Until recently the global financial markets were on an one-way trip to recovery. Basically since the Federal Reserve in September implicitly announced the Bernanke-Evans rule investors have been betting on an US economic recovery – higher real and nominal GDP growth – and the Bank of Japan’s decisive actions to implement a 2% inflation target also have helped the sentiment. However, the picture has become a lot more confusing in recent weeks as turmoil has returned to the global financial markets.
The key problem is that we do not exactly know why there has been a sharp spike in market volatility. There is a number of competing theories. The most popular theory is that this is all Ben Bernanke’s fault as he has announced the “tapering” of quantitative easing – that according to the critiques has caused markets to price in tighter monetary conditions in the future and that is the reason why bond yields are rising while inflation expectations and stock markets are declining. A competing theory is that the real reason for this is not really Bernanke, but rather monetary tightening in China, which is forcing Chinese investors to liquidate investments – including in US Treasuries. I have a lot of sympathy for the later theory even though I think it is also right that Bernanke’s comments over the past months have been having an negative impact.
So why is it important what is the cause of these market moves? It’s it enough to note that all indications are that we globally are now seeing a contraction in aggregate demand and central banks should respond to that by easing monetary conditions? Yes and no. Yes because it is clear that monetary conditions are indeed getting tighter everywhere. However, no because that was not necessarily clear until last week.
Low inflation expectations is necessarily not a monetary easing
Interestingly enough it seems like everybody have become Market Monetarists recently in the sense that they think that it is the fed that is driving the markets via (bad) communication and the commentators are exactly looking at market indicators monetary conditions – for example market expectations for inflation.
And it is of course the sharp drop in inflation expectations, which is causing a lot of concern and I obviously agree that central banks should keep an very close eye on inflation expectations as an indicator for monetary conditions. HOWEVER, we should never forget that inflation expectations could drop either because of tighter monetary conditions or because of a positive supply shock.
Market Monetarists of course argue that central banks should not respond to supply shocks – positive or negative – and I would in fact argue that the drop in inflation expectations we have seen recently in the US (and other places) is to a large extent driven by a positive supply shock. That is good news for real GDP growth. That is consistent with higher real bond yields and it not necessarily a problem (David Beckworth has been making that argument here). Hence, if the drop in inflation expectations had instead been primarily caused by tighter US monetary conditions then we should have expected to see the US stock markets plummet and the dollar should have strengthened.
That is of course what we have seen over the past week or so, but not in the month leading up to that. In that period the dollar was actually weakening moderately and the US stock market was holding up fairly well. That to me is an indication that the drop in inflation expectations have not only been about tighter US monetary condition.
Instead I think that we have seen a serious tightening of Chinese monetary condition and that has caused global commodity prices to drop. That is of course a negative demand shock in China, but it is a positive supply shock to the US economy. If that ONLY had been the case then it would be hard to the argument from a Market Monetarist perspective that the Federal Reserve should move to ease monetary conditions further. See my arguments from mid-May against monetary easing in responds to positive supply shocks here.
Avoid the confusion – set up an NGDP futures market
Sometimes it is pretty easy to “read” the markets to get an understanding of what is going on – it is for example pretty clear right now that Chinese monetary conditions are getting a lot tighter, but it is harder to say how much tighter US monetary conditions really have gotten over the past month or so and the bond market is certainly not a good indicator on its own (liquidity/flow effects vs expectational effects).
Hence, what should be the appropriate US monetary response? There is a significant difference between the appropriate respond to what is primarily a supply shock and what is primarily a demand shock. And it is of course not only me who is slightly confused about what is going on in the markets. Policy makers are likely to be at least as confused (likely a lot more…).
The best way to avoid any confusion is of course to set-up a market for exactly what the central bank is targeting. Hence, for an inflation targeting central bank there is of course inflation-linked bonds. However, that is not really a good guide for monetary policy if you want to avoid responding to supply shocks. Instead what we really need is NGDP-linked bonds. In the case of the US the US Treasury therefore should issue such bonds.
Had we had an US NGDP-linked bond now it would be very easy to see whether or not the markets where indeed pricing in tighter US monetary conditions and whether or not this should be a cause for concern. Furthermore, that would get us away from the constant discussion about whether higher bond yields is an indication of tighter or easier monetary conditions (it can in fact be both).
And finally if the there was an US NGDP-linked government bond then the fed could leave the time of “tapering” complete to the markets (See more on that here).