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

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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?

Between the money supply and velocity – the euro zone vs the US

When crisis hit in 2008 it was mostly called the subprime crisis and it was normally assumed that the crisis had an US origin. I have always been skeptical about the US centric description of the crisis. As I see it the initial “impulse” to the crisis came from Europe rather than the US. However, the consequence of this impulse stemming from Europe led to a “passive” tightening of US monetary conditions as the Fed failed to meet the increased demand for dollars.

The collapse in both nominal (and real) GDP in the US and the euro zone in 2008-9 was very similar, but the “composition” of the shock was very different. In Europe the shock to NGDP came from a sharp drop in money supply growth, while the contraction in US NGDP was a result of a sharp contraction in money-velocity. The graphs below illustrate this.

The first graph is a graph with the broad money supply relative to the pre-crisis trend (2000-2007) in the euro zone and the US. The second graph is broad money velocity in the US and the euro zone relative to the pre-crisis trend (2000-2007).

The graphs very clearly illustrates that there has been a massive monetary contraction in the euro zone as a result of M3 significantly undershooting the pre-crisis trend. Had the ECB kept M3 growth on the pre-crisis trend then euro zone nominal GDP would long ago returned to the pre-crisis trend. On the other hand the Federal Reserve has actually been able to keep M2 on the pre-crisis path. However, that has not been enough to keep US NGDP on trend as M2-velocity has contracted sharply relative the pre-crisis trend.

Said in another way a M3 growth target of for example 6.5% would basically have been as good as an NGDP level target for the euro zone as velocity has returned to the pre-crisis trend. However, that would not have been the case in the US and that I my view illustrates why an NGDP level target is much preferable to a money supply target.

The European origin of the crisis – or how European banks caused a tightening of US monetary policy

Not surprisingly the focus of the discussion of the causes of the crisis often is on the US given both the subprime debacle and the collapse of Lehman Brothers. However, I believe that the shock actually (mostly) originated in Europe rather than the US. What happened in 2008 was that we saw a sharp rise in dollar demand coming from the European financial sector. This is best illustrated by the sharp drop in EUR/USD from close to 1.60 in July 2008 to 1.25 in early November 2008. The rise in dollar demand is obviously what caused the collapse in US money-velocity and in that regard it is notable that the rise in money demand in Europe primarily was an increase in demand for dollar rather than for euros.

This is why I stress the European origin of the crisis. However, the cause of the crisis nonetheless was a tightening of US monetary conditions as the Fed (initially) failed to appropriately respond to the increase in dollar demand – mostly because of the collapse of the US primary dealer system. Had the Fed had a more efficient system for open market operations in 2008 then I believe the crisis would have been much smaller and would have been over already in 2009. As the Fed got dollar-swap lines up and running and initiated quantitative easing the recovery got underway in 2009. This triggered a brisk recovery in both US and euro zone money-velocity. In that regard it is notable that the rebound in velocity actually was somewhat steeper in the euro zone than in the US.

The crisis might very well have ended in 2009, but new policy mistakes have prolonged the crisis and once again European problems are causing most headaches and the cause now clearly is that the ECB has allowed European monetary conditions to become excessively tight – just have a look at the money supply graph above. Euro zone M3 has now dropped more than 15% below the pre-crisis trend. This policy mistake has to some extent been counteracted by the Fed’s efforts to increase the US money supply, but the euro crisis have also led to another downleg in US money velocity. The Fed once again has failed to appropriately counteract this.

Both the Fed and the ECB have failed

In the discussion above I have tried to illustrate that we cannot fully understand the Great Recession without understanding the relationship between US and euro zone monetary policy and I believe that a full understanding of the crisis necessitates a discussion of European dollar demand.

Furthermore, the discussion shows that a credible money supply target would significantly have reduced the crisis in the euro zone. However, the shock to US money-velocity shows that an NGDP level target would “perform” much better than a simple money supply rule.

The conclusion is that both the Fed and the ECB have failed. The Fed failed to respond appropriately in 2008 to the increase in the dollar demand. On the other hand the ECB has nearly constantly since 2008/9 failed to increase the money supply and nominal GDP. Not to mention the numerous communication failures and the massively discretionary conduct of monetary policy.

Even though the challenges facing the Fed and ECB since 2008 have been somewhat different in nature I would argue that proper nominal targets (for example a NGDP level target or a price level target) and better operational procedures could have ended this crisis long ago.

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Related posts:

Failed monetary policy – (another) one graph version
International monetary disorder – how policy mistakes turned the crisis into a global crisis

The Jedi mind trick – Matt O’Brien’s insightful version of the Chuck Norris effect

Our friend Matt O’Brien has a great new comment on the Atlantic.com. Matt is one of the most clever commentators on monetary matters in the US media.

In Matt’s new comment he set out to explain the importance of expectations in the monetary transmission mechanism.

Here is Matt:

“These aren’t the droids you’re looking for.” That’s what Obi-Wan Kenobi famously tells a trio of less-than-with-it baddies in Star Wars when — spoiler alert! — they actually were the droids they were looking for. But thanks to the Force, Kenobi convinces them otherwise. That’s a Jedi mind trick — and it’s a pretty decent model for how central banks can manipulate expectations. Thanks to the printing press, the Fed can create a self-fulfilling reality. Even with interest rates at zero.

Central banks have a strong influence on market expectations. Actually, they have as strong an influence as they want to have. Sometimes they use quantitative easing to communicate what they want. Sometimes they use their words. And that’s where monetary policy basically becomes a Jedi mind trick.

