The Mankiw-Darda rule tells the Fed to wait a bit with hikes

Greg Mankiw has a blog post commenting on my previous post on the so-called Mankiw rule.

I show in my post that according to both the original and a re-estimated version of the Mankiw rule the Federal Reserve should be hiking rates right now. I should stress again that I don’t think the Fed should hike interest rates – I am only using the Mankiw rule to illustrate why we likely are moving closer to a rate hike from the Fed (that is the is a difference between thinking about what the Fed will do rather than what it should do).

Greg makes some good points why the Fed should not hike rates yet:

Taken at face value, the rule suggests that it is time for the Fed to start raising the federal funds rate.  If you believe this rule was reasonably good during the period of the Great Moderation, does this mean the Fed should start tightening now, as the economy gets back to normal?

Maybe, but not necessarily. There are two problems with interpreting such rules today.

The first and most obvious problem is that odd things have been happening in the labor market for the past several years. The unemployment rate (one of the right hand side variables in this rule) may not be a reliable indicator of slack.

The second and more subtle problem is the nagging issue of the zero lower bound.  For several years, the rule suggested a target federal funds rate deeply in the negative territory.  We are out of that range now, but should the past “errors” influence our target today?  An argument can be made that because the Fed kept the target rate “too high” for so long (that is, at zero rather than negative), it should commit itself now to keeping the target “too low” as compensation (that is, at zero for longer than the rule recommends).  By systematically doing so, the Fed encourages long rates to fall by more whenever the economy hits the zero lower bound. Such a policy might lead to greater stability than strict adherence to the rule as soon as we leave negative territory.

I agree with both points. It seems particularly problematic for the original Mankiw rule that there seems to be a major problem on the US labour market with a discouraged worker effect – as a result the actual unemployment data tend to underestimate just how bad the situation has been (and still is?) on the US labour market. Many have simply given up looking for a job and left the labour market.

My good friend Michael Darda (MKM Partners) has suggested to deal with the discourage worker effect and other demographic problems by use the prime age employment ratio rather than the unemployment rate when estimating the Mankiw rule. Michael also uses core CPI rather than the core PCE deflator as a measure of inflation. The graph below shows the Mankiw-Darda rule (Michael’s estimate):

Mankiw Darda rule

 

We see that while the Mankiw-Darda rule has become increasingly “hawkish” since early 2011 it is still not “recommending” a rate hike – the predicted Fed fund rate is still negative (around -1.5%). Hence, it seems like the Mankiw-Darda rule is better at actually describing what the Fed is doing than the original Mankiw rule. This is not totally surprising.

Inflation targeting or price level targeting?

In an update to his post Greg makes some highly relevant comments, which will appeal to any Market Monetarist including myself:

There is another (related) argument for not raising rates now to offset shortfalls in the past. It is not about the interest rate. It is about the price level, the ultimate goal of monetary policy and measure of its performance.

If you plot the PCE deflator, there is a clear shortfall relative to a 2% price-level target. A 2% price level target fits very well during Greenspan’s time.  By the end of 2008, we were exactly on the 1992-target. But when I look at that plot starting in 2009 until the most recent data I see a gap.

A price-level target rule is optimal in normal times (Ball, Mankiw, and Reis) but is also an optimal policy in response to the dangers of the zero lower bound (Woodford). We have to catch up for the shortfall in the price level right now. And if you look at inflation expectations from surveys or markets, there seems to be no catch up expected, indicating that policy is still too tight.

Obviously I would prefer a nominal GDP level target to a price level target, but I think a price level target as here suggested by Greg is much preferable to an inflation target.

As I noted in my own previous post “inflation has drifted lower” since 2008. This is exactly the point Greg makes (based on comments from Ricardo Reis). Since 2008 the Fed has failed to keep the PCE price level on a 2% path trend. The graph below illustrates this:

Price gap US

 

The graph shows that it looks as if the Fed prior to 2008 had a 2% price level target and the actual price level closely followed a 2% trend line. However, since then inflation has consistently been below 2% and as a result the “price gap” has become increasingly negative.

This is paradoxical as the Fed now officially has 2% inflation target, while it prior to 2008 did not have such a target.

This is obviously another argument for why the original Mankiw rule at the moment is too “hawkish”. On the other hand one can certainly also discuss whether the Fed should close the “price gap” or not. Here I have the relatively pragmatic view that the Fed should let bygones-be-bygones as we over the past five years have seen some supply side adjustments. Furthermore, the decline in the price gap does not only reflect demand-side factors but likely also reflects a positive supply shock. In that regard it should be noted that longer-term inflation expectations in the US still remain above 2% (5-year/5-year US breakeven inflation this morning is 2.4%).

Therefore, if I was on the FOMC I would not favour a one-off money injection to close the price gap, but on the other hand the Mankiw-Darda rule and the consideration about the price gap also shows that the FOMC should not be in a hurry to tighten monetary conditions either. The Fed’s gradual and fairly well-communicated policy to continue “tapering” and then sometime next year gradually start increasing the fed funds rate therefore is consistent with a policy of ensuring nominal stability and it is also reducing the risk of a 1937-style premature tightening of monetary conditions, which would send the US economy back in recession. Said in another way I find it hard to be very critical about how the Fed at the moment is balancing risks both to the upside and to the downside.

A NGDP level target rule solve our problems

The discussion about the Mankiw rule illustrates two problems in common monetary policy thinking. First there remains a major focus on the US labour market. The problem of course is that we really don’t know the level of structural unemployment and this is particularly the case right now after we in 2008 got out of whack. Second, while inflation clearly has remained below 2% since 2008 we don’t know whether this is due to supply side factors or demand side factors.

