Select Committee on Economic Affairs

Corrected oral evidence: Quantitative easing

Tuesday 2 March 2021

3 pm

 

Watch the meeting: https://parliamentlive.tv/event/index/c48d54f3-8eb8-4ebb-b2ba-a80eebea88af

Members present: Lord Forsyth of Drumlean (The Chair); Lord Bridges of Headley; Viscount Chandos; Lord Haskel; Lord King of Lothbury; Baroness Kingsmill; Baroness Kramer; Lord Monks; Lord Skidelsky; Lord Stern of Brentford.

Evidence Session No. 7              Virtual Proceeding              Questions 56 - 67

 

Witnesses

I: Rupert Harrison, Portfolio Manager and Chief Macro-Strategist, Multi-Asset Strategies Group, BlackRock; Dr Mohamed El-Erian, President, Queens’ College, University of Cambridge, and Chief Economic Adviser, Allianz.

 

USE OF THE TRANSCRIPT

  1. This is an uncorrected transcript of evidence taken in public and webcast on www.parliamentlive.tv.
  2. Any public use of, or reference to, the contents should make clear that neither Members nor witnesses have had the opportunity to correct the record. If in doubt as to the propriety of using the transcript, please contact the Clerk of the Committee.
  3. Members and witnesses are asked to send corrections to the Clerk of the Committee within 14 days of receipt.

 


17

 

Examination of witnesses

Rupert Harrison and Dr Mohamed El-Erian.

Q56            The Chair: Welcome to this session of the Economic Affairs Committee. We are joined by witnesses Rupert Harrison, portfolio manager and chief macro-strategist at BlackRock, and Dr Mohamed El-Erian, president of Queens’ College, Cambridge and chief economic adviser at Allianz. Welcome to both of you and thank you for giving evidence to us today.

Perhaps I could begin by asking you, Dr El-Erian, whether monetary policy decisions are in danger of being directed by the needs of the Treasury, and what are the consequences if they are?

Dr Mohamed El-Erian: Let me start, Lord Forsyth, by thanking you and all the members of the committee. It is wonderful to be with you. Thank you for this honour. It is wonderful to see some old friends and colleagues on the screen.

In relation to your question, monetary policy is being driven by the needs of the economy, and fiscal policy, and the Treasury in particular, has to play a primary role at this stage. The UK faces both a short-term challenge and a longer-term challenge. Neither of those issues can be addressed without the active involvement of fiscal policy. Monetary policy is there to play a support role. If we think of a car, the driver is fiscal policy at this stage, but the co-pilot is monetary policy. It looks as though monetary policy is being driven by fiscal policy but, in effect, they are both being driven by the needs of the economy.

Rupert Harrison: Thank you, Lord Forsyth, for having me today. It is a great privilege.

I strongly agree. I do not think that monetary policy is in danger of being driven by the requirements of the Treasury. As you have heard, I have been reading through some of the transcripts of your earlier meetings, and I think it is clearly the case that in a low interest rate environment, where monetary policy is very constrained by the zero lower bound, you get a blurring or potential blurring of the boundaries between monetary and fiscal policy, which can lead to problems of perception.

I do not think that is an actual problem in the UK. I am absolutely confident that decisions of the Bank are made by the Bank in the context of its inflation remit. Even if you could get the internal members of the MPC signed up to some kind of conspiracy that the Bank was going to act to support government fiscal policy, the external members of the MPC are a very important part of the institution and it is implausible that they would all be involved in such discussions. I am very confident that the strength of the institution is such that that actual independence has not been compromised.

I agree with some of your previous witnesses that more attention could be paid to communication, explanation and justification of some of the size and parameters of the decisions, in order to avoid the risk of perceptions. That is an inevitable consequence of the environment we find ourselves in, where, as Mohamed El-Erian just explained, monetary policy is inevitably very constrained and we are more reliant on the kinds of interventions that are either fiscal policy or are somewhere between monetary and fiscal policy, some co-ordination between the two.

The Chair: You think that the £150 billion QE was purely driven by the Bank’s remit in respect of inflation.

Rupert Harrison: Yes. I think it was driven by the Bank’s remit on inflation and its remit on financial stability. You have heard from other witnesses that QE has several functions. In a sense, it has a market-maker of last resource function in very distressed financial markets. There is a function supporting demand in the economy and there is a function supporting broader financial conditions, in order to meet the inflation objective and broader macroeconomic objectives. That was the reason for it.

It is a strength of the UK system that the Bank felt able to co-ordinate the timing of the announcement with the Treasury. That shows a certain amount of maturity and confidence in its independence, and it is effective. Markets and business find it reassuring when they see policymakers acting in a co-ordinated way. That was a sign of strength. There could be greater focus on communication in order to ensure that any perceptions of the erosion of independence are avoided.

