The stock market has reached “a permanently high plateau” (if the Fed does not mess up again…)

Last week I wrote a post criticizing Fed chair Janet Yellen for apparently becoming a stock picker. Later later in the week she spoke before the US House Financial Services Committee in Washington she seemed to tone down a bit her “stock picking” comments, but she nonetheless commented on the general valuation of the US stock market.

I am still critical about the idea that the Fed has a view at all on the valuation of the US stock market, but lets for a second forget that and instead address the issue of US stock market valuation. I am certainly no equity analyst and the normal disclaimer applies – this is not investment advice. This is an quasi-academic excise.

Last week Yellen said that in her assessment US asset values “aren’t out of line with norms“. Said in another way – the US stock market is basically fairly valued.

Equity strategists and investors have many different methods to evaluate stock market valuation. An often used method is what has become known as the so-called Fed-model (named by the legendary equity strategist Ed Yardeni).

An alternative Fed-model

The Fed-model basically says that there is a close historical relationship between the so-called earnings yield (the inverse of the P/E ratio) and US Treasury bond yields. While there certainly is good theoretical reason to discuss the model there is no doubt that over time the “model” as fitted the development in the US stock market fairly.

I will here use a slightly altered version of the Fed-model. Instead of using the earning yields I look at the ratio between on the one hand Private consumption expenditure (as a monthly proxy for nominal spending/NGDP) and stock prices (I use the Wilshire 5000 index here). I compare that not with US Treasury yields but instead with the yield on Aaa corporate bonds. I have “calibrated” my “earnings yield”  (PCE/Wilshire5000) so it is in January 1980 was exactly equal to the corporate bond yield. This obviously is an ad hoc assumption, but it ensures that the average “valuation” of the stock markets is more or less zero for the period since 1975.

The graph below shows that there is a quite close historical correlation between the “earnings yield” and the yield on US corporate bonds.

Fed model

We can show basically the same thing by looking at the Wilshire 5000 in level versus what I below call “fundamentals”. “Fundamentals” I here define as the ratio of Private Consumption Expenditure to the corporate bond yield. Also here I have calibrated the “model” so January 1980 is our “starting point”.

Wilshare 5000

Both graphs above illustrate Yellen’s argument that stocks are not overvalued. In fact US stock prices exactly seem to reflect “fundamentals” – at least if we use my version of the Fed-model.

There is no bubble – it is easy to explain what have happened since 2009  

Some central bankers and a lot of internet-Austrians are eager to claim that the development in stock prices since 2009 in some way reflect monetary policy “manipulation” of the stock market. Obviously we cannot understand the development in stock prices without understanding monetary policy, but there is nothing “unnatural” about what have happened and as the graphs above illustrates it doesn’t really look like there is a US stock market bubble.

In fact we can use the Fed-model to explain the development in stock prices fairly well since Wilshire 5000 hit rock bottom in 2009. Since then Private Consumption Expenditure has rebounded and Corporate bond yields have come down. Both factors are obviously bullish for stock prices according to my adjusted Fed-model. Furthermore, stocks became significantly undervalued in 2008-9 and this in fact seems to most important in terms of the stock market valuation.

Looking at the adjusted Fed-model Wilshire 5000 is now basically at “fair value” levels. So going forward we need either to see Private Consumption Expenditure to increase or Corporate bond yields to drop to see further (fundamentally driven) stock market gains.

I should again stress that this is not the work of an equity strategist and I am not providing investment advice here. My only concern is to discuss whether or not we can say that actions from the Federal Reserve have manipulated stock prices in such away that we can say there is a bubble in the US stock market.

 The stock market has reached “a permanently high plateau” - until the Fed once again mess up things…

Famously Irving Fisher shortly before the stock market crashed in 1929 announced that the US stock market had reached “a permanently high plateau”. I might be repeating this mistake by argueing that we are now basically trading at “fair value” levels for the US stock. So let me hedge my position (quite) a bit – unless the Federal Reserve will make another policy mistake then US stocks are at a permanently high plateau. Other central banks like the PBoC or the ECB might also very well mess up things.

