Yellen is transforming the US economy into her favourite textbook model

When you read the standard macroeconomic textbook you will be introduced to different macroeconomic models and the characteristics of these models are often described as keynesian and classical/monetarist. In the textbook version it is said that keynesians believe that prices and wages are rigid, while monetarist/classical economist believe wages and prices are fully flexible. This really is nonsense – monetarist economists do NOT argue that prices are fully flexible neither did pre-keynesian classical economists. As a result the textbook dictum between different schools is wrong.

I would instead argue that the key element in understanding the different “scenarios” we talk about in the textbook is differences in monetary regimes. Hence, in my view there are certain monetary policy rules that would make the world look “keynesian”, while other monetary policy rules would make the world look “classical”. As I have stated earlier – No ‘General Theory’ should ignore the monetary policy rule.

The standard example is fixed exchange rates versus floating exchange rates regimes. In a fixed exchange rate regime – with rigid prices and wages – the central bank will use monetary policy to ensure a fixed exchange and hence will not offset any shocks to aggregate demand. As a result a tightening of fiscal policy will cause aggregate demand to drop. This would make the world look “keynesian”.

On the other hand under a floating exchange rate regime with for example inflation targeting (or NGDP targeting) a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the central bank is targeting a fixed rate of inflation it will ease monetary policy to offset the fiscal tightening. This mean that the world becomes “classical”.

We here see that it is not really about price rigidities, but rather about the monetary regime. This also means that when we discuss fiscal multipliers – whether or not fiscal policy has an impact on aggregate demand – it is crucial to understand what monetary policy rule we have.

In this regard it is also very important to understand that the monetary policy rule is not necessarily credible and that markets’ expectations about the monetary policy rule can change over time as a result of the actions and communication of the central and that that will cause the ‘functioning’ the economy to change. Hence, we can imagine that one day the economy is “classical” (and stable) and the next day the economy becomes “keynesian” (and unstable).

Yellen is a keynesian – unfortunately

I fear that what is happening right now in the US economy is that we are moving from a “classical” world – where the Federal Reserve was following a fairly well-defined rule (the Bernanke-Evans rule) and was using a fairly well-defined (though not optimal) monetary policy instrument (money base control) – and to a much less rule based monetary policy regime where first of all the target for monetary policy is changing and equally important that the Fed’s monetary policy instrument is changing.

When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation.

It is also clear that Yellen is extraordinarily uncomfortable about thinking about monetary policy in terms of money creation (money base control) and only think of monetary policy in terms of controlling the interest rate. And finally Yellen is essentially telling us that she (and the Fed) are better at forecasting than the markets as she continues to downplay in the importance of the fact that inflation expectations have dropped markedly recently.

This is very different from the views of Ben Bernanke who at least at the end of his term as Fed chairman left the impression that he was conducting monetary policy within a fairly well-defined framework, which included a clear commitment to offset shocks to aggregate demand. As a result the Bernanke ensured that the US economy – like during the Great Moderation – basically became “classical”. That was best illustrated during the “fiscal cliff”-episode in 2013 where major fiscal tightening did not cause the contraction in the US economy forecasted by keynesians like Paul Krugman.

However, as a result of Yellen’s much less rule based approach to monetary policy I am beginning to think that if we where to have a fiscal cliff style event today (it could for example be a Chinese meltdown) then the outcome would be a lot less benign than in 2011.

How a negative shock would play with Yellen in charge of the Fed

Imagine that the situation in China continues to deteriorate and develop into a significant downturn for the Chinese economy. How should we expect the Yellen-fed to react? First of all a “China shock” would be visible in lower market inflation expectations. However, Yellen would likely ignore that.

She has already told us she doesn’t really trust the market to tell us about future inflation. Instead Yellen would focus on the US labour market and since the labour market is a notoriously lagging indicator the labour market would tell her that everything is fine – even after the shock hit. As a result she would likely not move in terms of monetary policy before the shock would show up in the unemployment data.

Furthermore, Yellen would also be a lot less willing than Bernanke was to use money base control as the monetary policy instrument and rather use the interest rate as the monetary policy instrument. Given the fact that we are presently basically stuck at the Zero Lower Bound Yellen would likely conclude that she really couldn’t do much about the shock and instead argue that fiscal policy should be use to offset the “China shock”.

All this means that we now have introduced a new “rigidity” in the US economy. It is a “rigidity” in the Fed monetary policy rule, which means that monetary policy will not offset negative shocks to US aggregate demand.