There is of course a way around these problems – nominal GDP level targeting – and as I have argued in a recent post it in fact looks as if the Fed has followed a 4% NGDP level target rule since July 2009.

That would not have been my preferred policy in 2009, 2010 or 2011 as I would have argued that the Fed should have done a lot more to bring the NGDP level back to the pre-crisis trend-level. However, as time has gone by and we have had numerous supply shocks and some supply adjustments have gone on for nearly six years I have come to the conclusion that it is time to let bygones be bygones. We can do little to change the mistakes of six years ago today. But what we – or rather what the Fed can do – is to announce a policy for the future, which significantly reduces the likelihood of repeating the mistakes of 2008-9.

Therefore, the Fed should obviously announce a NGDP level target policy. Whether the Fed would target a 4% or a 5% path for the NGDP level is less important to me. It would be the right policy, but it would also be a pragmatic way around dealing with uncertainties regarding the state of the US labour markets and to avoid having supply side shock distorting monetary policy decisions.

PS My friend Marcus Nunes also comments on the Mankiw rule. Marcus seems to think that I am advocating that the Fed should tighten monetary policy. I am not doing that. All I have been saying it that the original Mankiw rule indicates that the Fed should tighten monetary conditions and that this is an indication of the direction we are moving in.

PPS My “playing around” with the Mankiw rule should be seen in the perspective that I am currently thinking quite a bit – in my day-job – about when the Fed will actually hike relative to what the markets are thinking the Fed will do. If the Fed moves earlier than expected by markets then it obviously is going to have clear implications for the global financial markets.

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Certainly not perfect, but Fed policy is not worse than during the Great Moderation (an answer to Scott Sumner)

Scott Sumner has replied to my previous post in which I argued that the Federal Reserve de facto has implemented a 4% NGDP level targeting regime (without directly articulating it).

Scott is less positive about actual Fed policy than I am. This is Scott answering my postulate that he would have been happy about a 4% NGDP growth path had it been announced in 2009:

Actually I would have been very upset, as indeed I was as soon as I saw what they were doing.  I favored a policy of level targeting, which meant returning to the previous trend line.

Now of course if they had adopted a permanent policy of 4% NGDP targeting, I would have had the satisfaction of knowing that while the policy was inappropriate at the moment, in the long run it would be optimal.  Alas, they did not do that.  The recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.

I most admit that I am a bit puzzled by Scott’s comments. Surely one could be upset in 2009 – as both Scott and I were – that the Fed did not do anything to bring back the nominal GDP level back to the pre-crisis trend and it would likely also at that time have been a better policy to return to a 5% trend rather than a 4% trend. However, I would also note that that discussion is mostly irrelevant for present day US monetary policy and here I would note two factors, which I find important:

  1. We have had five years of supply side adjustments – five years of “internal devaluation”/”wage moderation” so to speak. It is correct that the Fed didn’t boost aggregate demand sufficiently to push down US unemployment to pre-crisis levels, but instead it has at least kept nominal spending growth very stable (despite numerous shocks – see below), which has allowed for the adjustment to take place on the supply side of the economy and US unemployment is now nearly back at pre-crisis levels (yes employment is much lower, but we don’t know to what extent that is permanent/structural or not).
  2. Furthermore, we have had numerous changes to supply side policies in the US – mostly negative such as Obamacare and an increase in US minimum wages, but also some positive such as the general general reduction in defense spending and steps towards ending the “War on Drugs”.

Given these supply side factors – both the adjustments and the policy changes – it would make very little sense in my view to try to bring the NGDP level back to the pre-2008 trend-level and I don’t think Scott is advocating this even though his comments could leave that impression. Furthermore, given that expectations seem to have fully adjusted to a 4% NGDP level-path there would be little to gain from targeting a higher NGDP growth rate (for example 5%).

The Fed is more credible today than during the Great Moderation

Furthermore, I would dispute Scott’s claim that the Fed’s policy is not credible. Or rather while the monetary policy regime is not well-articulated by the Fed it is nonetheless pretty well-understood by the markets and basically also by the Fed itself (even though that from time to time could be questioned).

Hence, both the markets and the Fed fully understand today that there effectively is no liquidity trap. There might be a Zero Lower Bound on interest rates but if needed the Fed can ease monetary policy through quantitative easing. This is clearly well-understood by the Fed system today and the markets fully well knows that if a new shock to for example money-velocity where to hit the US economy then the Fed would most likely once again step up QE. This is contrary to the situation prior to 2008 where the Fed certainly had not articulated a policy of how to conduct monetary policy at the Zero Lower Bound and this of course was a key reason why the monetary policy stance became so insanely tight in 2008.

This does in no way mean that monetary policy in the US is perfect. It is certainly not – just that it is no less credible than monetary policy was during the Greenspan years and that the Fed today is better prepared to conduct monetary policy at the ZLB than prior to 2008.

NGDP has been more stable since 2009/2010 than during the Great Moderation

If we look at the development in nominal GDP it has actually been considerably more stable – and therefore also more predictable – than during the Great Moderation. The graph below illustrates that.

NGDP gap New Moderation

It is particularly notable in the graph that the NGDP gap – the percentage difference between the actual NGDP level and the NGDP trend – has been considerably smaller in the period from July 2009 and until today than during the Great Moderation (here said to be from 1995 until 2007). In fact the average absolute NGDP gap (the green dotted lines) was nearly three times as large during the Great Moderation than it has been since July 2009. Similarly inflation expectations has been more stable since July 2009 than during the Great Moderation and there unlike in the euro zone there are no signs that inflation expectations have become unanchored.

It is easy to be critical about the Fed’s conduct of monetary policy in recent years, but I find it very hard to argue that monetary policy has been worse than during the Great Moderation. 2008-9 was the catastrophic period, but since 2009/10 the Fed has re-established a considerable level of nominal stability and the Fed should be given some credit for that.