And yes monetary policy failure is the biggest risk at the moment as I see it. The US economy is in recovery, stock prices continue to inch up and financial market volatility is low.

Why? Exactly because monetary policy in the US in general has returned to what Bob Hetzel has called a Lean-Against-the-Wind with credibility-regime. While Fed policy is far from perfect we broadly-speaking can say the Fed has returned to a (quasi) rule-based monetary policy where the markets in general are able to predict changes to the monetary policy stance. If anything the Fed is probably expected to deliver 4% nominal GDP growth - and this is exactly what the Fed has done in recent years.

However, if the Fed for some reason where to change cause (or change the implicit target) for example because it is becoming preoccupied with asset prices as in 1928-29 we could see the Fed trigger a negative shock to the US economy and that surely would send the US stock market down.

The Fed should certainly not worry about stock market valuation, but if it delivers a stable and predictable monetary policy regime then it will also create the best environment for a stable development in stock markets. In fact a predictable and strictly rule based monetary policy would make it extremely boring to be an equity strategist…

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Stock picker Janet Yellen

If you are looking for a new stock broker look no further! This is Fed chair Janet Yellen at her testimony in the US Senate yesterday:

“Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

This is quite unusual to say the least that the head of most powerful central bank in the world basically is telling investors what stocks to buy and sell.

Unfortunately it seems to part of a growing tendency among central bankers globally to be obsessing about “financial stability” and “bubbles”, while at the same time increasingly pushing their primary nominal targets in the background. In Sweden an obsession about household debt and property prices has caused the Riksbank to consistently undershot its inflation target. Should we now start to think that the Fed will introduce the valuation of biotech and social media stocks in its reaction function? Will the Fed tighten monetary policy if Facebook stock rises “too much”? What is Fed’s “price target” in Linkedin?

I believe this is part of a very unfortunate trend among central bankers around the world to talk about monetary policy in terms of “trade-offs”. As I have argued in a recent post in the 1970s inflation expectations became un-anchored exactly because central bankers refused to take responsibility for providing a nominal anchor and the excuse was that there are trade-offs in monetary policy – “yes, we can reduce inflation, but that will cause unemployment to increase”.

Today the excuse for not providing a nominal anchor is not unemployment, but rather the perceived risk of “bubbles” (apparently in biotech and social media stocks!)  The result is that inflation expectations again are becoming un-anchored – this time the result, however, is not excessively high inflation, but rather deflation. The impact on the economy is, however, the same as the failure to provide a nominal anchor will make the working of the price system less efficient and therefore cause a general welfare lose.

I am not arguing that there is not misallocation of credit and capital. I am just stating that it is not a task for central banks to deal with these problems. In think that moral hazard problems have grown significantly since 2008 – particularly in Europe. Therefore governments and international organisations like the EU and IMF need to reduce implicit and explicit guarantees and subsidies to (other) governments, banks and financial institutions to a minimum. And central banks should give up credit policies and focus 100% on monetary policy and on providing a nominal anchor for the economy and leave the price mechanism to allocate resources in the economy.

Never reason from a price change – version #436552

This is ECB’s chief economist Peter Praet in an interview with Les Echos:

 “Normally, a fall in prices would be able to support purchasing power and, therefore, domestic demand. But demand has remained weak, including in the biggest euro area economies”

It seems like Praet is not entirely sure about the difference between supply and demand shocks, but let me just illustrate the dffference in two graphs (I don’t have much time so I did it by hand and with the help of an iPhone…)

ASAD

The European situation is the graph on the right.

The un-anchoring of inflation expectations – 1970s style monetary policy, but now with deflation

In country after country it is now becoming clear that we are heading for outright deflation. This is particularly the case in Europe – both inside and outside the euro area – where most central banks are failing to keep inflation close to their own announced inflation targets.

