New Economist

Why not target unit labour costs?

Perhaps I am missing some fatal flaw, but I have found  econoblogger KNZN's arguments in favour of central banks targeting unit labour costs quite persuasive. It has the advantage over inflation targets of excluding exogenous shocks. It also forces the monetary authorities to take more account of productivity. Here is the nub of KZNZ's arguments:

The main purpose of this approach is to have a simple and easily understood (by the market) answer to the question of how to react to supply shocks. The appropriate response to supply shocks is a matter of great controversy in macroeconomics: should a central bank accommodate supply shocks and let the inflation rate rise temporarily in order to avoid a recession or a slowing of growth (or a boom, in the case of a favorable supply shock), or should it lean heavily against the inflationary impact (or the deflationary impact) of supply shocks in order to pursue an unchanged target inflation rate? The labor cost target settles the question: if the shock is to domestic productivity or to the labor market, then lean against the inflationary impact; if the shock is entirely outside the domestic labor market and production process, then accommodate (except to the extent that you expect the shock to have indirect effects on productivity and the labor market, such as might arise, for example, from sticky real wages).

The main arguments against this approach I can think of are:
1) the objection that this would put undue focus on wage bargaining
2) estimates of unit labour costs are subject to considerable revision - unlike the CPI.

Mark Thoma's post is, as always, worth reading. Your views welcome.

Why the New Monetary Consensus sucks

We've had old-Keynesians, so I guess it's time for post-Keynesians. The Levy Institute's L. Randall Wray has written an intriguing little paper which argues that the foundations of mainstream, modern central banking is bunkum.

I'm a little more orthodox than Wray, but it's often good to consider different opinions. So here's the abstract for A Post-Keynesian View of Central Bank Independence, Policy Targets, and the Rules-versus-Discretion Debate

This paper addresses three issues surrounding monetary policy formation: policy independence, choice of operating targets, and rules versus discretion. According to the New Monetary Consensus, the central bank needs policy independence to build credibility; the operating target is the overnight interbank lending rate, and the ultimate goal is price stability.

This paper provides an alternative view, arguing that an effective central bank cannot be independent as conventionally defined, where effectiveness is indicated by ability to hit an overnight nominal interest rate target. Discretionary policy is rejected, as are conventional views of the central bank’s ability to achieve traditional goals such as robust growth, low inflation, and high employment. Thus, the paper returns to Keynes’s call for low interest rates and euthanasia of the rentier.

Tackling financial distress: BIS calls for 'speed limits'

Considerable attention has been devoted to the annual Federal Reserve gathering at Jackson Hole this Labor Day weekend. For a good summary see Brad de Long's post I Am Not at the Jackson Lake Lodge This Labor Day Weekend, James Hamilton on The Taylor Rule and the housing boom, and Greg Ip's report Two Heavyweights Weigh in on Greenspan’s Legacy

But another recent central bank gathering is worth mentioning. The Reserve Bank of Australia held their annual research conference late August, concentrating this year on a very timely topic, the structure and resilience of the financial system. While some attention has been given to the paper by Fed Reserve Board's Karen Dynan and Donald Kohn, The Rise in U.S. Household Indebtedness: Causes and Consequences (PDF), I particularly enjoyed a paper by BIS official Claudio Borio: Change and Constancy in the Financial System: Implications for Financial Distress and Policy (PDF). Borio argues that a phase of "major structural change" in financial markets has "spawned an extraordinary variety of new instruments and markets" in recent decades, while the volume of transactions "has surged to unprecedented highs".

These profound changes have had implications for the potential dynamics of financial distress. Financial distress is more likely to involve the evaporation of market liquidity and to have far-reaching cross-border effects. New players are more likely to be at its origin and/or to amplify it. The dynamics of distress may have become more unpredictable. And the transfer of risk to the household sector may arguably have lengthened the time lag between the build-up of embedded risk in the financial system and its overt emergence.

But the sea-changes we have observed should not blind us to what has remained constant. For it is what has not changed that holds the key to the more durable aspects of financial instability. This paper has argued that the main form of financial instability with potentially serious macroeconomic costs has historically been, and continues to be, overextension in risk-taking and balance-sheets in good times, masked by the veneer of a vibrant economy, ie. the occasional build-up of financial imbalances that at some point unwind, inflicting damage on the economy.