The true nature of central banking isn’t about interest rates. It’s about making and keeping promises. And that brings me to a confession. I lied earlier. Central banks don’t really buy or sell short-term bonds when they lower or raise short-term interest rates. They don’t need to. The market takes care of it. If the Fed announces a target and markets believe the Fed is serious about hitting that target, the Fed doesn’t need to do much else. Markets don’t want to bet against someone who can conjure up an infinite amount of money — so they go along with the Fed.

Don’t underestimate the power of expectations. It might sound a like a hokey religion, but it’s not. Consider Switzerland. Thanks to the euro’s endless flirtation with financial oblivion, investors have piled into the Swiss franc as a safe haven. That sounds good, but a massively overvalued currency is not good. It pushes inflation down to dangerously low levels, and makes exports uncompetitive. So the Swiss National Bank (SNB) has responded by devaluing its currency — setting a ceiling on its value at 1.2 Swiss francs to 1 euro. In other words, the SNB has promised to print money until its money is worth what it wants it to be worth. It’s quantitative easing with a target. And, as Evan Soltas pointed out, the beauty of this target is that the SNB hasn’t even had to print money lately, because markets believe it now. Markets have moved the exchange rate to where the SNB wants it.”

This is essentially the Star Wars version of the Chuck Norris effect as formulated by Nick Rowe and myself. The Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.

It is pretty simple. It is all about credibility. A central bank has all the powers in the world to increase inflation and nominal GDP (remember MV=PY!) and if the central bank clearly demonstrates that it will use this power to ensure for example a stable growth path for the NGDP level then it might not have to do any (additional) money printing to achieve this. The market will simply do all the lifting.

Imagine that a central bank has a NGDP level target and a shock to velocity or the money supply hits (for example due to banking crisis) then the expectation for future NGDP (initially) drops below the target level. If the central bank’s NGDP target is credible then market participants, however, will know that the central bank will react by increasing the money base until it achieves it’s target. There will be no limits to the potential money printing the central bank will do.

If the market participants expect more money printing then the country’s currency will obviously weaken and stock prices will increase. Bond yields will increase as inflation expectations increase. As inflation and growth expectations increase corporations and household will decrease their cash holdings – they will invest and consume more. The this essentially the Market Monetarist description of the monetary transmission mechanism under a fully credible monetary nominal target (See for example my earlier posts here and here).

This also explains why Scott Sumner always says that monetary policy works with long and variable leads. As I have argued before this of course only is right if the monetary policy is credible. If the monetary target is 100% credible then monetary policy basically becomes endogenous. The market reacts to information that the economy is off target. However, if the target is not credible then the central bank has to do most of the lifting itself. In that situation monetary policy will work with long and variable lags (as suggested by Milton Friedman). See my discussion of lag and leads in monetary policy here.

During the Great Moderation monetary policy in the euro zone and the US was generally credible and monetary policy therefore was basically endogenous. In that world any shock to the money supply will basically be automatically counteracted by the markets. The money supply growth and velocity tended to move in opposite directions to ensure the NGDP level target (See more on that here). In a world where the central bank is able to apply the Jedi mind trick the central bankers can use most of their time golfing. Only central bankers with no credibility have to work hard micromanaging things.

“I FIND YOUR LACK OF A TARGET DISTURBING”

So the reason European central bankers are so busy these days is that the ECB is no longer a credible. If you want to test me – just have a look at market inflation expectations. Inflation expectations in the euro zone have basically been declining for more than a year and is now well below the ECB’s official inflation target of 2%. If the ECB had an credible inflation target of 2% do you then think that 10-year German bond yields would be approaching 1%? Obviously the ECB could solve it’s credibility problem extremely easy and with the help of a bit Jedi mind tricks and Chuck Norris inflation expectations could be pegged at close to 2% and the euro crisis would soon be over – and it could do more than that with a NGDP level target.

Until recently it looked like Ben Bernanke and the Fed had nailed it (See here – once I believed that Bernanke did nail it). Despite an escalating euro crisis the US stock market was holding up quite well, the dollar did not strengthen against the euro and inflation expectations was not declining – clear indications that the Fed was not “importing” monetary tightening from Europe. The markets clearly was of the view that if the euro zone crisis escalated the Fed would just step up quantitative ease (QE3). However, the Fed’s credibility once again seems to be under pressures. US stock markets have taken a beating, US inflation expectations have dropped sharply and the dollar has strengthened. It seems like Ben Bernanke is no Chuck Norris and he does not seem to master the Jedi mind trick anymore. So why is that?

Matt has the answer:

“I’ve seen a lot of strange stuff, but nothing quite as strange as the Fed’s reluctance to declare a target recently. Rather than announce a target, the Fed announces how much quantitative easing it will do. This is planning for failure. Quantitative easing without a target is more quantitative and less easing. Without an open-ended commitment that shocks expectations, the Fed has to buy more bonds to get less of a result. It’s the opposite of what the SNB has done.

Many economists have labored to bring us this knowledge — including a professor named Ben Bernanke — and yet the Fed mostly ignores it. I say mostly, because the Fed has said that it expects to keep short-term interest rates near zero through late 2014. But this sounds more radical than it is in reality. It’s not a credible promise because it’s not even a promise. It’s what the Fed expects will happen. So what would be a good way to shift expectations? Let’s start with what isn’t a good way.”

I agree – the Fed needs to formulate a clear nominal target andit needs to formulate a clear reaction function. How hard can it be? Sometimes I feel that central bankers like to work long hours and want to micromanage things.

UPDATE: Marcus Nunes and Bill Woolsey also comments on Matt’s piece..

Jens Weidmann, do you remember the second pillar?

Today the ECB is very eager to stress it’s 2% inflation target. However, a couple of years ago the ECB in fact had two targets – the so-called two pillars of monetary policy. The one was the inflation target and the other was a money supply target – the so-called reference value for the growth rate of M3.

