of direct controls on the supply of money to the economy; and how monetary and fiscal policy should cohere as part of overall macro-economic management, including the institutional roles and relationships between the finance ministry and the central bank.
These are awkward questions that do not yield easy answers. Yet they are the issues that ministers need to interrogate. The Treasury sets the central bank’s remit; its ministers must explore these questions. Simply rearranging the software and the specification of the equations in a central bank economic model will not meet the challenge.
