The “Weidmann rule” and the asymmetrical budget multiplier (is the euro zone 50% keynesian?)

During Christmas and New Years I have been able to (nearly) not think about monetary policy and economics, but I nonetheless came across some comments from Bundesbank chief Jens Weidmann from last week, which made me think about the connection between monetary policy rules and fiscal austerity in the euro zone. I will try address these issues in this post.  

This is Jens Weidmann:

“The euro zone is recovering only gradually from the harshest economic crisis in the post-war period and there are few price risks. This justifies the low interest rate…Low price pressure however cannot be a licence for arbitrary monetary easing and we must be sure to raise rates at the right time should inflation pressure mount.”

It is the second part of the quote, which is interesting. Here Weidmann basically spells out his preferred reaction function for the ECB and what he is saying is that he bascially wants an asymmetrical monetary policy rule – when inflation drops below the ECB’s 2% inflation target the ECB should not “arbitrary” cut its key policy rate, but when inflation pressures increase he wants the ECB to act imitiately.

It is not given that the ECB actually has such a policy rule, but given the enormous influence of the Bundesbank on ECB policy making it is probably reasonable to assume that that is the case. That in my view would mean that Summer Critique does not apply (fully) to the euro zone and as a result we can think of the euro zone as being at least 50% “keynesian” in the sense that fiscal shocks will not be fully offset by monetary policy. As a result it would be wrong to assume that the budget multiplier is zero in the euro zone – or rather it is not always zero. The budget multiplier is asymmetrical.

Let me try to illustrate this within a simple AS/AD framework.

First we start out with a symmetrical policy rule – an inflation targeting ECB. Our starting point is a situation where inflation is at 2% – the ECB’s official inflation target – and the ECB will move to offset any shock (positive and negative) to aggregate demand to keep inflation (expectations) at 2%. The graph below illustrates this.

ASAD AD shock

If the euro zone economy is hit by a negative demand shock in the form of for example fiscal tightening across the currency union the AD curve inititally shifts to the left (from AD to AD’). This will push inflation below the ECB’s 2% inflation target. As this happens the ECB will automatically move to offset this shock by easing monetary policy. This will shift the AD curve back (from AD’ to AD). With a credible monetary policy rule the markets would probably do most of the lifting.

The Weidmann rule – asymmetry rules

However, the Weidmann rule as formulated above is not symmetrical. In Weidmann’s world a negative shock to aggregate demand – for example fiscal tightening – will not automatically be offset by monetary policy. Hence, in the graph above the negative shock aggregate demand (from AD to AD’) will just lead to a drop in real GDP growth and in inflation to below 2%. Given the ECB’s official 2% would imply the ECB should move to offset the negative AD shock, but that is not the case under the Weidmann rule. Hence, under the Weidmann rule a tightening of fiscal policy will lead to drop in aggregate demand. This means that the fiscal multiplier is positive, but only when the fiscal shock is negative.

This means that the Sumner Critique does not hold under the Weidman rule. Fiscal consolidation will indeed have a negative impact on aggregate demand (nominal spending). In that sense the keynesians are right – fiscal consolidation in the euro zone has likely had an negative impact on euro zone growth if the ECB consistently has followed a Weidmann rule. Whether that is the case or not is ultimately an empirical question, but I must admit that I increasingly think that that is the case. The austerity drive in the euro zone has likely been deflationary. However, it is important to note that this is only so because of the conduct of monetary policy in the euro area. Had the ECB instead had an fed style Evans rule with a symmetrical policy rule then the Sumner Critique would have applied also for the euro area.

The fact that the budget multiplier is positive could be seen as an argument against fiscal austerity in the euro zone. However, interestingly enough it is not an argument for fiscal stimulus.  Hence, according to Jens Weidmann the ECB “must be sure to raise rates at the right time should inflation pressure mount”. Said in another way if the AD curve shifts to the right – increasing inflation and real GDP growth then the ECB should offset this with higher interest rates even when inflation is below the ECB’s 2% inflation target.

This means that there is full monetary offset if fiscal policy is eased. Therefore the Sumner Critique applies under fiscal easing and the budget multiplier is zero.

The Weidmann rule guarantees deflation 

Concluding, with the Weidmann rule fiscal tightening will be deflationary – inflation will drop as will real GDP growth. But fiscal stimulus will not increase aggregate demand. The result of this is that if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).

