Does raising base rates really reduce inflation?

[TheMotorcycleBoy]

Part of what she's saying is that raising rates in the 70's was a useful tool to fight inflation those days, because the ratio of fiscal-debit/GDP was lower and the much of the excessive money supply which (in addition to oil supply shocks) cause inflation came from bank loan creation for the private sector.

I am not an economist, but I feel she is getting bogged down in details of transmission mechanisms, rather than dealing with the underlying issue of too high a money supply.

Unfortunately now in the 2020s we have higher ratios of fiscal debt/GDP, and hence higher rates are actually making fiscal-debt more expensive, which could make the problem worse since the government will then to more money the next year to pay off debt at a higher rate of interest.

All this is saying is that because Governments carry so much more debt now, rising interest rates means paying to borrow is a lot more painful. Which is true, but that means that rising interest rates will have a stronger effect on inflation, forcing Govts to cut their borrowing more quickly. The heavily indebted, like water companies and private equity and LBO's are already suffering badly, and will need restructuring. Housing in the UK will take a little longer because of the number of outstanding fixed rate mortgages which have not yet reverted to market rates.

Hi Nimrod,

It's worth pointing out that, whilst our and their predicament are similar, she's American and so what she is most keenly describing, is that they will never cut their borrowing more quickly. That is, they always raise their debt ceiling - it's never reduced. Indeed it was very recently raised and that's led to the largest issuance of T-bills on record.

https://www.axios.com/2023/06/05/debt-c ... y-issuance

Hence J Powell is pulling in one direction on a monetary lever, whilst Congress pushes in the reverse direction on the fiscal lever.

She at some point refers to the fact that a significant part of US debt will be purchased abroad where those buyers aren't necessarily being squeezed by the same lending environment in the US, and that all of the new money which appears in the Treasury's coffers will of course fuel further inflation. For that reason I don't think she's bogged down with the transmission mechanism, she's making the point that the transmission mechanisms influence the Fed's ability to tackle inflation. Note the bit in the interview she says JP won't say "we need less fiscal" because it's not in the Fed's purview. However, the problems which beset the US are shared by us and many others, demographic shifts, healthcare+pension costs so arguably her US-centric perspective is still appropriate to the UK.

Matt

[Nimrod103]

I am not an economist, but I feel she is getting bogged down in details of transmission mechanisms, rather than dealing with the underlying issue of too high a money supply.




All this is saying is that because Governments carry so much more debt now, rising interest rates means paying to borrow is a lot more painful. Which is true, but that means that rising interest rates will have a stronger effect on inflation, forcing Govts to cut their borrowing more quickly. The heavily indebted, like water companies and private equity and LBO's are already suffering badly, and will need restructuring. Housing in the UK will take a little longer because of the number of outstanding fixed rate mortgages which have not yet reverted to market rates.

Hi Nimrod,

It's worth pointing out that, whilst our and their predicament are similar, she's American and so what she is most keenly describing, is that they will never cut their borrowing more quickly. That is, they always raise their debt ceiling - it's never reduced. Indeed it was very recently raised and that's led to the largest issuance of T-bills on record.

https://www.axios.com/2023/06/05/debt-c ... y-issuance

Hence J Powell is pulling in one direction on a monetary lever, whilst Congress pushes in the reverse direction on the fiscal lever.

She at some point refers to the fact that a significant part of US debt will be purchased abroad where those buyers aren't necessarily being squeezed by the same lending environment in the US, and that all of the new money which appears in the Treasury's coffers will of course fuel further inflation. For that reason I don't think she's bogged down with the transmission mechanism, she's making the point that the transmission mechanisms influence the Fed's ability to tackle inflation. Note the bit in the interview she says JP won't say "we need less fiscal" because it's not in the Fed's purview. However, the problems which beset the US are shared by us and many others, demographic shifts, healthcare+pension costs so arguably her US-centric perspective is still appropriate to the UK.

Matt

The USA has so many advantages which stem from a prosperous and ingenious private sector economy, abundant natural resources, and the World's major currency which everyone wants to own. Everyone wants to lend to the USA, as long as the returns are reasonably attractive.