The second pillar in many ways made a lot of sense – at least as a instrument for monetary analysis. The second pillar was put into the ECB tool box by the Bundesbank which insisted that monetary analysis was as important as a pure inflation target. Read for example former ECB chief economist and Bundesbanker Otmar Issing’s defense of the two-pillar set-up here.

The starting point for calculating the reference value for M3 was the equation of exchange:

(1) MV=PY

or in growth rates:

(2) m+v=p+y

(2) of course can be re-written to:

(2)’ m=p+y-v

If we assume trend real GDP growth (y) is 2% you can calculate the reference value for m that will ensure 2% inflation over the medium term. You of course also have to make an assumption about velocity. ECB used to think that trend growth in v was -0.5 to -1%.

This give us the following reference growth rate for M3 (m-target):

(3) m-target=2+2-(-1)=5% (4.5% if you assume velocity growth of -0.5%)

Said in another way if the ECB keeps M3 growing at 5% year-in and year-out then inflation should be around 2% in the medium term. An yes, this is of course exactly what Milton Friedman recommend long ago.

2.5% M3 growth is hardly inflationary

Today we got the latest M3 numbers for the euro zone. The calvinists should be happy – M3 decelerated sharply to 2.5% y/y in April. Half of what should be the reference growth rate for M3 – and that is ignoring the fact that velocity has collapsed.

What does that tells us about the inflationary risks in the euro zone? Well, there are no inflationary risks – there are only deflationary risks.

Using the assumptions above we can calculate the long-term inflation if M3 keeps growing by 2.5% – from (2)’ we get the following:

(4) p=m-y+v

(4)’ p=2.5-2+(-1)=-0.5%

So it is official! Monetary analysis as it used to be conducted in the Bundesbank is telling you that we are going to have deflation in the euro zone in the medium term! And don’t tell me about monetary overhang – the ECB is in the business of letting bygones be bygones (otherwise the ECB would target the NGDP LEVEL or the price LEVEL) and by the way the ECB spend lots of time in 2004-7 to explain why money supply growth overshot the target.

Jens Weidmann – monetarist or calvinist?

The Bundesbank brought in monetary analysis and a money supply focus to the ECB so I think it is only fair to ask whether Bundesbank chief Jens Weidmann still believe in monetary analysis? If he is true to the strong monetarist traditions at the Bundesbank then he should come out forcefully in favour of monetary easing to ensure M3 growth of at least 5% – in fact it should be much higher as velocity has collapsed, but at least to bring M3 back to 5% would be a start.

I hope the Bundesbank will soon refind it’s monetarist traditions…please make Milton Friedman and Karl Brunner proud!

PS I of course still want the ECB to introduce a NGDP level target, but less would make me happy – a 5-10% target range for M3 (the range prior to the crisis) and a minimum price on European inflation linked bonds would would clearly be enough to at least avoid collapse.

Maybe Jens Weidmann and Francios Hollande should switch jobs

There seem to be two main positions on how to solve the European crisis. One represented by Bundesbank chief Jens Weidmann and that is that monetary policy should not be eased anymore and fiscal policy needs to be tightened (this is the Calvinist position). The other position is held by the new French president Francios Hollande who wants to spur European growth by easing fiscal policy (this is the keynesian position)

I would claim that both positions are wrong. At the core of the European crisis is rising public debt ratios in Europe. The public debt ration (d) is defined in the following way:

(1) d=D/NGDP

Where D is public debt in euros and NGDP is nominal GDP.

Anybody with rudimentary monetarist insights would inform you that D is determined by the fiscal authorities, while NGDP is determined by monetary policy (remember MV=PY).

If you want to stabilize or reduce d then you have to either decrease D and/or increase NGDP. So what you basically need is fiscal tightening and monetary easing.

Unfortunately Weidmann is basically arguing for reducing NGDP and Hollande is arguing in favour of increasing D. Both positons will lead to an increase in d and hence worsen the crisis. Hence, it would be better if the two gentleman switched jobs  – at least mentally. It would be a lot more productivity if Weidmann argued for monetary easing and Hollande argued for fiscal consolidation. That would do the job and the crisis would come to an end fairly fast.

Between the need for fiscal tightening and the need for increasing NGDP I have no doubt that it is much more important to increase NGDP. The public debt ratios in Europe has not primarily increased because fiscal policy has been eased, but because NGDP has collapsed. In that sense the crisis is not a debt crisis, but a monetary crisis.

….

Note to the two gentlemen:

To President Hollande (The keynesian): Fiscal policy cannot increase NGDP. Recommend reading: There is no such thing as fiscal policy

To Bundesbank chief Weidmann (The Calvinist): Monetary policy is a panache and it can increase NGDP as much as you like it to be increased. Recommend reading: “Ben Volcker” and the monetary transmission mechanism

Next stop Moscow

I am writing this as I am flying to Moscow to spend a couple of days meeting clients in Moscow. It will be nice to be back. A lot of things are happing in Russia at the moment – especially politically. A new opposition has emerged to President Putin’s regime. However, even though politics always comes up when you are in Russia I do not plan to talk too much about the political situation. Everybody is doing that – so I will instead focus my presentations on monetary policy matters as I believe that monetary policy mistakes have been at the core of economic developments in Russia over the last couple of years. I hope to add some value as I believe that few local investors in Russia are aware of how crucial the monetary development is.

