The absurdity of the current monetary policy dominance exposed

We start to see the absurdity of the current reliance on monetary policy as a counter-stabilisation tool, when you read the calls from the Bank of England Monetary Policy Committee member talking about the risk of a ‘significant inflation undershoot’. In a detailed analysis of the current situation, the external MPC member noted that inflation was falling faster than expected because the supply constraints were reversing quickly. She also noted that the interest rate hikes had now reached a point where unemployment was certain to rise and lead to, in the face of the supply reversals, to deflation. And that would require faster and larger interest rate cuts. Here is an insider admitting that the Bank of England is more or less gone rogue and out-of-step with reality. Overshoot at the top of the hiking cycle, swinging to a massive undershoot at the bottom. Absurd.

Speech by External Member of the Bank of England MPC

The external member of the MPC and LSE Professor of Economics gave a talk at the Scottish Economic Society conference in Glasgow (April 4, 2023) – Quantitative Easing and Quantitative Tightening – where she commented on current monetary policy settings.

The first part of her speech concentrated on myths surrounding QE.

She correctly refutes the popular claims that QE is about money being “”‘created’ or ‘printed'”, which she considers to be part of the “most pernicious myths about QE”.

QE is “a tool … which … can potentially affect longer-term interest rates”.

That is all it ever was and is.

A lot of the myths about QE come from mainstream monetary economics itself which considers that the central bank controls the money supply by adding or subtracting bank reserves, which then allegedly allow the banks to loan more or less.

So a lot of mainstream economists claimed during the early days of the GFC when a lot of central banks followed the practice of the Bank of Japan and started swapping reserves for bonds (QE) that it would be inflationary because the money supply would expand too quickly.

They also claimed that it would stimulate bank lending and therefore get the world out of the GFC-recession because banks now had more reserves to loan out.

They were wrong on both counts because their theoretical framework is wrong.

Banks do not loan out reserves to retail borrowers.

They create loans out of thin air which create deposits (liquidity).

That process depends on how many credit-worthy borrowers come through the door seeking loans.

And while the mainstream claim that the causality runs from reserves to broad money, the reality is that it works in the opposite direction – the demand for loans creates deposits and liquidity, which then through the payments system (the daily system of reconciliation of all the cross-bank transactions), creates a demand for reserves.

And if there are not enough reserves currently in the banking system, then the central bank provides them to maintain financial stability (so all the ‘cheques clear’).

So, with such a flawed theoretical approach, it was no wonder the mainstream were confused about QE.

The speech by the MPC member clarifies these aspects of QE, yet most academic economists are still teaching the flawed stuff.

She wrote (her speech was published) that:

… for the private-sector as a whole, QE involves swapping one type of liquid asset – reserves – with another – government bonds.

That is why descriptions of QE as ‘money printing’ fall wide of the mark. The net amount of assets and liabilities held by the private sector, and held by the consolidated public sector, remains unchanged.

However, she also claims that QE is not about “government financing”.

The claim is that central banks are not interested in the fiscal position of the government but just engage in these asset swaps “in order to achieve their inflation targets”.

But the reality is quite different.

The primary bond market participants know that when the central bank is buying up government bonds in the secondary market that they can quickly off-load the debt they purchase to the central bank.

The central bank action drives bond yields down towards zero or lower, depending on the scale, and plays the private bond investors out of the action.

While there is no ‘credit risk’ attached to say British government gilts (bonds), QE becomes more obviously a ‘financing’ activity for governments in the Eurozone, where the ECB has been buying massive quantities of government debt to keep yields low to ameliorate the credit risk that the Member State debt carries for private bond investors.

In that situation, the ‘financing’ aspect of QE is very transparent, even though the central bankers continue to deny it.

It is less obvious in the case of currency-issuing governments but only a little less so!

However, I really want to focus on the latter part of her speech where she talked about interest rate setting.

First, she noted that:

… there is no link between QE and recent inflation outturns.

Why?

Because:

… inflation over the past 18 months was caused by large and unexpected external shocks, primarily the war in Ukraine, and the strong global demand for goods at a time of global supply chain disruption, which could not have been offset by any realistic monetary policy …

I would emphasise that the supply-demand imbalance was largely due to the supply restrictions rather than a massive boost to demand.

She noted that:

… extremely large external shocks, and not domestic demand conditions, have been the overwhelming cause of this period of very high inflation … above-target inflation can be accounted for by the extraordinary increase in global energy prices caused by the war in Ukraine, and by the increase in globally-traded goods prices stemming from the effects and after-effects of the pandemic … much of the rest of the inflation increase stemmed from the indirect effects of these shocks via the supply chain.

So claims that fiscal expansion was the problem are not supported here.

Yes, the income support during the pandemic from fiscal policy helped keep private spending up and created price pressures in goods markets as supply became highly constrained due to Covid.

