China: It just got worse – more bad news and more policy mistakes

It is becoming increasingly clear that the Chinese authorities are mismanaging the economic and financial situation and the risk that the authorities will to cause something to blow increases day by day.

First we had the ill-advised attempts to prop up the falling Chinese stock market by the Chinese authorities essentially buying stocks and by to some extent banning the selling of stocks.

Now the Chinese authorities are trying something even more stupid – shooting the messenger:

Chinese authorities have arrested nearly 200 people for alleged online rumor-mongering about China’s stock market turmoil and a recent, deadly chemical factory explosion in Tianjin.

Among the arrested is Wang Xiaolu, a journalist for financial publication Caijing Magazine, “who has been placed under ‘criminal compulsory measures’ for suspected violations of colluding with others and fabricating and spreading fake information on securities and futures market,” according to Chinese state media.

This smells of desperation and signals to global investors that the Chinese authorities really are clueless about what is going on in the economy and in the markets.

Obviously the Chinese stock markets are not falling because of “rumours”, but this is the well-known behavior of many governments around the world – when the markets are going up it is because of the great policies of the government, but when they are going down it is because of the evil actions of “speculators”.

Meanwhile the Chinese authorities are continuing to claim that everything is fine and that real GDP is growing above 7%. However, looking at all other indicators of Chinese growth it is clear that the Chinese economy is slowing fast and is growing much less than 7%.

Just take two sets of data published today. First of all, the final Caixin/Markit manufacturing purchasing managers’ index (PMI) dropped to 47.3 in August – the lowest reading since March 2009 and down from 47.8 in July.

Second and equally telling South Korean exports dropped as much as 14.7% y/y in August – much more than the consensus expectation of a 5.9% y/y drop. China of course is a key market for South Korean exports and South Korean export normally is a very good indicator of Chinese manufactoring activity.

Given the kind of drop in the Chinese stock markets we have seen in August and what the commodity markets are telling us and given the macroeconomic data coming out it is pretty hard to avoid the conclusion that China was hit by a “sudden stop” in August as we saw a serious escalation of the currency and capital outflows.

This is of course also what we have been seeing in the currency markets, where the Chinese authorities have been forced to allow the renminbi to weaken. The forward markets are telling us that more devaluations should be expected.

To make things worse we today got yet another policy failure when the People’s Bank of China (PBoC) in yet another attempt to make the problems go away announced that it will try to limit capital outflows by imposing a reserve requirement on financial institutions trading in foreign-exchange forwards for clients. This is essentially a form of currency controls.

This is of course just another attempt of trying to shoot the messenger. The markets are telling us that more devaluations are coming. How do you manage that problem? Shot down the market. Again this smells of panic and the likely consequence is to further escalate the outflows rather than the opposite.

But it not only smells of panic – it also is doing a lot of harm to the Chinese economy. Maybe paradoxically the small stepwise devaluations of the renminbi have signaled to the markets that more devaluations are coming and as a result this has escalated currency and capital outflows.

As a result the PBoC has had to do even more intervention in the currency markets to prop up the renminbi. This of course is essentially monetary tightening and the consequence will be a further slowdown of the Chinese economy and likely also more financial distress.

Let the RMB float!

This is also an important lessons to other “peggers”. There is no such thing as a small devaluation. Either you maintain your peg or you let you currency float.

So to me there is really only one way out of this problem for the Chinese authorities – stop the shenanigans and let the renminbi float freely!

This likely would lead to a major drop in the Chinese currency in the near-term, but the alternative is that the outflows continues and if the PBoC continues to intervene and continues to introduce draconian anti-market measures (such as jailing journalists and banding FX and equity selling) and then the crisis will just deepen.

The developments in the past few weeks have reminded us all that China really still very much is an Emerging Markets and that the Chinese authorities are much less in control of events than many people believed.

The Chinese authorities had it easy as long as the structural tailwinds kept the capital flows coming in and the US kept monetary policy easy. However, now we are seeing a sharp structural slowdown in the Chinese economy, currency outflows and an effective tightening of US monetary conditions. As a consequence it is becoming more and more evident that the Chinese authorities are not the supermen that they sometimes have been made up to be.