Here are my main topics:

1) The crucial link between oil prices, exchange rate developments and monetary policy. Hence, what we could call the petro-monetary transmission mechanism in the Russian economy

2) Based on the analysis of the petro-monetary transmission mechanism I will demonstrate that the deep, but short, Russian recession in 2008-9 was caused by monetary policy failure. This is what Robert Hetzel calls the “monetary disorder view” of recession

3) Why the Russian economy is in recovery and the role played by monetary easing

4) Changing the monetary regime: The Russian central bank (CBR) has said it wants to make the Russian ruble freely floating in 2013 (I doubt that will happen…). What could be the strategy for CBR to move in that direction?

The petro-monetary transmission mechanism
When talking about the Russian economy with investors I often find that they have a black-box view of the Russian economy. For most people the Russian economy seems very easy to understand – too easy I would argue. On the one hand the they see oil prices going up or down and on the other hand they see growth going up or down.

And it is also correct that if one has a look at real or nominal GDP growth of the past decade then one would spot a pretty strong correlation to changes in oil prices. That makes most people think that when oil prices increase Russian exports increase and as result GDP increases. However, this is the common mistake when doing economics based on a simple quasi-Keynesian national accounting identity Y=C+I+X+G+NX.

What most people believe is happening is that net exports (NX) increase when oil prices increase. As a result Y increases (everything else is just assumed to be a function of Y). However, a closer look at the Russian data will make you realise that this is not correct. In fact during the boom-years 2005-8 net exports was actually “contributing” negatively to GDP growth as import growth was outpacing export growth.

So what did really happen? Well, we have to study the crucial link between oil prices, the ruble exchange rate and money supply.

As I have described in an earlier post the Russian central bank (CBR) despite its stated goal of floating the ruble suffers from a distinct fear-of-floating. The CBR simply dislikes currency volatility. Therefore, when the ruble is strengthening the CBR would intervene in the FX market (printing ruble) to curb the strengthening. And it would also intervene (buying ruble) when the currency is weakening. In recent years it has been doing so by managing the ruble against a basket of euros (55%) and dollars (45%).

This is really the reason for the link between oil prices and the GDP (both real and nominal) growth. Imagine that oil prices increases strongly as was the case in the years just prior to crisis hit in 2008. In such that situation oil exports revenues will be increasing (even if oil output in Russian is stagnated). With oil revenues increasing the ruble would tend to strengthen. However, the CBR is keeping the ruble more or less stable against the EUR-USD basket and it therefore will have to sell ruble (increase the money supply) to avoid the ruble strengthening (“too much” for CBR’s liking).

This is the petro-monetary link. Increased oil prices increase the money supply as a result of the CBR quasi-fixing of the ruble.

Therefore, it makes much more sense instead of a national account approach to go back to the most important equation in macroeconomics – the equation of exchange:

(1) MV=PY

Russian money-velocity (V) has been declining around a fairly stable trend over the past decade. We can therefore assume – to make things slightly easier that V has been growing (actually declining) at a fairly stable rate v’. We can then write (1) in growth rates:

(2) m+v’=p+y

As we know from above money supply growth (m) is a function of oil prices (oil) – if CBR is quasi-pegging the ruble:

(3) m=a*oil

a is a constant.

Lets also introduce a (very!) simple Phillips curve into the economy:

(4) p=by

p is of course inflation and y is real GDP growth. Equation 2,3 and 4 together is a very simple model of the Russian economy, but I frankly speaking think that is all you need to analyse the business cycle dynamics in the Russian economy given the present monetary policy set-up. (You could analyse the risk of bubbles in property market by introducing traded and non-trade goods, but lets look at that in another blog post).

If we assume oil prices (oil) and trend-velocity (v’) are exogenous it is pretty easy to solve the model for m, p and y.

Lets solve it for y by inserting (3) and (4) into (2). Then we get:

(2)’ a*oil+v’=(1+b)y

(2)’ y= a/(1+b)*oil+1/(1+b)*v’

So here we go – assuming sticky prices (the Phillips curve relationship between p and y) we get a relationship between real GDP growth and oil price changes similar to the “common man’s model” for the Russian economy. However, this link does only exist because of the conduct of monetary policy. The CBR is managing the float of the ruble, which creates the link between oil prices and real GDP growth. Had the CBR instead let the ruble float freely or linked the ruble in some way to oil prices then the oil price-gdp link would have broken down.

The CBR caused the 2009 crisis

You can easily use the model above to analyse what happen to the Russian economy in 2008-2009. I have already in a previous post demonstrated that the CBR caused the crisis in 2008-9 by not allowing the ruble to depreciate enough in the autumn of 2008.

Lets have a short look at the crisis through the lens of the model above. What happened in 2008 was that oil prices plummeted. As a consequence the ruble started to weaken. The CBR however, did not want to allow that so it intervened in the FX market – buying ruble and selling foreign currency. That is basically equation (3). Oil prices (oil) dropped, which caused the Russian money supply (m) to drop 20 % in October-November 2008.

As m drops it most follow from (2) that p and/or y will drop as well (remember we assume v’ to be constant). However, because p is sticky – that’s equation (4) – real GDP (y) will have to drop. And that is of course what happened. Russia saw the largest drop in real GDP (y) in G20.

It’s really that simple…and everything that followed – for example a relatively large banking crisis – was caused by these factors. Had the ruble been allowed to drop then the banking crisis would likely have been much smaller in scale.

Recovery time…

On to the next step. In early 2009 the Federal Reserve acted by moving towards more aggressive monetary easing and that caused global oil prices to rebound. As a result the ruble started to recover. Once again that CBR did not allow the ruble to be determined by market forces. Instead the CBR moved to curb the strengthening of the ruble. We are now back to equation (3). With oil prices (oil) increasing money supply growth (m) finally started to accelerate in 2009-10. With m increasing p and y would have to increase – we know that from equation (2) – and as p is sticky most of the initial adjustment would happen through higher real GDP growth (y). That is exactly what happened and that process has continued more or less until today.

