Are we really going to have to do all this again?
Worrying about the Bank of England's plan for a big recession
My first love was macroeconomics. My first job was economics reporter at City A.M. during the Eurozone crisis in 2012. My second job was head of macroeconomic policy at the Adam Smith Institute, working on trying to update the Bank of England’s remit. Back then, during the double-dip recession – which was later revised away – we were concerned that without a change in the Bank of England’s remit, it would mis-perceive supply-side inflation as indicating an overheating economy and deliberately cause a recession by crashing total spending in the economy (which is equivalent to nominal GDP or aggregate demand).
We ultimately failed to switch the Bank of England’s remit, from targeting inflation to targeting nominal GDP. According to friends who are much closer to the internal workings, there was a brief period during Mark Carney’s early months as Bank of England governor when it was on the table as an option, and it might have come through. But alas it did not.
Still, as much as I thought and think that nominal GDP targeting is the most robust policy out there when it comes to avoiding recessions, I wasn’t too worried. Firstly, that’s because it’s always hard to focus on macroeconomics when you’re outside of a recession. A slump focuses the mind and it’s hard to think of anything but macro. But outside a downturn the eyes glaze over. How can this really matter, you think to yourself.
But secondly and more importantly, I thought that macroeconomic policymakers had learned the lessons of the Great Recession. I thought they agreed that flexible inflation targeting was flexible because it told you to ‘look through’ inflation that is clearly coming from the supply side – like a pandemic, major war, and gigantic energy crisis – and contract policy only in response to inflation when it’s driven by the demand side. It’s not always possible to know where inflation is coming from, of course, and it’s even harder to judge when core inflation – typically used as an indicator of the stance of monetary policy because it’s less affected by input prices than broader inflation – is running high too. So I wasn’t too worried. Properly operated flexible inflation targeting will have similar outcomes to nominal GDP targeting.
The Bank of England’s monetary policy report yesterday, however, has put the fear of God into me. Why have I been wasting my time thinking about irrelevant microeconomic supply side issues all these years since 2014, I think. I’ve forgotten all the finer points of macro. I partied during summer, and now winter is here. This week the Bank of England’s monetary policy committee raised interest rates 0.75pp in order to tame inflation. I think this is probably the wrong decision. But what worries me much, much, much more is that they are planning for dramatically below-trend total spending growth in the coming years (that is, aggregate spending across the whole economy, including the private sector and government spending).
Not only is the Bank expecting a long recession. But they’re expecting total nominal spending, which they control, to rise 3.3%, 1.3%, and 0.7% over the next three years – compared to trend growth of around 4-5%. This will make the unavoidable downturn from higher energy costs and other supply-side problems into a much deeper and longer recession where far more people lose their jobs than really have to.
Mike Bird cautions that this forecast is based on the market being right about the path of interest rates – which the Bank itself expressly disagrees with in its report. It seems to me that if the market disagrees this strongly with the Bank, its position is not likely to be very credible, and if they do have a credible position somewhere in there, they should be communicating it much more loudly and strongly.
In a basic macro model of the economy, total demand – the total amount of spending people are doing in the economy – interacts with total supply – the total amount of goods and services on offer. Total supply is determined by our technology, institutions, capital, skills, and resource inputs. Generally it increases slowly over time as we invent new technology – but it sometimes drops rapidly if there are natural disasters, wars, or big institutional dislocations like Brexit.
Total demand is the amount of money we can all spend in nominal terms – either total spending, or total earnings, or total output, which are three sides of the same three-sided coin. This is affected by monetary policy: which simplistically is how much money there is in the economy to spend, which the central bank controls either directly by creating new digital money and using it to buy government bonds (gilts) or indirectly by changing its policy interest rate.
Now, clearly, printing more money does not make us richer. It doesn’t make us more or less able to produce iPhones, or drycleaning services, or to redecorate homes, or to produce energy. It can even make us poorer. If we print too much money, especially in an unexpected way, then it makes it hard to decide between different product offers and different jobs, causing dislocations in the economy. People don’t take the best jobs, stay unemployed for too long, some businesses can’t afford to buy inputs or pay workers, and so on.
But printing too little money can make us poorer too, for symmetrical reasons. The economy is like a game of musical chairs. When it’s going well, there are enough chairs for all of us. Playing with too little money is like playing with too few chairs. In economics we say that wages are sticky downwards, i.e. that people don’t like to see their numerical wage fall. The labour market is the most important market in the economy. If we expect there to be a certain amount of money in the economy to settle our contracts with, and then there is less, money will stop doing its job as a common mediator of value as various people will value it differently. Markets will stop clearing. We will get unemployment. Firms will hold off on investment.
The market will fix this eventually, but only after a completely unnecessary period of adjustment where we redenominate all our prices and contracts under the terms implied by the new growth path of spending, rather than the old one, i.e. a recession or even a depression. This is the recession that the Bank of England yesterday has said it wants, in order to get prices down (for its own sake). This will mean hundreds of thousands or millions of people out of work, and therefore a loss in all the stuff they could be producing: reduced consumption and investment for everyone.
Money’s value is inherently meaningless – inherently we only care about the stuff we get with it. Yen having many more zeroes on prices than the pound has not made Japanese poorer than Brits. Why constantly change the expectations for where the macroeconomy is going and make firms uncertain about whether they can afford certain investments and certain employees?
This is controlled flight into terrain. If the Bank of England goes ahead with its plan to cut inflation by tightening policy so much that we have a recession, we will regret it big time.
P.S. I also had a long post on the Works in Progress substack, talking about agglomeration benefits, and why a major recent academic paper does not prove they don’t exist (or that they aren’t important).
Policy interest rates work slightly differently in different countries: in the USA, the main policy interest rate is in fact just another way of talking about money printing. In the UK, the Bank of England also pays interest on reserves that commercial banks hold at the Bank of England, and charges interest on money that it lends to those banks. By raising both rates (which it does in tandem) it makes them less keen to lend out money into the real economy, and more keen to hold it at the Bank of England. This ultimately reduces both the velocity of money and the supply of it, through the money multiplier effect. But all we need to think about right now is that higher interest rates is tighter money, meaning less of it going around.
'This is the recession that the Bank of England yesterday has said it wants, in order to get prices down (for its own sake).' I may have misunderstood this, but why do you say it's for the BoE's sake? Isn't it for the sake of savers who will soon see their £100k nest egg reduced to £80k, or workers who, for the most part, will be getting lower wages in real terms?
Is it your view that inflation is going to fall back to 2% without any action by the BoE? If so, why?
Also, we are almost certainly already in a recession despite the BoE having done no QT at all until about a week ago (and even then, only a token amount). A recession has seemed nailed on ever since inflation hit double digits and retail energy prices doubled.