The UK is not productive, beset by welfarism and vested interests, no significant natural resources and an overwhelming need to borrow for day to day expenses. Successive governments have run away from these problems, but the IMHO nemesis is rapidly approaching. We could have eased the problem by raising rates sooner, but just raising taxes will not control inflation unless the money is used to reduce our deficit and maybe cut debt. I am still unclear as to whether the US will escape recession, but I cannot see how we will.

[tjh290633]

Somewhere in the back of my mind is the relationship between the money supply and the. Velocity of circulation. I wonder if the cashless society has any effect on the velocity of money?

TJH

[TheMotorcycleBoy]

Part of what she's saying is that raising rates in the 70's was a useful tool to fight inflation those days, because the ratio of fiscal-debit/GDP was lower.

Was the nature of the UK GDP different in the 70's than today ie prior to the Chinese industrial revolution ? Were we not a more industrial nation in the 70's, actually producing products ?

Or is that observation not relevant. I mean, what does the UK produce now, what GDP ?

I'm sure it was. However I think that what Lyn is remarking about in the US, is a feature shared by other developed countries. i.e. similar demographic trends from say the 1920s to 2020s, and as of recent decades the increase in MS as a result of public fiscal policies rather than lending into the private sector.

Watch the whole clip if you have the time (48 mins), but the presenter does a couple of irrelevant plugs in various points which you can always FFWD over.

https://www.youtube.com/watch?v=O-Ns8CrkunI

Matt

[TheMotorcycleBoy]

Well that would be stating the bleeding obvious, and when I read it that doesn't seem to be the point he's making. He's ridiculing people for linking tax to spending; he's mocking the concept of government accountability to the taxpayer; he's encouraging the man in the street to proclaim that "tax doesn't pay for stuff" based on the say-so of someone who calls himself a chartered accountant.

GS

You can of course believe what you like, but the simple operational fact of the UK spending system is that tax collection, and government settlement are not connected. Not at all - anywhere up the chain.

To the extent that there are two separate acts of Parliament covering them. The Supply and Appropriation Act gives government departments the authority to make payments in Sterling. The Finance Act gives HMRC the authority to collect taxes.

Every day the Consolidated Fund Account at the Bank of England starts with a zero balance, and every day ~£400m of state pension expenditure is transferred from that account to the Paymaster drawing account by 8:30am, which is then used to settle the BACS payments across the banking system. The Bank of England has no authority to halt a payment. s13 and s15 of the Exchequer and Audit Departments Act 1866 requires that the Bank make the issues.

Tax collection proceeds separately into HMRC's accounts at the Bank of England. It is only swept into the Consolidated Fund at the end of the day.

The net result of all this is that government spending adds money to the system and taxation drains it. Paying a nurse causes income tax and national insurance, when the nurse spends their remaining salary that causes VAT to arise. Then the remainder is used to pay salaries and profit which causes more income tax and NI and a little corporation tax perhaps. The spending of the what is left continues down the chain, like a stone skipping across a pond. If nobody saves anything anywhere down the spending chain then the sum of the taxation streams will exactly equal what government spent for any positive tax rate. All tax rates do is change is the number of transactions necessary to get there. It's a simple geometric series.

There isn't a fixed amount of money people are fighting over. It's a dynamic quantity that grows and shrinks as necessary to get transactions done. The quantity of taxation raised has little to do with the rates charged and more to do with the amount people decide to save rather than spend.

What that means is that, in real terms, taxation is about reducing the capacity of the private sector to offer jobs to people. That leaves some people unemployed, which the public sector can then hire to achieve the public purpose and pay accordingly. That payment is always newly created money. Each time, every time - just has it has been for the last 150 years or so.

Gory details here if you're interested.

Hi Neil,

Thanks for sharing the link. I've downloaded the pdf (200ish pages). Before I start reading can you tell me, is it "An Accounting Model of the UK Exchequer" a totally objective, pure facts article or is it written with a MMT slant? I'm asking this as there are a few MMT referred on the website you posted.

thanks Matt

[NeilW]

Thanks for sharing the link. I've downloaded the pdf (200ish pages). Before I start reading can you tell me, is it "An Accounting Model of the UK Exchequer" a totally objective, pure facts article or is it written with a MMT slant? I'm asking this as there are a few MMT referred on the website you posted.

thanks Matt

You have 200 pages of very detailed facts.

