The Bank of England bases its forecasts on conventional models. But when it comes to monetary policy, there are many approaches it should explore instead – particularly the narrative one, writes Paul Ormerod
The Bank of England’s handling of inflation has been met with increasing levels of criticism. Despite its suite of academically fashionable mathematical and econometric models, the Bank seems to be acting in a daze, unable to comprehend what is going on.
A paper just published in the American Economic Review advocates an alternative way of understanding monetary policy and its impacts on the economy. The article in question has more standing than most. It is the Presidential address to the American Economic Association at their annual conference held earlier in the year.
Christina Romer of the University of California at Berkeley gave the address as President, and the paper is written with her husband David.
The paper is unusual for a top economics journal because it mainly consists of words. There are a few charts and statistical relationships, but the essence of the paper is in the title: “Does Monetary Policy Matter? The Narrative Approach after 35 Years”.
The question is very pertinent because the Federal Reserve doesn’t appear to attach much importance to the quantity of money – like both the Bank of England and the European Central Bank.
The 35 years refers to a paper the two economists published in the late 1980s advocating an approach to macroeconomic analysis based on a thoughtful reading of text rather than using abstruse maths.
In the Presidential address, they offer a post-war monetary history of the United States to identify significant contractionary and expansionary changes in monetary policy.
The narrative approach is an empirical technique which gathers systematic evidence from contemporaneous qualitative sources such as newspapers, government reports, and policy meeting transcripts, and incorporates it into statistical analysis.
The Romers conclude that monetary policy is indeed important. Monetary shocks have large effects on unemployment, output, and inflation.
Intriguingly, they argue that an analysis of available policy records suggests a contractionary monetary shock likely occurred in the United States in 2022. Based on the empirical estimates of the effect of previous shocks, they expect substantial negative impacts on real GDP and inflation as we move through 2023 and into 2024.
This is exactly what prominent monetary economists such as Tim Congdon here have been arguing. A sharp monetary contraction has been experienced in the US, the UK and the EU, and a recession is therefore expected.
The narrative approach is one which should be investigated more thoroughly. With UCL colleagues David Tuckett and Rickard Nyman, I published a paper in 2018 entitled “News and narratives in financial systems: exploiting big data for systemic risk assessment”. The piece actually appeared as a Bank of England Working Paper, Nyman having spent some time at the Bank on secondment when Andy Haldane was Chief Economist.
Haldane appreciated that a wide range of approaches should be explored to get a better understanding of how the economy as a whole behaves. In addition to narratives, he encouraged work on, for example, networks and agent based models.
None of these will prove to be a panacea. Indeed, the Romers stress that this applies to their own narrative methodology. But the Bank has hardly been so successful that it can afford to ignore alternatives to their own conventional models which have proved to be so inadequate.