As I argued in my previous blog post this is essentially the ‘dollar bloc’, which is falling apart. If the Chinese authorities continues to try to fight the inevitable – a fairly large renminbi depreciation – then a lot more harm will be done to the Chinese economy and the risk of full-scale financial crisis increases dramatically.

We have it all here – monetary strangulation through a badly constructed monetary regime, political mismanagement and when the story of this crisis will be written I don’t doubt there will be lots of talk of moral hazard and cronyism as well. In fact when I watch the actions of the Chinese authorities I am reminded of the way the Suharto regime in Indonesia (mis)handled the crisis in 1997-98.

It was the same finger-pointing at “evil speculators” and the introduction of draconian and ill-advised methods to prop up the currency. In the end it all failed – the central bank was forced to allow a major devaluation, but only after an ill-fated attempt to prop up the currency more or less had blown up the financial system and caused a major contraction in the economy. And it was of course also an end of the Suharto regime (probably the most positive effect of the crisis).

The Chinese Communist party today should remember how and why Suharto’s regime fell apart. China can still avoid a Indonesian style crisis, but then the Chinese authorities should stop copying Suharto’s policies.

The ‘dollar bloc’ was never an optimal currency area and now it is falling apart

Global stock markets are in a 2008ish kind of crash today and I really don’t have much time to write this, but I just want to share my take on it.

To me this is fundamentally about the in-optimal currency union between the US and China. From 1995 until 2005 the Chinese renminbi was more or less completely pegged to the US dollar and then from 2005 until recently the People’s Bank of China implemented a gradual managed appreciation of the RMB against the dollar.

This was going well as long as supply side factors – the opening of the Chinese economy and the catching up process – helped Chinese growth.

Hence, China went through one long continues positive supply shock that lasted from the mid-1990s and until 2006 when Chinese trend growth started to slow. With a pegged exchange rate a positive supply causes a real appreciation of the currency. However, as RMB has been (quasi)pegged to the dollar this appreciation had to happen through domestic monetary easing and higher inflation and higher nominal GDP growth. This process was accelerated when China joined WTO in 2001.

As a consequence of the dollar peg and the long, gradual positive supply shock Chinese nominal GDP growth accelerated dramatically from 2000 until 2008.

However, underlying something was happening – Chinese trend growth was slowing due to negative supply side headwinds primarily less catch-up potential and the beginning impact of negative labour force growth and the financial markets have long ago realized that Chinese potential growth is going to slow rather dramatically in the coming decades.

As a consequence the potential for real appreciation of the renminbi is much smaller. In fact there might be good arguments for real depreciation as Chinese growth is fast falling below trend growth, while trend itself is slowing.

With an quasi-pegged exchange rate like the renminbi real depreciation will have to happen through lower inflation – hence through monetary tightening. And this I believe is part of what we have been seeing in the last 2-3 years.

The US and China is not an optimal currency area and therefore the renminbi should of course not be pegged to the dollar. That was a problem when monetary conditions became excessively easy in China ahead of 2008 (and that is a big part of the commodity boom in that period), but it is an even bigger problem now when China is facing structural headwinds.

Yellen was the trigger

Hence, the underlying cause of the sell-off we have seen recently in the Chinese and global stock markets really is a result of the fact that the US and China is not an optimal currency area and as Chinese trend growth is slowing monetary conditions is automatically tightened in China due to the quasi-peg against the dollar.

This of course is being made a lot worse by the fact that the Fed for some time has become increasingly hawkish, which as caused an strong appreciation of the dollar – and due to the quasi-peg also of the renminbi. And worse still – in July Fed chair Janet Yellen signaled that the Fed would likely hike the Fed funds rate in September. This to me was the trigger of the latest round of turmoil, but the origin of the problem is a structural slowdown in China and the fact China is not an optimal currency area.

China should de-peg and Yellen should postpone rate hikes

Obviously the Chinese authorities would love the Fed to postpone rate hikes or even ease monetary policy. This would clearly ease the pressures on the Chinese economy and markets, but it is also clear that the Fed of course should not conduct monetary policy for China.