But that doesn’t constitute classifying the inflation as a traditional ‘demand pull’ (excessive spending) event.

The reason is that the supply side (productive capacity) grows slowly over time and so if nominal demand (spending) becomes too strong relative to the current capacity, then the problem is a demand-side one and policy tightening is required to being the two sides back into balance.

But capacity utilisation of existing productive capacity can adjust quickly.

So, if there is an imbalance between spending and supply but there is also significant idle supply capacity (workers sick, machines, trucks and ships idle) then the solution is not to cut spending significantly, as in the previous scenario, but to wait for the supply-side to resolve and capacity utilisation rates to increase.

That is why I considered this inflationary period to be transitory rather than entrenched and did not support any attempts to significantly attack the demand-side.

Interestingly, the MPC member admits that:

… extremely high interest rates in the middle of the pandemic would not have prevented inflation rising far above target; would have required extremely high unemployment rates and even larger falls in real wages; and would have led to an enormous inflation undershoot when the energy shock faded.

On the current monetary policy position, she noted that relative to the expectations that interest rate settings were based on:

… the terms-of-trade shock that has pushed UK inflation far above target … has reversed even faster. Oil and gas prices and futures have fallen sharply, while indices of global supply chain disruptions and shipping costs are back to pre-pandemic levels. Food-price inflation increased in February, though in part this reflects the lagged effects of the energy-price shock (through its impact on fertiliser prices, for example), as well as adverse weather conditions in agriculture.

Which tells you that the interest rate hikes were excessive and that the Bank of England (and all central banks that hiked) have a mistaken assessment of what has been driving the inflationary pressures.

And the actual factors involved are largely not sensitive to interest rate manipulation unless you push them so high that recession is inevitable and deep pain is endured.

Among the central banks, only the Bank of Japan management understood this and have held rates low while providing fiscal support for cost-of-living pressures on low-income families.

The MPC member now believes that “Headline inflation will fall more sharply, as direct impacts and indirect effects via the supply chain reverse.”

And here is where the absurdity of the current stance really becomes evident:

In recent months Bank Rate has increased further into restrictive territory, to 4.25 per cent. As the effects of the large and rapid tightening in policy gradually come through over the course of 2023 and 2024, this is likely to drag demand well below its potential, loosening the labour market and pulling down on inflation. In the absence of further counterbalancing cost-push shocks, I judge inflation is likely to fall well below target.

So, in an environment where the driving factors of the inflation are not related to over-spending and are reversing quickly, the Bank of England has set about compounding the problem by a full scale overkill on the demand-side which will push the economy towards (or into) recession with higher unemployment and income loss, and multiply the inflation decline to the point that Britain will experience deflation.

And, be left with a damaging pool of unemployed and increased poverty.

The same scenario is playing out elsewhere as a result of the ridiculous monetary policy choices being made.

I predicted last year that Japan would come out of the inflationary episode just as fast as the rest of the world after experiencing the same sort of external shocks.

The difference will be that unemployment has remained low and the government has provided fiscal support for low-income families.

All nations could have engaged in that approach and should have.

To her credit, the MPC member said she did not support the MPC position on tightening and now believes that the Bank has erred, which means that:

… the high current level of Bank Rate will require an earlier and faster reversal, to avoid a significant inflation undershoot.

What a sorry tale.

And it is clear that the external member is at odds with the Bank of England’s chief economist who told the press earlier this week that (Source):

On balance, the onus remains on ensuring enough monetary tightening is delivered to ‘see the job through’ and sustainably return inflation to target,

In other words, no recognition of the reality before us and he will probably vote for even higher interest rates.

The orthodox sabotage merchants.

IMF still cannot understand the reality either

In the most recent IMF Fiscal Monitor (April 3, 2023) there was an article – Inflation and Disinflation: What Role for Fiscal Policy? – which claimed that the interest rate hikes were effective in disciplining the inflation and should be continued but that they should be accompanied by fiscal austerity with some targetted support for low-income families.

This IMF blog post (April 3, 2023) – Fiscal Policy Can Help Tame Inflation and Protect the Most Vulnerable – provides a sort of summary of the Chapter in the Fiscal Monitor.

Effectively the IMF claims:

Fiscal policy can support monetary policy in dealing with inflation because it also affects aggregate demand.

They advocate government spending cuts with a slight nuance.

That is, that they are recommending a bout of fiscal austerity to accompany the interest rate hikes but with some fiscal cash transfers provided to the poor.

A slight concession on the IMF madness.

Conclusion

I repeat my position on dealing with the current inflation:

1. Hold interest rates constant (as in Japan).

2. Do not expand fiscal policy significantly.

3. Provide fiscal support to the low-income families.

4. Watch the supply-side reversal gather pace.

That is enough for today!

(c) Copyright 2023 William Mitchell. All Rights Reserved.