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Monday
Jul042016

Brexit, regime uncertainty, and monetary policy

In light of Brexit, Lars Christensen has called on Mark Carney to adopt a 4% NGDP target. In doing so, he has argued that the result of the vote has increased regime uncertainty, which constitutes a negative supply shock. I disagree.

In a previous post Lars criticised the concept of regime uncertainty on the grounds that it was too Keynesian:

Higgs’ description is – believe it or not – fundamentally Keynesian in its character (no offence meant Bob): An increase in regime uncertainty reduces investments and that directly reduces real GDP. This is exactly similar to how the fiscal multiplier works in a traditional Keynesian model.

I don't see the problem. For me, an advantage of regime uncertainty is that it puts flesh on the bones of Keynes' "animal spirits". Rather than waving your hands and talking about the confidence fairy, regime uncertainty offers a clear mechanism to show how policy announcements can impact the economy. And that impact is not damaging the potential growth rate per se, but altering the immediate spending decisions of market participants. The two concepts are closely related - regime uncertainty will undoubtedly cause potential growth to fall. But in the first instance regime uncertainty affects aggregate demand.

Another way of putting this is that in the equation of exchange, MV=PY, there are two types of aggregate demand shock. Either the money supply can change (i.e. M), or "velocity". Technically, the definition of velocity is anything that affects PY holding M constant. Practically, this means shocks to spending that aren't brought about by changes in the money supply. In other words, they are changes in the demand to hold money.

My claim is that we don't need to alter what Higgs means by regime uncertainty to preserve a monetarist framework.

In a separate post, Lars says that,

First of all, it is clear that Brexit has caused an increase in particular demand for US dollar and other safe assets. This is essentially a precautionary increase in money demand and for a given money base this [is] a passive tightening of monetary conditions.

Secondly in my view, more importantly, the increase in regime uncertainty should basically be seen as a drop in the expected trend growth rate in both the UK and the euro zone. This means that we should expect the natural interest rate to drop both in the UK and in the euro zone and maybe even globally.

I don't believe there's a need to combine these two valid points.

I agree that the surprise referendum result has generated uncertainty about the future institutional structure of the UK. And it is not just economic uncertainty, it is policy uncertainty. In fact, it's not just policy uncertainty, it's bona fide regime uncertainty. Lars' first point is that regime uncertainty, and the typical response to uncertainty - hoarding cash, buying gold - constitute an increase in the demand for money. This means that V has fallen, and this ceteris parabus so has (MV). I agree with this, but view it is a negative AD shock.

This regime uncertainty is likely to lead to lower growth prospects, but there are many things that affect future growth other than regime uncertainty. Indeed there's widespread certainty that regardless of the type of deal the UK get, and who the Prime Minister will be to negotiate it, Brexit will be economically damaging. Our future productive capacity has been dented by reduced economic cooperation with the EU. Thus Lars' second point that expected trend growth has collapsed is also true. But I don't see this as part and parcel of regime uncertainty. I see it as a separate shock.

The fact that sterling has weakened doesn't demonstrate that regime uncertainty is a negative supply shock, it just suggests that the negative supply shock has thus far dominated the negative demand shock. And I would give credit to Mark Carney for minimising the impact of regime uncertainty - he has calmly and credibly signalled that interest rates are more likely to be cut rather than increased. He hasn't said "a negative supply shock will put upward pressure on inflation and we will carefully monitor inflation expectations to ensure they remain anchored". Rather, he's said "we won't let AD contract". Perhaps he is a closet NGDP targeter after all!

Whilst I'd like to see the Bank of England adopt an NGDP target, unfortunately I don't see the present environment as being especially fertile. And crucially the reason is that inflation is currently well below target. If inflation was on target then whether Brexit constitutes a supply shock or a demand shock would matter because an NGDP target would imply a different policy response to an inflation target. For example, if inflation were currently 2% then a negative supply shock would cause an inflation targeting central banker to tighten policy.But an NGDP targeter would see no reason to change the policy stance. Thus a closet NGDP targeter might be tempted to jump ship. But inflation is 0.3%, and the Bank of England have plenty of room to permit supply shocks to manifest themselves without tightening. The regime doesn't really matter right now.

Finally, Lars says "In a Market Monetarist set-up this [a Keynesian view of regime uncertainty] will only have impact if the monetary authorities allowed it" which is true. Fortunately, however, Carney seems willing to offset regime uncertainty.

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