So in the same way that it is a problem the Germany and Greece are in a monetary union together it is a problem that China and the US are in a quasi-currency union. Therefore, the Chinese should of course give up the dollar peg and let the renminbi float freely and my guess is that will be the outcome in the end. The only question is whether the Chinese authorities will blow up something on the way or not.

Finally, it is now also very clear that this is a global negative demand shock and this is having negative ramifications for US demand growth – this is clearly visible in today’s stock market crash, massively lower inflation expectations and the collapse of commodity prices. The Fed should ease rather than tighten monetary policy and the same goes for the ECB by the way. If the ECB and Fed fail to realize this then the risk of a 2008 style event increases dramatically.

We should remember today as the day where the ‘dollar bloc’ fell apart.

PS I have earlier argued that China might NEVER become biggest economy in the world. Recent events are a pretty good indication that that view is correct and I was equally right that you shouldn’t bet on a real appreciation of the renminbi.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Icelandic monetary policy has become too easy – Sedlabanki is (rightly) trying to catch up

Yesterday the Icelandic central bank Sedlabanki hiked its key policy rate by 50bp to 5.50%. The hike was fully expected by the markets and is the second hike this year.

I don’t have much time to write about this, but let me just briefly say that I think there are very good reasons for Sedlabanki to hike rates – in fact it looks as if Sedlabanki is even falling behind the curve and more rate hikes might be warranted.

Overall I think there are three very strong reasons for tightening monetary conditions in Iceland:

1) I have earlier argued that Sedlabanki since Mar Gudmundsson became governor in July 2009 has had a de facto 4.5% nominal GDP target (See here after 50:03). Hence, until recently NGDP was kept on a 4.5% path, but over the past year or so NGDP growth clearly has accelerated and Sedlabanki now forecasts NGDP growth of 10.6% in 2015, which clearly is far too strong and is not consistent with Sedbanki’s 2.5% inflation target.

NGDP gap Iceland

2) It is always extremely useful in the conduct of monetary policy to keep an eye on market expectations and here the signal is very, very clear. Recently inflation expectations have increased rather dramatically and both 2, 5 and 10 year breakeven inflation rates are now around 4.5% inflation – way above Sedlabanki’s 2.5% inflation target.

Breakeven iceland

3) Money supply growth is picking up and (unadjusted) M3 growth is now approaching 15%, which sends a clear signal that inflation and nominal GDP growth could pick up even further. The adjusted M3 numbers, which probably is a more truthfully indicator of inflationary pressures have accelerated to above 5%, which also indicates increased inflationary pressures.

M3 ICELAND

So all in all I think it is very justified to hike interest rates for Sedlabanki and more is certainly needed to bring NGDP growth back towards 4-4-5% and reduce inflation expectations back towards Sedlabanki’s inflation target.

One thing I have noted is that while I here focus on nominal variables and on expectations Sedlabanki is more focused on the labour market situation and the recent wage agreements.

To me the wage agreements is not the cause of inflation, but rather a symptom of high inflation expectations and hence an overly easy monetary policy. That said, I do think that the Icelandic labour market system tend to create an inflationary bias in monetary policy (It is back to the old rules vs discretion debate). But I have to return to that topic in a later post…

PS it is rather incredible that Iceland after a massive banking crisis in 2008-9 now is one of the very few countries in Europe with robust nominal spending growth and a need for monetary tightening. Well done – now make sure not to repeat the mistakes of earlier days.

PPS big news out of Kazakhstan this morning – the central bank has floated the tenge. I strongly believe that this is the right decision on part of the Kazakh authorities. Pegged exchanges is generally not a good idea for commodity exporters (unless they peg to the export price).

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

The Christensen Media Blitz on the euro, ‘Open Borders’, China and ‘currency war’

I have been in a bit of media blitz recently. Here is some of it:

I have been on Russia Today’s Boom-Bust show to talk to Ameera David about the euro and why I think the euro is a Monetary Strangulation Mechanism. Watch here (after 3:35).

And while we are talking about the euro here is an op-ed of mine from the Danish newspaper Jyllandsposten on the same topic (in Danish).