What we are basically seeing is an un-anchoring of inflation expectations. What is happening in my view is that central bankers are failing to take responsibility for inflation and in a broader sense for the development in nominal spending. Central bankers simply are refusing to provide an nominal anchor for the economy.

To understand this process and to understand what has gone wrong I think it is useful to compare the situation in two distinctly different periods - the Great Inflation (1970s and earlier 1980s) and the Great Moderation (from the mid-1980s to 2007/8).

The Great Inflation – “Blame somebody else for inflation”

Monetary developments were quite similar across countries in the Western world during the 1970s. What probably best describes monetary policy in this period is that central banks in general did not take responsibility for the development in inflation and in nominal spending – maybe with the exception of the Bundesbank and the Swiss National Bank.

In Milton Friedman’s wonderful TV series Free to Choose from 1980 he discusses how central bankers were blaming everybody else than themselves for inflation (see here)

As Friedman points out labour unions, oil prices (the OPEC) and taxes were said to have caused inflation to have risen. That led central bankers like then Fed chairman Arthur Burns to argue that to reduce inflation it was necessary to introduce price and wage controls.

Friedman of course rightly argued that the only way to curb inflation was to reduce central bank money creation, but in the 1970s most central bankers had lost faith in the fundamental truth of the quantity theory of money.

Said in another way central bankers in the 1970s simply refused to take responsibility for the development in nominal spending and therefore for inflation. As a consequence inflation expectations became un-anchored as the central banks did not provide an nominal anchor. The result was predictable (for any monetarist) – the price level driffed aimlessly, inflation increased, became highly volatile and unpredictable.

Another thing which was characteristic about monetary policy in 1970s was the focus on trade-offs – particularly the Phillips curve relationship that there was a trade-off between inflation and unemployment (even in the long run). Hence, central bankers used high unemployment – caused by supply side factors – as an excuse not to curb money creation and hence inflation. We will see below that central bankers today find similar excuses useful when they refuse to take responsibility for ensuring nominal stability.

The Great Moderation – “Inflation is always and everywhere monetary phenomenon” 

That all started to change as Milton Friedman’s monetarist counterrevolution started to gain influence during the 1970s and in 1979 the newly appointed Federal Reserve chairman Paul Volcker started what would become a global trend towards central banks again taking responsibility for providing nominal stability and in the early 1990s central banks around the world moved to implement clearly defined nominal policy rules – mostly in the form of inflation targets (mostly around 2%) starting with the Reserve Bank of  New Zealand in 1990.

Said in the other way from the mid-1980s or so central banks started to believe in Milton Friedman’s dictum that “Inflation is always and everywhere monetary phenomenon” and more importantly they started to act as if they believed in this dictum. The result was predictable – inflation came down dramatically and became a lot more predictable and nominal spending/NGDP growth became stable.

By taking responsibility for nominal stability central banks around the world had created an nominal anchor, which ensured that the price mechanism in general could ensure an efficient allocation of resources. This was the great success of the Great Moderation period.

The only problem was that few central bankers understood why and how this was working. Robert Hetzel obvious was and still is a notable exception and he is telling us that reason we got nominal stability is exactly because central banks took responsibility for providing a nominal anchor.

That unfortunately ended suddenly in 2008.

The Great Recession – back to the bad habits of the 1970s

If we compare the conduct of monetary policy around the world over the past 5-6 years with the Great Inflation and Great Moderation periods I think it is very clear that we to a large extent has returned to the bad habits of the 1970s. That particularly is the case in Europe, while there are signs that monetary policy in the US, the UK and Japan is gradually moving back to practices similar to the Great Moderation period.

So what are the similarities with the 1970s?

1) Central banks refuse to acknowledge inflation (and NGDP growth) is a monetary phenomenon.

