Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call

In a very surprising move the Swedish Riksbank this morning cut its key policy rate by 50bp to 0.25%. It was about time! The Riksbank has for a very long time undershot its 2% inflation target and inflation expectations have consistently been below 2% for a long time as well.

The interesting question now is what is next? The Riksbank is now very close to the Zero Lower Bound and with inflation still way below the inflation target one could argue that even more easing is needed.

I have earlier addressed how to conduct monetary policy at the ZLB for small-open economies like Sweden. Traditional quantitative easing obviously is an option, but it is also possible to get some inspiration from the works of such great economists as Lars E. O. Svensson or Bennett McCallum.

Already back in 2012 I wrote a post about what advice Bennett would give to the Riksbank in a situation like it now find itself in. This is from my blog post Sweden, Poland and Australia should have a look at McCallum’s MC rule

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? …

…What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target…

…The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

…So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank … should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

…Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank…can.. avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

That is it – now back to writing on the Polish central bank’s failure to do the right thing at it’s rate decision yesterday.

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See also A scary story: The Zero Lower Bound and exchange rate dynamics

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The monetary transmission mechanism – causality and monetary policy rules

Most economists pay little or no attention to nominal GDP when they think (and talk) about the business cycle, but if they had to explain how nominal GDP is determined they would likely mostly talk about NGDP as a quasi-residual. First real GDP is determined – by both supply and demand side factors – and then inflation is simply added to get to NGDP.

Market Monetarists on the other hand would think of nominal GDP determining real GDP. In fact if you read Scott Sumner’s excellent blog The Money Illusion – the father of all Market Monetarist blogs – you are often left with the impression that the causality always runs from NGDP to RGDP. I don’t think Scott thinks so, but that is nonetheless the impression you might get from reading his blog. Old-school monetarists like Milton Friedman were basically saying the same thing – or rather that the causality was running from the money supply to nominal spending to prices and real GDP.

In my view the truth is that there is no “natural” causality from RGDP to NGDP or the other way around. I will instead here argue that the macroeconomic causality is fully dependent about the central bank’s monetary policy rules and the credibility of and expectations to this rule.

In essenssens this also means that there is no given or fixed causality from money to prices and this also explains the apparent instability between the lags and leads of monetary policy.

From RGDP to NGDP – the US economy in 2008-9?

Some might argue that the question of causality and whilst what model of the economy, which is the right one is a simple empirical question. So lets look at an example – and let me then explain why it might not be all that simple.

The graph below shows real GDP and nominal GDP growth in the US during the sharp economic downturn in 2008-9. The graph is not entirely clearly, but it certainly looks like real GDP growth is leading nominal GDP growth.

RGDP NGDP USA 2003 2012

Looking at the graph is looks as if RGDP growth starts to slow already in 2004 and further takes a downturn in 2006 before totally collapsing in 2008-9. The picture for NGDP growth is not much different, but if anything NGDP growth is lagging RGDP growth slightly.

So looking at just at this graph it is hard to make that (market) monetarist argument that this crisis indeed was caused by a nominal shock. If anything it looks like a real shock caused first RGDP growth to drop and NGDP just followed suit. This is my view is not the correct story even though it looks like it. I will explain that now.

A real shock + inflation targeting => drop in NGDP growth expectations

So what was going on in 2006-9. I think the story really starts with a negative supply shock – a sharp rise in global commodity prices. Hence, from early 2007 to mid-2008 oil prices were more than doubled. That caused headline US inflation to rise strongly – with headline inflation (CPI) rising to 5.5% during the summer of 2008.

The logic of inflation targeting – the Federal Reserve at that time (and still is) was at least an quasi-inflation targeting central bank – is that the central bank should move to tighten monetary condition when inflation increases.

Obviously one could – and should – argue that clever inflation targeting should only target demand side inflation rather than headline inflation and that monetary policy should ignore supply shocks. To a large extent this is also what the Fed was doing during 2007-8. However, take a look at this from the Minutes from the June 24-25 2008 FOMC meeting:

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards. In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation… 

…Conditions in some financial markets had improved… the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen. Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. 

Hence, not only did some FOMC members (the majority?) believe monetary policy was easy, but they even wanted to move to tighten monetary policy in response to a negative supply shock. Hence, even though the official line from the Fed was that the increase in inflation was due to higher oil prices and should be ignored it was also clear that that there was no consensus on the FOMC about this.

The Fed was of course not the only central bank in the world at that time to blur it’s signals about the monetary policy response to the increase in oil prices.

Notably both the Swedish Riksbank and the ECB hiked their key policy interest rates during the summer of 2008 – clearly reacting to a negative supply shock.

Most puzzling is likely the unbelievable rate hike from the Riksbank in September 2008 amidst a very sharp drop in Swedish economic activity and very serious global financial distress. This is what the Riksbank said at the time:

…the Executive Board of the Riksbank has decided to raise the repo rate to 4.75 per cent. The assessment is that the repo rate will remain at this level for the rest of the year… It is necessary to raise the repo rate now to prevent the increases in energy and food prices from spreading to other areas.

The world is falling apart, but we will just add to the fire by hiking interest rates. It is incredible how anybody could have come to the conclusion that monetary tightening was what the Swedish economy needed at that time. Fans of Lars E. O. Svensson should note that he has Riksbank deputy governor at the time actually voted for that insane rate hike.

Hence, it is very clear that both the Fed, the ECB and the Riksbank and a number of other central banks during the summer of 2008 actually became more hawkish and signaled possible rates (or actually did hike rates) in reaction to a negative supply shock.

So while one can rightly argue that flexible inflation targeting in principle would mean that central banks should ignore supply shocks it is also very clear that this is not what actually what happened during the summer and the late-summer of 2008.

