Leave it to the market to decide on “tapering”

The rally in the global stock markets has clearly run into trouble in the last couple of weeks. Particularly the Nikkei has taken a beating, but also the US stock market has been under some pressure.

If one follows the financial media on a daily basis it is very clear that there is basically only one reason being mentioned for the decline in global stock markets – the possible scaling back of the Federal Reserve’s quantitative easing.

This is three example from the past 24 hours. First CNBC:

“Stocks posted sharp declines across the board Wednesday, with the Dow ending below 15,000, following weakness in overseas markets and amid concerns over when the Fed will start tapering its bond-buying program on the heels of several mixed economic reports.”

And this is from Bloomberg:

“U.S. stocks fell, sending the Standard & Poor’s 500 Index to a one-month low, as jobs and factory data missed estimates and investors speculated whether the Federal Reserve will taper bond purchases.”

And finally Barron’s:

“Fear that the central bank may start scaling back its $85 billion in monthly bond purchases has helped trigger a sharp increase in market volatility over the last couple of weeks both here and overseas.”

I believe that what we are seeing in the financial markets right now is telling us a lot about how the monetary transmission mechanism works. Market Monetarists say that money matters and markets matter. The point is that the markets are telling us a lot about the expectations for future monetary policy. This is of course also why Scott Sumner likes to say that monetary policy works with long and variable LEADS.

Hence, what we are seeing now is that US monetary conditions are being tightened even before the fed has scaled back asset purchases. What is at work is the Chuck Norris effect. It is the threat of “tapering” that causes US stock markets to decline. Said in another way Ben Bernanke has over the past two weeks effectively tightened monetary conditions. I am not sure that that was Bernanke’s intension, but that has nonetheless been the consequence of his (badly timed) communication.

This is also telling us that Market Monetarists are right when we say that both interest rates and money supply data are unreliable indicators of monetary conditions – at least when they are used on their own. Market indicators are much better indicators of monetary conditions.

Hence, when the US stock market drops, the dollar strengthens and implied market expectations of inflation decline it is a very clear signal that US monetary conditions are becoming tighter. And this is of course exactly what have happened over the last couple of weeks – ever since Bernanke started to talk about “tapering”. The Bernanke triggered the tightening, but the markets are implementing the tigthening.

Leave it to the market to decide when the we should have “tapering”

I think it is pretty fair to say that Market Monetarists are not happy about what we are seeing playing out at the moment in the US markets or the global markets for that matter. The reason is that we are now effectively getting monetary tightening. This is certainly premature monetary tightening – unemployment is still significantly above the fed’s unofficial 6.5% “target”, inflation is well-below the fed’s other unofficial target – 2% inflation – and NGDP growth and the level NGDP is massively below where we would like to see it.

It is therefore hardly the market’s perception of where the economy is relative to the fed’s targets that now leads markets to price in monetary tightening, but rather it is Bernanke’s message of possible “tapering” of assets purchases, which has caused the market reaction.

This I believe this very well illustrates three problems with the way the fed conducts monetary policy.

First of all, there is considerable uncertainty about what the fed is actually trying to target. We have an general idea that the fed probably in some form is following an Evans rule – wanting to continue to expand the money base at a given speed as long as US unemployment is above 6.5% and PCE core inflation is below 3%. But we are certainly not sure about that as the fed has never directly formulated its target.

Second, it is clear that the fed has a clear instrument preference - the fed is uncomfortable with conducting monetary policy by changing the growth rate of the money base and would prefer to return to a world where the primary monetary policy instrument is the fed funds target rate. This means that the fed is tempted to start “tapering” even before we are certain that the fed will succeed in hitting its target(s). Said, in another way the monetary policy instrument is both on the left hand and the right hand side of the fed’s reaction function. By the way this is exactly what Brad DeLong has suggested is the case. Brad at the same time argues that that means that the fiscal multiplier is positive. See my discussion of that here.

Third the fed’s policy remains extremely discretionary rather than being rule based. Hence, Bernanke’s sudden talk of “tapering” was a major surprise to the financial markets. This would not have been the case had the fed formulated a clear nominal target and explained its “reaction function” to markets.

Market Montarists of course has the solution to these problems. First of all the fed should clearly formulate a clear nominal target. We obviously would prefer an NGDP level target, but nearly any nominal target – inflation targeting, price level targeting or NGDP growth targeting – would be preferable to the present “target uncertainty”.

Second, the fed should leave it to the market to decide on when monetary policy should be tightened (or eased) and leave it to the market to actually implement monetary policy. In the “perfect world” the fed would target a given price for an NGDP-linked bond so the implied market expectation for future NGDP was in line with the targeted level of NGDP.

Less can, however, do it – the fed could simply leave forecasting to either the markets (policy futures and other forms of prediction markets) or it could conduct surveys of professional forecasters and make it clear that it will target these forecasts. This is Lars E. O. Svensson’s suggestion for “targeting the forecast” (with a Market Monetarist twist).

Concluding, the heightened volatility we have seen in the US stocks markets over the last two weeks is mostly the result of monetary policy failure – a failure to formulate a clear target, a failure to be clear on the policy instrument and a failure of making it clear how to implement monetary policy.

Bernanke don’t have to order the printing of more money. We don’t need more or less QE. What is needed is that Bernanke finally tells us what he is really targeting and then he should leave it to the market to implement monetary policy to hit that target.

PS I could have addressed this post to Bank of Japan and governor Kuroda as well. Kuroda is struggling with similar troubles as Bernanke. But he could start out by reading these two posts: “Mr. Kuroda please ‘peg’ inflation expectations to 2% now” and “A few words that would help Kuroda hit his target”. Kuroda should also take a look at what Marcus Nunes has to say.

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9 Comments

  1. Benjamin Cole

     /  June 6, 2013

    I cannot understand this constant sniveling in some quarters that QE has to be scaled back, in the USA or Japan.

    Why? Why stop QE?

    Japan is in deflation, and the USA just posted a 0.7 percent PCE inflation rate.

    Both central banks should make it clear that they show resolve for growth, until they hit sustained growth targets (such as 3 percent real growth for eight straight quarters), come what may.

    They simply have to destroy the inflation bugaboo, and the thought that they will buckle in the face of even midl inflationary pressures.

    Sadly, this will never happen. Fighting inflation is seen as a moral and ethical cause inside central banks, cloistered as they are, and secure from voter backlash.

    Reply
  2. Philo

     /  June 6, 2013

    This post might help Bernanke or Kuroda carry out his intentions, but I think you would need a different post for Draghi–it’s not clear that he’s even trying to do the right thing.

    Reply
    • James in London

       /  June 6, 2013

      To be honest, I think we know why there is this talk of “tapering”. As well as targeting inflation, “growth” and now unemployment, the Fed is also targeting the S&P 500.

      It wanted a stock market rally, but is now concerned the rally has gone on too long, and got too far ahead of economic recovery. I think this “tapering” talk is designed to take the steam out of the stock market rally without stopping the economic recovery.

      The problem is that by targeting so many things apart from the one that really matters, nominal income, they cause confusion and the stock market and other assets get bid up by financial markets, when a really clear lead to non-financial actors is what is really needed.

      Reply
      • James,

        You are completely right.

        Furthermore, it should certainly not be the purpose of monetary policy to hit any “target” for the level of the stock market. That said, I believe the stock market is a quite good indicator for future NGDP. At the moment the signal from that indicator is telling me monetary policy is getting tighter – both in the US and Japan.

        Of course if the fed was targeting the price of an NGDP linked bond we would not have these problems.

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