2) Central banks are concerned about trade-offs and have multiple targets (often none-monetary) rather focusing on one nominal target. 

Regarding 1) We have again and again heard central bankers say that they are “out of ammunition” and that they cannot ease monetary policy because interest rates are at zero – hence they are indirectly saying that they cannot control nominal spending growth, the money supply and the price level. Again and again we have heard ECB officials say that the monetary transmission mechanism is “broken”.

Regarding 2) Since 2008 central banks around the world have de facto given up on their inflation targets. In Europe for now nearly two years inflation has undershot the inflation targets of the ECB, the Riksbank, the Polish central bank, the Czech central bank and the Swiss National Bank etc.

And to make matters worse these central banks quite openly acknowledge that they don’t care much about the fact that they are not fulfilling their own stated inflation targets. Why? Because they are concerning themselves with other new (ad hoc!) targets – such as the development in asset prices or household debt.

The Swedish Riksbank is an example of this. Under the leadership of Riksbank governor the Stefan Ingves the Riksbank has de facto given up its inflation targeting regime and is now targeting everything from inflation, credit growth, property prices and household debt. This is completely ad hoc as the Riksbank has not even bothered to tell anybody what weight to put on these different targets.

It is therefore no surprise that the markets no longer see the Riksbank’s official 2% inflation target as credible. Hence, market expectations for Swedish inflation is consistency running below 2%. In 1970s the Riksbank failed because it effectively was preoccupied with hitting an unemployment target. Today the Riksbank is failing – for the same reason: It is trying to hit another other non-monetary target – the level of household debt.

European central bankers in the same way as in the 1970s no longer seem to understand or acknowledge that they have full control of nominal spending growth and therefore inflation and as a consequence they de facto have given up providing a nominal anchor for the economy. The result is that we are seeing a gradual un-anchoring of inflation expectations in Europe and this I believe is the reason that we are likely to see deflation becoming the “normal” state of affairs in Europe unless fundamental policy change is implemented.

Every time we get a new minor or larger negative shock to the European economy – banking crisis in Portugal or fiscal and political mess in France – we will just sink even deeper into deflation and since there is nominal anchor nothing will ensure that we get out of the deflationary trap. This is of course the “Japanese scenario” where the Bank of Japan for nearly two decade refused to take responsibility for providing an nominal anchor.

And as we continue to see a gradual unchoring of inflation expectations it is also clear that the economic system is becomimg increasingly dysfunctional and the price system will work less and less efficiently – exactly as in the 1970s. The only difference is really that while the problem in 1970s was excessively high inflation the problem today is deflation. But the reason is the same – central banks refusal to take responsibility for providing a nominal anchor.

Shock therapy is needed to re-anchor inflation expectations

The Great Inflation came to an end when central banks around the world finally took responsibility for providing a nominal anchor for the economy through a rule based monetary policy based on the fact that the central bank is in full control of nominal spending growth in the economy. To do that ‘shock therapy’ was needed.

For example example the Federal Reserve starting in 1979-82 fundamentally changed its policy and communication about its policy. It took responsibility for providing nominal stability. That re-anchored inflation expectations in the US and started a period of a very high level of nominal stability – stable and predictable growth in nominal spending and inflation.

To get back to a Great Moderation style regime central banks need to be completely clear that they take responsibility for for ensuring nominal stability and that they acknowledge that they have full control of nominal spending growth and as a consequence also the development in inflation. That can be done by introducing a clear nominal targeting – either restating inflation targets or even better introducing a NGDP targeting.

Furthermore, central banks should make it clear that there is no limits on the central bank’s ability to create money and controlling the money base. Finally central banks should permanently make it clear that you can’t have your cake and eat it – central banks can only have one target. It is the Tinbergen rule. There is one instrument – the money base – should the central bank can only hit one target. Doing anything else will end in disaster. 