What is behind this tendency for excessive risk-taking? The usual four horsemen of the (financial) apocalypse:

And behind this form of instability hide four enduring characteristics of financial activity and human behaviour, viz. deep-seated and pervasive (asymmetric) information problems in financial relationships; powerful positive feedback mechanisms within the financial system as well as between the financial system and the real economy; limitations in risk perceptions; and limitations in incentives. The sea-changes observed may affect the specific manifestation of these elements and their prominence, but should not be expected to alter them in a fundamental way.

What are the policy implications? Borio sees a the need to design and implement "effective speed limits" for financial markets:

..more could be done in designing policies that would seek to limit overextension in risk-taking and balance sheets (“speed limits”). Admittedly, very good work has been done in encouraging improvements in risk measurement and management and in risk disclosures. Even so, given limitations in risk perceptions and incentives, the effectiveness of these steps may not, in the end, fully match expectations.

Ideally, speed limits would become more binding as the risk of overextension increases. Three guidelines could inform their design. First, as with fiscal policy, on balance built-in stabilisers appear superior to discretionary measures. This could be achieved, for instance, by calibrating prudential instruments based on experience over whole business cycles or stress estimates. Second, discretionary measures could be deployed to complement built-in stabilisers if and when it was judged appropriate. This could help to tailor the measures to specific features of the overextension. Third, close cooperation between different authorities with responsibility for, or whose policies impinged on, financial stability would be needed. This would involve prudential and monetary authorities in the first instance, but also accounting standard setters and tax authorities.

...Despite the challenges, some progress in this direction has been made in recent years. Continuing to travel along this road holds out the prospect of edging closer to securing lasting financial stability.

BIS is often overlooked by the financial commentariat; much of their work is done quietly behind the scenes. But where BIS leads, central banks often follow. Watch this space.

Opening up the IMF?

The long-standing deal between the great powers was that the US Government would appoint the head of the World Bank, and the Europeans would get the head of the IMF. Hopes that this cosy arrangement might unravel with the departure of World Bank President Paul Wolfowitz came to naught, with the recent uncontested appointment of former US Trade Representative, Robert B. Zoellick.

However the surprise resignation of IMF Managing Director Rodrigo Rato has re-opened the issue. While the UK government backed Zoellick, they seem to have doubts about another European heading up the IMF, according to this evening's Financial Times story: UK calls to open up IMF chief selection

Britain added its voice to calls from developing countries against the French-led drive to position Dominique Strauss-Kahn as the sole candidate to succeed Rodrigo Rato as managing director of the International Monetary Fund.

Alistair Darling, the UK chancellor of the exchequer, will on Tuesday urge European colleagues to apply the brakes to the selection of a new IMF chief and not to be bounced into making a quick decision.

“The UK believes there should be an open and transparent process for selecting the next managing director of the IMF,” a British Treasury spokesman said, adding that the successful candidate could well be a non-European. “The UK will be pressing the fund’s board to set out publicly criteria and a timetable for the appointment process.”

At a board meeting on Monday afternoon in Washington, directors from the Middle East and Latin America were set to lead calls for an open global competition for the job. The post has traditionally been held by a European under an unwritten convention by which the US in turn chooses one of its citizens to be president of the World Bank. Some were clearly infuriated by what they saw as a move by the Europeans to pre-empt discussion about the succession by rallying around a single candidate.

Strauss-Kahn is by no means an unworthy candidate. But an open competition would give other suitable candidates a chance, especially those from developing countries. They might just know a thing or two about development that a senior European politician doesn't.

Explaining the UK's 'great moderation'

..under inflation targeting the United Kingdom has enjoyed, so far, the most stable macroeconomic environment in its recorded history, with the volatilities of the business-cycle components of real GDP, national accounts aggregates, and inflation measures having been, post-October 1992, systematically lower than for any of the previous monetary regimes/historical periods since the metallic standards era.

But where does this remarkable stability come from? A forthcoming article in the Journal of Money, Credit, and Banking by ECB economist Luca Benati explains: The 'Great Moderation' in the United Kingdom (PDF). The paper compares the likelihood of two main rival explanations – the ‘good luck’ versus ‘good policy’ debate. Benati's main results are summarised below:

So, was it good luck? Based on our results ..it looks like it was indeed. To recapitulate, results from counterfactual simulations show that (1) the Great Inflation was due, to a dominant extent, to large demand non-policy shocks, and to a lesser extent–especially in 1973 and 1979–to supply shocks; (2) imposing the 1970s’ monetary rule over the entire sample period would have made almost no difference in terms of inflation and output growth outcomes; and (3) alternatively, mechanically ‘bringing the Monetary Policy Committee back in time’ would only have had a limited impact on the Great Inflation episode.