It now seems like we have gone full cycle and that the Russian economy is operating close to full capacity and there are pretty clear signs that we now are moving back to an overly expansionary monetary policy. The question therefore is what is next for the CBR?

Time to move to a new monetary regime

The Russian central bank has announced that it wants to move to a freely floating ruble in 2013. That would make good sense as the discussion above in my view pretty clearly demonstrates that the CBR’s present monetary policy set-up has been extremely costly and lead to quite significant misallocation of economic resources.

Furthermore, as I have demonstrated above the link between economic activity and oil prices only exist in the Russian economy do to the conduct of monetary policy in Russia. If the ruble was allowed to fluctuate more freely, then we would get a much more stable development in not only inflation and nominal GDP (which is fully determined by monetary factors), but also in real GDP.

But how would you move from the one regime to the other. The simple solution would of course be to announce one day that from today the ruble is freely floating. That, however, would still beg the question what should the CBR then target and what instruments should it use to achieve this target?

Obviously as a Market Monetarist I think that the CBR should move towards a monetary regime in which relative prices are not distorted. A NGDP level targeting regime would clearly achieve that. That said, I am very sceptical about the quality of national account data in Russia and it might therefore in praxis be rather hard to implement a strict NGDP level targeting regime (at least given the present data quality). Second, even though I as a Friedmanite am strongly inclined to be in favour floating exchange rates I also believe that using the FX rate as a monetary instrument would be most practical in Russia given it’s fairly underdeveloped financial markets and (over) regulated banking sector.

Therefore, even though I certainly think a NGDP level target regime and floating exchange rates is a very good long-term objective for Russia I think it might make sense to move there gradually. The best way to do so would be for the CBR to announce a target level for NGDP, but implement this target by managing the ruble against a basket of euros and dollars (that is basically the present basket) and oil prices (measured in ruble).

Even though the CBR now is targeting a EUR-USD basket it allows quite a bit of fluctuations around the basket. These fluctuations to a large extent are determined by fluctuations in oil prices. Therefore, we can say that the CBR effective already has included oil prices in the basket. In my view oil prices effectively are somewhere between 5 and 10% of the “basket”. I think that the CBR should make that policy official and at the same time it should announce that it would increase the oil prices share of the basket to 30% in 1-2 years time. That I believe would more or less give the same kind of volatility in the ruble we are presently seeing in the much more freely floating Norwegian krone.

Furthermore, it would seriously reduce the link between swings in oil prices and in the economy. Hence, monetary policy’s impact on relative prices would be seriously reduced and as I have shown in my previous post there has been a close relationship between oil prices measured in ruble and nominal GDP growth. Hence, if the stability of oil prices measured in ruble is increased (which would happen if oil prices is included in the FX basket) then nominal GDP will also become much more stable. It will not be perfect, but I believe it would be a significant step in the direction of serious increasing nominal stability in Russia.

I am now finishing this blog post in the airport in Moscow waiting for a local colleague to pick me up, while talking to a very drunk ethic Russian Latvian who is on his way to Kazakhstan. He is friendly, but very drunk and not really interested in monetary theory…I hope the audience in the coming days

International monetary disorder – how policy mistakes turned the crisis into a global crisis

Most Market Monetarist bloggers have a fairly US centric perspective (and from time to time a euro zone focus). I have however from I started blogging promised to cover non-US monetary issues. It is also in the light of this that I have been giving attention to the conduct of monetary policy in open economies – both developed and emerging markets. In the discussion about the present crisis there has been extremely little focus on the international transmission of monetary shocks. As a consequences policy makers also seem to misread the crisis and why and how it spread globally. I hope to help broaden the discussion and give a Market Monetarist perspective on why the crisis spread globally and why some countries “miraculously” avoided the crisis or at least was much less hit than other countries.

The euro zone-US connection

– why the dollar’ status as reserve currency is important

In 2008 when crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused to drop by both a contraction in velocity and in the money supply. Reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss franc – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss franc will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over.

Why was the contraction so extreme in for example the PIIGS countries and Russia?

While the Fed failed to increase the money supply enough to counteract the increase in dollar demand it nonetheless acted through a number of measures. Most notably two (and a half) rounds of quantitative easing and the opening of dollar swap lines with other central banks in the world. Other central banks faced bigger challenges in terms of the possibility – or rather the willingness – to respond to the increase in dollar demand. This was especially the case for countries with fixed exchanges regimes – for example Denmark, Bulgaria and the Baltic States – and countries in currencies unions – most notably the so-called PIIGS countries.

I have earlier showed that when oil prices dropped in 2008 the Russian ruble started depreciated (the demand for ruble dropped). However, the Russian central bank would not accept the drop in the ruble and was therefore heavily intervening in the currency market to curb the ruble depreciation. The result was a 20% contraction in the Russian money supply in a few months during the autumn of 2008. As a consequence Russia saw the biggest real GDP contraction in 2009 among the G20 countries and rather unnecessary banking crisis! Hence, it was not a drop in velocity that caused the Russian crisis but the Russian central bank lack of willingness to allow the ruble to depreciate. The CBR suffers from a distinct degree of fear-of-floating and that is what triggered it’s unfortunate policy response.

The ultimate fear-of-floating is of course a pegged exchange rate regime. A good example is Latvia. When the crisis hit the Latvian economy was already in the process of a rather sharp slowdown as the bursting of the Latvian housing bubble was unfolding. However, in 2008 the demand for Latvian lat collapsed, but due to the country’s quasi-currency board the lat was not allowed to depreciate. As a result the Latvian money supply contracted sharply and send the economy into a near-Great Depression style collapse and real GDP dropped nearly 30%. Again it was primarily the contraction in the money supply rather and a velocity collapse that caused the crisis.