The Federal Reserve and the Bank of Japan have certainly moved in that direction of providing a nominal anchor in the last couple of years, while most central banks in Europe – including most importantly the ECB – needs a fundamental change of direction in policy to achieve a re-anchoring of inflation expectations and thereby avoiding falling even deeper into the deflationary trap.

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PS This post has been greatly inspired by re-reading a number of papers by Robert Hetzel on the Quantity Theory of Money and how to understand the importance of central bank credibility. In that sense this post is part of my series of “Tribute posts” to Robert Hetzel in connection with his 70 years birthday.

PPS Above I assume that central banks have responsibility for providing a nominal anchor for the economy. After all if a central bank has a monopoly on money creation then the least it can do is to live up to this responsibility. Otherwise it seems pretty hard to argue why there should be any central bank at all.

Hollande’s Danish spectacles – Is France the next trouble spot in the euro zone?

This is from the Telegraph:

François Hollande has been urged to drop his new dark-rimmed Danish designer spectacles for ones “Made in France”, with Gallic makers saying his choice is unpatriotic at a time when the government is promoting home-grown products.

Domestic spectacle makers saw red when they discovered two weeks ago that their Socialist president had exchanged his old French rimless glasses for rectangular, retro Scandinavian ones.

The directors of a company called Roussilhe, near Nantes, western France and employing 35 people, decided to send him a pair of similar specs “but 100 per cent made in France” with a label guaranteeing proof of origin.

The pair came with a letter in which the bosses fretted about the “intense international competition” they faced, the need to “bolster local savoir-faire” and “to retain our jobs after two decades of layoffs”.

“By wearing our glasses, you will become an ambassador of French spectacles around the world,” they wrote.

Mr Hollande, whose office pointed out that the lenses of his current glasses are in fact French and only the frames foreign, reportedly phoned the company no sooner had he read the letter and offered to buy another pair of their sunglasses for the summer on the spot.

A second French company then waded in, with Sabine Begault Vagner from Orleans sending him a “pretty pair of blue and red rectangular glasses”. The Elysée rang her too, saying the president would use them as his spares.

The “spectacle affair” emerged on the day that Arnaud Montebourg, France’s flamboyant economy minister was due to unveil his “roadmap for French economic recovery”, including a plan to create “tamper-proof” secret codes on tags for wine, foie gras and other local products to promote “le Made in France”.

Besides irking French spectacle makers, Mr Hollande’s change in glasses has triggered furious debate among political observers over their symbolism.

Jacques Séguéla, the advertising guru, said the new glasses were “final proof of his reformist coming of age”.

It is rumoured that the Danish Prime Minister recently had a glass of French red wine. There was no public uproar over that in Denmark.

But given this story it is hard not to think why France will not be the next euro zone country to get into (renewed) trouble…

 

 

David Beckworth says goodbye to inflation targeting

David Beckworth just sent me a new paper – Inflation Targeting: A Monetary Policy Regime Whose Time Has Come and Gone – he has written on why it is time to say goodbye to inflation targeting.

Here is the abstract:

Inflation targeting emerged in the early 1990s and soon became the dominant monetary-policy regime. It provided a much-needed nominal anchor that had been missing since the collapse of the Bretton Woods system. Its arrival coincided with a rise in macroeconomic stability for numerous countries, and this led many observ- ers to conclude that it is the best way to do monetary policy. Some studies show, however, that inflation targeting got lucky. It is a monetary regime that has a hard time dealing with large supply shocks, and its arrival occurred during a period when they were small. Since this time, supply shocks have become larger, and inflation targeting has struggled to cope with them. Moreover, the recent crisis suggests it has also has a tough time dealing with large demand shocks, and it may even contribute to financial instability. Inflation targeting, therefore, is not a robust monetary-policy regime, and it needs to be replaced.

David is an extremely clever guy and everything he writes on monetary matters is very interesting and insightful so it would be rather foolish not to read his latest paper. I will start right away – there is after all no World Cup football tonight!