This is of course exactly what we have seen over the past five years. But don’t blame fiscal austerity – blame the Weidmann rule.

NGDP euro zone USA

PS I should really acknowledge that this is a variation over a theme stressed by Larry Summers and Brad Delong in their paper Fiscal Policy in a Depressed Economy. See my discussion of that paper here.

About these ads

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.

 

Fed NGDP targeting would greatly increase global financial stability

Just when we thought that the worst was over and that the world was on the way safely out of the crisis a new shock hit. Not surprisingly it is once again a shock from the euro zone. This time the badly executed bailout (and bail-in) of Cyprus. This post, however, is not about Cyprus, but rather on importance of the US monetary policy setting on global financial stability, but the case of Cyprus provides a reminder of the present global financial fragility and what role monetary policy plays in this.

Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster 

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity.

Hence, lets for example imagine that a sovereign default in an euro zone country shocks investors, who run for cover and starts buying ‘safe assets’. Among other things that would be the US dollar. This would obviously be similarly to what happened in the Autumn of 2008 then US monetary policy became ‘adaptive’ when interest rates effectively hit zero. As a consequence the US dollar rallied strongly. The ill-timed interest rates hikes from the ECB in 2011 had exactly the same impact – a run for safe assets caused the dollar to rally.

In that sense under an ‘adaptive’ monetary policy the Fed is effective allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

As the Fed is a ‘global monetary superpower’ a tightening of US monetary conditions by default leads to a tightening of global monetary conditions due to the dollar’s role as an international reserve currency and due to the fact that many central banks around the world are either pegging their currencies to the dollar or at least are ‘shadowing’ US monetary policy.

In that sense a negative financial shock from Europe will be ‘escalated’ as the fed conducts monetary policy in an adaptive way and fails to offset negative velocity shocks.

This also means that under an ‘adaptive’ policy regime the risk of contagion from one country’s crisis to another is greatly increased. This obviously is what we saw in 2008-9.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity as Fed policy automatically would counteract the shock to US money-velocity. As a consequence there would be no reason to expect any major negative impact on for example the overall performance of US stock markets. Furthermore, as a ‘global monetary policy’ the automatic increase in the US money base would curb the strengthening of the dollar and hence curb the tightening of global monetary conditions, which great would reduce the global financial fallout from the euro zone sovereign default.

Finally and most importantly the financial markets would under a system of a credible Fed NGDP target figure all this out on their own. That would mean that investors would not necessarily run for safe assets in the event of an euro zone country defaulting – or some other major financial shock happening – as investors would know that the supply of the dollar effectively would be ‘elastic’. Any increase in dollar demand would be meet by a one-to-one increase in the dollar supply (an increase in the US money base). Hence, the likelihood of a ‘global financial panic’ (for lack of a better term) is massively reduced as investors will not be lead to fear that we will ‘run out of dollar’ – as was the case in 2008.

The Bernanke-Evans rule improves global financial stability, but is far from enough

We all know that the Fed is not operating an NGDP targeting regime today. However, since September last year the Fed clearly has moved closer to a rule based monetary policy in the form of the Bernanke-Evans rule. The BE rule effective mean that the Fed has committed itself to offset any shock that would increase US unemployment by stepping up quantitative easing. That at least partially is a commitment to offset negative shocks to money-velocity. However, the problem is that the fed policy is still unclear and there is certainly still a large element of ‘adaptive’ policy (discretionary policy) in the way the fed is conducting monetary policy.  Hence, the markets cannot be sure that the Fed will actually fully offset negative velocity-shocks due to for example an euro zone sovereign default. But at least this is much better than what we had before – when Fed policy was high discretionary.

Furthermore, I think there is reason to be happy that the Bank of Japan now also have moved decisively towards a more rule based monetary policy in the form of a 2% inflation targeting (an NGDP targeting obviously would have been better). For the past 15 year the BoJ has been the ‘model’ for adaptive monetary policy, but that hopefully is now changing and as the yen also is an international reserve currency the yen tends to strengthen when investors are looking for safe assets. With a more strict inflation target the BoJ should, however, be expected to a large extent to offset the strengthening of the yen as a stronger yen is push down Japanese inflation.