Then something completely different – here I am telling Berlingske Business the story of my Great-great grandfather Sven Persson who emigrated to Denmark from Sweden in 1880 and hence contributed to the economic development in both countries. I make the case for completely Open Borders and argues that that we could double global GDP if we removed all anti-immigration regulation globally. See my ‘video blog’ here (also in Danish).

Here is an op-ed from the Danish Business Daily Børsen on the Chinese on the Chinese devaluations and why the talk of ‘currency war’ mostly is nonsense.

Finally here is an interview (in French) with Atlantico.fr about the risk of a repeat of the 1997 Asian crisis, My answer is yes, the Chinese situation is worrying, but the good news is that we have floating exchange rates across Asia rather than fixed exchange rates.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Ronald Reagan comments on Donald Trump’s immigration plan

I can’t stand protectionism in any form. Therefore, I get terribly upset when I hear calls for closed borders – also when it comes to immigration. Therefore I am not impressed with this either:

(Donald) Trump outlined three “core principles”: that the U.S. must build a wall across the U.S.-Mexico border, that immigration laws must be fully enforced and that “any immigration plan must improve jobs, wages and security for all Americans.”

…He would also consider tariffs and foreign aid cuts and would seize “all remittance payments derived from illegal wages.”

I could of course comment on Donald Trump’s plans to turn the US into North Korea myself, but I will instead leave it to a president, who Trump claims made the US great. Watch Ronald Reagan’s comments on Trump’s “Wall” here.

And if that is not enough for you take a look at this.

HT Steve Horwitz

Malaysia has a freely floating Renggit – and thank god for that!

The Chinese surprise devaluation yesterday and has put currencies across Asia further under pressure. This is only a natural and the most stupid thing local Asian central bankers could do would be to fight it. Rather as China moves closer to a freely floating exchange rate it should inspire other Asian countries to do the same thing and I am therefore happy to see that the Vietnamese central bank this morning has widened the fluctuation band for the Dong and in that sense moved a bit closer to a freely floating Dong. Even though the hand has been forced somewhat by the PBoC’s devaluation yesterday it is nonetheless positive that we are seeing a move towards more freely floating exchange rates in Asia.

In that since it is not a “currency war”, but rather a liberation war, which in the end hopefully will secure monetary sovereignty to Asian nations such as Vietnam.

The floating Renggit is a blessing – also when it drops

This morning we are also seeing big moves in the Malaysian Renggit and the Renggit has already been under some pressure recently on the back of a worsening of Malaysia’s terms-of-trade and increased political uncertainty.

The sell-off in the Renggit has sparked some local concerns and the demands for the central bank to “do something” to prop up the Renggit are surely on the rise. However, it is extremely important to remember that the problem for Malaysia is not that the Renggit is weakening. Rarther the Renggit-weakness is a symptom of the shocks that have hit the Malaysian economy – lower commodity prices (Malaysia is a commodity exporter), increased political uncertainty and Chinese growth concerns.

None of this is good news for the Malaysian economy, but the fact that this is reflected in the Renggit is not a problem. Rather it would be a massive problem if Malaysia today had had a fixed exchange rate regime has was the case during the Asian crisis in 1997.

So the Malaysian central bank (BNM) should be saluted for sticking to the floating exchange rate policy, which has served Malaysia very well for nearly exactly a decade.

In fact BNM should move even closer to a purely free float and waste no opportunity to stress again and again that the value of the Renggit is determined by market forces and that the BNM’s sole purpose of monetary policy is to ensure nominal stability. The BNM should of course observe exchange rate developments in the sense it gives useful information about the monetary stance, but never again should the BNM try to peg or quasi-peg the Renggit to a foreign currency. That would be the recipe for disaster. As would such stupid ideas as currency and capital controls.

My friend Hishamh over at the Economics Malaysia blog has an extremely good post on his take on the Renggit situation. You should really read all of it. The post not only tells you why the freely floating Renggit is the right thing for Malaysia, but it is also extremely good in terms of making you understand why every (ok most…) countries in Asia should move in the direction of the kind of currency regime that they have in Malaysia.