 

 

When forward guidance fails: the Fisher equation and the Swedish paradox

On 3 July the Swedish central bank, Riksbanken, cut its key policy rate by 50bp to 0.25%. Most analysts – and the markets – were taken by surprise by this decision. It was particularly surprising as Riksbanken’s governor Stefan Ingves had been voted down by a majority of Riksbanken’s board.

Most people – including myself – would say that when a central bank cuts it key policy rate more than expected, it is monetary easing, and it seemed that was how the market was interpreting Riksbanken’s move – the Swedish krona weakened significantly and Swedish share prices spiked. However, something was not as it should be – Swedish inflation expectations dropped (!) on the back of the rate decision, e.g. Swedish 2-year breakeven inflation dropped from around 0.85% before the rate decision to around 0.65% after the rate decision. This is a paradox – a Swedish paradox: when you cut rates you get lower inflation expectations. So judging from the inflation expectations Riksbanken had actually tightened monetary conditions rather than eased.

BE inflation expectations Sweden

The Fisher equation and focusing on the wrong target

So what went wrong? The answer in my view is that Riksbanken is focusing on the wrong policy target. Hence, the bank communicates in terms of interest rates rather than inflation expectations. And yes, the interest rates are an intermediate target.

Riksbanken controls the Swedish money base and it can use this to control money market rates – in the short term. However, the so-called Tinbergen rule also tells us that a central bank can only hit one target if it has one instrument.

Therefore, if Riksbanken targets interest rates it cannot at the same time effectively target inflation (expectations). Unless it uses an additional “instrument”, such as credibility. If the market believes that Riksbanken will always adjust monetary parameters to ensure that it hits its 2% inflation target, it will be able to move the money market rate (temporarily) away from the ‘natural’ interest rates.

Hence, if Riksbanken’s inflation target is fully credible, inflation expectations will basically be pegged at 2%. However, if the inflation target is not credible, the story is very different, and as inflation expectations are presently well below 2%, it is very clear that the 2% inflation target is presently not credible and has not been credible for years.

A way to illustrate this is to have a look at the so-called Fisher equation:

(1) i = r + pe

i is the nominal interest rate, r is the real interest rate and pe is inflation expectations. When we talk about money market rates we can also see i as the policy rate.

It follows logically from (1) that if the inflation target is fully credible – that is, if pe is ‘fixed’ – a cut in i will ‘automatically’ lower r. On the other hand, if inflation expectations are not well-anchored, a cut in i might as well reduce pe.

I believe this is exactly what happened in Sweden on the back of Riksbanken’s surprise cut.

Not only is Riksbanken communicating in terms of interest rates (rather than inflation expectations) but it is also communicating in terms of the interest rate path. Hence, Riksbanken is not only announcing rate decisions but it is also communicating about future expected changes in the policy rate.

In that regard it is important that Riksbanken actually lowered its expectations for interest rates in two years even more than it lowered its present key policy rate. In other words, Riksbanken flattened the money market rate curve. So for a given real interest rate Riksbanken is actually indirectly telling the market that it expects inflation expectations to decline even further in the coming two years.

Obviously this is not what Riksbanken meant to say (I hope) but when it chooses to focus on interest rates rather than inflation expectations, this is what the market will focus on as well. Riksbanken’s interest rate focus therefore ‘overruled’ the focus on inflation expectations. In fact, in Riksbanken’s statement there was no reference to the market’s inflation expectations.

Lesson: central banks should focus on the ultimate policy target rather than the intermediate one 

I think the lesson we can learn from thisis that central banks should not focus on intermediate targets – such as interest rates and the interest rate path – but should focus on the ultimate policy goal – in the case of Riksbanken expected inflation.