Therefore, the recent changes of monetary policy rules in the US and Japan likely is very good news for global financial stability. However, the new regimes are still untested and is still not fully trusted by the markets. That means that investors can still not be fully convinced that a sovereign default in a minor euro zone country will not cause global financial distress.

The Fed’s easing is working…in Mexico

Is the “Bernanke-Evans rule” working? Hell yes! At least in Mexico!

The Mexican economy recovered fast from the shock in 2008-9 and real GDP has been growing around 5% in the last three years and now growth is getting a further boost from the Fed’s monetary easing. Just take a look at the graphs below – especially keep an eye on what have happened since September 13 when the so-called Bernanke-Evans rule effectively was announced.

The Bernanke-Evans rule boosts the Mexican stock market

MXN stock market

Mexican consumers get a boost from Bernanke

conconfMEX

Mexican industrialists are falling in love with Bernanke

PMI mexico

The US-Mex monetary transmission mechanism

A traditional Keynesian interpretation of what is going on would be that Bernanke’s monetary easing is boosting US industrial production, which is leading to an increase in Mexican exports to the US. The story is obviously right, but I would suggest that it is not the most important story. Rather what is important is the monetary transmission mechanism from the US to Mexico.

Here is that story. When the Fed steps up monetary easing it leads to a weakening of the dollar against all other currencies – including the Mexican peso as funds flow out of the US and into the Mexican markets. The Mexican central bank Banxico now has two options. Either the central bank de facto allows the peso to strengthen or it decides to “import” the Fed’s monetary easing by directly intervening in the currency market – buying dollars and selling pesos – or by cutting interest rates. No matter how this is done the result will be an increase in the Mexican money supply (relative to what otherwise would have happened). This in my view is what is driving the rally in the Mexican stock market and the spike in consumer and business confidence. It’s all monetary my friend.

Obviously Banxico don’t have to import the monetary easing from the US, but so far have chosen to do so. This has probably been well-advised, but the Mexican economy is certainly not in need of a US scale monetary easing. What is right for the US is not necessarily right for Mexico when it comes to monetary easing. Therefore, Banxico sooner or later have stop “importing” monetary easing from the US.

Luckily the Banxico can choose to “decouple” from the US monetary easing by allowing the peso to strengthen and thereby curb the increase in the money supply and reduce potential inflationary pressures. This in fact seems to be what has been happening in recent weeks where the peso has rallied against the dollar.

This is not the place to discuss what Banxico will do, but think the discussion of the US-Mex monetary transmission mechanism pretty well describe what many Emerging Markets central banks are now facing – monetary easing from the US is forcing them to choose between a stronger currency or a monetary expansion. However, unlike what Brazilian Finance Minister Mantega seems to think this is not such a terrible thing. Banxico and the Brazilian central bank and other EM central banks remain fully in charge of monetary policy themselves and if the central banks are clear about their monetary targets then the markets will do most of the lifting through the exchange rate channel.

Imagine for example that the Mexican peso starts to strengthen dramatically. Then that likely will push down Mexican inflation below Banxico’s inflation target pretty fast. With inflation dropping below the inflation target the markets will start to price a counter-reaction and a stepping up of monetary easing from Banxico and that in itself will curb the strengthening of the peso. Hence, the credibility of the central bank’s target is key.

And it is here that the Brazilians are facing a problem. As long as the central bank has one target things are fine. However, the Brazilian authorities often try to do more than one thing with monetary policy. Imagine the Brazilian economy is growing nicely and inflation is around the central bank’s inflation target. Then a positive monetary shock from the US will lead the Brazilian real to strengthen. That is no problem in terms of the inflation target. However, it will likely also lead the Brazilian export sector facing a competitiveness problem. Trying to “fix” this problem by easing monetary policy will on the other hand lead to excessively easy monetary policy. The Brazilian authorities have often tried to solve this “problem” by trying to curb currency inflows with different forms of currency restrictions and taxes. That has hardly been a success and luckily the Mexican authorities are much less interventionist in their attitudes.

The lesson here is that the Federal Reserve is a monetary superpower and the Fed can export monetary easing to other countries, but that do not mean that the Fed is in charge of monetary policy in Brazil or Mexico. The Brazilian and Mexican central banks can also choose not to import the monetary easing by simply letting their currencies strengthen and instead focus on it’s own monetary policy targets instead of trying to solve other “problems” such as competitiveness concerns. Excessive focus on competitiveness will lead central banks to ease monetary policy too much and the result is often rising inflationary pressures and bubbles.