Here is a bit of Hishamh’s excellent comments:

Another week, another multi-year low for the Ringgit. Since BNM appears to have stopped intervening, the Ringgit has continued to weaken against the USD, to what appears to be everyone’s consternation. There is this feeling that BNM should do something, anything, to halt the slide – cue: rumours over another Ringgit peg and capital controls.

To me, this is all a bit silly. Why should BNM lift a finger? Both economic theory and the empirical evidence is very clear – in the wake of a terms of trade shock, the real exchange rate should depreciate, even if it overshoots. NOT doing so would create a situation where the currency would be fundamentally overvalued, and we would therefore be risking another 1997-98 style crisis. Note the direction of causality here – it isn’t the weakening of the exchange rate that gave rise to the crisis, but rather the avoidance of the adjustment.

Pegging the currency under these circumstances would be spectacularly stupid. I’ll have more to say about this in my next post.

….

In the present circumstances, it’s not even clear why BNM should in fact intervene. You can make the argument that the Ringgit is fundamentally undervalued, and the FX market has overshot; but I have no idea why this is considered “bad”. If you want to live in a world of free capital flows, FX volatility is the price you pay.

… Malaysia’s latest numbers puts reserve cover at 7.6 months retained imports, and 1.1 times short term external debt, versus the international benchmark of 3 months and 1 times. Malaysia is at about par for the rest of the region, apart from outliers like Singapore and Japan.

Australia and France on the other hand, have just two months import cover, while the US, Canada and Germany keep just one month. You might argue that since these are advanced economies, there’s little concern over their international reserves. I would argue that that viewpoint is totally bogus. Debt defaults and currency crises were just as common in advanced economies under the Bretton Woods system. The lesson here is more about commitment to floating rather than the level of reserves. One can’t help but see the double standards involved here.

…All in all, this alarmism betrays a lack of general economic knowledge in Malaysia, even among people who should know better. Or maybe I’m being too harsh – it’s really a lack of knowledge of international macro and monetary economics.

…The Bank of Canada, the Reserve Bank of Australia, and the Reserve Bank of New Zealand, have all aggressively cut interest rates and talked down their own currencies – it’s the right thing to do in the face of a commodity price crash. BNM on the other hand has to walk and talk softly, softly, because Malaysians seem to think the Ringgit ought to defy economic laws.

Bravo! Please follow Hishamh! His blog posts are always good and insightful.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

China should float the renminbi

The big news of the day is that the Chinese authorities have allowed the renminbi to depreciate by 2%. This has triggered the normal sensationalist warnings about an upcoming “currency war”.

I must say I find these warnings to be rather uneducated about monetary theory and about monetary history. Hence, normally it is said that devaluations have the purpose of improving “competitiveness” and that such policy is an act of beggar-thy-neighbor and that this kind of policies caused a protectionist spiral during the Great Depression.

However, this is not in fact correct. First, of all if a country needs to ease monetary policy to stabilise nominal spending then it follows logically that the currency of the country will have to depreciate. That, however, need not be the purpose, but rather a side-effect of monetary easing. Rather it is normally so that if we look at historical examples of large devaluations – for example the US in 1933 or Argentina in 2001-2 then the primary effect of the monetary easing is a sharp recovery in domestic demand, which actually tends to benefit exports from neighboring countries rather than hurt them.

Furthermore, during the 1930s it was not the countries, which gave up the gold standard and devalued, which introduced protectionist measures. Rather it was the countries, which refused to give up the gold standard, which instead increased tariffs and other protectionist measures.

Furthermore, we are in a situation of still relatively meager global growth and deflationary tendencies around the world and in such a world monetary easing should be welcomed rather than criticized as it will help spur global growth.

Finally it is somewhat paradoxically that anybody would criticize a 2% devaluation, while not at the same time demand that commodity exporters like Russia, Brazil and Norway –  which have seen the currencies weaken substantially recently – should do something to prop up their currencies. Obviously these countries should not be criticized for allow their currencies to weaken in response to a negative shock to the economy, but neither should China. Today’s devaluation is not a hostile act – it is a attempt to stabilize Chinese aggregate demand and as such the policy should be welcomed.