Q57            Lord Bridges of Headley: Thank you both for joining us. Dr El-Erian, you said that a risk facing the global economy is “a repeat of the policy mistake of the global financial crisis: that of winning the war against the threat of a global depression but, importantly, failing to secure … high, inclusive and durable economic growth”. What, in your mind, needs to change, in light of that comment, and what is the role of central banks in that change?

Dr Mohamed El-Erian: A risk that I worry about a lot is that we win the war again against Covid and against a depression or long recession, but we fail once again to establish the conditions for sustained, high and inclusive growth.

What needs to happen? Four things need to happen. When I describe them, you will understand why I worry about this risk.

The first thing is the continued provision of immediate relief. There are people suffering for no reasons that they have control over. There is a real risk of reversible short-term problems becoming embedded in the structure of the economy and becoming longer-term problems that are very difficult to reverse. Short-term unemployment could become long-term unemployment. The young unemployed risk even becoming unemployable because every year the system produces more school-leavers and an employer is more likely to opt for someone coming straight out of school than someone who has been sitting at home for a few years. Companies that face short-term liquidity problems could go bankrupt, even though they would be viable in normal circumstances. A whole set of relief measures is needed. The UK has been doing well on that, and it needs to continue.

The second thing is to make sure that we win the war over Covid; that we continue to support vaccination, continue to help reduce infections and, importantly, continue to guard against new variants. These are very short-term issues, and they will tend to occupy the attention of most policymakers. They will help overcome what I call the war.

However, securing the peace requires that simultaneously, in pursuing those two objectives, we pursue two other objectives and start early. The first has to do with the supply side. We will come out of this shock with impaired productivity and impaired supply-side responsiveness. There are steps that can and should be taken now to reduce the drag coming up.

We also need to think seriously about the demand side. There is a risk that we come out with a major shock to household economic security. We may face the problem of having both a demand deficiency and a supply deficiency at a time when we are trying to pivot from crisis management to durable recovery. That is the context.

It is not clear what the primary role of central banks is in any of those four things, so I go back to the notion that, for too long, central banks have been carrying too much of the burden when it comes to policy response, not because they wanted to do so and not because they were interested in mission creep, but because other entities, particularly in the United States and the eurozone, did not step up to the challenge of the policy hand-off. That is the challenge we face today: excessive reliance on central banks and the consequences of past excessive reliance on central banks.

Again, I stress that the central banks role is a support role. How does it support? First, as Mr Harrison rightly said, it should try to limit the risk of financial instability and financial volatility undermining what the economy is trying to do, which is to recover. That is the first role.

The second is to ensure that finance is available and goes to sectors that warrant financial support, and not in a way that creates what people call zombie companies.

The final role is to continue the close co-ordination with the Treasury, something where the UK has been far ahead of any other country I know. That is absolutely critical at this stage of the recovery. This policy approach that is well co-ordinated must continue.

Until recently, I have lived most of my life outside the UK, so I have seen QE in the UK from the outside, and I have been able to compare and contrast. The UK has set the example for how the policy should be pursued. Having said that, I stress that there is no perfect policy tool. Every policy tool comes with benefits, costs and risks. Unless you co-ordinate closely with other policy-making entities, that equation can quickly turn quite nasty.

The Chair: I am hoping to get through eight questions in the course of the hour. Lord Bridges, do you want to come back on that?   

Lord Bridges of Headley: I have a quick question for Rupert Harrison, if I may. Rupert, do you agree with what you have just heard: excessive reliance on central banks, yes or no? In particular, from your vantage point at BlackRock, can you say a bit about the problem or perceived issue with zombie companies and whether you see the creation of zombie companies as something we should be much more focused on than we might be at the moment?

Rupert Harrison: I agree, essentially, with everything that you have just heard from Mohamed El-Erian. There has been excessive reliance on central banks. I agree that it has been mainly in the United States and in the eurozone where, for various political and institutional reasons, there have been, at times, degrees of dysfunction in other arms of policy-making. I do not think that has generally been the case in the UK.

When it comes to securing inclusive, strong and long-lasting growth, it is very important to remember that policies should be directed at the right targets. Central banks are well suited to maintaining financial stability and delivering macroeconomic stability, as currently defined by meeting their inflation targets. They are not well suited to distributional issues, or institutions and labour markets. Those are issues for other entities, primarily Governments. It is very important to keep the right instrument focused on the target that it should be focused on.

Zombie companies are a difficult issue. In practice, I am not sure it has a huge amount of importance for central banking, because I do not think it is an argument against stimulative monetary policy that a side-effect may be zombie companies. There needs to be the right policy tool. We need to make sure that we have effective corporate governance and insolvency regimes so that the allocation of capital in the economy is effective. I do not think that they should be a reason for constraining monetary policy.