Imagine that Riksbanken had issued the following statement last week:

‘Inflation expectations are presently well below Riksbanken’s 2% inflation target. This is unsatisfactory and as a consequence the repo rate is now being cut by 0.5 percentage points to 0.25% and Riksbanken is fully committed to introducing further monetary easing if needed to ensure that market expectations will fully reflect its 2% inflation target. If needed the repo rate will be cut further and Riksbanken will actively intervene in the currency markets to ease monetary conditions through the FX channel until inflation expectations are at 2%’.

I think it is pretty clear that such a statement would have caused an immediate jump in (market) inflation expectations to 2%. This would obviously also have caused a significant drop in real interest rates – both as a result of the lower nominal rates AND, more importantly, through higher inflation expectations.

What a difference a few words make…

PS Riksbanken is not alone in terms of these problems. The ECB faces a similar problems, while the Fed and the Bank of Japan are focusing on the ultimate policy goal rather than on intermediate targets. However, during Operation Twist in 2011-12 the Fed was facing Riksbanken-style problems.

PPS In Swedish CPI there is an explicit (mortgage) interest rate component, weighing around 5% of total CPI (and hence, of course, incl when calculating breakeven inflation), implying that shorter breakeven inflation should indeed come down by some 0.3 p.p. if a full pass-through into mortgage rates from the cut. That, however, does not really change the point. The Riksbank is targeting CPI so it is really irrelevant why inflation is too low.

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Related blog posts:

Committed to a failing strategy: low for longer = deflation for longer?
Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call
A scary story: The Zero Lower Bound and exchange rate dynamics

 

India’s fiscal mess

The Economic Times has a depressing story on the state of public finances in India:

…Expecting the fiscal deficit to come in at 4.1% of GDP for the whole of 2014-15 was widely predicted to be unrealistic, but the speed at which the gap between actual numbers and the projected figure has closed has exceeded earlier years. Last year, for instance, the fiscal deficit was around a third of the budgeted amount in the first two months of the year.

Essentially, what the government did was roll over, to the next year, payments which would have ideally come in towards the end of the previous financial year. The petroleum ministry, for instance, saw its expenditure for the first two months of this year coming in at 39% of its annual budget. In the same months of last year, the petroleum ministry had spent virtually nothing. Effectively what the government had done was delay payments of the fuel subsidy to oil companies till 2014-15. This way, it didn’t have to account for the expenditure in the previous year, resulting in a lower deficit. This way, it didn’t have to account for the expenditure in the previous year, resulting in a lower deficit. “The government left a number of expenditures uncovered,” points out Rajiv Kumar, senior fellow at the Centre for Policy Research.

Kumar points to the interesting fact that the fiscal deficit for the month of March last year was actually negative — in other words, the government received more funds into its coffers than was paid out of them for that month. “There was sharp fiscal compression in that month — more so than in earlier years,” he says, alluding to the fact that the government did not spend as much as it usually did.

March is an unusual month for government spending as the cement sector is well aware. Every March, cement consumption across the country spikes sharply. In recent years, that spike has been anywhere between 10% and 13%, but it’s followed in the subsequent month by a sharp fall. The spike is often because government departments would like to use up their budgets before the end of the financial year and binge on construction activity which was originally budgeted but failed to take off.

In contrast, in the early months of the new financial year, construction activity is slow as government budgets take time to be approved. Indeed government expenditure in March is regularly in excess of 15% of the budgeted amount for the year. In other months, the spending averages around 7-8%. In 2013 and 2014, though, the effect was more muted.

This, along with rolling over subsidy payments to the next year, helped the government push the fiscal deficit into negative territory. On the revenue side, dividend payments were sharply higher than originally budgeted for 2013-14 — by as much as 44%. “Notice also that the budgeted dividend payments by public sector undertakings [PSUs] for 2014-15 are much lower than earned in 2013-14,” says Sabnavis. Effectively the government asked PSUs to pay up higher amounts in dividends the previous financial year, with the sweetener that they wouldn’t be forced to do so again next year.