Give up the fine-tuning and let the renminbi float

That being said I also think that today’s devaluation is rather foolish – simply because I want more and not less. In my view the right policy would be for China to swiftly move towards a free floating renminbi and a total liberalization of capital and currency flows and to introduce a policy to stabilize nominal demand (NGDP) growth in the Chinese economy.

Hence, every other large economy in the world – with the exception of those trapped in the euro – have floating exchange rates and in general the purpose of monetary policy in these countries is to provide nominal stability in some form. China should of course do the same thing. That would be to the great benefit of China and would once and for all stop the silly discussion about “competitive devaluations”.

Have I written about this before? You bet – just have a look here:

Bernanke knows why ‘currency war’ is good news – US lawmakers don’t

‘The Myth of Currency War’

Don’t tell me the ‘currency war’ is bad for European exports – the one graph version

The New York Times joins the ‘currency war worriers’ – that is a mistake

The exchange rate fallacy: Currency war or a race to save the global economy?

Is monetary easing (devaluation) a hostile act?

Fiscal devaluation – a terrible idea that will never work

Mises was clueless about the effects of devaluation

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

The luck of the ‘Scandies’

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Yellen should re-read Friedman’s “The Role of Monetary Policy” and lay the Phillips curve to rest

It is the same thing every month – anybody seriously interested in financial markets and the global economy are sitting and waiting for the US labour market report to come out even though the numbers are notoriously unstable and unreliable.

Why is that? The simple answer is that it is not because the numbers are important on their own, but because the Federal Reserve seems to think the labor market report is very important.

And that particularly goes for Fed-chair Janet Yellen who doesn’t seem to miss any opportunity to talk about labour market conditions.

The problematic re-emergence of the Phillips curve as a policy indicator

To Janet Yellen changes in inflation seems to be determined by the amount of slack in the US labour market and if labour market conditions tighten then inflation will rise. This of course is essentially an old-school Phillips curve relationship and a relationship where causality runs from labour market conditions to wage growth and on to inflation.

This means that for the Yellen-fed labour market indicators essentially are as important as they were for former Fed chairman Arthur Burns in the 1970s and that could turn into a real problem for US monetary policy going forward.

Yellen should re-read Friedman’s “The Role of Monetary Policy”

To understand this we need to go back to Milton Friedman’s now famous presidential address delivered at the Eightieth Annual Meeting of the American Economic Association – “The Role of Monetary Policy” – in 1967 in, which he explained what monetary policy can and cannot do.

Among other things Friedman said:

What if the monetary authority chose the “natural” rate – either of interest or unemployment – as its target? One problem is that it cannot know what the “natural” rate is. Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the natural rate will itself change from time to time. But the basic problem is that even if the monetary authority knew the natural rate, and attempted to peg the market rate at that level, it would not be led to determinate policy. The “market” rate will vary from the natural rate for all sorts of reasons other than monetary policy. If the monetary authority responds to these variations, it will set in train longer term effects that will make any monetary growth path it follows ultimately consistent with the policy rule. The actual course of monetary growth will be analogous to a random walk, buffeted this way and that by the forces that produce temporary departures of the market rate from the natural rate.

To state this conclusion differently, there is always a temporary trade-off between inflation and unemployment: there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation which generally means, from a rising rate of inflation. The widespread belief that there is a permanent trade-off is a sophisticated version of the confusion between “high” and “rising” that we all recognize in simpler forms. A rising rate of inflation may reduce unemployment, a high rate will not.

…To state the general conclusion still differently, the monetary authority controls nominal quantities – directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity – an exchange rate, the price level, the nominal level of income, the quantity of money by one or another definition – or to peg the rate of change in a nominal quantity – the rate of inflation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money.

It cannot use its controls over nominal quantities to peg a real quantity – the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real income, or the rate of growth of the real quantity of money.

For many years – at least going back to the early 1990s – this was the clear consensus among mainstream macroeconomists. It is of course a variation of Friedman’s dictum that “inflation is always and everywhere a monetary phenomena.”

