Speaking at the annual conference of the Association for Financial Markets in Europe (AFME) on Tuesday, Paul Tucker explains his thinking on monetary strategy in the context of an emerging economic recovery.
Paul Tucker draws attention to the substantial degree of uncertainty about the “amount of slack in the economy currently and prospectively”. Productivity has fallen over recent years, leaving it some 15% below current estimates of its pre-crisis trend path. Though he places some weight on the argument that the root of that poor performance lies in the damage that a malfunctioning banking system has done to the allocation of capital within the economy, he emphasises “ we do not understand why productivity has been so weak”.
Paul Tucker describes the trade-off the Monetary Policy Committee has faced. On the one hand, following a long period of above-target inflation and with extraordinary monetary stimulus, there is a risk that inflation expectations drift away from the 2% target. On the other, a prolonged weakness in activity could damage the economy’s medium-term supply capacity. For some time, he has been pursuing a ‘probing’ approach: “Provide stimulus; pause to see whether inflation expectations remain anchored; if, but only if, they are and more stimulus is needed, provide it.” The Monetary Policy Committee’s new Forward Guidance framework is consistent with that probing approach.
Paul Tucker sets out how forward guidance can be particularly useful during a period when the recovery is beginning to take hold. “Saying more about the Committee's approach to policy in this way might be particularly valuable during a period when signs of recovery have become more apparent. These are conditions in which it would be very easy for the financial markets, businesses and households to jump to the mistaken conclusion that monetary stimulus will soon begin to be withdrawn. Given the slack in the economy, the Committee is not in a rush.”
Paul Tucker cautions that while forward guidance can forestall avoidable uncertainty about the MPC’s reaction function, it does not affect the greater uncertainty about the evolution of the recovery. He explains there is a broad band of uncertainty about the MPC’s August forecast for unemployment. Paul Tucker says his own probability distribution for unemployment is "broadly flat" in the sense that he does not regard a slow fall in unemployment as materially more likely than a period of robust job creation. “Probabilistically, that could explain part of the rise in the money market curve given the signs of recovery.”
Paul Tucker observes that it should not be a complete surprise that recovery is finally underway, given various "Keynesian" policies designed by the Bank to stimulate the economy: in addition to the massive amount of monetary stimulus, the Bank’s various liquidity schemes – the Funding for Lending Scheme, the Extended Collateral Term Repo scheme and the Discount Window Facility – have eased conditions in bank funding markets. In light of this, the Bank’s Financial Policy Committee has been able to recommend a relaxation of liquidity standards for banks.
Paul Tucker cautions, however, that the Bank’s policy interventions do not remove the need for a rebalancing of demand. “The UK economy entered the crisis with too much debt in banking, in the household sector, in government and, for the nation as a whole, externally.”
Moreover, he underlines how a resilient banking system is another precondition for sustained and better balanced recovery. “Their repair is now underway. That has required, and will continue to require, realism about asset values, expected losses and risks – not pretending, taking the medicine. In that sense, it is a policy in the spirit of Hayek. So the overall policy package has combined Keynes and Hayek.”
Paul Tucker concludes by emphasising the need for the MPC to avoid misperceptions about the likely course of policy. “But by adopting a probing approach and maintaining an eclectic approach to its assessment of the outlook, the MPC has the wherewithal to provide broadly the right degree of stimulus without risking, or diluting its commitment to, price stability."