Q58            Viscount Chandos: How different do you see the QE programme since March 2020 from the earlier phases? Maybe Rupert Harrison could start, as you were an insider for the earlier phases and an outsider more recently.

Rupert Harrison: I was an outsider from the very beginning in that I entered government in 2010 when QE had already been established by Lord King and others. There has not been a huge difference. There has been a difference in scale and pace.

In the overall period since 2008, the UK central bank expanded its balance sheet more slowly on average than many other central banks, but in the last year that has not been the case. The expansion has been similar; in fact, it is very slightly larger as a share of GDP than the Fed or the ECB. It has been largely focused on the same assets, sovereign assets. There has been an element of corporate credit. A very important part of the response has been term funding for banks in the UK. The system is very bank intermediated, and that is a very important part of the overall support for the economy.

The context is the big difference. This is a very different kind of recession. It is more of a natural disaster, a temporary restraint on activity, so the policy needed to act as a more aggressive bridge across the pandemic. With the advent of vaccines, we now have the prospect of what I think will be a very rapid recovery. Managing the exit from the policy will again be different from what was a very long protracted cycle after 2008, so the main difference is context rather than the policy itself.

Dr Mohamed El-Erian: I mostly agree with what Mr Harrison said, but I stress that the slight differences in scale and scope have meant very different experiences across countries. It was a very large intervention, particularly in March/April. The scope also varied enormously. The Federal Reserve went much further, including buying high-yield or junk bonds. That is a big difference. It influences the conditioning of financial markets when a central bank takes on the fault risk so explicitly.

Finally, you have seen differences in the UK versus the eurozone and the US. The UK has done better in making sure that QE impacts the economy. If you think of the ratio of how much you impact financial assets versus how much you impact the economy, the UK has been able to impact the economy much more than the US has been able to do.

Viscount Chandos: To clarify that last point, do you think that is because of the dominance of banks as a source of funding, as opposed to the corporate bond market?

Dr Mohamed El-Erian: As Mr Harrison said, that has an important role, but the co-ordination with the Treasury and the focus on the ultimate prize, which is the economy, has been much greater here than it is in the United States.

Q59            Lord Haskel: Both our witnesses have expertise beyond the UK. Dr Mohamed El-Erian referred to his just now. Japan was the first in 2001 to deal with deflation. The Fed did it in 2008 but stopped in 2014, and we have just been told how it has reacted to the pandemic, as, in fact, most countries reacted to the pandemic. In what ways does the Bank of England’s QE programme differ from the QE implemented by other central banks, apart from the direction that Mr Harrison referred to just now?

Rupert Harrison: The similarities are much greater than the differences. They have all, effectively, been expanding their balance sheets and buying assets, largely sovereign assets. As you say, the Bank of Japan blazed the trail in this, and everyone else has been catching up. There are some important differences. The Federal Reserve has been, as we have just heard, extremely aggressive in the breadth and scope of its interventions in the credit markets, with things like the Main Street facility. Essentially, that comes down to replacing aspects of economic policy that in the UK are delivered by the Treasury and other organs as a matter of default, but are harder to get in place quickly through the US political system.

The other very important difference, which we may come on to, which is hugely significant going forward, is the Fed’s new monetary policy framework. It is hard to understate how important that is. All other central banks now have to decide how they are going to respond to the fact that the world’s major central bank has adopted a couple of very important changes, particularly explicit average inflation targeting and abandoning any attempt to use a Phillips curve framework to anticipate future changes in inflation through the tightness of the labour market. Those are much more important changes than the small changes in the design and composition of QE across the different central banks. 

Dr Mohamed El-Erian: As Lord King and Lord Stern know, I have been looking at this issue in great detail. In fact, I wrote a book on it in 2016, because I was worried about its direction, so I am much more sensitive to small differences than Mr Harrison.

With that disclosure, if we think of what QE or unconventional monetary policy is, it is a mix balance sheet operations, interest rate conduct and forward policy guidance. We have seen differences in all three that have gotten bigger. For example, as I mentioned earlier on QE, the Fed has gone into areas where other central banks have been very hesitant to go. On interest rates, the eurozone has gone to negative rates. Other central banks have been more hesitant. On forward guidance, they have all been similar, but with important little nuances which the marketplace picks on immediately. The marketplace has been conditioned not only to follow central banks but to try to influence them.

In response to the question, Lord Haskel, the experience varies, but the biggest thing that varies is the impact on the economy, as opposed to the impact on just financial markets.