In this regard it is also notable that financial market volatility in the US today is at a historical low point – lower than during most of the Great Moderation period. This I believe to a large extent reflects a considerable level of “nominal predictability”.

No less sensitive to shocks than during the Great Moderation

Scott argues “(t)he recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.” 

It is obviously correct that the Fed has failed to spell out that it is actually targeting a 4% NGDP level path and I agree with Scott that this is a major problem and that means that the US economy is much more sensitive to shocks than otherwise would be the case. However, I would also stress that first of all during the Great Moderation the Fed had an even less clear target officially than is the case today.

Second, we should not forget that we have actually seen considerable shocks to the global and to the US economy since 2009/10. Just think of the massive euro crisis, Greece’s de facto default, the Cyprus crisis, the “fiscal cliff” in the US, a spike in oil prices 2010-12 and lately a sharp rise in global geopolitical tensions. Despite of all these shocks US NGDP has stayed close to the 4% NGDP path started in July 2009.

This to me is a confirmation that the Fed has been able to re-establish a considerable level of nominal stability. It has not been according to Market Monetarist game plan, but it is hard to be critical about the outcome.

In regard to the so-called “fiscal cliff” – the considerable tightening of fiscal policy in 2013 – it is notable that Scott has forcefully and correctly in my view argued that it had no negative impact on total aggregate nominal demand exactly because of monetary policy – or rather the monetary policy regime – offset the fiscal shock.

This is of course the so-called Sumner critique. For the Sumner critique to hold it is necessary that the monetary policy regime is well-understood by the markets and that the regime is credible. Hence, when Scott argues that 2013 confirmed the Sumner critique then he is indirectly saying that the monetary policy regime was credible in 2013. Had the monetary policy regime not been credible then the fiscal tightening likely would have led to a sharp slowdown in US growth.

It is time to let bygones be bygones

Nearly exactly a year ago I argued in a post that it is time to let bygones be bygones in US monetary policy:

Obviously even though the US economy seems to be out of the expectational trap there is no guarantee that we could not slip back into troubled waters once again, (but)…

… it is pretty clear to most market participants that the Fed would likely step up quantitative easing if a shock would hit US aggregate demand and it is fairly clear that the Fed has become comfortable with using the money base as a policy instrument…

… I must admit that I increasingly think – and most of my Market Monetarist blogging friends will likely disagree – that the need for a Rooseveltian style monetary positive shock to the US economy is fairly small as expectations now generally have adjusted to long-term NGDP growth rates around 4-5%. So while additional monetary stimulus very likely would “work” and might even be warranted I have much bigger concerns than the lack of additional monetary “stimulus”.

Hence, the focus of the Fed should not be to lift NGDP by X% more or less in a one-off positive shock. Instead the Fed should be completely focused on defining its monetary policy rule. A proper rule would be to target of 4-5% NGDP growth – level targeting from the present level of NGDP. In that sense I now favour to let bygones to be bygones as expectations now seems to have more or less fully adjusted and five years have after all gone since the 2008 shock.

Therefore, it is not really meaningful to talk about bringing the NGDP level back to a rather arbitrary level (for example the pre-crisis trend level). That might have made sense a year ago when we clearly was caught in an expectations deflationary style trap, but that is not the case today. For Market Monetarists it was never about “monetary stimulus”, but rather about ensuring a rule based monetary policy.  Market Monetarists are not “doves” (or “hawks”). These terms are only fitting for people who like discretionary monetary policies.

This remains my view. Learn from the mistakes of the past, but lets get on with life and lets instead focus fully on get the Fed’s target well-defined.

PS I hate being this positive about the Federal Reserve. In fact I am really not that positive. I just argue that the Fed is no worse today than during the Great Moderation.

The Fed’s un-announced 4% NGDP target was introduced already in July 2009

Scott Sumner started his now famous blog TheMoneyIllusion in February 2009 it was among other things “to show that we have fundamentally misdiagnosed the nature of the recession, attributing to the banking crisis what is actually a failure of monetary policy”.

Said in another way the Federal Reserve was to blame for the Great Recession and there was only one way out and that was monetary easing within a regime of nominal GDP level targeting (NGDP targeting).

NGDP targeting is of course today synonymous Scott Sumner. He more or less single-handedly “re-invented” NGDP targeting and created an enormous interest in the topic among academics, bloggers, financial sector economists and even policy makers.

The general perception is that NGDP targeting and Market Monetarism got the real break-through in 2013 when the Federal Reserve introduced the so-called Evans rule in September 2012 (See for example Matt Yglesias’ tribute to Scott from September 2012).

This has also until a few days ago been my take on the story of the success of Scott’s (and other’s) advocacy of NGDP targeting. However, I have now come to realize that the story might be slightly different and that the Fed effectively has been “market monetarist” (in a very broad sense) since July 2009.

The Fed might not have followed the MM game plan, but the outcome has effectively been NGDP targeting

Originally Scott basically argued that the Fed needed to bring the level nominal GDP back to the pre-crisis 5% trend path in NGDP that we had known during the so-called Great Moderation from the mid-1980s and until 2007-8.

We all know that this never happened and as time has gone by the original arguments for returning to the “old” NGDP trend-level seem much less convincing as there has been considerable supply side adjustments in the US economy.

Therefore, as time has gone by it becomes less important what is the “starting point” for doing NGDP targeting. Therefore, if we forgive the Fed for not bringing NGDP back to the pre-crisis trend-level and instead focus on the Fed’s ability to keep NGDP on “a straight line” then what would we say about the Fed’s performance in recent years?

Take a look at graph below – I have used (Nominal) Private Consumption Expenditure (PCE) as a monthly proxy for NGDP.