PS don’t think that is this a zero sum – just because the Fed’s easing is working in Mexico does not mean that it is not working in the US.

PPS Nick Rowe once told a similar story about Hong Kong…with another FX regime.

The fiscal cliff has never been a market theme

When I over the last couple of days have looked at my twitter account nine of ten tweets have been about the “fiscal cliff” and the financial media all over the world have been all about that horrible “cliff”. Commentators from left to right in the US have issued warnings about the horrors of the fiscal cliff. Yes, it has felt very much like we indeed have been heading for an economic meltdown. Economic slowdown in China or the euro crisis is not important – the only thing important is the fiscal cliff (blah, blah…)

Just take a look at what Google Trends is telling us. The graph below shows searches for “fiscal cliff” over the last 90 days.

googlecliff

Since mid-November the searches for “fiscal cliff” has clearly picked up and really spiked in the last couple of weeks.

However, despite the desperate efforts of pundits and the financial media the fiscal cliff has never really become a serious market theme. The best way to illustrate this is to look at the US stock market – and more specifically on two sets of stocks – defense stocks and “consumer discretionaries”. Both sectors should be expected to be impacted heavily in the event of a full-blown fiscal cliff event as a result of tax hikes and cuts in US defend spending. I have looked the two sectors’ performance during 2012 relative to the overall stock market performance (S&P500).

If the market really had been worried about the fiscal cliff we should have seen defense stocks and consumer discretionaries plummet. However, as the graph below shows that has certainly not been the case.

fiscal cliff

In fact both consumer discretionaries and defence stocks have outperformed the overall US stock market since August-September. Therefore if anything the performance of these two sub-indices have been positively correlated with the fiscal cliff “worries”.

In fact I would argue that the markets have paid little substantial attention to the ongoing political noise from Washington. It is for example notable that defence stocks have continued to do well despite Obama’s reelection.

This of course do not prove that fiscal policy is not important – far from it, but other things are certainly much more important and the markets are a lot more forward-looking than it seems to be the “normal” perception in the financial media. The discussion of the fiscal cliff has not been (a market moving) surprise to the markets and neither has been the political “show” that we have seen in recent weeks. Yes, the US political system is dysfunctional, but that is really no surprise to the markets. Nor is it likely to be a surprise to US corporations and consumers. As consequence it hard to believe that the fiscal cliff can be classified as an “shock” to the economic system.

A the fiscal cliff as a textbook take-it-or-leave-it game

As my good friend professor Peter Kurrild-Klitgaard has noted the negotiations about the fiscal cliff has been a complete textbook example of a take-it-or-leave-it game. Even though pundits on the left and the right of US politics have bashed both the GOP and the Democrats for failing in the negotiations there is really nothing surprising about how the negotiations have played out. Any student of game theory would tell you that and apparently the markets understand game theory better than pundits and the financial media reporters.

There is no reason to play the blame game here – both the GOP and the Democrats (including the President) have so far pretty much behaved rationally (in a game theoretical sense) – that of course do not mean that what they are doing is nice to look at or for that matter in the interest of the American people, but game theorists would not be surprised – neither has the markets been.

For good discussion of the game theoretical aspects of the fiscal cliff negotiation see this excellent post by John Patty on the “The Math of Politics” blog from December 14 2012.

The real market mover is monetary policy

Finally let me just repeat the Market Monetarist position (see more previous posts on the issue here, here, here and here). Monetary policy dominates fiscal policy – the Fed will be able to counteract any negative shock to aggregate demand (or nominal GDP). The performance of consumer discretionary stocks pretty well illustrates this. As the market started to price in QE3 in August and later was positively surprised by the implicit announcement of the Bernanke-Evans rule in September consumer discretionaries have rallied. Hence, at least judging from the stock market performance monetary policy has dominated fiscal policy worries. I am not arguing that if the there had not been a “deal” on the fiscal cliff the markets would have not seen a set-back, but I am certainly arguing that this issue has gotten far to much attention compared to have relatively unimportant the issue is.

I am normally not making predictions here, but I today predict that “fiscal cliff” searches on Google has already peaked (but no I am not a betting man). From today the fiscal cliff is so much 2012. It is time to focus on something else…also for the financial media.