If the market realizes this – and I believe that is actually what might be happening right now – then the financial markets might not work as the stabilizing factoring in the US economy that it was in 2013 during the fiscal cliff-event and as a result the US economy is becoming more “keynesian” and therefore also a less stable US economy.

Only a 50% keynesian economy

However, Yellen’s economy is only a 50% keynesian economy. Hence, imagine instead of a negative “China shock” we had a major easing of US fiscal policy, which would cause US aggregate demand to pick up sharply. Once that would cause US unemployment to drop Yellen would move to hike interest rates. Obviously the markets would realize this once the fiscal easing would be announced and as a result the pick up in aggregate demand would be offset by the expected monetary tightening, which would be visible in a stronger dollar, a flattening of the yield curve and a drop in equity prices.

In that sense the fiscal multiplier would be zero when fiscal policy is eased, but it would be positive when fiscal policy is tightened.

What Yellen should do 

I am concerned that Yellen’s old-school keynesian approach to monetary policy – adaptive expectations, the Phillips curve and reliance of interest rates as a policy instrument – is introducing a lot more instability in the US economy and might move us away from the nominal stability that Bernanke (finally) was able to ensure towards the end of his terms as Fed chairman.

But it don’t have to be like that. Here is what I would recommend that Yellen should do:

Introduce a clear target for monetary policy

  • Since Mid-2009 US nominal GDP has grown along a nearly straight 4% path (see here). Yellen should make that official policy as this likely also would ensure inflation close to 2% and overall stable demand growth, which would mean that shocks to aggregate demand “automatically” would be offset. It would so to speak make the US economy “classical” and stable.

Make monetary policy forward-looking

  • Instead of focusing on labour conditions and a backward-looking Phillips curve Yellen should focus on forward-looking indicators. The best thing would obviously be to look at market indicators for nominal GDP growth, but as we do not have those at least the Fed should focus on market expectations for inflation combined with surveys of future nominal GDP growth. The Fed should completely give up making its own forecasts and particularly the idea that FOMC members are making forecasts for the US economy seems to be counter-productive (today FOMC members make up their minds about what they want to do and then make a forecast to fit that decision).

Forget about interest rates – monetary policy is about money base control

  • With interest rates essentially stuck at the Zero Lower Bound it becomes impossible to ease monetary policy by using the interest rate “instrument”. In fact interest rates can never really be an “instrument”. It can be a way of communicating, but the actual monetary policy instrument will alway be the money base, which is under the full control of the Federal Reserve. It is about time that the Fed stop talking about money base control in discretionary terms (as QE1, QE2 etc.) and instead start to talk about setting a target for money base growth to hit the ultimate target of monetary policy (4% NGDP level targeting) and let interest rates be fully market determined.

I am not optimistic that the Fed is likely to move in this direction anytime soon and rather I fear that monetary policy is set to become even more discretionary and that the downside risks to the US economy has increased as Yellen’s communication is making it less likely that the markets will trust her to offset negative shocks to the US economy. The Keynesians got what they asked for – a keynesian economy.

PS I have earlier had a similar discussion regarding the euro zone. See here. That post was very much inspired by Brad Delong and Larry Summers’ paper Fiscal Policy in a Depressed Economy.

PPS I would also blame Stanley Fischer – who I regret to say thought would make a good Fed chairman – for a lot of what is happening right now. While Stanley Fischer was the governor of the Bank of Israel he was essentially a NGDP targeting central banker, but now he seems preoccupied with “macroprudential” analysis, which is causing him to advocate monetary tightening at a time where the US economy does not need it.

PPPS I realize that my characterization of Janet Yellen partly is a caricature, but relative to Ben Bernanke and in terms of what this means for market expectations I believe the characterization is fair.

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: For US readers note that I will be “touring” the US in the end of October.

Brad, Ben (Beckworth?) and Bob

I have been a bit too busy to blog recently and at the moment I am enjoying a short Easter vacation with the family in the Christensen vacation home in Skåne (Southern Sweden), but just to remind you that I am still around I have a bit of stuff for you. Or rather there is quite a bit that I wanted to blog about, but which you will just get the links and some very short comments.