PCE gap

If we use July 2009 – the month the 2008-9 recession officially ended according to NBER – as our starting point (rather than the pre-crisis trend) then it becomes clear that in past five years PCE (and NGDP) has closely tracked a 4% path. In fact at no month over the past five years have PCE diverged more than 1% from the 4% path. In that sense the degree of nominal stability in the US economy has been remarkable and one could easily argue that we have had higher nominal stability in this period than during the so-called Great Moderation.

In fact I am pretty sure that if somebody had told Scott in July 2009 that from now on the Fed will follow a 4% NGDP target starting at the then level of NGDP then Scott would have applauded it. He might have said that he would have preferred a 5% trend rather than a 4% trend, but overall I think Scott would have been very happy to see a 4% NGDP target as official Fed policy.

The paradox is that Scott has not sounded very happy about the Fed’s performance for most of this period and neither have I and other Market Monetarists. The reason for this is that while the actual outcome has looked like NGDP targeting the Fed’s implementation of monetary policy has certainly not followed the Market Monetarist game plan.

Hence, the Market Monetarist message has all along been that the Fed should clearly announce its target (a NGDP level target), do aggressive quantitative easing to bring NGDP growth “back on track”, stop focusing on interest rates as a policy instrument and target expected NGDP rather than present macroeconomic variables. Actual US monetary policy has gradually moved closer to this ideal on a number of these points – particularly with the so-called Evan rule introduced in September 2012, but we are still very far away from having a Market Monetarist Fed when it comes to policy implementation.

However, in the past five years the implementation of Fed policy has been one of trial-and-error – just think of QE1, QE2 and QE3, two times “Operation Twist” and all kinds of credit policies and a continued obsession with using interest rates rates as the primary policy “instrument”.

I believe we Market Monetarists rightly have been critical about the Fed’s muddling through and lack of commitment to transparent rules. However, I also think that we today have to acknowledge that this process of trail-and-error actually has served an important purpose and that is to have sent a very clear signal to the financial markets (and others for that matter) that the Fed is committed to re-establishing some kind of nominal stability and avoiding a deflationary depression. This of course is contrary to the much less clear commitment of the ECB.

The markets have understood it all along (and much better than the Fed)

Market Monetarists like to say that the markets are better at forecasting and the collective wisdom of the markets is bigger than that of individual market participants or policy makers and something could actually indicate that the markets from an early point understood that the Fed de facto would be keeping NGDP on a straight line.

An example is the US stock market bottomed out a few months before we started to establish the new 4% trend in US NGDP and the US stock markets have essentially been on an upward trend ever since, which is fully justified if you believe the Fed will keep this de facto NGDP target in place. Then we should basically be expecting US stock prices to increase more or less in line with NGDP (disregarding changes to interest rates).

Another and even more powerful example in my view is what the currency markets have been telling us. I  (and other Market Monetarists) have long argued that market expectations play a key role in the in the implementation of monetary policy and in the monetary policy transmission mechanism.

In a situation where the central bank’s NGDP level target is credible rational investors will be able to forecast changes in the monetary policy stance based on the actual level of NGDP relative to the targeted level of NGDP. Hence, if actual NGDP is above the targeted level then it is rational to expect that the central bank will tighten the monetary policy stance to bring NGDP back on track with the target. This obviously has implications for the financial markets.

If the Fed is for example targeting a 4% NGDP path and the actual NGDP level is above this target then investors should rationally expect the dollar to strengthen until NGDP is back at the targeted level.

And guess what this is exactly how the dollar has traded since July 2009. Just take a look at the graph below.

NGDP gap dollar index 2

We are looking at the period where I argue that the Fed effectively has targeted a 4% NGDP path. Again I use PCE as a monthly proxy for NGDP and again the gap is the gap between the actual and the “targeted” NGDP (PCE) level. Look at the extremely close correlation with the dollar – here measured as a broad nominal dollar-index. Note the dollar-index is on an inverse axis.

The graph is very clear. When the NGDP gap has been negative/low (below target) as in the summer of 2010 then the dollar has weakened (as it was the case from from the summer of 2010under spring/summer of 2011. And similarly when the NGDP gap has been positive (NGDP above target) then the dollar has tended to strengthen as we essentially has seen since the second half of 2011 and until today.

I am not arguing that the dollar-level is determining the NGDP gap, but I rather argue that the dollar index has been a pretty good indicator for the future changes in monetary policy stance and therefore in NGDP.

Furthermore, I would argue that the FX markets essentially has figured out that the Fed de facto is targeting a 4% NGDP path and that currency investors have acted accordingly.

It is time for the Fed to fully recognize the 4% NGDP level target

Just because there has a very clear correlation between the dollar and the NGDP gap in the past five years it is not given that that correlation will remain in the future. A key reason for this is – and this is a key weakness in present Fed policy – that the Fed has not fully recognize that it is de facto targeting a 4%. Therefore, there is nothing that stops the Fed from diverging from the NGDP rule in the future.

Recognizing a 4% NGDP level target from the present level of NGDP in my view should be rather uncontroversial as this de facto has been the policy the Fed has been following over the past five years anyway. Furthermore, it could easily be argued as compatible  with the Fed’s (quasi) official 2% inflation target (assuming potential real GDP growth is around 2%).

In my previous post I argued that the ECB should introduce a 4% NGDP target. The Fed already done that. Now it is just up to Fed Chair Janet Yellen to announce it officially. Janet what are you waiting for?

Is Karnit Flug jeopardizing Stan Fischer’s “straight line policy”? Not yet, but…

It is no secret that I think that Stanley Fischer did a good job as governor of the Bank of Israel from 2005 to 2013. He basically saved Israel from the Great Recession by essentially keeping Israeli nominal GDP “on a straight line”. During his time in office the Israeli NGDP level diverged no more than 1-1.5% from what we could call the Fischer-trend.

