Two Clocks in Stockholm

This year’s economics laureates explain why a central bank’s words matter as much as its rates. Israel is about to find out how much.

Robert Hall has spent much of his working life telling Americans when their recessions began. For 46 years he chaired the committee at the National Bureau of Economic Research that dates the turns of the American business cycle, and its verdicts famously arrive late. The recession that began in December 2007 was not declared until December 2008, by which time Lehman Brothers was already gone. The committee he led keeps the clock that looks backwards.

Michael Woodford keeps the other one. His life’s work argues that the most powerful thing a central bank does is not what it does today but what it persuades people it will do tomorrow. On Monday the Royal Swedish Academy of Sciences gave the two men the economics prize together, for the microeconomic foundations of macroeconomic stabilisation.

The pairing is more elegant than it looks. In a 1978 paper, Hall showed that if households spend according to what they expect to earn over their lifetimes, then changes in their spending should be almost impossible to forecast. Only news moves them. If spending follows expectations, then expectations are where policy must work. In 1982, with Frederic Mishkin, Hall estimated that roughly four households in five behave this way, while the rest live hand to mouth.

Woodford built a cathedral on that foundation. His 2003 book, Interest and Prices, borrowed its title from Knut Wicksell’s study of 1898 and showed that firms set prices by looking ahead at their costs, their rivals and, above all, the path of interest rates. A central bank that merely moves its rate this month is pulling a lever attached to very little. A central bank that convinces firms and families where rates are heading has its hand on the whole machine. Hence forward guidance, and hence the long, careful statements that now follow every rate meeting. Woodford’s paper at Jackson Hole in 2012, delivered when rates were stuck near zero, made the case for forward guidance just as the Federal Reserve was moving towards explicit promises about how long they would stay there.

The Nobel committee said the laureates had helped smooth out the economy’s peaks and troughs. It also noted that Woodford’s framework tells a central bank facing an energy shock to lean against inflation rather than accommodate it, which was the great mistake of the 1970s. That is not an academic point this year. The energy shock that followed the American and Israeli strikes on Iran in February showed how quickly a war in the Gulf reaches the price of bread in Ramat Gan.

Here is the irony the committee left unspoken. Kevin Warsh, the new chair of the Federal Reserve, has argued that forward guidance went too far, and he is trying to make the Fed say less. His case is not foolish: a central bank that promises too much loses room to change its mind. But Woodford never argued that central bankers should simply talk more. His point was that silence is also a message. Firms will form expectations about rates whatever the central bank says; the only question is whether the bank shapes them or leaves the guessing to traders.

Israel offers an unusually clean test, because its central bank has long been run by people steeped in exactly these questions. Stanley Fischer, who had supervised Ben Bernanke’s doctoral thesis at MIT, rebuilt the Bank of Israel’s decision making around a monetary committee created by law in 2010, with published minutes recording how the vote split, though not who voted which way. His successor but one, Amir Yaron, came from Wharton, where his best known work with Ravi Bansal belongs to the same family of consumption reasoning that Hall helped found. The 2004 paper even thanks “Bob Hall” among the economists who commented on it. Its argument is that investors fear not only bad years but long stretches of slower growth, and they price that fear into everything they own.

That machinery is now being tested by everything at once. The Bank of Israel has cut its rate repeatedly since last November, to 3.5 per cent by the summer, as inflation settled within its target. In August, Yaron signalled that the next decision would rest on real time data because uncertainty had risen, with the labour market, inflation, geopolitics and the public finances all pulling in different directions. He has also warned that whoever forms the next government will inherit a difficult debt trajectory and a defence budget enlarged by war.

Notice what he was doing. Even a promise to decide meeting by meeting is guidance. It tells firms and borrowers not to bank on cuts. The Warsh school calls that restraint. The Woodford school would call it the same instrument, played quietly.

This is where Israel’s experience matters to everyone else. A small open economy at war cannot afford a central bank whose words are cheap. The shekel, the risk premium on Israeli bonds and the mortgage payments of families in Beersheba all depend on whether people believe the Bank of Israel will do what it says, whoever sits in the Finance Ministry after the election on 27 October. Credibility is the one asset a central bank cannot print, and it is the asset Woodford’s models quietly assume. Hall supplies the sober footnote. Because spending responds to news rather than forecasts, a central bank that squanders its credibility will discover the damage only after it is done, and the statisticians will confirm it a year later.

Stockholm also passed over a third timekeeper. Adrian Pagan, the Australian econometrician who sat on his country’s central bank board in the late 1990s, spent two decades with Don Harding turning the American committee’s slow judgement into a transparent rule that any country can apply. Their awkward finding was that much of the cycle’s shape follows simply from the economy’s average growth rate and how much it wobbles, a humbling test for elaborate models, Woodford’s included. A clock is only as good as the ruler it is checked against.

That is the real lesson of honouring these two men together. One clock tells us where we have been, slowly and reliably. The other tries to tell us where we are going, and works only if people believe it. Central banks need both, and the temptation in hard times is to trust only the first.

In December the laureates will collect their medals in Stockholm. The room where the next recession will be decided will not be there, nor in Washington, nor in Jerusalem. It is spread across millions of kitchen tables where households weigh whether to spend or to save. Nobody chairs that room. Everybody votes in it.