It's written avoiding using any MMT jargon and is from the ground up. I'm not quite sure what you mean by an MMT slant. The work was undertaken to show exactly, in precise detail with reference to the institutions and the law, how the UK financial and monetary system functions - rather than the caricature those people who call themselves economists use.

MMT described how the money system works in reality - much as Post Keynesian Pricing Theory explains how firms and customers reach pricing decisions in reality. The very basis of both of them is that they are derived from the facts, not abstract beliefs.

The 200 pages were written to test what MMT says and whether that is the case in the UK.

[NeilW]

Somewhere in the back of my mind is the relationship between the money supply and the. Velocity of circulation. I wonder if the cashless society has any effect on the velocity of money?

That relationship is undeterminable.

Breaking turnover down into money and velocity sounds great in theory, but it is impossible to apply in practice. It's a classic case of a static analysis that doesn't work dynamically.

For example:

1) Government pays a pension, and the pensioner sticks the money in a drawer or a bank account. The 'money supply' is increased but there are no transactions, so no effect on inflation

2) Government pays a pension, the pensioner spends, VAT is collected and everybody downstream from them spends that income, paying VAT as they go. The result is no increase in the money supply, but a vast increase in transactions - the number of which is governed by the tax rate, and therefore a potential impact on inflation.

The same with bank loans

1) A mortgage is drawn down, and the property seller puts the money in a bank account. The 'money supply' is increased but there are no further transactions, so no effect on inflation.

2) A mortgage is drawn down, and the property seller pays off their loan, then spends the rest, and everybody downstream pays off a bit of a loan, and spends the rest. The result is no increase in the money supply, but a vast increase in transactions, and a potential impact on inflation.

Then you have the spending coin/saving coin split. The idea that if you swap money for bonds that will magically stop spending. It doesn't work - because we have repo markets. Repo markets are bank loans, and bank loans create money. Savings are easily spent thanks to the money changers at the temple.

Similarly spending money can spend decades in a deposit account doing nothing other than moving accounts. 'Rainy day funds' don't get spent until there is a rainy day. That money is locked away from the spending cycle. Spending money is easily saved.

Both of these conclusion are obvious once you understand that, in banking, loans create deposits which then create capital, and the real limiting factor is a nebulous concept known as 'creditworthiness'.

[Nimrod103]

Somewhere in the back of my mind is the relationship between the money supply and the. Velocity of circulation. I wonder if the cashless society has any effect on the velocity of money?

That relationship is undeterminable.

Breaking turnover down into money and velocity sounds great in theory, but it is impossible to apply in practice. It's a classic case of a static analysis that doesn't work dynamically.

For example:

1) Government pays a pension, and the pensioner sticks the money in a drawer or a bank account. The 'money supply' is increased but there are no transactions, so no effect on inflation

2) Government pays a pension, the pensioner spends, VAT is collected and everybody downstream from them spends that income, paying VAT as they go. The result is no increase in the money supply, but a vast increase in transactions - the number of which is governed by the tax rate, and therefore a potential impact on inflation.

In this example, I am not clear that the money supply has actually increased. It depends where the money for the Govt to pay the pension has come from. If it is from debt, then the supply has indeed increased. If it is from NI or some other tax, the money supply has not increased. It doesn't matter what the pensioner does with the money. If he deposits it in a bank, the bank then lends it out.

The same with bank loans

1) A mortgage is drawn down, and the property seller puts the money in a bank account. The 'money supply' is increased but there are no further transactions, so no effect on inflation.

2) A mortgage is drawn down, and the property seller pays off their loan, then spends the rest, and everybody downstream pays off a bit of a loan, and spends the rest. The result is no increase in the money supply, but a vast increase in transactions, and a potential impact on inflation.