However, Fischer is no longer at the BoI. Instead former deputy governor Karnit Flug has taken over – effectively from July 2013 and officially from November 2013. The question then is has Mrs. Flug been able to maintain Fischer’s “straight line policy” in place? The graph below gives us the answer.

Karnit Flug NGDP

The picture is pretty clear – essentially coinciding with Flug taking over as BoI governor the slowdown in NGDP growth (already started in 2012) has accelerated and we have now dropped somewhat below the Fischer-trend. It would be foolish to say that this in any way is catastrophic, but the change is nonetheless visible and should give reason for serious concern if it is allowed to continue to “drift off”.

Are inflation expectations becoming un-anchored? 

I have earlier warned that there is a risk that we are seeing inflation expectations becoming un-anchored in for example the euro zone because policy makers are preoccupied with everything else than focusing on their nominal target (for example an inflation target).

On the other hand I have also praised the Bank of Israel for always communicating in terms of (market) inflation expectations relative to the BoI’s 1-3% inflation target (range). However, one could argue that the Bank of Israel is beginning to look more like the Swedish Riksbank (which is preoccupied with household debt and  property prices) or the ECB (which is preoccupied by “everything else”).

A look at inflation expectations can tell us whether these fears are justified or not.

Inflation expectations Israel

The graph shows five different measures of inflation expectations. The first four are inflation expectations based on financial market pricing (BoI’s calculations) and the last one is based on a survey of professional forecasters.

Most of the measures show that there has been a pretty consistent downtrend in most of the measures of inflation expectations for little more than a year. However, it is also notable that we are still within the BoI’s 1-3% inflation target range and 5-year and 10-year inflation expectations are still close to 2% and as remained fairly stable.

Therefore, it is too early to say that inflation expectations have become un-anchored, but it should also be noted that we might be risking a sneaking un-anchoring of inflation expectations if policy actions is not taken to avoid it.

Bringing us back on the “straight line”

The recent rate cuts from the Bank of Israel shows that the BoI is not completely ignorant to these risks and I believe that particularly the latest rate cut to 0.25% on August 25 is helping in curbing deflationary pressures. However, more could likely be done to insure against the deflationary risks.

So what should Karnit Flug and her colleagues at the Bank of Israel do to bring us back to the Fischer-trend and to avoid an un-anchoring inflation expectations?

I have three suggestions:

1) Avoid repeating the mistakes of the Riksbank. The Swedish Riksbank has consistenly for some time now undershoot its official inflation target and in my view this has very much been the result of a preoccupation with household debts and property prices. Historical the Bank of Israel has avoided making this mistake, but there are undoubtedly voices within the BoI that what monetary policy to be more dependent on the development household debt and property prices (these voices are within all central banks these days…)

That said, the Bank of Israel is far from being the Riksbank and so far the emphasis on property market developments in communication about monetary policy has not been overly problematic, but that could change in the future and if the BoI became more focused on these issues then I fear that that could led to a more fundamental un-anchoring of inflation expectations and therefore a more unstable economic development.

2) Avoid repeating the mistakes of the ECB. While the Riksbank has been preoccupied with property prices the ECB has been preoccupied with fiscal policy. There are some signs that the Bank of Israel is getting a bit too focused on fiscal policy rather than focusing on monetary policy. Hence, Mrs. Flug has recently been in a bit of war of words with Finance Minister Yair Lapid about the public budget deficit (see for example here).

While I have sympathy for Mrs. Flug’s fiscal conservatism it is not really the task of any central bank to have a view on fiscal policy other than just take fiscal policy as an exogenous factor when setting policy instruments to hit the central bank’s target. The Bank of Israel should make this completely clear so market participants do not come to think that the BoI will keep monetary policy overly tight (ECB fashion) to punish the Israeli government for overly easy fiscal policy.

3) Pre-announce what to at the Zero Lower Bound. With the BoI’s key policy rates at 0.25% we are effectively at the Zero Lower Bound (ZLB). It is no secret that (Market) Monetarists like myself don’t think that the ZLB is a binding constraint on the possibility for further easing monetary policy. However, the ZLB is often a mental constraint on monetary policy makers.

I think that most observers of the BoI knows that the BoI does not have major “mental” problem with using other instruments – than the interest rate – to ease monetary. Hence, the BoI has since 2008 both bond quantitative easing by buying government bonds and intervened in the currency market to weaken the Israeli shekel. It could easily do that again and I think most market participants full well knows this. Hence, in that sense Israel is in a much better than for example the euro zone.

However, instead of letting the market guessing what it might do in the future if necessary the BoI should already today announce what instrument it would be using to conduct monetary policy at the ZLB. Personally I think the most suitable “instrument” to use for small open economy is the exchange rate channel either in the way it has been done for years by the Monetary Authority of Singapore (MAS) or in recent years by the Swiss and Czech central banks.

I think the best option would simply be for the BoI to announce that it – if needed – could put a floor under USD/ILS and at the same time announce that it will keep the door open for moving up this floor until inflation expectations on all relevant time horizons are between 2 and 2.5%. That in my view would likely lead to a weakening of the shekel of a magnitude to bring inflation expectations immediately in line with this narrow “target” range.

Karnit Flug doesn’t have an easy job to do, but she has a solid foundation to build on

There is no doubt that there is a risk that Stan Fischer’s achievements as Bank of Israeli governor could be jeopardized. However, Karnit Flug has not failed yet and she still have the opportunity to continue the success of Stan Fischer.

But then this has to focus on bringing back the “straight line policy” and ensuring that inflation expectations do not become un-anchored. Hence, she needs to not allow herself to be distracted by the development in property prices and fiscal policy and instead focus on how to conduct monetary policy in a transparent and efficient way at the Zero Lower Bound.

PS I am well-aware that Stan Fischer no longer officially is a proponent of NGDP level targeting and that the BoI does not have an NGDP level target, but rather an inflation target. However, thing of a NGDP target as an intermediate target to implement the “ultimate” target – the inflation target. If the BoI for example keeps the NGDP level on a 5% path and we assume that potential real GDP growth is 2% then the outcome will be 2% over the cycle.

Let me say it again – The Kuroda recovery will be about domestic demand and not about exports

This morning we got strong GDP numbers from Japan for Q1. The numbers show that it is primarily domestic demand – private consumption and investment – rather than exports, which drive growth.

This is from Bloomberg:

Japan’s economy grew at the fastest pace since 2011 in the first quarter as companies stepped up investment and consumers splurged before the first sales-tax rise in 17 years last month.

Gross domestic product grew an annualized 5.9 percent from the previous quarter, the Cabinet Office said today in Tokyo, more than a 4.2 percent median forecast in a Bloomberg News survey of 32 economists. Consumer spending rose at the fastest pace since the quarter before the 1997 tax increase, while capital spending jumped the most since 2011.

…Consumer spending rose 2.1 percent from the previous quarter, the highest since a 2.2 percent increase in the first three months of 1997.

So it is domestic demand, while net exports are actually a drag on the economy (also from Bloomberg):

Exports rose 6 percent from the previous quarter and imports climbed 6.3 percent.

The yen’s slide since Abe came to power in December 2012 has inflated the value of imported energy as the nation’s nuclear reactors remain shuttered after the Fukushima disaster in March 2011.

The numbers fits very well with the story I told about the excepted “Kuroda recovery” (it is not Abenomics but monetary policy…) a year ago.

This is what I wrote in my blog post “The Kuroda recovery will be about domestic demand and not about exports” nearly exactly a year ago (May 10 2013):

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

…I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we seeing the yen weaken, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

the focus on the“competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

While I am happy to acknowledge that today’s numbers likely are influenced by a number of special factors – such as increased private consumption ahead of planned sales tax hikes and likely also some distortions of the investment numbers I think it is clear that I overall have been right that what we have seen in the Japanese economy over the past year is indeed a moderate recovery led by domestic demand .

The biggest worry: Inflation targeting and a negative supply shock

That said, I am also worried about the momentum of the recovery and I am particularly concerned about the unfortunate combination of the Bank of Japan’s focus on inflation targeting – rather than nominal GDP targeting – than a negative supply shock.

This is particularly the situation where we are both going to see a sales tax hike – which will increase headline inflation – and we are seeing a significant negative supply shock due to higher energy prices. Furthermore note that the Abe administration’s misguided push to increase wage growth – to a pace faster than productivity growth – effectively also is a negative supply shock to the extent the policy is “working”.

While the BoJ has said it will ignore such effects on headline inflation it is likely to nonetheless at least confuse the picture of the Japanese economy and might make some investors speculate that the BoJ might cut short monetary easing.

This might explain three factors that have been worrying me. First, of all while broad money supply in Japan clearly has accelerated we have not see a pick-up in money-velocity. Second, the Japanese stock market has generally been underperforming this year. Third, we are not really seeing the hoped pick-up in medium-term inflation expectations.

All this indicate that the BoJ are facing some credibility problems – consumers and investors seem to fear that the BoJ might end monetary easing prematurely.

To me there is only one way to fundamentally solve these credibility problems – the BoJ should introduce a NGDP level target of lets say 3-4%. That would significantly reduce the fear among investors and consumers that the BoJ might scale back monetary easing in response to tax hikes and negative supply shocks, while at the same time maintain price stability over the longer run (around 2% inflation over the medium-term assuming that potential real GDP growth is 1-2%).

PS Q1 2014 nominal GDP grew 3.1% y/y against the prior reading of 2.2% y/y.

PPS See also my previous post where I among other things discuss the problems of inflation targeting and supply shocks.

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.

Monetary sovereignty is incompatible with inflation targeting

When I started working in the financial sector nearly 15 years ago – after 5 years working for government – one thing that really puzzled me was how my new colleagues (both analysts and traders) where thinking about exchange rates.

As a fairly classically thinking economist I had learned to think of exchange rates in terms of the Purchasing Power Parity. After all why should we expect there to be a difference between the price of a Big Mac in Stockholm and Brussels? Obviously I understood that there could be a divergence from PPP in the short-run, but in the long-run PPP should surely expected to hold.

Following the logic of PPP I would – in the old days – have expected that when an inflation number was published for a country and the number was higher than expected the currency of the country would weaken. However, this is not how it really was – and still is – in most countries. Hence, I was surprised to see that upside surprises on the inflation numbers led to a strengthening of the country’s currency. What I initially failed to understand was that the important thing is not present inflation, but rather the expected future changes to monetary policy.

What of course happens is that if a central bank has a credible inflation target then a higher than expected inflation number will lead market participants to expect the central bank to tighten monetary policy.

Understanding exchange rate dynamic is mostly about understanding monetary policy rules

But what if the central bank is not following an inflation-targeting rule? What if the central bank doesn’t care about inflation at all? Would we then expect the market to price in monetary tightening if inflation numbers come in higher than expected? Of course not.

A way to illustrate this is to think about two identical countries – N and C. Both countries are importers of oil. The only difference is that country N is targeting the level of nominal GDP, while country C targets headline inflation.

Lets now imagine that the price of oil suddenly is halved. This is basically a positive supply to both country N and C. That causes inflation to drop by an equal amount in both countries. Realizing this market participants will know that the central bank of country C will move to ease monetary policy and they will therefore move reduce their holdings of C’s currency.

On the other hand market participants also will realize that country N’s central bank will do absolutely nothing in response to the positive supply shock and the drop in inflation. This will leave the exchange of country N unchanged.

Hence, we will see C’s currency depreciate relatively to N’s currency and it is all about the differences in monetary policy rules.

Exchange rates are never truly floating under inflation targeting

I also believe that this example actually illustrates that we cannot really talk about freely floating exchange rates in countries with inflation targeting regimes. The reason is that external shifts in the demand for a given country’s currency will in itself cause a change to monetary policy.

A sell-off in the currency causes the inflation to increase through higher import prices. This will cause the central bank to tighten monetary policy and the markets will anticipate this. This means that external shocks will not fully be reflected in the exchange rate. Even if the central bank does to itself hike interest rates (or reduce the money base) the market participants will basically automatically “implement” monetary tightening by increasing demand for the country’s currency.

This also means that an inflation targeting nearly by definition will respond to negative supply shocks by tightening monetary policy. Hence, negative external shocks will only lead to a weaker currency, but also to a contraction in nominal spending and likely also to a contraction in real GDP growth (if prices and wages are sticky).

Monetary policy sovereignty and importing monetary policy shocks

This also means that inflation targeting actually is reducing monetary policy sovereignty. The response of some Emerging Markets central banks over the past year illustrates well.

Lets take the example of the Turkish central bank. Over the past the year the Federal Reserve has initiated “tapering” and the People’s Bank of China has allowed Chinese monetary conditions to tighten. That has likely been the main factors behind the sell-off in Emerging Markets currencies – including the Turkish lira – over the past year.

The sell-off in Emerging Markets currencies has pushed up inflation in many Emerging Markets. This has causes inflation targeting central banks like the Turkish central bank (TCMB) to tighten monetary policy. In that sense one can say that the fed and PBoC have caused TCMB to tighten monetary policy. The TCMB hence doesn’t have full monetary sovereignty. Or rather the TCMB has chosen to not have full monetary policy sovereignty.

This also means that the TCMB will tend to import monetary policy shocks from the fed and the PBoC. In fact the TCMB will even import monetary policy mistakes from these global monetary superpowers.

The global business cycle and monetary policy rules

It is well-known that the business cycle is highly correlated across countries. However, in my view that doesn’t have to be so and it is strictly a result of the kind of monetary policy rules central banks follow.

In the old days of the gold standard or the Bretton Woods system the global business cycle was highly synchronized. However, one should have expected that to have broken down as countries across the world moved towards officially having floating exchange rates. However, that has not fully happened. In fact the 2008-9 crisis lead to a very synchronized downturn across the globe.

I believe the reason for this is that central banks do in fact not fully have floating exchange rate. Hence, inflation targeting de facto introduces a fear-of-floating among central banks and that lead central banks to import external shocks.

That would not have been the case if central banks in general targeted the level of NGDP (and ignored supply shocks) instead of targeting inflation.

So if central bankers truly want floating exchanges – and project themselves from the policy mistakes of the fed and the PBoC – they need to stop targeting inflation and should instead target NGDP.

PS It really all boils down to the fact that inflation targeting is a form of managed floating. This post was in fact inspired by Nick Rowe’s recent blog post What is a “managed exchange rate”?

Sam Bowman calls for nominal spending targeting in the euro zone

My friend Sam Bowman, Research Director at the Adam Smith Institute, has written a letter to the Financial Times calling for the introduction of a nominal spending target in the euro zone. This is from Sam’s letter:

…While supply-side reforms are usually helpful and fiscal integration may help some eurozone states, Europe’s main problem is monetary.

Nominal spending has collapsed in the eurozone since 2008 and is still well below its pre-crisis trend level. As a result, Europe’s unemployed face a problem of musical chairs: too many jobseekers chasing too little money.

The eurozone’s best hope is for the European Central Bank to pursue a more expansionary monetary policy to raise nominal spending in the eurozone to its pre-crisis trend level, and commit to a nominal spending target thereafter.

Monetary chaos is the source of Europe’s woes: only monetary stability will overcome them.

I fully agree. The ECB can end the European crisis tomorrow by introducing a nominal spending target. Even a very modest proposal of 4% nominal GDP growth targeting would do the trick. Unfortunately nobody in Frankfurt or Brussels seems to be listening.

Did Bennett McCallum run the SNB for the last 20 years?

Which central bank has conducted monetary policy in the best way in the last five years? Among “major” central banks the answer in my view clearly would have to be the SNB – the Swiss central bank.

Any Market Monetarist would of course tell you that you should judge a central bank’s performance on it’s ability to deliver nominal stability – for example hitting an nominal GDP level target. However, for an small very open economy like the Swiss it might make sense to look at Nominal Gross Domestic Demand (NGDD).

This is Swiss NGDD over the past 20 years.

NGDD Switzerland

Notice here how fast the NGDD gap (the difference between the actual NGDD level and the trend) closed after the 2008 shock. Already in 2010 NGDD was brought back to the 1993-trend and has since then NGDD has been kept more or less on the 1993-trend path.

Officially the SNB is not targeting NGDD, but rather “price stability” defined as keeping inflation between 0 and 2%. This has been the official policy since 2000, but at least judging from the actually development the policy might as well have been a policy to keep NGDD on a 2-3% growth path. 

Bennett McCallum style monetary policy is the key to success

So why have the SNB been so successful?

My answer is that the SNB – knowingly or unknowingly – has followed Bennett McCallum’s advice on how central banks in small open economies should conduct monetary policy. Bennett has particularly done research that is relevant to understand how the SNB has been conducting monetary policy over the past 20 years.

First, of all Bennett is a pioneer of NGDP targeting and he was recommending NGDP targeting well-before anybody ever heard of Scott Summer or Market Monetarism.  A difference between Market Monetarists and Bennett’s position is that Market Monetarists generally recommend level targeting, while Bennett (generally) has been recommending growth targeting.

Second, Bennett has always forcefully argued that monetary policy is effective in terms of determining NGDP (or NGDD) also when interest rates are at zero and he has done a lot of work on optimal monetary policy rules at the Zero Lower Bound (See for example here). One obvious policy is quantitative easing. This is what Bennett stressed in his early work on NGDP growth targeting.  Hence, the so-called Mccallum rule is defined in terms the central bank controlling the money base to hit a given NGDP growth target. However, for small open economies Bennett has also done very interesting work on the use of the exchange rate as a monetary policy tool when interest rates are close to zero.

I earlier discussed what Bennett has called a MC rule. According to the MC rule the central bank will basically use interest rates as the key monetary policy rule. However, as the policy interest rate gets close to zero the central bank will start giving guidance on the exchange rate to change monetary conditions. In his models Bennett express the policy instrument (“Monetary Conditions”) as a combination of a weighted average of the nominal exchange rate and a monetary policy interest rate.

SNB’s McCallum rule

My position is that basically we can discribe SNB’s monetary policy over the past 20 years based on these two key McCallum insights – NGDP targeting and the use of a combination of interest rates and the exchange rate as the policy instrument.

To illustrate that I have estimated a simple OLS regression model for Swiss interest rates.

It turns out that it is very to easy to model SNB’s reaction function for the last 20 years. Hence, I can explain 85% of the variation in the Swiss 3-month LIBOR rate since 1996 with only two variables – the nominal effective exchange rate (NEER) and the NGDD gap (the difference between the actual level of Nominal Gross Domestic Demand and the trend level of NGDD). Both variables are expressed in natural logarithms (ln).

The graph below shows the actually 3-month LIBOR rate and the estimated rate.

SNB policy rule

As the graph shows the fit is quite good and account well for the ups and down in Swiss interest rates since 1996 (the model also works fairly well for an even longer period). It should be noted that I have done the model for purely illustrative purposes and I have not tested for causality or the stability of the coefficients in the model. However, overall I think the fit is so good that this is a pretty good account of actual Swiss monetary policy in the last 15-20 years.

I think it is especially notable that once interest rates basically hit zero in early 2010 the SNB initially started to intervene in the currency markets to keep the Swiss franc from strengthening and later – in September 2011 – the SNB moved to put a floor under EUR/CHF at 120 so to completely curb the strengthening of Swiss franc beyond that level. As a result the nominal exchange rate effectively has been flat since September 2011 (after an initial 10% devaluation) despite massive inflows to Switzerland in connection with the euro crisis and rate of expansion in the Swiss money supply has accelerated significantly.

Concluding, Swiss monetary policy has very much been conducted in the spirit of Bennett McCallum – the SNB has effectively targeted (the level of) Nominal Gross Domestic Demand and SNB has effectively used the exchange rate instrument to ease monetary conditions with interest rates at the Zero Lower Bound.

The result is that the Swiss economy only had a very short period of crisis in 2008-9 and the economy has recovered nicely since then. Unfortunately none of the other major central banks of the world have followed the advice from Bennett McCallum and as a result we are still stuck in crisis in both Europe and the US.

PS I am well-aware that the discuss above is a as-if discussion that this is what the SNB has actually said it was doing, but rather that it might as well been officially have had a McCallum set-up.  

PPS If one really wants to do proper econometric research on Swiss monetary policy I think one should run a VAR model on the 3-month LIBOR rate, the NGDD gap and NEER and all of the variables de-trended with a HP-filter. I will leave that to somebody with econometric skills and time than myself. But I doubt it would change much with the conclusions.

Richard Fisher and the “working men and women of America”

This is Richard Fisher, President of Federal Reserve Bank of Dallas:

“We have made rich people richer,” Fisher told CNBC today. “The question is, what have we done for the working men and women of America?”

Fisher was one of the earliest and most outspoken advocates of winding down the bond-buying program…

I had to read the comment a couple of times to make sure that I understood correctly. Fisher actually claims that the fed should scale back monetary easing because it is not doing anything for the “working men and women of America”.

Fisher’s comments are truly bizarre. Most wealthy Americans are still very wealthy (I have no problem with that) – crisis or not – but it is pretty clear that the overly tight monetary policies in the US over the past fives years has been the main cause of the significant increase in US unemployment and in that sense been a massive assault on the “working men and women of America”.

If Richard Fisher seriously wants to do you something for the “working men and women” then he should come out and support to bring back the level of nominal GDP to the pre-crisis trend level. That undoubtedly would be the best “employment policy” anybody could come up with in the present situation. However, I suspect that Fisher is just coming up with random arguments for opposing monetary easing rather than truly caring about the “working men and women of America”. I am not impressed…

employment NGDP

—–

PS I am certainly not claiming to be speaking on behalf of the “working men and women of America” – I just find ludicrous when somebody actually in a position to do something for these people through his actions (opposing monetary easing) is doing exactly the opposite.

PPS I don’t think it should be the job of central banks to hit a certain “employment level” or any other real variable and I find the fed’s “dual mandate” seriously flawed, but it is certainly not the job of central banks to “destroy jobs” either. A proper NGDP level targeting regime will provide the best nominal framework for letting the labour market work in a proper and undistorted way and as such would indirectly ensure the highest level of employment given the structures of the economy.

PPPS I wrote this on a flight to Stockholm. I had been thinking about writing something about Swedish monetary policy or Africa (the topic I will be speaking about in Stockholm today), but you can all blame Richard Fisher for distracting me.

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