The story was – and still is – the same for the so-called PIIGS countries in the euro zone. Take for example the Greek central bank. It is not able to on it’s own to increase the money supply as it is part of the euro area. As the crisis hit (and later escalated strongly) banking distress escalated and this lead to a marked drop in the money multiplier and drop in bank deposits. This is what caused a very sharp drop in the Greek board money supply. This of course is at the core of the Greek crisis and this has massively worsened Greece’s debt woes.

Therefore, in my view there is a very close connection between the international spreading of the crisis and the currency regime in different countries. In general countries with floating exchange rates have managed the crisis much better than countries with countries with pegged or quasi-pegged exchange rates. Obviously other factors have also played a role, but at the key of the spreading of the crisis was the monetary policy and exchange rate regime in different countries.

Why did Sweden, Poland and Turkey manage the crisis so well?

While some countries like the Baltic States or the PIIGS have been extremely hard hit by the crisis others have come out of the crisis much better. For countries like Poland, Turkey and Sweden nominal GDP has returned more or less to the pre-crisis trend and banking distress has been much more limited than in other countries.

What do Poland, Turkey and Sweden have in common? Two things.

First of all, their currencies are not traditional reserve currencies. So when the crisis hit money demand actually dropped rather increased in these countries. For an unchanged supply of zloty, lira or krona a drop in demand for (local) money would actually be a passive or automatic easing of monetary condition. A drop in money demand would also lead these currencies to depreciate. That is exactly what we saw in late 2008 and early 2009. Contrary to what we saw in for example the Baltic States, Russia or in the PIIGS the money supply did not contract in Poland, Sweden and Turkey. It expanded!

And second all three countries operate floating exchange rate regimes and as a consequence the central banks in these countries could act relatively decisively in 2008-9 and they made it clear that they indeed would ease monetary policy to counter the crisis. Avoiding crisis was clearly much more important than maintaining some arbitrary level of their currencies. In the case of Sweden and Turkey growth rebound strongly after the initial shock and in the case of Poland we did not even have negative growth in 2009. All three central banks have since moved to tighten monetary policy – as growth has remained robust. The Swedish Riksbank is, however, now on the way back to monetary easing (and rightly so…)

I could also have mentioned the Canada, Australia and New Zealand as cases where the extent of the crisis was significantly reduced due to floating exchange rates regimes and a (more or less) proper policy response from the local central banks.

Fear-of-floating via inflation targeting

Some countries fall in the category between the PIIGS et al and Sweden-like countries. That is countries that suffer from an indirect form of fear-of-floating as a result of inflation targeting. The most obvious case is the ECB. Unlike for example the Swedish Riksbank or the Turkish central bank (TCMB) the ECB is a strict inflation targeter. The ECB does target headline inflation. So if inflation increases due to a negative supply shock the ECB will move to tighten monetary policy. It did so in 2008 and again in 2011. On both occasions with near-catastrophic results. As I have earlier demonstrated this kind of inflation targeting will ensure that the currency will tend to strengthen (or weaken less) when import prices increases. This will lead to an “automatic” fear-of-floating effect. It is obviously less damaging than a strict currency peg or Russian style intervention, but still can be harmful enough – as it clear has been in the case of the euro zone.

Conclusion: The (international) monetary disorder view explains the global crisis

I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also lead to a monetary contraction in especially Europe. Not because of an increase demand for euro, lats or rubles, but because central banks tighten monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as member of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

The international transmission was not caused by “market disorder”, but by monetary policy failure. In a world of freely floating exchange rates (or PEP – currencies pegged to export prices) and/or NGDP level targeting the crisis would never have become a global crisis and I certainly would have no reason to write about it four-five years after the whole thing started.

Obviously, the “local” problems would never have become any large problem had the Fed and the ECB got it right. However, the both the Fed and the ECB failed – and so did monetary policy in a number of other countries.

DISCLAIMER: I have discussed different countries in this post. I would however, stress that the different countries are used as examples. Other countries – both the good, the bad and the ugly – could also have been used. Just because I for example highlight Poland, Turkey and Sweden as good examples does not mean that these countries did everything right. Far from it. The Polish central bank had horrible communication in early 2009 and was overly preoccupied the weakening of the zloty. The Turkish central bank’s communication was horrific last year and the Sweden bank has recently been far too reluctant to move towards monetary easing. And I might even have something positive to say about the ECB, but let me come back on that one when I figure out what that is (it could take a while…) Furthermore, remember I often quote Milton Friedman for saying you never should underestimate the importance of luck of nations. The same goes for central banks.

PS You are probably wondering, “Why did Lars not mention Asia?” Well, that is easy – the Asian economies in general did not have a major funding problem in US dollar (remember the Asian countries’ general large FX reserve) so dollar demand did not increase out of Asia and as a consequence Asia did not have the same problems as Europe. Long story, but just show that Asia was not key in the global transmission of the crisis and the same goes for Latin America.

PPS For more on the distinction between the ‘monetary disorder view’ and the ‘market disorder view’ in Hetzel (2012).

PEP, NGDPLT and (how to avoid) Russian monetary policy failure

I am sitting in Riga airport and writing this. I have an early (too early!) flight to Stockholm. I must admit it makes it slightly more fun to sit in an airport when you can do a bit of blogging.