First, Brad DeLong is far to hard on us monetarists when he tells his story about “The Monetarist Mistake”. Brad story is essentially that the monetarists are wrong about the causes of the Great Depression and he is uses Barry Eichengreen (and his new book Hall of Mirrors to justify this view. I must admit I find Brad’s critique a bit odd. First of all because Eichengreen’s fantastic book “Golden Fetters” exactly shows how there clearly demonstrates the monetary causes of the Great Depression. Unfortunately Barry does not draw the same conclusion regarding the Great Recession in Hall of Mirrors (I have not finished reading it all yet – so it is not time for a review yet) even though I believe that (Market) Monetarists like Scott Sumner and Bob Hetzel forcefully have made the argument that the Great Recession – like the Great Depression – was caused by monetary policy failure. (David Glasner has a great blog on DeLong’s blog post – even though I still am puzzled why David remains so critical about Milton Friedman)

Second, Ben Bernanke is blogging! That is very good news for those of us interested in monetary matters. Bernanke was/is a great monetary scholar and even though I often have been critical about the Federal Reserve’s conduct of monetary policy under his leadership I certainly look forward to following his blogging.

The first blog posts are great. In the first post Bernanke is discussing why interest rates are so low as they presently are in the Western world. Bernanke is essentially echoing Milton Friedman and the (Market) Monetarist message – interest rates are low because the economy is weak and the Fed can essentially not control interest rates over the longer run. This is Bernanke:

If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.

To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.

It will be hard to find any self-described Market Monetarist that would disagree with Bernanke’s comments. In fact as Benjamin Cole rightly notes Bernanke comes close to sounding exactly as David Beckworth. Just take a look at these blog posts by David (here, here and here).

So maybe Bernanke in future blog posts will come out even more directly advocating views that are similar to Market Monetarism and in this regard it would of course be extremely interesting to hear his views on Nominal GDP targeting.

Third and finally Richmond Fed’s Bob Hetzel has a very interesting new “Economic Brief”: Nominal GDP: Target or Benchmark? Here is the abstract:

Some observers have argued that the Federal Reserve would best fulfi ll its mandate by adopting a target for nominal gross domestic product (GDP). Insights from the monetarist tradition suggest that nominal GDP targeting could be destabilizing. However, adopting benchmarks for both nominal and real GDP could offer useful information about when monetary policy is too tight or too loose.

It might disappoint some that Bob fails to come out and explicitly advocate NGDP level targeting. However, I am not disappointed at all as I was well-aware of Bob’s reservations. However, the important point here is that Bob makes it clear that NGDP could be a useful “benchmark”. This is Bob:

At the same time, articulation of a benchmark path for the level of nominal GDP would be a useful start in formulating and communicating policy as a rule. An explicit rule would in turn highlight the importance of shaping the expectations of markets about the way in which the central bank will behave in the future. A benchmark path for the level of nominal GDP would encourage the FOMC to articulate a strategy (rule) that it believes will keep its forecasts of nominal GDP aligned with its benchmark path. In recessions, nominal GDP growth declines significantly. During periods of inflation, it increases significantly.

The FOMC would then need to address the source of these deviations. Did they arise as a consequence of powerful external shocks? Alternatively, did they arise as a consequence either of a poor strategy (rule) or from a departure from an optimal rule?

That I believe is the closest Bob ever on paper has been to give his full endorsement of NGDP “targeting” – Now we just need Bernanke (and Yellen!) to tell us that he agrees.


UPDATE: This blog post should really have had the headline “Brad, Ben, Bob AND George”…as George Selgin has a new blog post on the new(ish) blog Alt-M and that is ‘Definitely Not “Ben Bernanke’s Blog”’

ECB: “We’re not sure we can get out of it”

When Milton Friedman turned 90 years back in 2002 Ben Bernanke famously apologized for the Federal Reserve’s role in the Great Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

On Twiiter Ravi Varghese has paraphrased Bernanke to describe the role of the ECB in the present crisis:

“You’re right, we did it. We’re very sorry. But we’re not sure we can get out of it.”

Brilliant…follow Ravi on Twiiter here (and follow me here). has the only data the FOMC needs

Justin Ivring did it! With some help from his body Kenneth D’Amica he has set up a new website, which shows a real-time forecast for next year’s expected US NGDP growth. The forecast is based on financial market data. I think it is tremendously promising and look very much forward to start to follow the data on the website.

I certainly looking forward to following during this week’s FOMC policy announcement. We will know in real-time whether or not monetary policy has been tightened or not.

This is really the only data the FOMC would need to look at in the future. I am not kidding. The FOMC should announce that it would like to see a market forecast of 6% or 7% NGDP growth next year and that it will conduct monetary policy in such a fashion as to ensure this target until a certain level for NGDP is hit. Thereafter after it should be made clear that the FOMC will keep market expectations for NGDP at 4 or 5%.