Then there is the tactic to give rosy estimates for the coming year, in order to give the markets and economists something to cheer about. Total subsidies for 2014-15 were pegged in the interim budget at just about 0.3% higher than the revised estimates for 2013-14. The government’s previous track record in managing subsidies gave little reason to believe this.

Last year, for instance, revised estimates were higher than their original budgeted amounts by 11%. Despite that experience, budget estimates were pegged at a lower level than a year before. At the same time, expectations of tax revenues are pegged at overly optimistic levels as well. All this means little fiscal room for Arun Jaitley when he presents his first budget next week.

India has enormous potential, but this story is yet another example of why India continues to fail to live up to her potential. I hope Premier Minister Narendra Modi’s new government will deliver on the promised reforms. Unfortunately given the historical experience it is hard to be optimistic.

Happy birthday Bob!

Today is the day. July 3 2014. Robert Hetzel is turning 70 today. Happy birthday Bob! I hope you will have a great day with your wife Mary and the rest of your family.

To quote myself:

Bob has been a great inspiration to me since the early 1990s and he is undoubtedly one of the economists who have had the greatest influence on my own thinking about monetary matters. Equally important today is that I am very happy to say that Bob is not only a professional inspiration. I am also proud to call Bob my friend.

And yes I write quite a bit about Bob’s contribution to monetary theory and the plan is certainly that I will continue to do that in the future. I will continue my series on Bob’s contributions in the coming weeks, but for now have a look at what I have already written about him over the last couple of years.

This is a list of Hetzel related blog posts:

The Fisher-Hetzel Standard: A much improved “gold standard”
Bob Hetzel’s great idea
Celebrating Robert Hetzel at 70
The ECB should give Bob Hetzel a call
Forget about Yellen or Summers – it should be Chuck Norris or Bob Hetzel
Bob Hetzel speaking at CEPOS
The Hetzel-Ireland Synthesis
The eagle has landed – Bob Hetzel visits Denmark
If you want to know about the Great Recession read Robert Hetzel
Firefighter Arsonists – the myth of the central bankers as ‘good’ crisis managers
A few words that would help Kuroda hit his target
Imagine the FOMC had listened to Al Broaddus in 2003
Monetary disorder – not animal spirits – caused the Great Recession
The cheapest and most effective firewall in the world
Buy “The Great Recession: Market Failure or Policy Failure”
Guess what Greenspan said on November 17 1992

And here is a cartoon for you Bob. I am sure you will enjoy it.

Friedman

PS Doug Irwin was kind enough to send me the cartoon. It is from New York Times in 1970. I hope there is no copyright issue, but after all this is a kind of birthday present to Bob so I will have to risk it. After all Milton used to be Bob’s (favorite) teacher at the University of Chicago. 

PPS This is me in London yesterday being interviewed about the ECB. And yes it is very Hetzelian.

 

 

Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call

In a very surprising move the Swedish Riksbank this morning cut its key policy rate by 50bp to 0.25%. It was about time! The Riksbank has for a very long time undershot its 2% inflation target and inflation expectations have consistently been below 2% for a long time as well.

The interesting question now is what is next? The Riksbank is now very close to the Zero Lower Bound and with inflation still way below the inflation target one could argue that even more easing is needed.

I have earlier addressed how to conduct monetary policy at the ZLB for small-open economies like Sweden. Traditional quantitative easing obviously is an option, but it is also possible to get some inspiration from the works of such great economists as Lars E. O. Svensson or Bennett McCallum.

Already back in 2012 I wrote a post about what advice Bennett would give to the Riksbank in a situation like it now find itself in. This is from my blog post Sweden, Poland and Australia should have a look at McCallum’s MC rule

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? …

…What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target…

…The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

…So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank … should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

…Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank…can.. avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

That is it – now back to writing on the Polish central bank’s failure to do the right thing at it’s rate decision yesterday.

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See also A scary story: The Zero Lower Bound and exchange rate dynamics

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