Q60            Lord Skidelsky: I have a question relating to what has been said. We have heard quite a bit. We have asked witnesses in the past about the real purpose of QE, and the answer we tended to get was that it was to reduce the cost of borrowing and that kind of thing. To what extent have different central banks had different purposes? To what extent have they been interested in the exchange rate channel in their QE policy? I know that has been at the centre of the debate in Australia, for obvious reasons. I wonder whether it was a factor in UK policy.

Dr Mohamed El-Erian: I do not think it has been a primary influence. I do not think that exchange rates have been targeted explicitely with QE, but central banks have kept an eye on them. QE itself has evolved, and that has exchange rate implications. Initially, it was simply to counter dysfunctioning markets. Then it became something much bigger when the hand-off to other policy entities was not possible. As Mr Harrison said, it had a particular angle in certain countries. I do not think that QE has been used to target explicitly exchange rates.

Rupert Harrison: All central bank models have the exchange rate as one mechanism by which QE affects the economy, and they will be aware of that. It has not been a major focus, partly because a taboo against explicitly commenting on exchange rates is enforced through the G7, G20 and other organisations. Most central bankers will seek to avoid commenting explicitly on exchange rates. There has been the occasional case where, particularly sometimes in the eurozone, the ECB has sought to talk down the euro at times, with limited success.

Lord Skidelsky: But in east Asia it has been somewhat different. That is my impression.

Rupert Harrison: Yes. There are very different policy frameworks where there have been either explicit or implicit exchange rate policies and manipulation at various times. That is very different. I am mainly talking about it in a developed market context.

Q61            Lord King of Lothbury: Good afternoon, gentlemen. Can I pick up on a couple of points that you have each made so far and then put them into a question? Mohamed, you talked about the need for substantial fiscal support during the period of restrictions, in order to help businesses and individuals cope with the fact that sectors of the economy have been shut down for quite a long period. Rupert, you talked about the exit strategy—I think that was the phrase that you used—from that very loose monetary policy.

If central banks, as they seem to be implying, continue with very loose monetary policy for quite a long while, and if we were to have a fiscal stimulus in the future, which I distinguish from fiscal support, what do you think the consequences of that might be?

Dr Mohamed El-Erian: Ideally, Lord King, fiscal policy and structural reforms would be the drivers of macroeconomic policy for the next stage. Macroprudential policies would be strengthened, and that would allow central banks to gradually and carefully exit from that policy paradigm. That is the goal, but it requires four different policy instruments to be co-ordinated. It requires openness to mid-course correction because, to use your phrase, Lord King, we are going through a radically uncertain time. That is your idea.

It is a very difficult transition. I cannot stress enough how difficult this transition is. If we fail to make the transition, there are three risks. One is market accidents. Two near accidents in the United States in the last five weeks were avoided by endogenous adjustments in the marketplace. The message should be clear that there has been a lot of risk-taking—I would call it irresponsible risk-taking—on the basis that the Federal Reserve is there to minimise any financial volatility. The first risk would be a market accident that spills back into the economy.

The second risk is inflation. We find that the price increase in this year—I distinguish this from a longer-term process of inflation—proves to be well above the targets of central banks. While both economists and central banks will rush to tell everybody that it is not inflation but a once and for all price adjustment because of mismatch between the responsiveness of demand and supply, the market will not listen. We have already seen what happens when the market tries to price in higher inflation; it tends to have consequences that could spill back on to the economy. That is the second risk if you do not get it right.

The third risk is that we worsen something that we should all be concerned about, which I call the inequality trifecta: the inadvertent worsening of the inequality of income, wealth and opportunity if the transition does not go smoothly. Those are the risks. I think they are risks that can be mitigated by very close policy co-ordination, but they are material risks for the period ahead.

Rupert Harrison: I think most central bankers would welcome fiscal stimulus in the short term, and that is certainly what we are going to get in the US. If the fiscal stimulus was large enough to result in very rapid growth and a closing of the output gap, and if that were to generate sustained sources of inflation, the normal response you would expect is that central banks would, probably quite gratefully, start to exit stimulative policy. That is unlikely. We need to reassess our whole toolkit.

Fiscal policy is extremely badly suited generally to stabilisation policy, because the kind of fiscal policy that we all want to see, which is well-targeted investment in infrastructure and other productive investments, takes a very long time and cannot be turned off and on very quickly. Also, for fiscal policy to be stimulative over more than one year, it has to be continually bigger. Deficits have to continue increasing. If you give everyone a cheque for £1,000 this year to support the economy, and if you carry on giving them a £1,000 cheque next year, that is not a further impetus to growth; that is just maintaining your fiscal support where it was this year. Fiscal policy is very badly designed for anything other than short-term stimulus around cutting taxes and putting cash in people’s pockets.