Finally, I strongly recommend to financial market reporters and commentators to get acquainted with It will make your reporting on fed comments much easier. Just imagine the following statement “Bernanke said blah, blah, blah…NGDP expectations dropped by XXbp indicating a tightening of monetary conditions on the back of Bernanke’s statement. Fed policy is still overly tight compared with the objective of…Analysts said that the fed needs to communicate more aggressively to push back NGDP expectations to the fed target.” 

Good job Justin and Kenneth!

PS See more on the construction of the data and relevant links to Justin’s work here.

This is why we need an NGDP futures market

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).

HT Cthorm


PS Scott Sumner and Evan Soltas have similar discussions

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.

Chuck Norris beats Wolfgang Schäuble

So far it is has been a remarkable week in the global financial markets. The ’deposit grab’ in Cyprus undoubtedly has shocked international investors and confidence in the ability of euro zone policy makers has dropped to an all-time low.

Despite of the ‘Cyprus shock’ global stock markets continue to climb higher – yes, yes we have seen a little more volatility, but the overall picture is that of a continued global stock market rally. That is surely remarkable when one takes into account the scale of the policy blunder committed by the EU in Cyprus and the likely long-lasting damage done to the confidence in EU policy makers.

I therefore think it is fair to conclude that so far Chuck Norris has beaten German Finance Minister Wolfgang Schäuble. Or said, in another way the Chuck Norris effect has been at work all week and that has clearly been a key reason why we have not (yet?) seen global-wide or even European-wide contagion from the disaster in Cyprus.

Just to remind my readers – the Chuck Norris effect of course is the effect that monetary policy not only works through expanding the money base, but also through guiding expectations.

When I early this week expressed my worries (or rather mostly my anger) over the EU’s handling of the situation in Cyprus a fixed income trader who is a colleague of mine comforted me by saying “Lars, you have now for half a year been saying that the Fed and the Bank of Japan are more or less doing the right thing so shouldn’t we expect the Fed and BoJ to offset any shock from the euro zone?” (I am paraphrasing a little – after all we were talking on a trading floor)

The message from the trader was clear. Yes, the EU is making a mess of things, but with the Bernanke-Evans rule in place and the Bank of Japan’s newfound commitment to a 2% inflation target we should expect that any shock from the euro zone to the US and Japanese economies would be ‘offset’ by the Fed and the BoJ by stepping up quantitative easing.

The logic is basically is that if an European shock pushes up US unemployment up we should expect the Fed to do even more QE and if that same shock leads to a strengthening of the yen (that mostly happens when global risk aversion increases) then the BoJ would also do more QE to try to meet its 2% inflation target. Said in another way any increase in demand for US dollar and yen is likely to be met by an increase in the supply of dollars and yen. In that sense the money base is ‘elastic’ in a similar sense as it would be under NGDP targeting. It is less perfect, but it nonetheless seems to be working – at least for now.

The fact that markets now expect the supply of dollars and yens to be at least quasi-elastic in itself means that the markets are not starting to hoard dollars and yen despite the ‘Cyprus shock’. This is the Chuck Norris effect at work – the central banks doesn’t have to do anything else that to reaffirm their commitment to their targets. This is exactly what the Federal Reserve did yesterday and what the new governor of Bank of Japan Kuroda is expected to do later today at his first press conference.

So there is no doubt – Chuck Norris won the first round against Wolfgang Schäuble and other EU policy makers. Thank god for that.


The graph Bernanke should look at before ‘exiting’ anything

Here is the Federal Reserve’s mandate:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

I don’t think it is the greatest mandate in the world, but it is the Fed’s mandate nonetheless.

I tried to estimate a simple reaction function for the fed based on “employment” (rate, Civilian Employment-Population ratio) and “prices” (PCE core inflation).  The estimation period is 1990 to 2007. 2008-13 is forecast.

Mankiw rule

Take a look at the forecast. The model is “forecasting” that the Fed funds target rate should be -7%!

I will leave it to my readers to judge whether the fed should ‘exit’ its quantitative easing programmes or not.

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

I stole this from Scott Sumner:

Sen. Tom Coburn (R., Okla.) asks whether all the major central banks easing might diminish the benefits and lead to trade protectionism.

“We don’t view monetary policy aimed at domestic goals a currency war,” [Bernanke] says. Easing policy can be “mutually beneficial” to other countries such as China, which depends on domestic demand in the U.S.

It’s a “positive-sum game, not a zero-sum game,” Bernanke says.