The new mortgage created by the bank increases money supply. Again it doesn't matter what the seller does with the money. If the seller pays down his mortgage, the money is destroyed and doesn't add to the supply. But the likelihood is that the new purchaser has a much larger mortgage than the seller, so overall the effect on money supply is positive. This is where interest rates act to restrain inflation.

AIMHO as I am not an economist.

[funduffer]

You have 200 pages of very detailed facts.

It's written avoiding using any MMT jargon and is from the ground up. I'm not quite sure what you mean by an MMT slant. The work was undertaken to show exactly, in precise detail with reference to the institutions and the law, how the UK financial and monetary system functions - rather than the caricature those people who call themselves economists use.

MMT described how the money system works in reality - much as Post Keynesian Pricing Theory explains how firms and customers reach pricing decisions in reality. The very basis of both of them is that they are derived from the facts, not abstract beliefs.

The 200 pages were written to test what MMT says and whether that is the case in the UK.

Can I thank Neil for posting this report. It is very interesting, but for a novice (excepting my 1970's A level in economics), it is pretty difficult to absorb in one reading!

I am intrigued by MMT (Is that Modern Monetary Theory, or Magic Money Tree!!!?).

I read blogs by some MMT proponents (Eg Richard Murphy) who are not 'mainstream economists', and I find their articles quite compelling.

My main comment, spoken from ignorance not knowledge, is that whilst the mechanics of the money system can be described, its usage to prescribe economic/monetary policies is subject to more nebulous concepts like confidence and market sentiment. Thus, applying MMT to monetary policy is not necessarily the wrong thing to do, but is subject to opinions that can drive the outcome in an unexpected direction.

MMT is something that more of us should try to understand, including politicians and journalists.

FD

[scotview]

You have 200 pages of very detailed facts.

MMT is something that more of us should try to understand, including politicians and journalists.

FD

Does MMT preclude the requirement (necessity) for an individual to have a productive job, pay taxes or invest/save ?

[ursaminortaur]

Does MMT preclude the requirement (necessity) for an individual to have a productive job, pay taxes or invest/save ?

It is a model of the economy so generally assumes people have to earn money to pay their taxes etc. However the model can look at the consequences if for instance the government were to set the tax rate to zero ( is give everyone a tax holiday ). The government could do this for a short time but would then either have to print money, increase borrowing or stop spending - all of which would have consequences if continued for any length of time.

[GoSeigen]

Probably high. Given recent FX rates against USD and the Euro.

I think he's saying if you buy a UK share that earns a lot abroad right now, that when GBP falls back to, for example, 1.20USD the value of that share's profits in GBP will rise.

Matt

Yep, high. I think sterling has support from expectation of further rate rises, this is in turn depressing UK stock prices. Will be interesting to see if that reverses in time.

GS

Here's the FT's take:

https://www.ft.com/content/6b828faa-aba1-43cc-9073-c139c5c0f9f9

In the context of the last 20 years, UK equities and credit are the cheapest global asset classes we can find,” says a Morgan Stanley note published Monday morning

GS

[NeilW]

I read blogs by some MMT proponents (Eg Richard Murphy) who are not 'mainstream economists', and I find their articles quite compelling.

Murphy is not MMT. He's a tax justice warrior who can do a bit of accounting. Might be a bit Post Keynesian, but is primarily a Robin Hood character with a penchant for giving free money to people for nothing in return.

The central thesis of MMT is the price anchor hypothesis - which replaces interest rate/money aggregate targeting as the stabilisation policy of the economy. That means interest rates at zero permanently, permanently low mortgage rates and no more free money to people who aren't prepared to invest in the economy.

Instead we put in place the automatic stabiliser of a guaranteed job at a living wage, which automatically cuts back government spending during boom times.

You cannot just give money to people for nothing in return. First rule of MMT.

[NeilW]

It depends where the money for the Govt to pay the pension has come from.

It doesn't come from anywhere. Government is the source of Sterling. It's a public monopoly.

There is no ordering of taxation and spending. They happen entirely asynchronously. The 'empty pot' belief is simply wrong as a matter of operational reality and the law.