I think we have abandoned thinking about deepening the tools of central banks far too soon. A very interesting proposal was published by some colleagues of mine, all former central bankers and former colleagues of yours: Stan Fischer, Philipp Hildebrand, Jean Boivin and Elga Bartsch. They proposed what they call a Standing Emergency Financing Facility, which is explicit monetary financing of fiscal policy but anchored within an inflation-targeting framework. It would be the kind of regime where central banks would say, “Okay, this month we’re going to give the Government this amount of money to spend on short-term stimulus”, and the elected Government would then have the choice of how to pass that through to the economy, through sending people cheques, cutting taxes, fixing holes in the road and so on, things that can get out of the door more quickly. That is a better solution than trying to burden conventional fiscal policy with what is, in effect, likely to be a multiyear stabilisation tool.

What we are all grappling with, ultimately, is the problem of the zero lower bound. We have reached the case where, at the moment, monetary policy as conventionally understood is less and less effective because interest rates are at zero, and QE has side-effects and is probably less effective than changing interest rates used to be. We could go further and give central banks more power and more tools to continue using monetary policy as the principal force of stabilisation if we were willing to countenance explicit monetary financing through very explicit institutional guardrails. I think that would be a much better solution.

Q62            Lord King of Lothbury: QE works in many ways, but one way is that it encourages risk-taking. Do you think that QE has, in practice, led to excessive risk-taking?

Rupert Harrison: I do not think that is immediately obvious. QE has become a well-understood part of central banks’ reaction functions. The market now understands that reaction function, and anticipates that QE will be part of the central bank response to uncertainty and economic downturn, and that is factored into market pricing.

That is a conventional and sensible part of how central bank reaction functions feed through into the economy. Whether it has led to excessive risk-taking comes into micro and macroprudential judgments about the balance sheets of individual institutions and is, therefore, a judgment for regulators and macroprudential supervisors. I do not think it is immediately obvious that QE has led to excessive risk-taking.

Dr Mohamed El-Erian: This is where I may have a difference with Mr Harrison. I think it has led to excessive risk-taking. It speaks to what Michael Mackenzie at the FT called a rational bubble. We are in a bubble, because financial assets are totally decoupled from fundamentals, but it is rational because the marketplace believes that a central bank will always be there.

I do not know about Rupert, but I can tell you that when I was at PIMCO investment decisions covered who would buy after us. If the entity buying after you is a central bank with a printing press in the basement, is a non-commercial participant in markets and not price sensitive, and is ready to use its printing press, it would give confidence to the marketplace to buy. I think that has led to excessive risk-taking.

The Chair: Thank you. I am conscious of time, but Lord Stern wants to come in on this question.

Q63            Lord Stern of Brentford: Thank you very much, Chair. For me, it is at the heart of the sustained recovery. Mohamed and Rupert, thank you both for coming. You have both raised the importance of having the recovery led by investments rather than a consumption boom. That seems to me to be the central challenge that we now face in turning this decade into one that is better than the last, or one that is just as bad or worse.

How do you think that monetary authorities and fiscal authorities can come together as we move out of the monetary policy and switch from support to stimulus? How can that be done in a way that drives investment rather than consumption? I am conscious of time and I know it is a big question, but it seems central.

Dr Mohamed El-Erian: First of all, I completely agree with you. The mistake of the previous emergence from a crisis is that we did not focus enough on investment. We went back to the old financially driven paradigm but with much greater central bank involvement. I do not think, Lord Stern, that central banks can play a primary role in helping the recovery to be focused on investments, but other entities can. What central banks must do is try to avoid shocks as we go forward, because investment decisions price in uncertainty. In a sports analogy, they will help play defence, but they will not be your forward scoring the goals. That will be left to somebody else.

Rupert Harrison: For the sake of brevity, I strongly agree. It is not primarily the responsibility of central banks. Central banks are interested in stabilisation policy and, ultimately, it is structural policy, government spending, tax and other policies that affect how much of that is investment. I strongly agree that a central bank providing a stable reaction function, monetary and macro stability, and reducing uncertainty should be extremely helpful in supporting investment, but that is the limit of it.

The Chair: Thank you for that brief answer.

Q64            Baroness Kingsmill: Good afternoon. My question has been partially answered already by Dr El-Erian, but I want to know about the expectation of market intervention. Markets and Governments expect there to be central bank interventions and therefore act accordingly. The two accidents that you referred to, Dr El-Erian, undoubtedly have arisen from precisely that sort of anticipation and expectation of intervention. Does that, in your view, mean that there is a loss of market discipline, for example, and that there is the risk of a decoupling of the real economy from financial markets?