I don’t think Bernanke is reading this blog, but I feel like quoting myself:

Monetary easing is not a negative or a zero sum game. In a quasi-deflationary world monetary easing is a positive sum game.

I have not always been impressed with Bernanke and he has certainly made his fair share of mistakes, but he certainly is more knowledgable about monetary policy than Republican lawmakers.


Bernanke says Friedman would have approved of Fed’s recent actions – I think is he more or less right

Ben Bernanke today in a speech further tried to explain the Fed’s recent policy actions. As Scott Sumner says in a comment: “The Fed seems to be getting a bit more market monetarist each day”. That might be slightly too optimistic of what is going on at the Fed and I remain frustrated about about two things in how Bernanke is communicating. First he is focusing on real variables (the labour market) rather than on nominal variables. Second, his discussion of the monetary transmission mechanism is overly focused on yields and interest rates rather than on money creation. That said, I continue to believe that the Fed is moving in the right direction. Bernanke’s speech today is further prove of that and I must say I feel increasingly optimistic that this will pull the US economy out of the crisis.

I am particularly encouraged by the following comments from Bernanke (my bold):

“In the category of communications policy, we also extended our estimate of how long we expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015. That doesn’t mean that we expect the economy to be weak through 2015. Rather, our message was that, so long as price stability is preserved, we will take care not to raise rates prematurely. Specifically, we expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens. We hope that, by clarifying our expectations about future policy, we can provide individuals, families, businesses, and financial markets greater confidence about the Federal Reserve’s commitment to promoting a sustainable recovery and that, as a result, they will become more willing to invest, hire and spend.”

Bernanke is beginning more clearly to spell out how his monetary policy rule looks like. This is what is needed is he whats to get the help from the Chuck Norris effect to reestablish nominal stability and pull the US economy out of this crisis.

Interestingly enough Bernanke was asked after his speech today whether he thinks Friedman would have supported the fed’s recent actions. Bernanke was stated that he was a “big fan” of Milton Friedman and then said that “I think he would’ve supported what we are doing”. I think Bernanke is broadly speaking correct. I am very sure that Friedman would have had the same reservation that I note about, but I am also pretty sure that he would have made the same recommendation regarding the US economy today as he did regarding the Japanese economy in 1997:

“The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

Japan’s recent experience of three years of near zero economic growth is an eerie, if less dramatic, replay of the great contraction in the United States. The Fed permitted the quantity of money to decline by one-third from 1929 to 1933, just as the Bank of Japan permitted monetary growth to be low or negative in recent years. The monetary collapse was far greater in the United States than in Japan, which is why the economic collapse was far more severe. The United States revived when monetary growth resumed, as Japan will.

The Fed pointed to low interest rates as evidence that it was following an easy money policy and never mentioned the quantity of money. The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the “drastic monetary measures” that the bank took in 1995 as evidence of “the easy stance of monetary policy.” He too did not mention the quantity of money. Judged by the discount rate, which was reduced from 1.75 percent to 0.5 percent, the measures were drastic. Judged by monetary growth, they were too little too late, raising monetary growth from 1.5 percent a year in the prior three and a half years to only 3.25 percent in the next two and a half.

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

James Pethokoukis uses the same quote in his comment on Bernanke – and I have used the quote earlier in discussing what Friedman would have said about European monetary policy. While I think that the situation in the euro zone today is very similar to the situation in Japan 1997 I would also argue that the US economy is in somewhat better shape today that Japan in the late 1990s. This of course means that some caution is warranted regarding monetary easing in the US, but to me at least the risks on US inflation still remain on the downside.

Again see the Friedman’s quote above and what Bernanke said today (quoted from Joe Weisenthal on Business Insider):

“We didn’t allow the fact that interest rates were very low to fool us into thinking that monetary policy was accommodative enough.”

It is very nice to see that Bernanke now finally is recognizing this. I would hope a all of his central banking colleagues around the world – particularly in Europe would understand this.

Finally I don’t think the Fed is all there yet. NGDP level targeting is much preferable to what the Fed is now trying to implement. Furthermore, I would hope Bernanke and his colleagues would try to get a bit more of a monetarist perspective on the monetary transmission mechanism instead of the continued focus on interest rates.

PS George Selgin has a slightly related blog post on discussing Austrians’ and Market Monetarists’ view of “Intermediate Spending Booms”

Update: Matt O’Brien has an excellent piece on Narayana Kocherlakota amazing transformation,


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