PS fiscal policy always have an impact of income distribution and as far and as I can see this is the real issue in the US, but that does not really make the discussion important from a macroeconomic perspective (unless it has supply side effects).

The fiscal cliff is not the end of the world

Today is supposed to be the end of the world – at least according to classic Mayan accounts (and Hollywood?). But so far we are still here and there are not really any signs that the world really is coming to an end today. However, judging from media reports the world might be coming to an end at least in economic terms as the feared “fiscal cliff” is drawing closer after U.S. House of Representatives Speaker John Boehner yesterday failed to get support for his so-called “plan B”.

The fear is that on January 1 we will get a massive US fiscal tightening unless a compromise to avoid it is reached. However, as I earlier have argued the fiscal cliff might not be as bad as it commonly is said to be. The fact is that no matter what US policy makers will have to tighten fiscal policy in the coming years as the size of the budget deficit clearly is unsustainable. Hence, it is just really a timing issue about when fiscal policy will have to be tightened. Fiscal tightening is unavoidable.

The Permanent Income Hypothesis and the Sumner Critique
- two reasons why the fiscal cliff is not the end of the world

Said in another way whether or not there is a compromise made on the fiscal cliff or not – this time around – it will have no impact on the average American’s Permanent Income. Hence, the average American will have to pay for the US budget deficit in some way or another today or tomorrow. There is really no way around it.

In his brilliant book “A Theory of the Consumption Function” Milton Friedman distinguished between permanent and transitory changes in income and he argued – contrary to the prevailing Keynesian dogma at the time – that only permanent changes in income would have an impact on private consumption.

This also means that if tax payers are given a tax break today, but are told that they will have to pay it all back in the form of higher taxes tomorrow then it will have no impact on private consumption today as the income increase is only transitory and will have no impact on the tax payers’ permanent income.

This would obviously also mean that if US tax rates are indeed increased in 2013 and that the revenue is used to reduce the US budget deficit then that will have no negative impact on the US tax payers’ permanent income as higher taxes today basically just mean that taxes will not have to be increased in the future.  This result of course is a variation of the so-called Ricardian Equivalence Theorem as formulated by Robert Barro in his classic article “Are government bonds net wealth?” from 1974.

Hence, if you believe in the fundamental truth of Friedman’s Permanent Income Hypothesis then you would expect the impact of a tax increase to cut the budget deficit and public debt to be much smaller than what the paleo-Keynesian textbook models would indicate.

One can of course debate whether the Permanent Income Hypothesis is correct or not and discuss especially the empirical validity of the Ricardian Equivalence Theorem (RET). Personally I am somewhat skeptical about assuming that RET will always hold.

However, on the other hand if the budget deficit is not reduced then sooner or later I certainly would expect some kind of RET style effect to kick in. That would naturally trigger consumers to cut spending on the expectation of higher taxes. The budget deficit will have to be cut – either through higher taxes or lower public spending - whether or not the fiscal cliff (if it happens).

I am not arguing that tax increases are good – certainly not. I think higher taxes have significantly negative supply side effects but I am very skeptical about the view that private consumption automatically will drop as much as the increase in taxes and even more skeptical that that would have an impact on aggregate demand (more on that below).

This discussion is similar to the discussion in a new paper by Matt Mitchell and Andrea Castillo. In their paper “What went wrong with the Bush tax cuts?” they discuss why the Bush tax cuts failed to spur growth.

I must admit I have not fully digested the paper yet (it just came out), but as I read it Mitchell and Castillo argue that the 2001 Bush tax cuts failed to have the intended economic impact primarily for two reasons. First, the tax cuts were announced to be temporary – and hence Milton Friedman would have told you that it would have no impact on permanent income and hence no impact on private consumption. Second, Mitchell and Castillo argue that since the tax cuts were not accompanied by similar budget cuts then consumers and investors would not expect the tax cuts to last – even if politicians had claimed they would.

I believe that if one argues that the Bush tax cuts failed to boost private consumption growth because of the reasons discussed above then you would have to think that there will be little impact on private consumption when the tax cuts expire. Again I am not talking about supply side effects, but the expected impact on private consumption and aggregate demand.

