Tuesday, 20 March 2012

The worst policy prescription

Former MPC member Andrew Sentance, has an article in the FT today in which he recommends a 'leaning against the wind' policy of raising interest rates to curb that inflation whose underlying cause is an excess of demand for energy over the available supply. This is the worst advice imaginable and seems to be driven by (a) considering this as purely a problem of excess demand; (b) the assumption that interest rate policy has no impact upon long run supply (so that central banks can concentrate solely upon managing inflation expectations).

However, the world's oil supply has stagnated with essentially zero growth in supply since 2005. Alternatives are difficult and so we can expect an extended period with little energy supply growth. It's facile to state, as Sentance does, that the inflation is "responsible for the slowdown in global growth". This gets causality backwards: to first order, growth in output is only possible with growth in energy inputs. With constant energy inputs, we cannot expect growth in output, so strengthening demand has to lead to higher prices rather than expanded output. The supply restrictions have caused the growth shortfall and the rise in prices, rather than the rise in prices causing the growth shortfall.

If energy supply stagnation leads to higher prices, how should we respond? I would recommend whatever policy response leads to fossil fuel substitutes being incentivised as quickly as possible. Sentance's prescription is higher rates - does this work? Higher rates depress demand, lowering energy prices and hence lowering incentives to invest in fossil fuel alternatives. Higher rates provide a higher yield on alternative investments to new energy infrastructure projects, raising the hurdle rate that these projects must achieve, lowering the incentive to invest in fossil fuel alternatives.

Sentance has it backwards: raising rates may well be the appropriate response to inflation caused by domestically generated wage-price spirals, but it is completely the opposite response to that required to the problem of global energy supply stagnation. The fact that we are running into supply constraints needs to be strongly signalled through the price mechanism so that there are incentives to invest in mitigating technologies. Interest rate rises are a demand depressing response to energy supply constraints. Since energy supply constraints will get worse over time if we do not develop alternatives, a policy which causes a contraction in demand rather than stimulating an alternative supply is a prescription for long term decline.

1 comment:

  1. I agree than Sentance's position is odd, and that we should not fight against commodity price rises by squeezing the rest of the economy to hold inflation down.

    But perhaps you go to far in the other direction.

    First, note that world oil supply hasn't been totally stagnant since 2005--the IEA has it rising by 6.5% from 2005 to the end of last year:

    2005 Q1 daily production: 84.1 mmb/d

    2011 Q4 avg daily production: 89.6 mmb/d

    Second, oil is the input in tightest supply, so the fact that it is growing slowly need not hold back the whole world economy to the extent that we can substitute for it and/or economise on it.

    By all means we should let the price rise, and we shouldn't expect too strong a supply-side response because it will be challenging to extract more, but it doesn't seem unreasonable to expect some increased supply, as we've seen already.