New research by Stephen Wright of Birkbeck College, University of London,
suggests that today’s central bankers may be pursuing their inflation targets
with excessive vigour. They seem confident that they know the ‘correct’
response of interest rates to shocks that hit the economy, he notes. But his
paper published in the January 2004 issue of the Economic Journal suggests
that this confidence may be misplaced: too much of the burden of monetary
policy is being borne by those with mortgages.
Conventional wisdom decrees that when inflation picks up, central banks
should ‘lean against the wind’. First, nominal interest rates should rise by
more than expected inflation, so that real interest rates rise; and second,
output should be pushed down in the process.
These two features provide the basis for the highly influential ‘Taylor Rule’,
which appears to capture pretty well the behaviour of central banks from the
1980s onwards. So, for example, suppose inflation picks up, and the central
bank responds by raising nominal rates, but by less than inflation. This
breaches the Taylor Rule. It would accordingly be viewed as providing
insufficient monetary discipline on the economy.
Wright's paper suggests that in taking this hardline view central bankers are
not taking sufficient account of the welfare of those who have mortgages. With
virtually all mortgage contracts, it is nominal not real interest rates that count
since, for a given level of debt, an increase in nominal rates lowers disposable
income, even when real rates do not rise.
There is a lot of evidence that many mortgage holders cannot protect
themselves against such cuts in disposable income by additional borrowing.
They are, in economists’ jargon, ‘credit-constrained’. So they have no
alternative but to lower their consumption. Thus, the rise in nominal rates may
have contractionary effects on the economy even if real rates fall.
Conversely (and more relevant to the recent past), if nominal rates are cut
due to falls in inflation, this may have a significantly stimulating impact on the
economy, even if real rates do not fall at the same time.
This hitherto-ignored ‘nominal asymmetry’ in the economy means that if
central banks adhere to the Taylor Rule, those who are credit-constrained
may end up bearing too much of the burden of central bank stabilisation, in
terms of a more volatile pattern of their consumption. Wright’s paper suggests
that a more equitable sharing of the burden would significantly change the
nature of the response of ‘optimal’ monetary policy to an inflationary shock.
First, real interest rates should definitely not rise, as the Taylor Rule decrees.
Second, it may even make sense to lean with the wind in terms of output. As
long as nominal rates rise, the contractionary impact on the consumption of
those who are credit-constrained provides an automatic dampener on the
economy. If this puts too much of a squeeze on debtors, it may make sense
for the central bank to provide a cushion by boosting the economy somewhat.
Central bankers are unlikely to be enthusiastic about the results in this paper,
since it would seem to provide an encouragement to the sort of lax monetary
policy seen in the 1970s. But it would be a mistake to draw this conclusion.
The results of this paper take it for granted that central bankers are committed
to achieving their inflation target in the long run (which in the 1970s many
central banks arguably were not). Nonetheless, it does suggest that the vigour
with which the target is pursued by present central bankers is excessive,
because too much of the burden of monetary policy is being borne by those
with mortgages. To that limited extent, the current generation of hardline
central bankers may have something to learn from their wimpish
predecessors of the 1970s.
ENDS
Notes for Editors: ‘Monetary Stabilisation with Nominal Asymmetries’ by
Stephen Wright is published in the January 2004 issue of the Economic
Journal.
The author is at Birkbeck College, University of London, 7-15 Gresse St,
London W1P 2LL (website: www.econ.bbk.ac.uk/faculty/wright).
For Further Information: contact Stephen Wright on 0207-631-6448 (fax.
0207-631-6416; email: s.wright@bbk.ac.uk); or RES Media Consultant
Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:
romesh@compuserve.com).