So what we in fact have is that a negative shock is causing a negative demand shock. This makes it look like a drop in real GDP is causing a drop in nominal GDP. This is of course also what is happening, but it only happens because of the monetary policy regime. It is the monetary policy rule – where central banks implicitly or explicitly – tighten monetary policy in response to negative supply shocks that “creates” the RGDP-to-NGDP causality. A similar thing would have happened in a fixed exchange rate regime (Denmark is a very good illustration of that).

NGDP targeting: Decoupling NGDP from RGDP shocks 

I hope to have illustrated that what is causing the real shock to cause a nominal shock is really monetary policy (regime) failure rather than some naturally given economic mechanism.

The case of Israel illustrates this quite well I think. Take a look at the graph below.

NGDP RGDP Israel

What is notable is that while Israeli real GDP growth initially slows very much in line with what happened in the euro zone and the US the decline in nominal GDP growth is much less steep than what was the case in the US or the euro zone.

Hence, the Israeli economy was clearly hit by a negative supply shock (sharply higher oil prices and to a lesser extent also higher costs of capital due to global financial distress). This caused a fairly sharp deceleration real GDP growth, but as I have earlier shown the Bank of Israel under the leadership of then governor Stanley Fischer conducted monetary policy as if it was targeting nominal GDP rather than targeting inflation.

Obviously the BoI couldn’t do anything about the negative effect on RGDP growth due to the negative supply shock, but a secondary deflationary process was avoid as NGDP growth was kept fairly stable and as a result real GDP growth swiftly picked up in 2009 as the supply shock eased off going into 2009.

In regard to my overall point regarding the causality and correlation between RGDP and NGDP growth it is important here to note that NGDP targeting will not reverse the RGDP-NGDP causality, but rather decouple RGDP and NGDP growth from each other.

Hence, under “perfect” NGDP targeting there will be no correlation between RGDP growth and NGDP growth. It will be as if we are in the long-run classical textbook case where the Phillips curve is vertical. Monetary policy will hence be “neutral” by design rather than because wages and prices are fully flexible (they are not). This is also why we under a NGDP targeting regime effectively will be in a Real-Business-Cycle world – all fluctuations in real GDP growth (and inflation) will be caused by supply shocks.

This also leads us to the paradox – while Market Monetarists argue that monetary policy is highly potent under our prefered monetary policy rule (NGDP targeting) it would look like money is neutral also in the short-run.

The Friedmanite case of money (NGDP) causing RGDP

So while we under inflation targeting basically should expect causality to run from RGDP growth to NGDP growth we under NGDP targeting simply should expect that that would be no correlation between the two – supply shocks would causes fluctuations in RGDP growth, but NGDP growth would be kept stable by the NGDP targeting regime. However, is there also a case where causality runs from NGDP to RGDP?

Yes there sure is – this is what I will call the Friedmanite case. Hence, during particularly the 1970s there was a huge debate between monetarists and keynesians about whether “money” was causing “prices” or the other way around. This is basically the same question I have been asking – is NGDP causing RGDP or the other way around.

Milton Friedman and other monetarist at the time were arguing that swings in the money supply was causing swings in nominal spending and then swings in real GDP and inflation. In fact Friedman was very clear – higher money supply growth would first cause real GDP growth to pick and later inflation would pick-up.

Market monetarists maintain Friedman’s basic position that monetary easing will cause an increase in real GDP growth in the short run. (M, V and NGDP => RGDP, P). However, we would even to a larger extent than Friedman stress that this relationship is not stable – not only is there “variable lags”, but expectations and polucy rules might even turn lags into leads. Or as Scott Sumner likes to stress “monetary policy works with long and variable LEADS”.

It is undoubtedly correct that if we are in a situation where there is no clearly established monetary policy rule and the economic agent really are highly uncertain about what central bankers will do next (maybe surprisingly to some this has been the “norm” for central bankers as long as we have had central banks) then a monetary shock (lower money supply growth or a drop in money-velocity) will cause a contraction in nominal spending (NGDP), which will cause a drop in real GDP growth (assuming sticky prices).

This causality was what monetarists in the 1960s, 1970s and 1980s were trying to prove empirically. In my view the monetarist won the empirical debate with the keynesians of the time, but it was certainly not a convincing victory and there was lot of empirical examples of what was called “revered causality” – prices and real GDP causing money (and NGDP).

What Milton Friedman and other monetarists of the time was missing was the elephant in the room – the monetary policy regime. As I hopefully has illustrated in this blog post the causality between NGDP (money) and RGDP (and prices) is completely dependent on the monetary policy regime, which explain that the monetarists only had (at best) a narrow victory over the (old) keynesians.

I think there are two reasons why monetarists in for example the 1970s were missing this point. First of all monetary policy for example in the US was highly discretionary and the Fed’s actions would often be hard to predict. So while monetarists where strong proponents of rules they simply had not thought (enough) about how such rules (also when highly imperfect) could change the monetary transmission mechanism and money-prices causality. Second, monetarists like Milton Friedman, Karl Brunner or David Laidler mostly were using models with adaptive expectations as rational expectations only really started to be fully incorporated in macroeconomic models in the 1980s and 1990s. This led them to completely miss the importance of for example central bank communication and pre-announcements. Something we today know is extremely important.

That said, the monetarists of the times were not completely ignorant to these issues. This is my big hero David Laidler in his book Monetarist Perspectives” (page 150):

“If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

Macroeconomists to this day unfortunately still forget or ignore the wisdom of David Laidler.

HT DL and RH.

A scary story: The Zero Lower Bound and exchange rate dynamics

I was in Sweden last week and again yesterday (today I am in Norway). My trips to Sweden have once again reminded me about the dangers of conducting monetary policy with interest rates at the Zero Lower Bound (ZLB). The Swedish central bank – Riksbanken – has cut is key policy rate to 1% and is like to cut it further to 0.75% before the end of the year so we are inching closer and closer to zero.

Riksbanken is just one of a number of European central banks close to zero on interest rates – most notably the ECB is at 0.25%. In the Czech Republic the key policy rate stands at 0.05%. And even Poland, Hungary, Norway are moving closer and closer to the ZLB.