Dr Mohamed El-Erian: I think that decoupling has occurred already in a major way. It was an original objective of policy to act through the financial asset channel as a means of promoting economic growth. You create conditions for the wealth effect, hoping that people holding assets who feel wealthier will spend more, and that will encourage companies to invest more and higher consumption and investment pull up the economy.

We have learned that that is not a very good way of uniquely running macro policy. In 2010, when Ben Bernanke led the pivot of QE from normalising markets to pursuing broad economic objectives, he stressed that it was about benefits, costs and risks. The major risk is that you decouple financial markets and create an unhealthy co-dependency. There is always co-dependency between financial markets and central banks, but the question is whether it is healthy or unhealthy. In my view, it has become unhealthy.

Not only do markets expect central banks to come in and repress any volatility, regardless of the source of that volatility, but they require it. They feel entitled to central bank support. That is particularly true for the Fed and the eurozone. I can cite example after example of where central banks have had to do a 180 in response to market reactions. Most recently, when Madame Lagarde, whom I regard very highly, came in and said that the ECB was not in the business of supporting risk spreads in Italy, she had to do a U-turn on that very quickly when the markets said, “Yes, you are”.

That leads me to the last issue. Is there excessive risk-taking? I can name you example after example, from celebrity SPACs—celebrities selling blank cheques investment vehicles who say, “Give me your money and I will invest it in the way I think is right. Believe me, even though everybody else is doing the same thing, I will be able to return your money at some point. Im going to give you a guaranteed return in the process of that”—to what is happening in the meme stocks. I can cite you example after example of where I believe that there has been too much risk-taking.

Baroness Kingsmill: It is becoming institutionalised in itself. It has become an expectation that any crisis that arises will be dealt with by a monetary policy and, therefore, as you say, risk-taking can become excessive because people expect there to be a safety net.

Dr Mohamed El-Erian: That is my assessment.

Rupert Harrison: I slightly disagree. It is obvious that we have had cycles in risk-taking and bubbles throughout history, long before we had quantitative easing, and long before we even had central banks. It is a feature of financial markets and human emotions. It is not a creation of QE. I agree that you can, at any time, always point to elements of market pricing that you might think were excessive or not.

There are two points. First, is there a decoupling between financial conditions and the real economy? I do not think that is obvious at all. I certainly do not think that central banks are the main reason for low equilibrium interest rates around the world. The main reason for that is structural; it is demographics and a very large structural demand for income-generating assets and safe stores of value. The fact is that most emerging markets are unable to create safe stores of value, so the enormous amount of money coming out of those markets generally seeks developed market assets to buy. It is also a function of the declining cost of capital goods.

Those are all reasons why we have low equilibrium interest rates around the world. I think people slightly overegg the ability of central banks to manipulate equilibrium interest rates. Therefore, the discount rates that underpin valuation models for other assets, such as equities, are not really controlled ultimately by central banks. They affect them momentarily, and they can push them away from an equilibrium position for a while as part of stabilisation policy, but not over decades. It is a structural issue. It is not the result of central banking.

Finally, markets anticipating central bank responses are a feature and not a glitch of the design of stabilisation policy. Stabilisation policy works because central banks have a well-understood reaction function. Market participants know what that reaction function is going to be, and that encourages market participants to invest and spend in the way the central banks hope they will in order to deliver stability.

When you get into the question of whether that is producing distortions, moral hazard or limiting the ability of markets to correctly price risk, there are far more micro issues about specific markets. The right solution there is for regulators and supervisors to look at individual balance sheets and sources of risk to see whether they are sources of concern.

Baroness Kingsmill: You mean that the central bankers are sending out signals in advance of any actual action. It is a case not of market anticipation, but of the Bank taking the lead.

Rupert Harrison: It is a core function of monetary policy. You always want a central bank to say, “This is my reaction function. If the economy turns down and we get lower growth, I will respond”. In the past, it was through lower interest rates; now it is through things like QE. Having the market and business understanding the central bank’s reaction function is a core way in which monetary policy can be effective. That is what I mean when I say it is a feature, not a glitch.

Baroness Kingsmill: Yes. It is the other side of the coin, if you see what I mean, of anticipating and therefore taking risks.

Rupert Harrison: Yes. It can be very effective. It can lead to policy being more effective without policy even having to be taken. If people understand that the policy will be taken, maybe it never needs to be taken.

Baroness Kingsmill: Thank you.

Q65            Baroness Kramer: For the sake of time, I will direct my question to Dr El-Erian. Mr Harrison, please leap in only if you think there is something you really need to add, change, adjust or correct.

You said very recently, Dr El-Erian, that central banks are approaching what you called a “no-exit paradigm”. I have to admit that rather chilled me. What does it mean for the future of QE, and what action should central banks be taking, obviously with reference to the Bank of England?