However logic demonstrates it is the other way around. Where did the money come from to pay the tax in the first place? Answer: initial government spending in the token they have a monopoly over. Ab initio, you can't get Sterling from anywhere else.

Therefore it is more correct to view spending as coming before taxation. Which then leads to a different view of the way spending impulses work - spending impulses that then correlate more precisely with the way bank lending and advances operate.

The conclusion then is that the government sector is just a particular sort of bank.

This is where interest rates act to restrain inflation.

They don't. It's a complete myth. It's the flow of money that's the mechanism, not the stock.

Interest rates are a distributional variable, not a control variable. They are there to move money from poor people paying mortgages and rent to rich people with deposits - while bankers take an increasing cut.

[XFool]

You can of course believe what you like, but the simple operational fact of the UK spending system is that tax collection, and government settlement are not connected. Not at all - anywhere up the chain.
...
Gory details here if you're interested.

10. Acknowledgments
...

"To the members of the UK Exchequer Lonely Wives group: your forbearance is greatly appreciated."

[Nimrod103]

This is where interest rates act to restrain inflation.

They don't. It's a complete myth.

Have these theories been put to the MPC? What did they say?

[TheMotorcycleBoy]

You have 200 pages of very detailed facts.

It's written avoiding using any MMT jargon and is from the ground up. I'm not quite sure what you mean by an MMT slant.

The whole premis of it, i.e. this notion that countries are fine printing money, sorry increasing their reserves merely because we shouldn't approach the bank balance of a country in a way analogous to that of a household.

Matt

[AsleepInYorkshire]

Before I am horse whipped and informed I'm not an economist I'll gladly agree with any and all punishments as quite simply this stuff just blows my brain

If QE has played a part in the current inflation why aren't the National Banks using QT (Quantitative Tightening) to counter inflation?

AiY(D)

[Tedx]

The BOE is engaging in QT (quantitative tightening)

We stopped buying bonds at the end of 2021. We stopped reinvesting the proceeds from maturing bonds in February 2022. And we began actively selling bonds in November 2022. As a result the amount of bonds we hold has started to fall.

The process of reversing or ‘unwinding’ QE, either by stopping reinvestments or selling bonds, is sometimes called ‘quantitative tightening’, or QT. It raises interest rates and lowers inflation. But the size of this impact depends on the economic circumstances of the time. Both QE and QT are likely to be more powerful when markets are stressed.

Just as with Bank Rate, it is the Monetary Policy Committee (MPC) that decides on QE and QT.

https://www.bankofengland.co.uk/monetar ... ive-easing

To my knowledge, the MPC are the only ones engaging in QT - all the rest have just stopped reinvestments.

[TheMotorcycleBoy]

The BOE is engaging in QT (quantitative tightening)

We stopped buying bonds at the end of 2021. We stopped reinvesting the proceeds from maturing bonds in February 2022. And we began actively selling bonds in November 2022. As a result the amount of bonds we hold has started to fall.

The process of reversing or ‘unwinding’ QE, either by stopping reinvestments or selling bonds, is sometimes called ‘quantitative tightening’, or QT. It raises interest rates and lowers inflation. But the size of this impact depends on the economic circumstances of the time. Both QE and QT are likely to be more powerful when markets are stressed.

Just as with Bank Rate, it is the Monetary Policy Committee (MPC) that decides on QE and QT.

https://www.bankofengland.co.uk/monetar ... ive-easing

To my knowledge, the MPC are the only ones engaging in QT - all the rest have just stopped reinvestments.

I believe that "by stopping reinvestments" they are still tightening. When the bonds mature and they don't reinvest the proceeds, they are effectively cancelling that money i.e. the face value of the bonds, so there's less (money) in the system. Ergo tightening.

So prematurely selling the bond holdings and erasing the returning sterling, or letting the maturing bonds "roll off" the balance sheet (i.e. not reinvesting proceeds) is the same concept of tightening. The difference being the timing, and of course by prematurely sale of the bonds, they are accelerating the process as they can choose to destroy more liquidity faster. Both reverse the process of reserve creation and then swapping sterling for gilt-edged assets which was the QE case.

At least that's my take.

Matt