Most of these central banks seem to be quite unprepared for what might happen at the Zero Lower Bound. In this post I will particularly focus on the exchange rate dynamics at the ZLB.

A Taylor rule world

Lets say we can describe monetary policy with a simple Taylor rule:

r = rN+a*(p-pT)+b(ygap)

In a “normal” world where everything is fine and the key policy rate (r) is well-above zero the central bank will hike or cut r in response to increasing or declining inflation (p) relative to the inflation target (pT) or in response to the output gap (ygap) increasing or decreasing. If the output gap is closed and inflation is at the inflation target then the central bank will set it’s key policy rate at the “natural” interest rate rN.

What happens at the ZLB?

However, lets assume that we are no longer in a normal world. Lets instead assume that p is well below the inflation target and the output gap is negative. As we know this is the case in most European countries today.

So if we plug these numbers into our Taylor rule above we might get r=1%. As long as r>0 we are not in trouble yet. The central bank can still conduct monetary policy with its chosen instrument – the key policy interest rate. This is how most inflation targeting central banks in the world are doing their business today.

But what happens if we get a negative shock to the economy. Lets for example assume that an overheated property markets starts to cool gradually and real GDP starts to slow. In this case the central bank according to it’s Taylor rule should cut its key policy rate further. Sooner or later the central bank hits the ZLB.

An then suddenly the currency starts strengthening dramatically

In fact imagine that the interest rate level needed to close the output gap and keep inflation at the inflation target is -2%.

We can say that monetary policy is neutral when the central bank sets interest rates according to the Taylor rule, but if interest rates are higher than the what the Taylor rule stipulates then monetary policy is tight. So if the Taylor rule tells us that the key policy rate should be -2% and the actual policy rate is zero then monetary policy is of course tight. This is what many central bankers fail to understand. Monetary policy is not necessarily easy just because the interest rate is low in a historical or absolute perspective.

And this is where it gets really, really dangerous because we now risk getting into a very unstable economic and financial situation – particularly if the central bank insists that monetary policy is already easy, while it is in fact tight.

What happens to the exchange rate in a situation where monetary policy is tightened? It of course appreciates. So when the “stipulated” (by the Taylor rule) interest rate drops to for example -2% and the actual interest rate is at 0% then obviously the currency starts to appreciates – leading to a further tightening of monetary conditions. With monetary conditions tightening inflation drops further and growth plummets. So now we might need an interest rate of -4 or -7%.

With that kind of monetary tightening you will fast get financial distress. Stock markets start to drop dramatically as inflation expectations plummets and the economy contracts. It is only a matter of time before the talk of banking troubles start to emerge.

The situation becomes particularly dangerous if the central bank maintains that monetary policy is easy and also claim that the appreciation of the currency is a signal that everything is just fine, but it is of course not fine. In fact the economy is heading for a massive collapse if the central bank does not change course.

This scenario is of course very similar to what played out in the US in 2008-9. A slowdown in the US property market caused a slowdown in the US economy. The Fed failed to respond by not cutting interest rates aggressive and fast enough and as a consequence we soon hit the ZLB. And what happened to the dollar? It strengthened dramatically! That of course was a very clear indication that monetary conditions were becoming very tight. Initially the Fed clearly failed to understand this – with disastrous consequences.

But don’t worry – there is a way out

The US is of course special as the dollar is a global reserve currency. However, I am pretty sure that if a similar thing plays out in other countries in the world we will see a similar exchange rate dynamics. So if the Taylor rule tells you that the key policy rate should be for example -4% and it is stuck at zero then the the currency will start strengthening dramatically and inflation and growth expectations will plummet potentially setting off financial crisis.

However, there is no reason to repeat the Fed’s failure of 2008. In fact it is extremely easy to avoid such a scenario. The central bank just needs to acknowledge that it can always ease monetary policy at the ZLB. First of all it can conduct normal open market operations buying assets and printing its own currency. That is what we these days call Quantitative Easing.

For small open economies there is an even simpler way out. The central bank can simply intervene directly in the currency market to weak its currency and remember the market can never beat the central bank in this game. The central bank has the full control of the printing press.

So imagine we now hit the ZLB and we would need to ease monetary policy further. The central bank could simply announce that it will weaken its currency by X% per months until the output gap is close and inflation hits the inflation target. It is extremely simple. This is what Lars E.O. Svensson – the former deputy central bank governor in Sweden – has termed the foolproof way out of deflation.

And even better any central bank, which is getting dangerously close to the ZLB should pre-announce that it will in fact undertake such Svenssonian monetary operations to avoid the dangerous of conducting monetary policy at the ZLB. That would mean that as the economy is moving closer to the ZLB the currency would automatically start to weaken – ahead of the central bank doing anything – and in that sense the risk of hitting the ZLB would be much reduced.

Some central bankers understand this. For example Czech central bank governor Miroslav Singer who recently has put a floor under EUR/CZK, but unfortunately many other central bankers in Europe are dangerously ignorant about these issues.

PS I told the story above using a relatively New Keynesian framework of a Taylor rule, but this is as much a Market Monetarist story about understanding expectations and that the interest rate level is a very bad indicator of the monetary policy stance.

Patri Friedman on Market Monetarism

Here is Patri Friedman on his blog “Patri’s Peripatetic Peregrinations”:

“I sent a friend an intro to market monetarism (a modern, blogosphere-inspired adjustment to the traditional monetarism my grandfather helped create). He was surprised I believed that printing money could be good, rather than agreeing with the Austrians.”

I am happy to see that Patri has read my paper on Market Monetarism.

There is of course nothing wrong in thinking that “printing money could be good” (under certain circumstances). In fact this is completely in line with what Patri’s grandfather Milton Friedman argued in terms of the Great Depression and the Japanese crisis.

Patri in his post also discusses how a “helicopter drop” could happen in a world of digital cash. Interestingly enough this discussion is similar to a recent internal Market Monetarist debate between Nick Rowe, Bill Woolsey and Scott Sumner about whether money is a medium of exchange or a medium of account. See for example here, here and here. Kurt Schuler also has contributed to the discussion. Finally Miles Kimball similarly has a very interesting post on the case for electronic money.

Patri’s discussion of digital cash to some extent also relates to my own discussion of monetary reform in Africa and the development of mobile based money (See for example here, herehere and here).

Anyway, I am happy to Patri seems to be showing some sympathy for Market Monetarism.

HT Lasse Birk Olesen

Dangerous bubble fears

Here is Swedish central bank governor Stefan Ingves in an op-ed piece in the Swedish newspaper Svenska Dagbladet last week:

“I also have to take responsibility for the long term consequences of today’s monetary policy…And there are risks associated with an all too low interest rate over a long period, which cannot be ignored.”

Said in another way if we keep interest rates too low we will get bubbles. So despite very clear signs that the Swedish economy is slowing Ingves would not like to ease monetary policy. Ingves in that sense is similar to many central bankers around the world. Many central bankers have concluded that the present crisis is a result of a bubble that bursted and the worst you could do is to ease monetary policy – even if the economic data is telling you that that is exactly what you should.

The sentiment that Ingves is expressing is similar to the view of the ECB and the fed in 2008/9: We just had a bubble and if we ease too aggressively we will get another one. Interestingly enough those central banks that did well in 2008/9 and eased monetary policy more aggressively and therefore avoided major crisis today seem to be most fearful about “bubbles”. Take the Polish central bank (NBP). The NBP in 2009 allowed the zloty to weaken significantly and cut interest rates sharply. That in my view saved the Polish economy from recession in 2009 – Poland was the only country in Europe with positive real GDP growth in 2009. However, today the story is different. NBP hiked interest rates earlier in the year and is now taking very long time in easing monetary policy despite very clear signs the Polish economy is slowing quite fast. In that sense you can say the NBP has failed this year because it did so well in 2009.

The People’s Bank of China in many ways is the same story – the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.

So the story is the same in Sweden, Poland and China. The countries that escaped the crisis did so by easing monetary conditions. As their exports collapsed domestic demand had to fill the gap and easier monetary policy made that possible. So it not surprising that these countries have seen property prices continuing to increase during the last four years and also have seen fairly strong growth in private consumption and investments. However, this now seem to be a major headache for central bankers in these countries.

I think these bubble fears are quite dangerous. It was this kind of fears that led the fed and the ECB to allow monetary conditions to become excessive tight in 2008/9. Riksbanken, NBP and the PBoC now risk making the same kind of mistake.

At the core of this problem is that central bankers are trying to concern themselves with relative prices. Monetary policy is very effective when it comes to determine the price level or nominal GDP, but it is also a very blunt instrument. Monetary policy cannot – and certainly should not – influence relative prices. Therefore, the idea that the central bank should target for example property prices in my view is quite a unhealthy suggestion.

Obviously I do not deny that overly easy monetary policy under certain circumstances can lead to the formation of bubbles, but it should not be the job of central bankers to prick bubbles.

The best way to avoid that monetary policy do not create bubbles is that the central bank has a proper monetary target such as NGDP level targeting. Contrary to inflation targeting where positive supply shocks can lead to what Austrians call relative inflation there is not such a risk with NGDP level targeting.

Let’s assume that the economy is hit by a positive supply shock – for example lower import prices. That would push down headline inflation. An inflation targeting central bank – like Riksbanken and NBP – in that situation would ease monetary policy and as a result you would get relative inflation – domestic prices would increase relative to import prices and that is where you get bubbles in the property markets. Under NGDP level targeting the central bank would not ease monetary policy in response to a positive supply shock and inflation would drop ease, but the NGDP level would on the other hand remain on track.

However, the response to a demand shock – for example a drop in money velocity – would be symmetric under NGDP level targeting and inflation target. Both under IT and NGDP targeting the central bank would ease monetary policy. However, this is not what central banks that are concerned about “bubbles” are doing. They are trying to target more than one target. The first page in the macroeconomic textbook, however, tells you that you cannot have more policy targets than policy instruments. Hence, if you target a certain asset price – like property prices – it would mean that you effectively has abandoned your original target – in the case of Riksbanken and NBP that is the inflation target. So when governor Ingves express concern about asset bubbles he effective has said that he for now is not operating an inflation targeting regime. I am sure his colleague deputy governor Lars E. O. Svensson is making that argument to him right now.

I don’t deny that bubbles exist and I am not claiming that there is no bubbles in the Swedish, Polish or Chinese economies (I don’t know the answer to that question). However, I am arguing that monetary policy is a very bad instrument to “fight” bubbles. Monetary policy should not add to the risk of bubbles, but “bubble fighting” should not be the task of the central bank. The central bank should ensure nominal stability and let the market determine relative prices in the economy. Obviously other policies – such as tax policy or fiscal policy should not create moral hazard problems through implicit or explicit guarantees to “bubble makers”.

Japan has been in a 15 year deflationary environment with falling asset prices and a primary reason for that is the Bank of Japan’s insane fear of creating bubbles. I doubt that the Riksbank, NBP or the PBoC will make the same kind of mistakes, but bubbles have clearly led all three central banks to become overly cautious and as a result the Swedish, the Polish and the Chinese economy are now cooling too much.

I should stress that I do not suggest some kind of “fine tuning” policy, but rather I suggest that central banks should focus on one single policy target – and I prefer NGDP level targeting – and leave other issues to other policy makers. If central banks are concerned about bubbles they should convince politicians to implement policies that reduce moral hazard rather than trying to micromanage relative prices and then of course focus on a proper and forward looking monetary policy target like NGDP level targeting.

PS Note that I did not mention the interest rate fallacy, but I am sure Milton Friedman would have told governor Ingves about it.
PPS You can thank Scandinavian Airlines for this blog post – my flight from London to Copenhagen got cancelled so I needed to kill some time before my much later flight.

Related posts:

Boom, bust and bubbles
The luck of the ‘Scandies’
Four reasons why central bankers ignore Scott Sumner’s good advice

The Czech interest rate fallacy and exchange rates

For many years Ludek Niedermayer was deputy central bank governor of the Czech central bank (CNB). Ludek did an outstanding job at the CNB where he was a steady hand on CNB’s board for many years. I have known Ludek for a number of years and I do consider him a good friend.

However, we often disagree – particularly about the importance of money. This is an issue we debate whenever we see each other – and I don’t think either of us find it boring. Unfortunately I have so far failed to convince Ludek.

Now it seems we have yet another reason to debate. The issue is over the impact of currency devaluation and the monetary transmission mechanism.

The Czech economy is doing extremely bad and it to me is pretty obvious that the economy is caught in a deflationary trap. The CNB’s key policy rate is close to zero and that is so far limiting the CNB from doing more monetary easing despite the very obvious need for monetary easing – no growth, disinflationary pressures, declining money-velocity and a fairly strong Czech koruna. However, the CNB seems nearly paralyzed. Among other things because the majority of CNB board members seem to think that monetary policy is already easy because interest rates are already very low.

What the majority on the CNB board fail to understand is of course that interest rates are low exactly because the economy is in such a slump. The majority on the CNB board members are guilty of what Milton Friedman called the “interest rate fallacy”.  As Friedman said in 1997:

“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.”

Looking at the Czech economy makes it pretty clear that monetary policy is not easy. If monetary policy was easy then property prices would not be declining and nominal GDP would not be contracting. If monetary policy was easy then inflation would be rising – it is not.

It therefore obvious that the Czech economy desperately needs monetary easing and since interest rates are already close to zero it is obvious that the CNB needs to use other instruments to ease monetary policy. To me the most obvious and simplest way to ease monetary policy in the present situation would be to use the exchange rate channel. The CNB should simply buy foreign currency to weaken the Czech koruna until a certain nominal target is met – for example bringing back the level of the GDP deflator back to its pre-crisis trend. The best way to do this would be to set a temporary target on Czech koruna against the euro – in a similar fashion as the Swiss central bank has done – until the given nominal target is reached. This is what Lars E. O. Svensson – now deputy governor of the Swedish central bank – has called the foolproof way out of deflation.

CNB governor Miroslav Singer seems to be open to this option. Here is what he said in a recent interview with the Czech business paper Hospodarske Noviny (my translation – with help from Czech friends and Google translate…):

“We talked about it in the central bank’s board about what the central bank can buy and put the money into circulation. What all can lend and – in extreme case – we can simply hand out money to citizens. Something that is sometimes referred to as “throwing money from a helicopter.” If it really was needed, it seems to be the easiest to move the exchange rate. It is logical for the country, which exports the products of eighty per cent of its GDP. If we felt that in our country there is a long deflationary pressures, the obvious way to deal with it is through a weakening currency.”

It should be stressed that I am slightly paraphrasing Singer’s comments, but the meaning is clear – governor Singer full well knows that monetary policy works and I certain agree with him on this issue. Unfortunately my good friend Ludek Niedermayer to some extent disagrees.

Here is Ludek in the same article:

“It would mean leaving a floating exchange rate and our trading partners would be able to complain, that we in this way supports our own exports”

Ludek here seems to argue that the way a weakening of the koruna only works through a “competitiveness channel” – in fact governor Singer seems to have the same view. However, as I have so often argued the primary channel by which a devaluation works is through the impact on domestic demand through increased inflation expectations (or rather less deflationary expectations) and an increase in the money base rather than through the competitiveness channel.

Let’s assume that the CNB tomorrow announced that it would set a new target for EUR/CZK at 30 – versus around 24.90 today (note this is an example and not a forecast). Obviously this would help Czech exports, but much more importantly it would be a signal to Czech households and companies that the CNB will not allow the Czech economy to sink further into a deflationary slump. This would undoubtedly lead households and companies to reduce their cash reserves that they are holding now.

In other words a committed and sizable devaluation to the Czech koruna would lead to a sharp drop in demand for Czech koruna – and for a given money supply this would effectively be aggressive monetary easing. This will push up money-velocity. Furthermore, as the CNB is buying foreign currency it is effectively expanding the money supply. With higher money supply growth and higher velocity nominal GDP will expand and with sticky prices and wages and a large negative output gap this would likely also increase real GDP.

This would be similarly to what happened for example in Poland and Sweden in 2008-9, where a weakening of the zloty and the Swedish krona supported domestic demand. Hence, the relatively strong performance of the Swedish and the Polish economies in 2009-10 were due to strong domestic demand rather than strong exports. Again, the exchange rate channel is not really about competitiveness, but about boosting domestic demand through higher money supply growth and higher velocity.

The good news is that the CNB is not out of ammunition and it is similarly good news that the CNB governor Singer full well knows this. The bad news is that he might not have convinced the majority on the CNB board about this. In that sense the CNB is not different from most central banks in the world – bubble fears dominates while deflationary risks are ignored. Sad, but true.

PS I strongly recommend for anybody who can read Czech – or can use Google translate – to read the entire interview with Miroslav Singer. Governor Singer fully well understands that he is not out of ammunition – that is a refreshing view from a European central banker.

Related posts:

Is monetary easing (devaluation) a hostile act?
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons
Mises was clueless about the effects of devaluation
The luck of the ‘Scandies’
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Monetary disorder in Central Europe (and some supply side problems)

The Fed can hit any NGDP target

I hate getting into debates where different bloggers go back and forth forever and never reach any conclusion. I am not blogging to get into debates, however, I must admit that Steven Williamson’s recent posts on NGDP level targeting have provoked me quite a bit.

In his first post Williamson makes a number of claims, which I find highly flawed. However, Scott Sumner has already at length addressed most of these issues in a reply to Williamson so I don’t want to get into that (and as you guessed I am fully in agreement with Scott). However, Williamson’s reply to Scott is not less flawed than his initial post. Again I don’t want to go through the whole thing. However, one statement that Williamson makes I think is a very common mistake and I therefore think a comment is in order. Here is Williamson:

“The key problem under the current circumstances is that you can’t just announce an arbitrary NGDP target and hit it with wishful thinking. The Fed needs some tools, and in spite of what Ben Bernanke says, it doesn’t have them.”

This is a very odd comment coming from somebody who calls himself a (New) Monetarist. It is at the core of monetarism in the sense of Friedman, Brunner, Meltzer, Cagan, Schwartz, Warburton and Yeager etc. that nominal GDP is determined by the central bank and no monetarist has ever acknowledged that there is a liquidity trap. Williamson claims that he does not agree with everything Friedman said, but I wonder what Friedman said he agrees with. If you don’t believe that NGDP is determined by the central bank then it makes absolutely no sense to call yourself a monetarist.

Furthermore, if you don’t think that the Fed can hit an NGDP target how could you think it could hit an inflation target? Both changes in NGDP and in prices are monetary phenomena.

Anyway, let’s get back to the question whether the central bank can hit an NGDP target and what instruments could be used to hit that target.

The simplest way to do it is actually to use the exchange rate channel. Let’s assume that the Federal Reserve wants to increase the US NGDP level by 15% and that it wants to do it by the end of 2013.

Scott has suggested using NGDP futures to hit the NGDP target, but let’s assume that is too complicated to understand for the critics and the Fed. Instead the Fed will survey professional forecasters about their expectations for the level of NGDP by the end of 2013. The Fed will then announce that as long as the “consensus” forecast for NGDP is below the target the Fed will step up monetary easing. The Fed will do the survey once a month.

Let’s start out with the first announcement under this new regime. Initially the forecasters are skeptical and forecast NGDP to be 12% below target. As a consequence the Fed announces a Swiss style exchange target. It simply announces that it will intervene in the FX market buying unlimited amounts of foreign currency until the US dollar has weakened 20% in nominal effective terms (and yes, the Fed has the instruments to do that – it has the printing press to print dollars). I am pretty sure that Williamson would agree that that directly would increase US NGDP (if not I would love to see his model…).

The following month the forecasters will likely have moved their forecasts for NGDP closer to the target level. But we might still have too low a level of forecasted NGDP. Therefore, the Fed will the following month announce a further “devaluation” by lets say 5%. The process will continue until the forecasted level for NGDP equals the target level. If the consensus forecast starts to overshoot the target the Fed will simply announce that it will reverse the process and revalue the dollar.

Therefore there is certainly no reason to argue 1) that the Fed can not hit any NGDP target 2) that the Fed does not have an instrument. The exchange rate channel can easily do the job. Furthermore, if the Fed announces this policy then it is very likely that the market will be doing most of the lifting. The dollar would automatically appreciate and depreciate until the market expectations are equal to the NGDP target.

If you have heard all this before then it is because this a variation of Irving Fisher’s compensated dollar plan and Lars E. O. Svensson’s foolproof way out of a liquidity trap. And yes, I have previously suggested this for small open economies, but the Fed could easily use the same method to hit a given NGDP target.

Update: I should note that the example above is exactly that – an example. I use the example to illustrate that a central bank can always increase NGDP and that the exchange rate channel is an effective tool to achieve this goal. However, the numbers mentioned in my post are purely “fictional” and again it example rather than a policy recommendation. That said, I am pretty that if the Fed did exactly as what I suggest above the US would very fast bee out of this crisis. The same goes for the ECB.

Update II: Marcus Nunes and Bill Woolsey also comment on Williamson. Nick Rowe comments on David Adolfatto’s anti-NGDP targeting post(s).

Britmouse just came up with the coolest idea of the year

Our good friend and die hard British market monetarist Britmouse has a new post on his excellent blog Uneconomical. I think it might just be the coolest idea of the year. Here is Britmouse:

“Will the ECB will stand by and let Spain go under?  Spain is a nice country with a fairly large economy.  It’d be a… shame, right?   So if the ECB won’t do anything, I think the UK should act instead.

David Cameron should immediately instruct the Bank of England to print Sterling, exchange it for Euros, and start buying up Spanish government debt.  Spain apparently has about €570bn of debt outstanding, so the Bank could buy, say, all of it.

We all know that the Bank of England balance sheet has no possible effect on the UK economy except when it is used to back changes in Bank Rate.  Right?  So these actions by the Bank can make no difference to, say, the Sterling/Euro exchange rate, and hence no impact on the demand for domestically produced goods and services in the UK.  Right?

Sure, the Bank would take on some credit risk and exchange rate risk.  But they can do all this in the Asset Purchase Facility (used for conventional QE), which already has a indemnity from the Treasury against losses.”

Your reaction will probably be that Britmouse is mad. But you are wrong. He is neither mad nor is he wrong. British NGDP is in decline and the Bank of England need to go back to QE as fast as possible and the best way to do this is through the FX market. Print Sterling and buy foreign currency – this is what Lars E. O. Svensson has called the the foolproof way out of a liquidity trap. And while you are at it buy Spanish government debt for the money. That would surely help curb the euro zone crisis and hence reduce the risk of nasty spill-over to the British economy (furthermore it would teach the ECB as badly needed lesson…). And by the way why do the Federal Reserve not do the same thing?

Obviously this discussion would not be necessary if the ECB would take care of it obligation to ensure nominal stability, but unfortunately the ECB has failed and we are now at a risk of a catastrophic outcome and if the ECB continues to refuse to act other central banks sooner or later are likely to step in.

You can think of Britmouse’ suggestion what you want, but think about it and then you will never again say that monetary policy is out of ammunition.

—-

Update – this is from a reply below. To get it completely clear what I think…

“Nickikt, no I certainly do not support bailing out either bank or countries. I should of course have wrote that. The reason why I wrote that this is a “cool idea” is that is a fantastic illustration of how the monetary transmission mechanism works and that monetary policy is far form impotent.

So if you ask me the question what I would do if I was on the MPC of Bank of England then I would clearly have voted no to Britmouse’s suggestion. I but I 100% share the frustration that it reflects. That is why I wrote the comment in the way I did.

So again, no I am strongly against bail outs and I fear the consequences in terms of moral hazard. However, Spain’s problems – both in terms of public finances and the banking sector primarily reflects ECB’s tight monetary policy rather than banking or public finance failure. Has there been mistake made in terms and public finances and in terms of the banking sector? Clearly yes, but the main cause of the problems is a disfunctional monetary union and monetary policy failure.”

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting (By David Eagle)

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting

- And a Bizarre Tale of Blind Macroeconomists

By David Eagle

Some central banks throughout the world, including the Central bank of Canada and the Federal Reserve, have been considering Price-Level Targeting (PLT) as an alternative to Inflation Targeting (IT). In this guest blog, I present my argument why PLT Pareto dominates IT.  My argument is simple, and one that many readers will consider so obvious that they would expect most monetary economists to be already aware of this Pareto domination.

Please read the following quotation from Shukayev and Ueberfeldt (2010):

Various papers have suggested that Price-Level targeting is a welfare improving policy relative to Inflation targeting. … Research on Inflation targeting and Price-level Targeting monetary policy regimes shows that a credible Price-level Targeting (PT) regime dominates an Inflation targeting regime.

Reading the above quotation indicates that economists already know that PLT Pareto dominates IT.  However, there is a bizarre twist to this literature, which we will discuss later in this blog.  I ask you to continue patiently reading and trust that the ending to the blog will be well worth the journey, even to market monetarists who oppose both PLT and IT.

In my last guest blog for The Market Monetarist, I discussed what I called the Two Fundamental Welfare Principles of Monetary Economics.  The First Principle concerned the Pareto implications when nominal GDP (NGDP) changes, but real GDP (RGDP) does not.  The Second Principle concerned the Pareto implications when RGDP changes, but NGDP does not.  Since PLT and IT have the same Pareto implications when RGDP changes, but NGDP does not; let us focus on the First Principle.  To do so, assume an economy where RGDP is known with perfect foresight; then the First Principle always applies.

A Nominal-Loan Example – Initial Expectations

Let us again consider a long term nominal loan.  This time, I will explain my argument with an example.  For this example, assume a €200,000 nominal mortgage with a 7.2% p.a. interest rate, compounded monthly, and a term of 15-years, and fixed, fully amortizing nominal monthly payments.  The monthly payment would then be a nominal €1820.09.  Let us assume that individual B borrowed the €200,000 from individual A.   The €1820.09 is the nominal amount B must pay A each month.

Let us also assume that both A and B expect inflation to be 2.4% p.a., compounded monthly, during this period.  They therefore built that expected inflation rate into their 7.2% p.a. negotiated nominal interest rate.[1]   Please note that in Finance, we second-naturedly convert per annum rates to per month rates when the rate is compounded monthly.  Thus, the 7.2% p.a. is actually 0.6% per month, and the 2.4% p.a. inflation rate is 0.2% per month.  While this monthly compounding adds an extra step and a source of confusion, I believe the gain in the realism of the example is worth it.

If inflation is the 2.4% p.a. expected rate, then the real value of the monthly payment at time t will equal 1820.09/(1.002)t where t is the number of months from the loan’s origination.  Since both A and B expect the inflation rate to be 2.4% p.a., compounded monthly, their expected real value[2] of this monthly loan payment at time t will be 1820.09/(1.002)t

As I discussed in my second guest blog on the Market Monetarist, PLT and IT have the same effect on the economy as long as the central bank is successful at meeting its target, whether that target is a price-level target or an inflation target.  Let us assume that under IT, the central bank’s inflation target is 2.4% p.a., whereas under PLT, the central bank’s price-level target at time t is 100(1.002)t.  Hence, under both PLT and IT, the central bank’s initial price-level trajectory is 100(1.002)t.

Scenarios of Missing the Target

When PLT and IT differ is when the central bank misses its target.  Suppose inflation on average over the first year turns out to be 1.2% p.a. instead of the expected  2.4% p.a (both rates are compounded monthly).  To be more clear given the monthly compounding issue, the central bank’s initially trajectory of the price level at one year (or at time t=12 months) was 100(1.002)12 = 102.43; however, the actual price level at one year turned out to be 100(1.001)12 = 101.21.  Under PLT, the central bank will try to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 101.21(1.002)t-12, which is less than the initial price-level trajectory of 100(1.002)t.  This is the phenomenon we call price-level base drift, which is caused by the central bank under IT letting bygones be bygones and merely aiming for future inflation to be consistent with its inflation target; the central bank under IT does not try to make up for lost ground.

The real value of the nominal loan payment at time t=12 when the actual inflation rate turns out to be1.2% 1820.09/1.00112 = €1798.39, which is greater than the expected nominal loan payment of €1776.97.

On the other hand, assume that the inflation rate on average over the first year was 3.6% p.a. rather than the targeted 2.4% p.a. This means that the actual price level at one year turned out to be 100(1.003)12 = 103.66.  Under PLT, the central bank would have tried to return the economy to its initial price-level target of 100(1.002)t.  However, under IT, the central bank would shift its price-level trajectory to 103.66(1.002)t-12, which is greater than the initial price-level trajectory of 100(1.002)t.

The real value of the nominal loan payment at time t=12 when the actual inflation rate was 3.6% instead of 2.4% is 1820.09/1.00312 = €1755,83, which is less that the initially expected value of €1776.97.

Comparing Actual to Expectations Beyond 12 Months

Because we are talking about four different scenarios, let PLT- and IT- represent PLT and IT when the inflation rate on average for the first year turns out to be 1.2% rather than 2.4%.  Let PLT+ and IT+ represent PLT and IT when the inflation on average for the first year turns out to be 3.6% rather than the expected 2.4%.  Under all four scenarios, assume that starting in at time t=24, which is 2 years after the loan began, the central bank is able to perfectly meet is price-level trajectory whether under PLT or IT and it does so for the remaining of the 15 years.

Under these assumptions, the real value of the monthly payment under PLT starting at time t=24 will be the same as expected because the central bank will get the price level back to its preannounced price-level target.  However, when the actual inflation rate for the first year turned out being 1.2%, the real value of the nominal monthly payment under IT would be 1820.09/((1.001)12(1.002)t-12) for t≥24 under the assumption the central bank (CB) then meets its target.  On the other hand, when the actual inflation rate for the first year turned out being 3.6%, the real value of the nominal monthly payment under IT would be 1820.09/((1.003)12(1.002)t-12) for t≥24 assuming the CB then meets its target.

The table below shows how the actual real values of these nominal loan payments compare to A and B’s original expectation under all four scenarios.

Note: This table only reports the payment at the end of each year.

That PLT Pareto dominates IT should be obvious from the table.  Under PLT, the central bank (CB) tries to get the real value of nominal loan payments to be back to what borrowers and lenders initially expected.  In other words, under PLT, the CB tries to reverse its mistakes.  Under IT, the CB makes its mistakes permanent.  Note that in the table under PLT, the real value of the nominal loan payments are as expected from time t=24 months on.  However, under IT, the real value of the nominal loan payments are either 1.21% less than expected when the CB fell short of its target, or 1.19% higher than expected when the CB overshot its target.  Clearly, both risk-averse borrowers and risk-averse lenders will be better off with the temporary deviations from expectations under PLT than under the permanent deviations under IT.

Kicking Borrowers or Lenders When They are Down

John Taylor referred to the price-level basis drift as the CB “letting bygones be bygones.”  After writing this blog, I have another view:  I view IT as meaning that when the CB hurts either borrowers or lenders because it is unable to meet its target, then the CB turns around and kicks that down borrower or lender again and again to make them suffer for the duration of their loan.  I have long opposed IT, but writing this blog makes me oppose it even more.  Why cannot other economists see IT for the Pareto damaging regime it is?

The issue of why PLT Pareto dominates IT is simple.  The risk to borrowers and lenders is not inflation risk; it is price-level risk.  To minimize price-level risk, we should not minimize inflation, we should minimize the deviation of the price-level from its expected value.  As such, when a central banking missing its target, it should not keep kicking those suffering from the CB’s past mistakes; the central bank should not make that miss permanent as in IT, but rather the CB should try to reverse that damage as it will try to do under PLT.  Hence PLT Pareto dominates IT.

The Bizarre Tale of the Blind Economists

Thank you all for bearing with me through my argument.  However, from the quote by Shukayev and Ueberfeldt, you knew that the economic profession already knew this.  After all, this is obvious.  (Lars, drink something before you read on; we don’t want your blood to boil too much.)

However, the argument that I gave is not the argument that the literature that Shukayev and Ueverfeldt cited.  That literature did not use the Pareto criterion; it used a loss function that included inflation.  (Yes, Lars, that xxxx loss function again.)

What the literature starting with Svenson (1999) found is that paradoxically when the central bank is trying to minimize a loss function involving inflation, it may actually be better able to do that through PLT than with IT.  That is what Shukayev and Ueverfeld (2010) meant when they said that the literature had found PLT welfare dominates IT.  That literature was referring to “welfare” as defined by their ad hoc loss function, not by their applying the Pareto criterion to the well being of borrowers and lenders.

Economists have been blinded from the obvious by their ad hoc assumption of a loss function involving inflation.  This bizarre twist to this literature is an example of the dangers that economists’ prejudices can enter into their ad hoc loss functions, causing them to miss the obvious.  In this case they have missed the obvious impacts on individual borrowers and lenders of PLT vs. IT.

Of course, there are other targeting regimes than just PLT and IT, but this blog focused on those two.  In my future writing, I plan to explain why NGDP level targeting Pareto dominates NGDP growth rate targeting, although the logic of that is really the same as I have just discussed; we just allow RGDP to vary so that the Second Fundamental Principle of Monetary Economics also applies.

Also, think about how the “kick them while they are down” characteristic of IT is relevant to the aftermath of the Financial crisis concerning the sovereign debt issues in Europe and the debt burdens on mortgage borrowers in the U.S. and elsewhere.  I guess I have to be careful here as I might be accused of starting riots.

References

Eagle, David and Dale Domian (2011), “Quasi-Real-Indexed Mortgages to the Rescue,” working paper delivered at the Western Economic Associating Meetings in San Diego, CA, http://www.cbpa.ewu.edu/~deagle/WEAI2011/QRIMs.doc

Shukayev, Malik and Alexander Ueberfeldt (2010).  “Price Level Targeting: What Is the Right Price?” Bank of Canada Working Paper 2010-8

Svensson, Lars E O, 1999. “Price-level Targeting versus Inflation Targeting: A Free Lunch?,”

Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 277-95, August.

© Copyright (2012) by David Eagle


[1] The traditional Fisher equation states that i @ r + E[π] where i is the nominal interest rate, r is the real interest rate, and π is the inflation rate.  A more exact relationship we use in Finance is (1+i)=(1+r)(1+E[π) where these rates are per compound period, in this case per month.  According to the approximate and traditional Fisher equation, the real interest rate would be 4.8%, which equals the 7.2% nominal rate less the 2.4% expected inflation (the more precise Fisher equation using the monthly rates concludes the real rate will be 4.79%).

[2] You may note that the real value of the monthly nominal payment is expected to decline over time.  In the mortgage literature, this is known as the “tilt effect” (See Eagle and Domian, 2011).


Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

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