Could you also talk about any need for co-ordination among the central banks, and whether that is a prerequisite? You talked about small differences between the behaviour of central banks having a very significant impact.

Dr Mohamed El-Erian: The risk of a no-exit paradigm is most acute for the European Central Bank, then the Federal Reserve and then the ECB. It is important that we note the differences between central banks.

Baroness Kramer: When you said the European Central Bank, the Federal Reserve and then the ECB, did you mean the Bank of England?

Dr Mohamed El-Erian: The Bank of England. My apologies, Baroness. The reason why is the required hand-off. It has a fiscal element, it has a monetary element, and it has a macro potential element. Co-ordinating the policy hand-off is very tricky. It is extremely tricky in the eurozone, for reasons that we all know. It is somewhat tricky in the US, and it is less tricky in the UK because of the amount of co-ordination that goes on.

This hand-off is not in the hands of the Fed and the ECB. The Fed and the ECB are dependent on others, so they cannot deliver that hand-off in policy. If you cannot do so, imagine where the ECB or the Fed will be. They cannot exit on their own because, if they try to exit on your own, they risk creating a financial crisis. Yet doing more has fewer benefits and lots more costs and risks.

My first job was at the International Monetary Fund, which is thought of as a multilateral central bank. The first thing I was told is, “We are in the business of solving crises, not creating them”. No central bank will willingly exit the policy paradigm unless it has relatively high assurance of the policy hand-off. The risk is that if that hand-off does not happen, particularly in the eurozone and in the United States, the central banks will be stuck in that paradigm for way too long, and the effectiveness of the paradigm will decline even more.

Baroness Kramer: Could I pick you up on that? You are basically saying, if I understand it, that the Bank of England has the most flexibility because of its ability to hand off the Treasury. Is it also chained to the ECB and the Fed, or can it act independently of them, or will it tip the global system in such a way that all three have to function, effectively, together?

Dr Mohamed El-Erian: That is a really important distinction. Thank you for bringing it up, Baroness Kramer. In a perfect world, we would have good policy co-ordination not just among central banks but beyond that. The reality for the UK is that it has more flexibility on its QE, and it faces less risk of no exit. However, it is in economic terms an open economy with vibrant financial markets, and therefore it imports the financial conditions of the rest of the world. In particular, it imports financial conditions influenced by two systemically important central banks, the Fed and the ECB. If the Fed and the ECB were not to deliver the hand-off that we all require, the policy challenge in the UK would be higher than it would be otherwise. 

The Chair: Rupert, do you want to comment?

Rupert Harrison: No. Essentially, I agree with all of that. The chances of exit will be much improved through greater policy co-ordination and a greater policy toolkit. We are artificially restricting the toolkit of central banks. We could allow them to do much more.

Q66            Lord Monks: Mr Harrison, when you were George Osborne’s adviser, which I think was prior to the appointment of Mark Carney as Governor, you explored changing the Bank of England’s mandate away from the focus on prices and inflation and towards growth and employment targets. The then Chancellor was looking to the Bank to take responsibility for growth while he was maintaining significant retrenchment on the fiscal side. Do you think it is appropriate at the moment to be looking at the mandate? Should we be bringing it on to the table for debate at the current time?

Rupert Harrison: That is a very good question. It might be quite a timely moment to do that. There were several reasons why we did quite a broad review of the Bank’s mandate in 2013. First, it is sensible, and a lot of countries now do this, to review central bank mandates on a regular basis. It had not been done in any deep sense since the Bank was made independent in 1997. Over that period, there had been considerable developments in the academic literature on average inflation targeting, price level targeting, nominal GDP targeting, et cetera. There had also been, as we know, rapid innovations in policy during the financial crisis, including QE and other sorts of extraordinary interventions. A new Governor was coming later that year, who had himself been at the forefront of many of those innovations in Canada, particularly forward guidance.

Finally, there was a short-term reason, which was that we, in the Treasury, were trying to communicate to market participants and to business that the UK was very focused on ensuring that monetary policy stimulus was effective in delivering a strong recovery as we recovered from the impact of the eurozone sovereign debt crisis, which had ended half way through 2012.

Part of the review, as you say, considered whether the mandate needed to be broadened to include an employment aspect, as the Fed has—some kind of dual mandate. In the end, we concluded that the Bank had enough flexibility within a pure inflation-targeting regime to be able to do what we felt the Bank should be doing, and what the Bank itself wanted to be able to do. There was enough flexibility, without needing a separate employment-based mandate or a growth focus, to do things like forward guidance and things that were already up and running under Lord King, such as the Funding for Lending scheme, and there was no need for anything more radical. We thought at the time that things like average inflation targeting or nominal GDP targeting had not been tried anywhere else, were quite risky and brought with them significant communication challenges. We did not want to go that far.