Central banks temporary can impact real variables such as unemployment or real GDP, but it cannot permanently impact these variables. Similarly there might be a short-term correlation between real variables and nominal variables such as a correlation between nominal wage growth (or inflation) and unemployment (or the output gap).

However, inflation or the growth of nominal income is not determined by real factors in the longer-term (and maybe not even in the short-term), but rather than by monetary factors – the balance between demand and supply of money.

The Yellen-fed seems to be questioning Friedman’s fundamental insight. Instead the Yellen-Fed seems to think of inflation/deflation as a result of the amount of “slack” in the economy and the Yellen-fed is therefore preoccupied with measuring this “slack” and this is what now seems to be leading Yellen & Co. to conclude it is time to tighten US monetary conditions.

This is of course the Phillips curve interpretation of the US economy – there has been steady job growth and unemployment is low so inflation most be set to rise no matter what nominal variables are indicating and not matter what market expectations are. Therefore, Yellen (likely) has concluded that a rate hike soon is warranted in the US.

This certainly is unfortunately. Instead of focusing on the labour market Janet Yellen should instead pay a lot more attention to the development in nominal variables and to the expectations about these variables.

What are nominal variable telling us?

Friedman mentions a number of variables that the monetary authorities directly or indirectly can control – among others the price level, the level of nominal income and the money supply. We could add to that nominal wages.

So what are these variables then telling us about the US economy and the state of monetary policy? Lets take them one-by-one.

We start with the price level – based on core PCE deflator.

PCE core

The graph shows that it looks as if the Federal Reserve has had a price level target since the (“official”) end of the 2008-9 recession in the summer of 2009. In fact at no time since 2009 has the actual price level (PCE core deflator) diverged more than 0.5% from the trend. Interestingly, however, the trend growth rate of the price level has been nearly exactly 1.5% – pretty much in line with medium-term market expectations for inflation, but below the Fed’s official 2% inflation target.

However, if we define the Fed’s actual target as the trend in the price level over the past 5-6 years then there is no indication that monetary policy should be tightened. In fact the actual price level has this year fallen slightly below the 1.5%-“target path” indicating if anything that monetary conditions is slightly too tight (but nearly perfect). Obviously if we want to hit a new 2% path then someeasing of monetary conditions is warranted.

So how about the favorite Market Monetarist-indicator – Nominal GDP?

NGDP gap

Again the picture is the same – the Fed has actually delivered a remarkable level of nominal stability since the summer of 2009. Hence, nominal GDP has grown nicely along at a trend since Q3 2009 and the actual NGDP level has remains remarkably close to the trend path for NGDP – as if the Fed was actually targeting the NGDP level along a (close to) 4% path.

And as with the price level – the present NGDP level is slightly below the trend over the past 5-6 years indicating a slightly too tight monetary stance. Furthermore, it should be noted that prediction markets such as Hypermind presently are predicting around 3.5% NGDP growth in 2015 – below the 4% de facto target. So again if anything US monetary policy is – judging from NGDP and NGDP expectations – just a tiny bit too tight.

And what about Milton Friedman’s favourite nominal indicator – the broad money supply? Here we look at M2.

M2 gap US

Once again we have seen a remarkable amount of nominal stability judging from the development in US M2 – particularly since 2011 with only tiny deviations in the level of M2 from the post-2009 trend. Milton Friedman undoubtedly would have praised the Fed for this. Hence, it looks as if the Fed actually have had a 7% growth path target for M2.

But again, recently – as is the case with the price level and NGDP – the actual money supply (M2) as dropped moderately below the the post-2009 trend indicating that monetary conditions are slightly too tight rather than too easy.

Then what about nominal wages? We here look at average hourly earnings for all all employees (total private).

wage gap

Surprise, surprise – again incredible nominal stability in the sense that average hourly earnings have grown very close to a near-perfect 2% trend in the past 5-6 years. However, unlike the other nominal measures recently the “wage gap” – the difference between actual nominal wages and the trend – has turned slightly positive indicating that monetary conditions is a bit too easy to achieve 2% trend growth in US nominal wages.

But again we are very, very close to the post-2009 trend. We could of course also notice that a 2% nominal wage growth target is unlikely to be comparable to a 2% inflation target if we have positive productivity growth in the US economy.

