Catherine Mann joined the Bank of England in September 2021, just as they say the shit was getting real. Since then she has consistently been one of the most restrictive members of the Monetary Policy Committee.
She loves delays. The former Citi chief economist has repeatedly addressed the issues of delay and transmission in speeches. It’s a hot topic: after a year and a half of rapid monetary tightening by central banks around the world, the $[insert meaninglessly large value] The question is whether we have already been slapped in the face by central banks or are yet to come.
Mann came back to this in an interesting speech today (attachment here). She is still firmly in the camp of rising rates – preferring “further tightening and sooner rather than later” – but questions the standard 18-24 month estimate of how long it will take for policy changes to take hold.
She said:
We have been raising interest rates for more than a year and by a total of 390 basis points. Should we have already seen a bigger impact on the real economy and inflation? Perhaps the “long and variable” lags are influenced by how monetary policy is transmitted through financial markets or through the expectations of participants in the real economy. Certainly the sequencing of the shocks we encountered must also play a role.
Lag was also a central theme of a speech by BoE Deputy Governor Ben Broadbent, the centrist father of UK macroeconomic policymaking, in late 2021. Broadbent said at the time:
A change in interest rates has its biggest impact on inflation only after a significant lag – probably eighteen months or more.
He added in a footnote:
In the literature, estimates of political lag seem to vary quite a bit. In Cloyne and Hurtgen (2016, ‘The macroeconomic effects of money policy: a new measure for the United Kingdom’, American Economic Journal: Macroeconomics), the authors note that the peak effects of changes in UK monetary policy take well over two years to come through . Cesa-Bianchi, Thwaites and Vicondoa (2020, ‘Monetary policy transmission in the United Kingdom: a high frequency Identification approach’, European Economic Review) provide indications of material effects after just under a year.
It was a sound argument then, and it still is today: bank estimates at the time suggested that the tightening needed to stem the inflationary tide (then, before the Ukraine war) would have 1) taken during the extreme uncertainty of must occur at the peak of the pandemic and 2) caused massive unemployment:
Still, this ~somewhere-in-the-middle~ approach is obviously unsatisfactory. More accurate lag estimates would improve monetary policy implementation in normal times. Abolishing the conventional 18-to-24 rate would represent a fairly significant shift in the MPC’s interest rate paradigm.
But of course times are never normal. Mann’s theory – based on some modeling and (excitement time) a new index of financial conditions (which happens to fit her long-standing hawk thesis) – is in this case:
1) financial markets have absorbed a significant chunk of past tightening; 2) that the sequencing of shocks and the embedding of inflation carries the risk of a worrying shift in expectations about an increase in the proportion of backward-looking actors in the real economy
She added:
Factors beyond the central bank’s control and interactions between channels may amplify or dampen the transmission of a particular policy decision.
In other words, the things on the right are playing stupid guys:
All this means that 18-to-24 is not only vague, but also waves away the different speeds at which rate hikes hit different parts of the markets and economy. As is evident, cable dealers and mortgage brokers react fairly quickly, while your parents and the local dive bar may not adjust their investment decisions immediately. In Mann Talk:
This is the stage in the transmission mechanism where delays are arguably most evident due to, among other things, the partial attention of agents and the staggered nature of contracts. Prices and wages are influenced by and can draw on demand and supply as well as the labor markets.
For readers who don’t have time to sift through the speech, here are some of Mann’s key points:
— Mortgage rates track rate hikes faster when rates are rising than when they’re falling (yeah, no shit)
— For equities, the benefits of shareholder payouts and the equity risk premium have outweighed the impact of tightening
– BoE MPC hiking has shielded sterling somewhat while the Federal Reserve does its thing
All of this adds up to . . . a new index! Treat your eyes to this beauty:
(Side note: God, that’s a boring name. “A UK Financial Conditions Index” – really? Surely “The MannSpread” would have been more appropriate? Other bottom line suggestions welcome.)
man explains:
This new index of financial conditions implies that financial conditions in the UK are currently not much tighter than average by historical standards. But after a full decade of short interest rates at the effective floor and relatively easy financial conditions, we have come a long way. What remains a mystery to us is how much tightening or tightening matters for transmission to the real economy and inflation…
Since both level and delta play a role in assessing the effectiveness of monetary policy transmission, what this suggests to me is that the forward-looking nature of financial markets has absorbed some of the intended tightening affecting the long and variable lags of the folk wisdom. Even more important is the apparent premature easing of conditions given the prospect of inflation building.
Mann spends the belly of the talk modeling these effects, focusing on the effects of an inflationary cost-pressure shock (ʸᵒᵘ ᵈᵒⁿ’ᵗ ᵍᵉᵗ ᵐᵃⁿʸ ᵒᶠ ᵗʰᵒˢᵉ ᵃʳᵒᵘⁿᵈ ʰᵉʳᵉ) and the impact of pricing. Super reductive, the latter means that companies react belatedly to inflation that has already occurred, which can create second-round effects.
The (colloquial) money chart is this:
Man:
Even though I’ve gradually increased the proportion of backward-looking companies in equal increments from aqua to orange to purple, the change in behavior is becoming more and more evident. A stronger backward bias not only worsens the trade-off between inflation and output, each subsequent step worsens the trade-off by more than the last one. . .
To reduce the risk of ending up in the “purple” world, we should weight inflation more heavily in our reaction function.
Their broader insight—which, we should reiterate, fits comfortably with their apparent ancestors—is that the “folk wisdom” 18-to-24 lag is wrong (sorry Ben), and that “in normal times, the monetary transfer into the Inflation is actually faster, peaking within the first year.”
Taking into account her assessment of the financial shock absorbers in place, she concludes:
Taken together, all of this results in financial conditions that are now looser than is likely to be needed to mitigate the embedding of persistent inflation in wage and price-setting paths. . .
With the risk of increasingly persistent inflation disproportionately rising with the share of reversing, I believe further tightening is needed and warn that a reversal is not imminent.
In the fairly placid world of the Bank of England MPC – where recent policy has been more or less dictated by bank employees while outsiders have been left on the sidelines – this is a throwing off of the proverbial gauntlet. We’re curious if any of the other MPC members want to pick it up.
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