Anyway, I have been giving quite a bit of thought to the Jeff Frankel’s idea about “Peg to the Export Price” (PEP). What Frankel’s is suggesting is that commodity exporters like Russia should peg their currencies to the price of the main commodity they export – in the case of Russia that would of course be the oil price.

This have made me think about the monetary transmission mechanism in an Emerging Market commodity exporter like Russia and how very few people really understand how monetary policy works in an economy like the Russian. I have, however, for more than a decade as part of my day-job spend quite a lot of time analysing the Russian economy so in this post I will try to spell out how I see the last couple of years economic development in Russia from a monetary perspective.

The oil-money nexus and why a higher oil price is a demand shock in Russia

Since the end of communism the Russian central bank has primarily conducted monetary policy by intervening in the currency market and currency intervention remains the Russian central bank’s (CBR) most important policy instrument. (Yes, I know this is a simplification, but bear with me…)

In the present Russian monetary set-up the CBR manages the ruble within a fluctuation band against a basket of euros (45%) and dollars (55%). The composition of the basket has changed over time and the CBR has gradually widened the fluctuation band so one can say that we today has moved closer to a managed or dirty float rather than a purely fixed currency. However, despite of for years having had the official intention of moving to a free float it is very clear that the CBR has a quite distinct “fear of floating”.  The CBR is not alone in this – many central banks around the world suffer from this rather irrational fear. This is also the case for countries in which the central banks officially pursue a floating exchange rate policy. How often have you not heard central bankers complain that the currency is too strong or too weak?

With the ruble being quasi-fixed changes in the money supply is basically determined by currency inflows and outflows and as oil and gas is Russia’s main exports (around 80% of total exports) changes in the oil prices determines these flows and hence the money supply.

Lets say that the global demand for oil increases and as a consequence oil prices increase by 10%. This will more or less lead to an 10% increase in the currency inflow into Russia. With inflows increasing the ruble will tend to strengthen. However, historically the CBR has not been happy to see such inflow translate into a strengthening of the ruble and as a consequence it has intervened in the FX market to curb the strengthening of the ruble. This basically means that that CBR is printing ruble and buying foreign currency. The logic consequence of this is the CBR rather than allowing the ruble to strengthen instead is accumulating ever-larger foreign currency reserves as the oil price is increasing. This basically has been the trend for the last decade or so.

So due to the CBR’s FX policy there is a more or less direct link from rising oil prices to an expansion of the Russian money supply. As we all know MV=PY so with unchanged money-velocity (V) an increase in M will lead to an increase in PY (nominal GDP).

This illustrates a very important point. Normally we tend to associate increases in oil prices with a supply shock. However, in the case of Russia and other oil exporting countries with pegged or quasi-pegged exchange rates an increase in the oil price will be a positive demand shock. Said in another other higher oil prices will push the AD curve to the right. This is also why higher oil prices have not always lead to a higher current account surplus in Russia – higher oil prices will boost private consumption growth and investments growth through an increase in the money supply. This is not exactly good news for the current account.

The point that an increase in oil prices is a demand shock in Russia is illustrated in the graph below. Over the past decade there has been a rather strong positive correlation changes in the price of oil (measured in ruble) and the growth of nominal GDP.

This correlation, however, can only exist as long as the CBR intervenes in the FX market to curb the strengthening of the ruble and if the CBR finally moved to a free floating ruble then the this correlation most likely would break down. Hence, with a freely floating ruble the money supply and hence NGDP would be unaffected by higher or lower oil prices.

PEP would effective have been a ‘productivity norm’ in Russia

So by allowing the ruble to appreciate when oil prices are increase it will effective stabilise the development the money supply and therefore in NGDP. Another way to achieve this disconnect between NGDP and oil prices would be to directly peg the ruble to the oil price. So an increase in the oil price of 10% would directly lead to an appreciation of the ruble of 10% (against the dollar).

As the graph above shows there has been a very close correlation between changes in the oil prices (measured in ruble) and NGDP. Furthermore, over the past decade oil prices has increased around 20% yearly versus the ruble and the yearly average growth of nominal GDP has been the exactly the same. As a consequence had the CBR pegged pegged the ruble a decade ago then the growth of NGDP would likely have averaged 0% per year.

With NGDP growth “pegged” by PEP to 0% we would effectively have had what George Selgin has termed a “productivity norm” in Russia where higher real GDP growth (higher productivity growth) would lead to lower prices. Remember again – if MV=PY and MV is fixed through PEP then any increase in Y will have to lead to lower P. However, as oil prices measured in ruble are fixed it would only be the prices of non-tradable goods (locally produced and consumed goods), which would drop. This undoubtedly would have been a much better policy than the one the CBR has pursued for the last decade – and a boom and bust would have been avoid from 2005 to 2009. (And yes, I assume that nominal rigidities would not have created too large problems).

Russia boom-bust and how tight money cause the 2008-9 crisis in Russia

Anybody who visits Moscow will hear stories of insanely high property prices and especially during the boom years from 2006 to when crisis hit in 2008 property prices exploded in Russia’s big cities such St. Petersburg and Moscow. There is not doubt in my mind that this property market boom was caused my the very steep increase in the Russian money supply which was a direct consequence of the CBR’s fear of floating the ruble. As oil prices where increasing and currency inflows accelerated in 2006-7 the CBR intervened to curb the strengthening of the ruble.

However, the boom came to a sudden halt in 2008, however, unlike what is the common perception the crisis that hit hard in 2008 was not a consequence of the drop in oil prices, but rather as a result of too tight monetary policy. Yes, my friends recessions are always and everywhere a monetary phenomenon and that is also the case in Russia!

Global oil prices started to drop in July 2008 and initially the Russian central bank allowed the ruble to weaken. However, as the sell-off in global oil prices escalated in Q3 2008 the CBR clearly started to worry about the impact it would have on ruble. As a consequence the CBR started intervening very heavily in the FX markets to halt the sell-off in the ruble. Obviously to do this the CBR had to buy ruble and sell foreign currency, which naturally lead to drop in the Russian foreign currency reserves of around 200bn dollars in Q3 2008 and a very sharp contraction in the Russian money supply (M2 dropped around 20%!). This misguided intervention in the currency market and the monetary contraction that followed lead to a collapse in Russian property prices and sparked a major banking crisis in Russia – luckily the largest Russian banks was not too badly affected by this a number medium sized banks collapsed in late 2008 and early 2009. As a consequence money velocity also contracted, which further worsened the economic crisis. In fact the drop in real GDP was the latest among the G20 in 2008-9.

…and how monetary expansion brought Russia out of the crisis

As the Russian FX reserve was dwindling in the Autumn 2008 the Russian central bank (probably) realised that either it would cease intervening in the FX or be faced with a situation where the FX reserve would vanish. Therefore by December 2008 the CBR stepped back from the FX market and allowed for a steeper decline in the value of the ruble. As consequence the contraction in the Russian money supply came to an end. Furthermore, as the Federal Reserve finally started to ease US monetary policy in early 2009 global oil prices started to recover and as CBR now did not allow the rub to strengthen at the same pace of rising oil prices the price of oil measured in ruble increase quite a bit in the first half of 2009.

The monetary expansion has continued until today and as a consequence the Russian economy has continued to recover. In fact contrary to the situation in the US and the euro zone one could easily argue that monetary tightening is warranted it in Russia.

Oil prices should be included in the RUB basket

I hope that my arguments above illustrate how the Russian crisis of 2008-9 can be explained by what the great Bob Hetzel calls the monetary disorder view. I have no doubt that if the Russian central bank had allowed for a freely floating ruble then the boom (and misallocation) in 2006-7 would have been reduced significantly and had the ruble been allowed to drop more sharply in line with oil prices in the Autumn of 2008 then the crisis would have been much smaller and banking crisis would likely have been avoided.

Therefore, the policy recommendation must be that the CBR should move to a free float of ruble and I certainly think it would make sense for Russia also to introduce a NGDP level target. However, the Russian central bank despite the promises that the ruble soon will be floated (at the moment the CBR say it will happen in 2013) clearly seems to maintain a fear of floating. Furthermore, I would caution that the quality of economic data in Russia in general is rather pure, which would make a regular NGDP level targeting regime more challenging. At the same time with a relatively underdeveloped financial sector and a generally low level of liquidity in the Russian financial markets it might be challenging to conduct monetary policy in Russian through open market operations and interest rate changes.

As a consequence it might be an idea for Russia to move towards implementing PEP – or rather a variation of PEP. Today the CBR manages the ruble against a basket of euros and dollars and in my view it would make a lot of sense to expand this basket with oil prices. To begin with oil prices could be introduced into the basket with a 20% weight and then a 40% weight for both euros and dollars. This is far from perfect and the goal certainly should still be to move to a free floating ruble, but under the present circumstances it would be much preferable to the present monetary set-up and would strongly reduce the risk of renewed bubbles in the Russian economy and as well as insuring against a monetary contraction in the event of a new sharp sell-off in oil prices.

…as I am finishing this post my taxi is parking in front of my hotel in Stockholm so now you know what you will be able to write going from Latvia to Sweden on an early Wednesday morning. Later today I will be doing a presentation for Danske Bank’s clients in Stockholm. The topics are Emerging Markets and wine economics! (Yes, wine economics…after all I am a proud member for the American Association of Wine Economists).

Understanding financial markets with MV=PY – a look at the bond market

Recently I have been thinking whether it would be possible to understand all financial market price action through the lens of the equation of exchange – MV=PY. In post I take a look at the bond market.

The bond market – its about PY expectations

A common misunderstanding among economic commentators is to equate easy monetary conditions with low bond yields. However, Milton Friedman long ago told us that bond yields are low when monetary policy have been tight – and not when it has been loose. Any Market Monetarist will tell you that monetary conditions are getting easier when nominal GDP growth is accelerating and and getting tighter when NGDP growth is slowing. So with this Friedmanite and market monetarist insight in mind there should be a relationship between higher bond yields and higher nominal GDP growth. Hence, when market participants expect MV to increase then we should also see bond yields increase.

The graph above shows the correlation between 10-year US bond yields and US NGDP growth. The graph illustrates that there is a fairly close correlation between the two series. Higher bond yields and higher NGDP hence seem to go hand in hand and as we know MV=PY we can conclude that higher bond yields is an indication of looser monetary policy. Furthermore, we should expect to see bond yields to increase – rather than decrease – when monetary policy is eased. Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing. 

Therefore, given the present slump we are in we should not be worried that rising bond yields will kill off the recovery – rather we should rejoice when long-term bond yields are rising because that is the best indictor that monetary conditions are becoming easer and that that will push up nominal GDP.

The brief discussion above in my view confirms some key market monetarist positions. First, financial markets are good indicators of the stance of monetary policy. Second, monetary policy works through expectations – with long and variable leads. Third low bond yields is an indication that monetary policy has been tight and not that it is loose.

UPDATE: In my original post I had used some wrong data. Clare Zempel kindly notified me about the mistake(s). I am grateful for the help. As a consequence of the wrong data I have revised part of the original text.

UPDATE 2: David Beckworth has an excellent post arguing the exactly the same as me: “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand.”. And take a look at David’s graph showing the relationship between expected NGDP growth and 10-year bond yields. Great stuff!

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