Aggregate demand is determined by monetary policy and not by fiscal policy

Even if the fiscal cliff would be a negative shock to private consumption and public spending it is certainly not given that that would lead to a drop in overall aggregate demand. As I have discussed in earlier posts if the central bank targets NGDP or inflation for that matter then the central bank tries to counteract any negative demand shock (for example a fiscal tightening) by a similarly sized monetary expansion.

Even if we assume that we are in a textbook style IS/LM world with sticky prices and where the money demand is interest rate sensitive the budget multiplier will be zero if the central bank follows a rule to stabilize aggregate demand/NGDP.

As I have shown in an earlier post the LM curve becomes vertical if the monetary policy rule targets a certain level of unemployment or aggregate demand. This is exactly what the Bernanke-Evans rule implies. Effectively that means that if the fiscal cliff were to push up unemployment then the Fed would simply step up quantitative easing to force back down unemployment again.

Obviously the Fed’s actual conduct of monetary policy is much less “automatic” and rule-following than I here imply, but it is pretty certain that a 3, 4 or 5% of GDP tightening of fiscal policy in the US would trigger a very strong counter-reaction from the Federal Reserve and I strongly believe that the Fed would be able to counteract any negative shock to aggregate demand by easing monetary policy. This of course is the so-called Sumner Critique.

The fiscal cliff is not going to be fun
…but it will certainly not be the end of the world

I am not arguing here that the fiscal cliff would be without problems. While the US certainly needs consolidation of public finances there are likely only small costs of postponing the fiscal adjustment and the uncertainty about the US tax code is certainly not good news from a supply side perspective. However, from a aggregate demand perspective I think there is much less reason to be worried than debate in the US would indicate.

Relax the world is not coming to an end…yet.

PS I admit that judging from the market action today we have to conclude that investors are likely not as relaxed about the fiscal cliff as I am. As a faithful Market Monetarist that leaves me with a bit of a dilemma – should I trust my own economic reasoning or should I trust the signals from the markets?

PPS this guy – my friend Martin – is well-prepared for an alien invasion (he is completely unprepared for the fiscal cliff)

MOH

Kocherlakota’s revelation

This is from Bloomberg:

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the central bank should hold the main interest rate near zero until unemployment falls below 5.5 percent, marking the first time he has linked policy to a specific economic goal.

“As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent,” Kocherlakota said today in the text of remarks prepared for a speech in Ironwood, Michigan, referring the policy-setting Federal Open Market Committee.

…Kocherlakota today embraced a proposal by Chicago Fed President Charles Evans to calibrate monetary policy based on specific economic goals. Evans advocates holding to near-zero rates until the jobless rate falls below 7 percent or inflation reaches 3 percent.

“My thinking has been greatly influenced by his,” Kocherlakota said, referring to Evans. “By increasing monetary accommodation, the Committee can better meet its employment mandate while still satisfying its price-stability mandate,” Kocherlakota said to business and community leaders at Gogebic Community College.

…”It’s an appropriate time to start thinking about when to begin the process of reversing the level of accommodation,” Kocherlakota said on May 9. “Six to nine months down the road, we should be thinking about initiating our exit strategy.”

Today, Kocherlakota said, “the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.”

Kocherlakota said today the central bank should give itself leeway by allowing inflation to deviate from its 2 percent target, saying the FOMC could contemplate raising rates if inflation rises above 2.25 percent. History suggests it’s unlikely inflation will rise above that point as long as the jobless rate remains above 5.5 percent, he said.

“The current economic impact of both forms of accommodation — low interest rates and asset purchases — depends on when the public believes that accommodation will be removed,” Kocherlakota said. Confident the Fed will keep the fed funds rate near zero until achieving 5.5 percent unemployment, “people will spend more today, and that will drive up economic activity,” he said.

This is pretty sensational – it seems like Kocherlakota finally understands. And it is it not only Kocherlakota. In fact it seems like there has been a completely transformation of the thinking at the Federal Reserve. I have no clue what happened at the Fed, but something happened. And it is good…

PS Just so it is 100% clear – I don’t think it is a good idea to target real variables like the unemployment rate and that it would make much more sense to introduce a proper NGDP level target, but at least variations of the Evans rules as suggested by Kocherlakota is much better than the status quo.

Update: See the entire speech here and a summary of Kocherlakota’s “liftoff plan”.

Update 2: Scott Sumner also comments on Kocherlakota.

Follow

Get every new post delivered to your Inbox.

Join 3,188 other followers

%d bloggers like this: