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.

Papers about money, regime uncertainty and efficient religions

I have the best wife in the world and she has been extremely understanding about my odd idea to start blogging, but there is one thing she is not too happy about and that is that I tend to leave printed copies of working papers scatted around our house. I must admit that I hate reading working papers on our iPad. I want the paper version, but I also read quite a few working papers and print out even more papers. So that creates quite a paper trail in our house…

But some of the working papers also end up in my bag. The content of my bag today might inspire some of my readers:

“Monetary Policy and Japan’s Liquidity Trap” by Lars E. O. Svensson and “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rate” by Bennett T. McCallum.

These two papers I printed out when I was writting my recent post on Czech monetary policy. It is obvious that the Czech central bank is struggling with how to ease monetary policy when interest rates are close to zero. We can only hope that the Czech central bankers read papers like this – then they would be in no doubt how to get out of the deflationary trap. Frankly speaking I didn’t read the papers this week as I have read both papers a number of times before, but I still think that both papers are extremely important and I would hope central bankers around the world would study Svensson’s and McCallum’s work.

“Regime Uncertainty – Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” – by Robert Higgs.

My regular readers will know that I believe that the key problem in both the US and the European economies is overly tight monetary policy. However, that does not change the fact that I am extremely fascinated by Robert Higgs’ concept “Regime Uncertainty”. Higgs’ idea is that uncertainty about the regulatory framework in the economy will impact investment activity and therefore reduce growth. While I think that we primarily have a demand problem in the US and Europe I also think that regime uncertainty is a highly relevant concept. Unlike for example Steve Horwitz I don’t think that regime uncertainty can explain the slow recovery in the US economy. As I see it regime uncertainty as defined by Higgs is a supply side phenomena. Therefore, we should expect a high level of regime uncertainty to lower real GDP growth AND increase inflation. That is certainly not what we have in the US or in the euro zone today. However, there are certainly countries in the world where I would say regime uncertainty play a dominant role in the present economic situation and where tight monetary policy is not the key story. My two favourite examples of this are South Africa and Hungary. I would also point to regime uncertainty as being extremely important in countries like Venezuela and Argentina – and obviously in Iran. The last three countries are also very clear examples of a supply side collapse combined with extremely easy monetary policy.

Furthermore, we should remember that tight monetary policy in itself can lead to regime uncertainty. Just think about Greece. Extremely tight monetary conditions have lead to a economic collapse that have given rise to populist and extremist political forces and the outlook for economic policy in Greece is extremely uncertain. Or remember the 1930s where tight monetary conditions led to increased protectionism and generally interventionist policies around the world – for example the horrible National Industrial Recovery Act (NIRA) in the US.

I have read Higg’s paper before, but hope to re-read it in the coming week (when I will be traveling a lot) as I plan to write something about the economic situation in Hungary from the perspective of regime uncertain. I have written a bit about that topic before.

“World Hyperinflations” by Steve Hanke and Nicholas Krus.

I have written about this paper before and I have now come around to read the paper. It is excellent and gives a very good overview of historical hyperinflations. There is a strong connection to Higgs’ concept of regime uncertainty. It is probably not a coincidence that the countries in the world where inflation is getting out of control are also countries with extreme regime uncertainty – again just think about Argentina, Venezuela and Iran.

“Morality and Monopoly: The Constitutional political economy of religious rules” by Gary Anderson and Robert Tollison.

This blog is about monetary policy issues and that is what I spend my time writing about, but I do certainly have other interests. There is no doubt that I am an economic imperialist and I do think that economics can explain most social phenomena – including religion. My recent trip to Provo, Utah inspired me to think about religion again or more specifically I got intrigued how the Church of Jesus Chris Latter day Saints (LDS) – the Mormons – has become so extremely successful. When I say successful I mean how the LDS have grown from being a couple of hundreds members back in the 1840s to having millions of practicing members today – including potentially the next US president. My hypothesis is that religion can be an extremely efficient mechanism by which to solve collective goods problems. In Anderson’s and Tollison’s paper they have a similar discussion.

If religion is an mechanism to solve collective goods problems then the most successful religions – at least those which compete in an unregulated and competitive market for religions – will be those religions that solve these collective goods problems in the most efficient way. My rather uneducated view is that the LDS has been so successful because it has been able to solve collective goods problems in a relatively efficient way. Just think about when the Mormons came to Utah in the late 1840s. At that time there was effectively no government in Utah – it was essentially an anarchic society. Government is an mechanism to solve collective goods problems, but with no government you have to solve these problems in another way. Religion provides such mechanism and I believe that this is what the LDS did when the pioneers arrived in Utah.

So if I was going to write a book about LDS from an economic perspective I think I would have to call it “LDS – the efficient religion”. But hey I am not going to do that because I don’t really know much about religion and especially not about Mormonism. Maybe it is good that we are in the midst of the Great Recession – otherwise I might write about the economics and religion or why I prefer to drive with taxi drivers who don’t wear seat belts.

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Update: David Friedman has kindly reminded me of Larry Iannaccone’s work on economics of religion. I am well aware of Larry’s work and he is undoubtedly the greatest authority on the economics of religion and he is president of the Association for the Study of Religion, Economics and Culture. Larry’s paper “Introduction to the Economics of Religion” is an excellent introduction to the topic.

Markets are telling us where NGDP growth is heading

I am still in Provo Utah and even though I have had a busy time I have watch a bit of Bloomberg TV and CNBC over the last couple of days (to fight my jet lag). I have noticed some very puzzling comments from commentators. There have been one special theme and that has come up again and again over the last couple of days among the commentators on US financial TV and that is that “yeah, monetary easing might be positive for the markets, but it is not have any impact on the real economy”. This is a story about disconnect between the economy and the markets.

I find that perception very odd, but it seems like a lot of commentators simply are not mentally able to accept that monetary policy is highly effective. The story goes that when the Federal Reserve and the ECB moves towards monetary easing then it might do the markets good, but “real people” will not be helped. I find it unbelievable that well-educated economists would make such claims.

Markets are forward-looking and market pricing is the best tool we have for forecasting the future. When stock prices are rising, bond yields are rising, the dollar is weakening and commodity prices are going up then it is a very good indication that monetary conditions are getting easier and easier monetary conditions mean higher nominal GDP growth (remember MV=NGP!) and with sticky prices and excess capacity that most likely also mean higher real GDP growth. That has always been that case and that is also the case now. There is no disconnect between the markets and the economy, but there is a disconnect between what many commentators would like to see (that monetary policy is not working) and the reality.

To try to illustrate the connection between the markets and NGDP I have constructed a very simple index to track market expectations of future NGDP. I have only used two market indicators – a dollar index and the S&P500. I am constructed an index based on these two indicators – I have looked year-year percentage changes in both indices. I have standardized the indices and deducted them from each other – remember higher S&P500 means higher NGDP, but a stronger dollar (a higher USD index) means lower NGDP. I call this index the NGDP Market Indicator. The indicator has been standardized so it has the same average and standard deviation as NGDP growth since 1990.

As the graph below shows this simple indicator for future NGDP growth has done a fairly good job in forecasting NGDP since 1990. (You can see the background data for the indicator here).

During the 1990s the indicator indicates a fairly stable growth rate of NGDP and that is in fact what we had. In 1999 the indicator started to send a pretty clear signal that NGDP growth was going to slow – and that is exactly what we got. The indicator also clearly captures the shock in 2008 and the recovery in 2009-10.

It is obvious that this indicator is not perfect, but the indicator nonetheless clearly illustrates that there in general is no disconnect between the markets and the economy – when stock prices are rising and the dollar is weakening at the same time then it would normally be indicating that NGDP growth will be accelerating in the coming quarters. Having that in mind it is of course worrying that the indicator in the last couple of months has been indicating a relative sharp slowdown in NGDP growth, which of course provides some justification for the Fed’s recent action.

I must stress that I have constructed the NGDP market indicator for illustrative purposes, but I am also convinced that if commodity prices and bond yields and maybe market inflation expectations were included in the indicator and the weighing of the different sub-indicators was based on proper econometric methods (rather than a simple unweighted index) then it would be possible to construct an indicator that would be able to forecast NGDP growth 1-4 quarters ahead very well.

So again – there is no disconnect between the markets and the economy. Rather market prices are very good indicators of monetary policy “easiness” and therefore of future NGDP. In fact there is probably no better indicator for the monetary policy stance than market prices and the Federal Reserve and other central banks should utilize market prices much more in assessing the impact of monetary policy on the economy than it presently the case. An obvious possibility is also to use a future NGDP to guide monetary policy as suggested by Scott Sumner.

Related posts:

Understanding financial markets with MV=PY – a look at the bond market
Don’t forget the ”Market” in Market Monetarism
Central banks should set up prediction markets
Market Monetarist Methodology – Markets rather than econometric testing
Brad, the market will tell you when monetary policy is easy
Keleher’s Market Monetarism

I think Ben just did it…

This is what I in a post earlier today asked the Federal Reserve to do:

Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.”

I must admit Ben Bernanke nearly got it right! Here is from the FOMC’s statement:

“The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.  Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.  The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective….

…To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. 

…The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. “

So we nearly got what I asked for: 1) A clear target – not an NGDP level target, but a light Mankiw rule/Evans rule based on the Fed’s dual mandate. 2) A clear instrument to increase the money base: Mortgage backed securities. 3) A promise to do more if the target is not hit.

Now the markets should do a lot of the additional lifting.

I think it would be ungrateful to ask for more – yes, yes it is not NGDP level targeting and a lot of things can go wrong, but today I think we can take a little victory lap. This is excellent news for the US economy and for the global economy. Then we can hope that we in the coming months will get an even more clear defined “Bernanke rule” so we finally can back to a rule based rather than a discretionary monetary policy.

Related posts:

Scott Sumner has two comments (here and here) on the FOMC decision.

David Beckworth also has a comment and so has David Glanser.

While Scott and two times David share my general happiness about the Fed’s actions our friend Marcus Nunes is less euphoric. Marcus as always been the skeptic among the Market Monetarist bloggers, but he has also often been right so maybe we should be a little bit careful in not being carried away.

Update: Dajeeps and JPIrving are also happy.

Update 2: Our friend Mayor(!) Bill Woolsey also comments on the fed. Bill is as happy as the rest of us with the progress in the thinking of the FOMC, but he also correctly raises some points about the dangers of targeting real variables such as unemployment rather than focusing on nominal variables such as the NGDP level. Bill’s comment in many ways can be seen as the Market Monetarist reply to George Selgin’s friendly reminder to us (the Market Monetarists) that we should not become too friendly with the fed exactly because the fed is now so clearly targeting a real variable. Bill post was however (I think) written prior to George’s comment. Needless to say I agree with George and Bill. The FOMC’s actions is major step forward, BUT I am certainly also somewhat uncomfortable with the fact that the fed now so clearly targeting a real – rather than a nominal – variable.

Time to end discretionary monetary policy!

This week has been nearly 100% about monetary policy in the financial markets and in the international financial media. In fact since 2008 monetary policy has been the main driver of prices in basically all asset classes. In the markets the main job of investors is to guess what the ECB or the Federal Reserve will do next. However, the problem is that there is tremendous uncertainty about what the central banks will do and this uncertainty is multi-dimensional. Hence, the question is not only whether XYZ central bank will ease monetary policy or not, but also about how it will do it.

Just take Mario Draghi’s press conference last week – he had to read out numerous different communiqués and he had to introduce completely new monetary concepts – just take OMT. OMT means Outright Monetary Transactions – not exactly a term you will find in the monetary theory textbook. And he also had to come up with completely new quasi-monetary institutions – just take the ESM. The ESM is the European Stability Mechanism. This is not really necessary and it just introduce completely unnecessary uncertainty about European monetary policy.

In reality monetary policy is extremely simple. Central bankers can fundamentally do two things. First, the central bank can increase or decrease the money base and second it can guide expectations. It is really simple. There is no reason for ESM, OMT, QE3 etc. The problem, however, is that central banks used to control the money base and expectations with interest rates, but with interest rates close to zero central bankers around the world seem to have lost the ability to communicate about what they want to do. As a result monetary policy has become extremely discretionary in both Europe and the US.

That need to change as this discretion is at the core the uncertainty about monetary policy. Central bankers therefore have to do two things to get back on track and to create some kind of normality. First, central banks should define very clear targets of what the want to achieve – preferably the ECB and the Fed should announce nominal GDP targets, but other target might do as well. Second, the central banks should give up communicating about monetary policy in terms of interest rates and rather communicate in terms of how much they want to change the money base.

In terms of changes in the money base the central banks should clarify how the money base is changed. The central bank can increase the money base, by buying different assets such as government bonds, foreign currencies, commodities or stocks. The important thing is that the central banks do not try to affect relative prices in the financial markets. When the Fed is conducting it “twist operations” it is trying to distort relative prices, which essentially is a form of central planning and has little to do with monetary policy. Therefore, the best the central banks could do is to define a clear basket of assets it will be buying or selling to increase or decrease the money base. This could be a fixed basket of bonds, currencies, commodities and stocks – or it could just be short-term government bonds. The important thing is that the central bank define a clear instrument.

This would remove the “instrument uncertainty” and the ECB or the Fed would not have to come up with new weird instruments every single month. Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.” 

In this world there would be no discretion at all – the central bank would be strictly rule following. It would use its well-defined policy instrument to always hit the policy target and there would be no problems with zero bound interest rates. But most important it would allow the financial markets to do most of the lifting as such set-up would be tremendously more transparent than what they are doing today.

Today we will see whether Ben Bernanke want to continue distorting relative prices and maintaining policy uncertainty by keeping the Fed’s highly discretionary habits or whether he want to ensure a target and rules based monetary policy.

PS a possibility would of course also be to use NGDP futures to conduct monetary policy as Scott Sumner has suggested, but that nearly seems like science fiction given the extreme conservatism of the world’s major central banks.

Friedman’s Japanese lessons for the ECB

I often ask myself what Milton Friedman would have said about the present crisis and what he would have recommended. I know what the Friedmanite model in my head is telling me, but I don’t know what Milton Friedman actually would have said had he been alive today.

I might confess that when I hear (former?) monetarists like Allan Meltzer argue that Friedman would have said that we were facing huge inflationary risks then I get some doubts about my convictions – not about whether Meltzer is right or not about the perceived inflationary risks (he is of course very wrong), but about whether Milton Friedman would have been on the side of the Market Monetarists and called for monetary easing in the euro zone and the US.

However, today I got an idea about how to “test” indirectly what Friedman would have said. My idea is that there are economies that in the past were similar to the euro zone and the US economies of today and Friedman of course had a view on these economies. Japan naturally comes to mind.

This is what Friedman said about Japan in December 1997:

“Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

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

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

So Friedman was basically telling the Bank of Japan to do quantitative easing – print money to buy government bonds (not to “bail out” the government, but to increase the money base).

What were the economic conditions of Japan at that time? The graph below illustrates this. I am looking at numbers for Q3 1997 (which would have been the data available when Friedman recommended QE to BoJ) and I am looking at things the central bank can influence (or rather can determine) according to traditional monetarist thinking: nominal GDP growth, inflation and money supply growth. The blue bars are the Japanese numbers.

Now compare the Japanese numbers with the similar data for the euro zone today (Q1 2012). The euro zone numbers are the red bars.

Isn’t striking how similar the numbers are? Inflation around 2-2.5%, nominal GDP growth of 1-1.5% and broad money growth around 3%. That was the story in Japan in 1997 and that is the story in the euro zone today.

Obviously there are many differences between Japan in 1997 and the euro zone today (unemployment is for example much higher in the euro zone today than it was in Japan in 1997), but judging alone from factors under the direct control of the central bank – NGDP, inflation and the money supply – Japan 1997 and the euro zone 2012 are very similar.

Therefore, I think it is pretty obvious. If Friedman had been alive today then his analysis would have been similar to his analysis of Japan in 1997 and his conclusion would have been the same: Monetary policy in the euro zone is far too tight and the ECB needs to do QE to “rejuvenate” the European economy. Any other view would have been terribly inconsistent and I would not like to think that Friedman could be so inconsistent. Allan Meltzer could be, but not Milton Friedman.

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* Broad money is M2 for Japan and M3 for the euro zone.

Related posts:

Meltzer’s transformation
Allan Meltzer’s great advice for the Federal Reserve
Failed monetary policy – (another) one graph version
Jens Weidmann, do you remember the second pillar?

Finding wisdom in letters to The Economist

It is always a pleasure to read The Economist. Normally, however, I do not find the letters to the editor especially interesting. However, when I picked up this week’s edition of the magazine today I stumbled on an interesting letter from Paul DeRosa. Mr. DeRosa writes about what Milton Friedman might have thought of the present crisis.

Here is from Mr. DeRosa’s letter to The Economist:

“At a seminar once, I remember hearing him [Friedman] make the generalization that monetary policy is easy only when the prices of assets are rising faster than the prices of the goods they produce…In any case, this thought applied to any reasonable constructed index of asset prices reveals that the Federal Reserve is barely on the easy side of neutral, and the European Central Bank has Europe in death grip”

I find Mr. DeRosa’s comments extremely interesting. The comments are interesting because it indicates that Milton Friedman indeed paid attention to asset prices as an indicator for the monetary policy stance – something that of course is at the core of Market Monetarism. Second, I believe the Mr. DeRosa’s conclusion is entirely correct – the markets are clearly telling us that monetary policy in the euro zone is insanely tight – and that the Fed is not doing a much better job.

Selgin’s challenge to the Market Monetarists

Anybody who have been following my blog knows how much admiration I have for George Selgin so when George speaks I listen and if he says I am wrong I would not easily dismiss it without very careful consideration.

Now George has written a challenge on Freebanking.org for us Market Monetarists. In his post “A Question for the Market Monetarists” George raises a number of issues that deserves answers. Here is my attempt to answer George’s question(s). But before you start reading I will warn you – as it is normally the case I think George is right at least to some extent.

Here is George:

“Although my work on the “Productivity Norm” has led to my being occasionally referred to as an early proponent of Market Monetarism, mine has not been among the voices calling out for more aggressive monetary expansion on the part of the Fed or ECB as a means for boosting employment.”

While it is correct that Market Monetarists – and I am one of them – have been calling for monetary easing both in the US and the euro zone this to me is not because I want to “boost employment”. I know that other Market Monetarists – particularly Scott Sumner – is more outspoken on the need for the Federal Reserve to fulfill it’s “dual mandate” and thereby boost employment (Udpate: Evan Soltas has a similar view – see comment section). I on my part have always said that I find the Fed’s dual mandate completely misguided. Employment is not a nominal variable so it makes no sense for a central bank to target employment or any other real variable. I am in favour of monetary easing in the euro zone and the US because I want the Fed and the ECB to undo the mistakes made in the past. I am not in favour of monetary policy letting bygones-be-bygones. I do, however, realise that the kind of monetary easing I am advocating likely would reduce unemployment significantly in both the euro zone and the US. That would certainly be positive, but it is not my motive for favouring monetary easing in the present situation. See here for a discussion of Fed’s mandate and NGDP targeting.

Said in another way what I want the is that the Fed and the ECB should to live up to what I have called Selgin’s monetary credo:

“The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability“

Back to George:

“There are several reasons for my reticence. The first, more philosophical reason is that I think the Fed is quite large enough–too large, in fact, by about $2.8 trillion, about half of which has been added to its balance sheet since the 2008 crisis. The bigger the Fed gets, the dimmer the prospects for either getting rid of it or limiting its potential for doing mischief. A keel makes a lousy rudder.”

This is the Free Banking advocate George Selgin speaking. The Free Banking advocate Lars Christensen does not disagree with George’s fundamental free banking position. However, George also knows that in the event of a sharp rise in money demand in a free banking regime the money supply will expanded automatically to meet that increase in money demand (I learned that from George). In 2007-9 we saw a sharp rise in dollar demand and the problem was not that the Fed did too much to meet that demand, but rather that it failed to meet the increase in money demand. Something George so well has described in for example his recent paper on the failed US primary dealer system. See here.

However, I certainly agree with George’s position that had monetary policy been conducted in another more rational way – for example within a well-defined NGDP targeting regime and a proper lender-of-last-resort regime – then the Fed would likely have had to expand it’s money base much less than has been the case. Here I think that we Market Monetarists should listen to George’s concerns. Sometimes some of us are to eager to call for what could sound like a discretionary expansion of the money base. This is not really the Market Monetarist position. The Market Monetarist position – at least as I think of it – is that the Fed and the ECB should “emulate” a free banking outcome and ensure that any increase in money demand is met by an increase in the money base. This should obviously be based on a rule based set-up rather than on discretionary monetary policy changes. Both the Fed and the ECB have been insanely discretionary in the past four years.

Back to George:

“The second reason is that I worry about policy analyses (such as this recent one) that treat the “gap” between the present NGDP growth path and the pre-crisis one as evidence of inadequate NGDP growth. I am, after all, enough of a Hayekian to think that the crisis of 2008 was itself at least partly due to excessively rapid NGDP growth between 2001 and then, which resulted from the Fed’s decision to hold the federal funds rate below what appears (in retrospect at least) to have been it’s “natural” level.” 

This is a tricky point on which the main Market Monetarist bloggers do not necessarily agree. Scott Sumner and Marcus Nunes have both strongly argued against the “Hayekian position” and claim that US monetary policy was not too easy prior to 2008. David Beckworth prior to the crisis clearly was arguing that US monetary policy was too easy. My own position is somewhere in between. I certainly think that monetary policy was too easy in certain countries prior to the crisis. I for example have argued that continuously in my day-job back in 2006-7 where I warned that monetary conditions in for example Iceland, the Baltic States and in South Eastern European were overly loose. I am, however, less convinced that US monetary policy was too easy – for the US economy, but maybe for other economies in the world (this is basically what Beckworth is talking about when he prior to crisis introduced the concept the Fed as a “monetary superpower”).

However, it would be completely wrong to argue that the entire drop in NGDP in the US and the euro zone is a result of a bubble bursting. In fact if there was any “overshot” on pre-crisis NGDP or any “bubbles” (whatever that is) then they certainly long ago have been deflated. I am certain that George agrees on that. Therefore the possibility that there might or might have been a “bubble” is no argument for maintain the present tight monetary conditions in the euro zone and the US.

That said, as time goes by it makes less and less sense to talk about returning to a pre-crisis trend level for NGDP both in the US and the euro zone. But let’s address the issue in slightly different fashion. Let’s say we are where presented with two different scenarios. In scenario 1 the Fed and the ECB would bring back NGDP to the pre-crisis trend level, but then thereafter forget about NGDP level targeting and just continue their present misguided policies. In scenario 2 both the Fed and the ECB announce that they in the future will implement NGDP level targeting with the use of NGDP futures (as suggested by Scott), but would initiate the new policy from the present NGDP level. I would have no doubt that I would prefer the second scenario. I can of course not speak from my Market Monetarist co-conspiritors, but to me the it is extremely important that we return to a rule based monetary policy. The actual level of NGDP in regard is less important.

And then finally George’s question:

“And so, my question to the MM theorists: If a substantial share of today’s high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?”

This is an empirical question and I am not in a position to give an concrete answer to that. However, would argue that most of the increase in unemployment and the lack of a recovery in the labour market both in the US and the euro zone certainly is due to a lack of spending and therefore monetary easing would likely significantly reduce unemployment in both the US and the euro zone.

Finally I don’t really think that George challenge to the Market Monetarists is question about wage-expectations. Rather I think George wants us to succeed in our endeavor to get the ECB and the Fed to target NGDP. While George does not spell it out directly I think he share the concern that I from time to time has voiced that we should be careful that we do not sound like vulgar Keynesians screaming for “monetary stimulus”. To many the call for QE3 from the sounds exactly like that and for exact that reason I have cautious in calling for another badly executed QE from the Fed. Yes, we certainly need to call for monetary easing, but no one should be in doubt that we want it within a proper ruled based regime.

I have in a number of posts since I started blogging in October last year warned that we should put more emphasis on our arguments for a rule based regime than on monetary expansion as our call for monetary easing creates confusion about what we really think. Or has I stated it back in November last year my my post NGDP targeting is not a Keynesian business cycle policy“:

“I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically”…if the central bank would implement a strict NGDP level target.

So when Market Monetarists (have)… called for “monetary stimulus” it NOT does mean that (we) want to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply…

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo.” 

I hope that that is an answer to George’s more fundamental challenge to us Market Monetarists. We are not keynesians and we are strongly against discretionary monetary policy and I want to thank George for telling us to be more clear about that.

Finally I should stress that I do not speak on behalf of Scott, Marcus, Nick, 2 times David, Josh and Bill (and all the other Market Monetarists out there) and I am pretty sure that the rest of the gang will join in with answers to George. After all most of us are Selginians.

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Update: George now has an update where is answers his own question. I think it is a good answer. Here is George:

“My further reflections make me more inclined to see merit in Market Monetarists’ arguments for more accommodative monetary policy.”

Update 2: Scott also has a comment on George’s posts. I think this is highly productive. We are moving forward in our understanding of not only the theoretical foundation for Market Monetarism, but also in the understanding of the economic situation.

Udpate 3: Also comments from David Glasner, Marcus Nunes and Bill Woolsey.
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Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Project African Monetary Reform (PAMR)

Project African Monetary Reform (PAMR) – post 1

The blogoshere is full of debates about US monetary policy and the mistakes of the ECB are also hotly debated. However, other than that there is really not much debate in the blogoshere about monetary policy issues in other countries. I have from I started blogging said that I wanted to broaden the monetary debate and make it less US-centric. Unfortunately I must say I also tend to write a lot about US monetary policy and there is no doubt that most of my readers are primarily interested in US monetary affairs. However, I still want to have a broader perspective on monetary theory, policy and history. Therefore as of today I am launching Project African Monetary Reform (PAMR).

I have no clue where PAMR will lead me other than I have a large interest in the African continent and it’s economies so why not combine it with my interest in monetary policy? My regular readers will know that I already have produced a number of posts related to African monetary issues. PAMR as such will not be a major change and I will not promise any regularity in my posts in the PAMR “series”, but I hope PAMR can be a framework within which I can write a bit more on African monetary matters. I will not get into the business of forecasting central bank behavior and market movements (I spend time on that kind of thing in my day-job), but I will hope to contribute to the discussion about monetary reform in Africa. Something still badly needed in many African countries.

In the process of studying monetary reform issues in Africa – we might even learn some good lessons for more “developed” economies like the US and the euro zone. So even if you are not interested in what is going on in Africa you might learn from tracking PAMR.

I therefore also would like to invite other economists, academics and policy makers with interest in African monetary reform to get in contact with me so we might be able to build a network of people with such interests. Furthermore, I would as always welcome guest posts concerning African monetary issues from other economists with special knowledge or interest in African monetary reform. I can be contacted at lacsen@gmail.com

Furthermore, I will invite you my dear readers to give me suggestions for the next post in the PAMR series. I want to take a look at the monetary policy set-up in a “random” African country. You my dear readers will make the choice on what country I should start with. But I rule out writing something on the three large ones: South Africa, Nigeria and Egypt. You can write the suggestion here or drop me a mail. I am all hears.

Some of my previous posts related to African monetary issues:

The spike in Kenyan inflation and why it might offer a (partial) solution to the euro crisis

“Good E-money” can solve Zimbabwe’s ‘coin problem’

M-pesa – Free Banking in Africa?

 

Imagine that a S&P500 future was the Fed’s key policy tool

Here is Yale economics professor Stephen Roach:

“The ECB is pretty much out of ammunition.”

This sentence probably best illustrates what is wrong with monetary policy thinking in today’s world. Obviously the ECB is not out of ammunition, but Roach’s perception is very common.

What Roach fails to realise is that when central banks announce what we in general terms could call the “key policy rate” it is really just announcing a intermediate target for a given market interest rate. What the central bank actually is doing it setting the money base to fix a given market interest rate at a given level. In that sense the interest rates is merely a tool for communication. Nothing else.

The problem is that in most standard macroeconomic models the central bank does not determine the money base – in fact there is no money in most of today’s mainstream macroeconomic models – but rather the “interest rate”. In a world where interest rates are well above zero that is not a major problem, but when the key policy rate gets close to zero you get a communication problem. However, this is really only a perceived problem rather than an actual problem. The central bank can always expand the money base – also if the key policy rate is zero or close to zero.

The mental problem really is that interest rates have replaced money in today’s mainstream (mostly New Keynesian) macroeconomic models. Lets therefore imagine that we constructed a simple macroeconomic model where there is no interest rate, but where the central bank’s communication tool is stock prices or rather stock futures.

Many economists would willingly accept that stock prices can influence both private consumption (through a wealth effect) and investments (through a funding cost effect) and as such that would not be different from the “normal” assumption about how interest rates influence domestic demand. Therefore, by influencing the stock prices the central bank would be able to influence domestic demand. Note of course that I on purpose am “keynesian” in my rhetoric just to make my point in regard to mainstreaming thinking of monetary policy. (Obviously stock prices as well and private consumption and investments are determined by expectations of future nominal income.)

Then now imagine that the central bank every month announces a certain level for the a stock market future instead of announcing a key policy interest rate. So for example in the case of the Federal Reserve the FOMC would every month announce a “target” for a given S&P500 future.

Would anybody question that the Fed could do this? And would anybody question whether the Fed could hit that target? No, of course not. The ECB obviously could do the exact same thing. There would be absolutely no technical problem in using stock prices (or rather stock futures) as a policy instrument.

Do you think Stephen Roach would argue that the ECB “pretty much” was out of ammunition had just increased it’s target for the Euronext 24 month future with 5%? No of course not and that in my view clearly illustrates that the zero bound on interest rates only is a mental problem, but an actual problem.

Finally note that I am not advocating that central banks should target stock prices (I advocate they should target an NGDP future), but I see little difference in such a policy instrument and interest rate targeting. Furthermore, there would not be a zero bound problem if the Fed was targeting S&P500 futures rather than interest rates and Stephen Roach might even realise that the ECB in no way is out of ammunition.

——

PS over the long run NGDP and stock prices are actually quite strongly correlated and hence if the Fed announced that S&P500 should increase by lets say 5% a year over the coming 5 years and that it would ensure that by buying (or selling) S&P futures then it would probably do a much better job at hitting a given level of NGDP or inflation for that matter than the Fed’s present weird policy of promising to keep interest rates low for longer or the silly operation twist.

PPS I am pretty sure that Stephen Roach full well knows that the ECB is not out of ammunition, but when you talk to journalists you might make some intellectual short-cuts that distorts what you really think. At least I hope that is what happened.

PPPS If the Fed wanted to target the NGDP level then it is pretty easy to construct indicator for future NGDP from S&P500 futures, TIPS inflation expectations, CRB futures and the nominal effective dollar rate and then the Fed could just use that as a communication tool. Then it would never ever again have to talk about QE or running out of ammunition.

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Update: When I started writing my post I was thinking that Nick Rowe might have  written something similar. And yes, indeed he actually wrote a number of posts on the topic. So take a look at Nick’s posts:

“The Bank of Canada should peg the TSE 300″ – revisited
Why the Bank of Canada should ‘rise’ interest rates
The Fed should buy pro-cyclical assets, not bonds

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