The results are, literally, shocking. But how to reconcile these findings with other recent analysis that points to a key role for the Bank of England's independence and inflation targeting regime?

Although in line with the literature on the U.S., these results are quite striking, in particular in the light of the more traditional, narrative approach which suggests that the monetary policy regime has been an important factor in explaining the Great Moderation in the United Kingdom.

One interpretation that could reconcile the two sets of results is based on the ‘indeterminacy hypothesis’ advocated, for the United States, by Clarida, Gali, and Gertler (2000) and Lubik and Schorfheide (2004). In a nutshell, the idea is that monetary policy was not sufficiently stabilising around the time of the Great Inflation, and therefore allowed self-fulfilling sunspot shocks. As our work in progress shows, this could have generated results qualitatively in line with those produced herein, as well as in the related work for the United States.

The perils of inflation targeting

Inflation targeting is popular amongst central banks, but not everyone is a fan. Axel Leijonhufvud writes about The perils of inflation targeting over at the VoxEU website. He fears it fuels cheap money and asset bubbles.

An expansionary monetary policy and an historical conjuncture that happens to produce no inflation will lead to asset price inflation and deterioration of credit. At some stage, central banks will have to mop the liquidity or see inflation do it for them.

Of course the Fed does not (yet) have an explicit inflation target, but it has managed to help produce two notable asset bubbles in the past decade all the same.

Globalisation, inflation and monetary policy: it's not all good news

Global factors "are becoming empirically more relevant for domestic inflation determination across a broad range of countries". That is the not-so-surprising conclusion of a new BIS working paper, Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation, by Claudio E. V. Borio and Andrew Filardo. The authors find declining sensitivity of inflation to domestic output gaps, and rising importance of global measures of economic slack.

The authors caution that their "conjecture" is "just preliminary", and that their "results rely critically on a specification that filters out the disinflationary trend from the data"; more research is needed. Nonetheless, if this "more globe-centric view of the inflation process" is correct, what would that mean for monetary policy? Globalisation might increase the risk of monetary policy errors, especially asset bubbles, while weakening central bankers control over real interest rates:

First, the growing importance of global factors would call for more intensive monitoring of external developments. ...Given the lags of monetary policy, it might be important for central banks to respond to developing trends before they show up at the borders and become embedded in price and wage setting behaviour. ...At the same time, measuring global slack conditions is likely to be a challenge. The well-known difficulty of measuring real-time domestic output gaps, and economic slack more generally, would be magnified in the case of their global counterparts.

Second, and more speculatively, one should guard against the risk of systematic errors in policy. If, for instance, the downward pressure on inflation resulting from globalisation was underestimated, the result might be a surprisingly subdued inflation rate alongside unusually low policy rates. This, in turn, might have a number of undesirable side-effects, such as the unwitting accommodation of the build-up of financial imbalances, notably “excessive” credit  and asset price increases that could raise material risks for the economy further down the road. Indeed, global economic developments in recent years bear a certain resemblance to this perspective. Conversely, failure to appreciate the build-up of global inflationary pressures could result in surprisingly strong inflation, with the risk that central banks might fall behind the curve.

Finally, and even more speculatively, questions could ultimately be raised about the very effectiveness of domestic monetary policy. To the extent that, in a proximate sense, domestic inflation became increasingly influenced by global capacity constraints, this could weaken the near-term efficacy of domestic monetary policy levers, because of their limited (ie domestic) reach. ...central banks might find it harder to control inflation in the short term or, at least, may need to adjust their instruments more vigorously. The power of policy could be complicated further by the implications of financial globalisation, which could be weakening the ability of central banks to influence domestic real interest  rates, especially longer-term rates, independently of global conditions.

Previous posts:
* HSBC: Measuring the global output gap 14 February 2006
* IMF: How has globalisation affected inflation? 14 April 2006
* What does globalisation mean for monetary policy? 10 October 2006

Paul Wolfowitz

Further confirmation from across the Atlantic of the British political rule of thumb that the left tend to get caught up in grubby financial deals, and the right in sex scandals. Paul Wolfowitz, President of the World Bank, is in trouble. This morning's Financial Times reports that he "personally directed the World Bank’s head of human resources to offer a bank official with whom he was romantically involved a large pay rise and a promotion". The banks conflict of interest rules prohibit staff from working under the authority of a colleague with whom they are romantically involved.