Conclusion: Preoccupation with the Phillips curve could course the Fed to hike too early

…Nominal variables tell the Fed to postpone a hike until 2016

The message from Milton Friedman is clear – we should not judge monetary conditions on real variables such as labour market conditions. Instead we should focus on nominal variables.

If we look at nominal variables – the price level, NGDP, the money supply and nominal wages – the conclusion is rather clear. The Fed has actually since 2009 delivered a remarkable level of nominal stability in terms of keeping nominal variables very close to the post-2009 trend.

If we want to think about the Bernanke-Fed the Fed had one of the following targets: 1.5% core PCE level targeting, 4% NGDP level targeting, 7% M2-level targeting or 2% wage level targeting at least after the summer of 2009.

However, the Yellen-Fed seems to be focusing on real variables – and particularly labour market variables – instead. This is apparently leading Janet Yellen to conclude that monetary conditions should be tightened.

However, nominal variables are telling a different story – it seems like monetary conditions have become slightly too tight within the past 6-12 months and therefore the Fed needs to communicate that it will not hike interest rates in September if it wants to keep nominal variables on their post-2009 path.

Obviously the Fed cannot necessarily hit more than one nominal variable at the time so the fact that it has kept at least four nominal variables on track in the past 5-6 years is quite remarkable. However, the Fed needs to chose one nominal target and particularly needs to give up the foolish focus on labour market conditions and instead fully commit to a nominal target. My preferred target would certainly be a 4% (or 5%) Nominal GDP level target.

And Chair Yellen, please lay the Phillips curve to rest if you want to avoid sending the US economy into recession in 2016!

PS My thinking on these issues has strongly be influence by my good friend Mike Darda.

PPS think of the present time as one where Milton Friedman would be more dovish than Arthur Burns.

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com. For US readers note that I will be “touring” the US in the end of October.

NBER paper: “On the Desirability of Nominal GDP Targeting”

I should really read this paper and so should you….

Abstract:

This paper evaluates the welfare properties of nominal GDP targeting in the context of a New Keynesian model with both price and wage rigidity. In particular, we compare nominal GDP targeting to inflation and output gap targeting as well as to a conventional Taylor rule. These comparisons are made on the basis of welfare losses relative to a hypothetical equilibrium with flexible prices and wages. Output gap targeting is the most desirable of the rules under consideration, but nominal GDP targeting performs almost as well. Nominal GDP targeting is associated with smaller welfare losses than a Taylor rule and significantly outperforms inflation targeting. Relative to inflation targeting and a Taylor rule, nominal GDP targeting performs best conditional on supply shocks and when wages are sticky relative to prices. Nominal GDP targeting may outperform output gap targeting if the gap is observed with noise, and has more desirable properties related to equilibrium determinacy than does gap targeting.

HT My beloved Mr. Chance

Horror graph of the week – Greek PMI collapses

If you ever read Friedman and Schwartz’s “A Monetary History of the United States” you know what happens when a central bank fails to act as a lender-of-last resort in the event of a bank run and/or at the same time fails to offset the impact on broad money growth of such bank run.

It of course happened in the US in 1930-31 and again in Europe after the collapse of Credit-Anstalt in Austria also in 1931. In both cases the result was a deep depression. Now it has happened again in Greece, but Greece is already in a deep economic depression.

Just have a look at this shocking graph from Macropolis.gr.

Greek PMI

There is no great reason to trust eyeball-econometrics, but judging from the sharp drop in Greek July PMI (released today) then we should expect another 10-15% drop in Greek real GDP in the next couple of quarters. That would mean that we soon will have seen Greek real GDP being halved since the start of this crisis.

I think it will be very hard to find any other example of a (peacetime) collapse of real GDP of this magnitude in any other country in the world in the past 200 years and there is nothing positive to say about this. It is the terrible consequence of massive policy failures in Brussels, Frankfurt, Berlin and Athens.

A truly Greek tragedy.

HT Joe Wiesenthal.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com.

Also note that I am on a Speaking Tour in the US in October. See more here.

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