The particular reason why it might now be worth revisiting the mandate and thinking about an employment aspect to it comes back to the point I made about the new Federal Reserve monetary policy framework. The Fed has done two things. It has exclusively now adopted a make-up strategy, so that it will want a period of below-target inflation to be followed by a period of above-target inflation, so it is explicitly targeting average inflation. It has also, equally importantly, effectively abandoned any attempt to use a Phillips curve relationship to anticipate future changes in inflation on the basis of a tight labour market.

That is on the back of empirical evidence from the last cycle. We had a very long cycle with, on the face of it, a very tight labour market in many countries, including the US, without much effect on inflation. Trying to forecast inflation using the labour market is increasingly difficult. There may be lots of reasons for that, including global influences on inflation, which mean that that relationship is less reliable than in the past. That now means that at the Fed they will tighten policy in the recovery only when they actually see the whites of the eyes of inflation. They have communicated very clearly that they want inflation to be above target for some time before they will even think about tightening policy.

We now have a much more dovish framework in the US. That is dramatically important for the global economy, for all other central banks and for financial markets. It is a much more dovish framework than we had before. The relevance to the UK is, first, are we going to do something similar? Ultimately, the review was brought about because of concerns that we all share about the proximity to the zero lower bound on interest rates and the reduced effectiveness of monetary policy. Things such as average inflation targeting should, in theory, allow you to make monetary policy more effective when you are near the zero lower band and reduce the chances of becoming constrained. You want some entrenched inflation back in the economy in order deliberately to try to raise inflation expectations and make your life easier in future. That is a debate we should be having in the UK. All central banks need to have a debate about whether they are going to follow the Fed.

As to the relevance of the target, in theory, you could justify all of that within a pure inflation targeting framework. You could say, “The benefits of average inflation targeting stand by themselves. This is how we are going to interpret an inflation mandate”. You could probably do it at present. You might want to acknowledge it formally in a mandate, but the Bank of England could probably do it right now within its existing mandate. It could say, “We choose to interpret our inflation target as being an average inflation target”. You could abandon the Phillips curve and say that you are going to stop trying to anticipate rises in inflation and wait for it to happen, again without an appeal to anything other than empirical evidence on the ability to forecast inflation.

However, in some of the more aggressive aspects of what the Federal Reserve and members of the FOMC have said about justifying the new framework, they have used the employment aspect of their mandate as part of the justification, particularly in some of the statements the Fed makes about the benefits of running the economy hot and running the economy as hot as possible, and the benefits particularly for marginalised groups in the economy. A lot of that would be more difficult for a central bank that did not have an employment aspect to its mandate. That makes it easier for FOMC members to talk about it and for the Fed staff to think about it.

From the point of view of a UK policymaker, you need a risk-management framework. We are not the United States. We do not have the dollar. It is a bit riskier for a central bank like the UK’s to abandon a pure inflation-targeting framework. There is a risk that markets might misinterpret what you were doing. You could see that reflected in risk premia in gilts or in a weaker currency if you got it wrong. There is always a risk associated with any change like that, but it has certainly been made easier by what the Fed has done.

Another element is that this is clearly still very new, as I think the Federal Reserve would acknowledge. We have not yet seen the Fed’s new framework tested through a cycle, so we do not know how it will turn out. You could justify waiting to see how it goes.

At present, I would probably come down on the side of saying that you can probably do everything you need to do at present within a pure inflation-targeting mandate. I certainly think that all these innovations make that debate perfectly legitimate, and probably a good one to have right now.

The Chair: Lord Bridges, I think you want to come in on the inflation point.

Q67            Lord Bridges of Headley: Yes. Thank you, Chair. Mohamed El-Erian, how great a risk do you reckon a sustainedI stress the word “sustained”—uptick in inflation is? We have heard from other witnesses, such as Tim Congdon and Liam Halligan, who say that this phase of QE, unlike previous phases of QE, given what has happened during Covid, is likely to lead to a rise in inflation. Do you agree? Do you think it will be sustained, and what will the consequences be?

Dr Mohamed El-Erian: I think there will be a rise in measured inflation, but I do not believe it will be sustained.

The Chair: That was a commendably short answer. Rupert Harrison.

Rupert Harrison: I agree.

The Chair: Do you want to come back, Lord Bridges?

Lord Bridges of Headley: No. They were wonderfully short answers. That is great. Thank you.

The Chair: I thank both our witnesses. It has been an absolutely fascinating session and very helpful. We are very grateful to you for giving us your time and for answering our questions so effectively and precisely. Thank you very much. You are very welcome to stay, if you wish, to hear our next witness.