But for a different perspective on one of America's favourite neocons, read the new New Yorker profile by John Cassidy: The Next Crusade: Paul Wolfowitz at the World Bank

UPDATE: The axe fell a month later, on 17 May, as The Washington Post informs us: Wolfowitz Resigns From World Bank

World Bank President Paul D. Wolfowitz resigned this afternoon, effective June 30, giving in to overwhelming pressure from bank staff and governments around the globe that he depart to end the ethics controversy that has consumed the institution.

Wolfowitz agreed to resign in negotiations with the bank's executive board, pre-empting a growing likelihood that he would have been formally reprimanded or fired, said bank officials who spoke on condition they not be named, citing the political sensitivity of the proceedings.

His resignation came as key members of the bank's 24-member executive board were mobilizing to push through a resolution expressing no-confidence in his leadership, a step that would have made it effectively impossible for him to continue, senior bank and Bush administration officials said.

The bank's board was moving toward that unprecedented step after a committee report that found that Wolfowitz broke ethics rules and undermined the reputation of the institution when he directed staff to award a substantial raise to his girlfriend and then covered up the details.

Is the BoE inflation fan flawed?

Kevin Dowd at Nottingham certainly thinks so. In an article in the March 2007 Journal of Macroeconomics, Too good to be true? The (In)credibility of the UK inflation fan charts, he argues that the Bank of England's model overestimates inflation risk:

This paper presents some simple methods to estimate the probability that realized inflation will breach a given inflation target range over a specified period, based on the Bank of England’s RPIX inflation forecasting model and the Monetary Policy Committee’s forecasts of the parameters on which this model is built. Illustrative results for plausible target ranges over the period up to 04Q1 indicate that these probabilities are low, if not very low, and strongly suggest that the Bank’s model over-estimates inflation risk.

Here is an ungated version.

I have always found it a tad ludicrous that the Bank's central CPI projection invariably manages to revert to the inflation target two year's out. Implied message: current rates are always appropriate. Could they not either use the fan to indicate upside or downside medium-term risks to their outlook, or as some other central banks do, publish their internal interest rate forecasts rather than just talk about implied market forecasts? Like Dowd, I'm not a great fan of the fan.

Bernanke on inequality

It's good to see Fed Governor Ben Bernanke talk today about The Level and Distribution of Economic Well-Being. Not another contribution to the 'happiness debate' - the talk is really about inequality. In this excerpt he propounds the standard skill-biased technical change thesis:

..understanding the sources of the long-term tendency toward greater inequality remains a major challenge for economists and policymakers. A key observation is that, over the past few decades, the real wages of workers with more years of formal education have increased more quickly than those of workers with fewer years of formal education. ...To a significant extent, to explain increasing inequality we must explain why the economic return to education and to the development of skills more generally has continued to rise.

Economists have hypothesized that technological advances, such as improvements in information and communications technologies, have raised the productivity of high-skilled workers much more than that of low-skilled workers. ...If new technologies tend to increase the productivity of highly skilled workers relatively more than that of less-skilled workers--a phenomenon that economists have dubbed "skill-biased technical change"--then market forces will tend to cause the real wages of skilled workers to increase relatively faster. Considerable evidence supports the view that worker skills and advanced technology are complementary.

Buit it doesn't explain all recent trends:

Although skill-biased technical change appears to be an important cause of the rise in earnings inequality, it does not provide a complete explanation for that trend. The hypothesis cannot explain, for example, why the sharp rise in investment in information technology in the 1990s was not accompanied by a higher rate of increase in wage inequality. Nor can it explain why the wages of workers in the middle of the distribution have grown more slowly in recent years than those of workers at the lower end of the distribution, even though, of the two groups, workers in the middle of the distribution are typically the better educated (Autor, Katz, and Kearney, 2006; Autor, Levy, and Murnane, 2003).

As for the policy conclusions, you can probably guess those:

...the challenge for policy is not to eliminate inequality per se but rather to spread economic opportunity as widely as possible. Policies that focus on education, job training, and skills and that facilitate job search and job mobility seem to me to be a promising means for moving toward that goal. By increasing opportunity and capability, we help individuals and families while strengthening the nation's economy as well.

No surprise there. But I was surprised (and disappointed) that he failed to cite the excellent recent paper by fellow FOMC member Janet Yellen, on Economic Inequality in the United States.