US capital spending and a lesson in the monetary transmission mechanism

This is from Bloomberg.com:

Companies in the U.S. are beginning to empty their deep pockets and boost capital spending as they look past the specter of sequestration and global growth risks.

Orders for capital goods excluding aircraft and military equipment — an indicator of future business investment — increased 1.5 percent in May, a third consecutive advance and the longest streak since October 2011. Chief executive officers are more optimistic about the economy, based on the Business Roundtable’s quarterly outlook index, which rose to 84.3 in the second quarter, the highest in a year.

Spending on information technology is up 4 percent this year compared with 2 percent last year, according to the median in asurvey of 203 businesses by Computer Economics, a research company in Irvine, California.

…Such increases are set to bolster the U.S. expansion between now and year-end as companies unleash cash from their record-high balance sheets amid a brighter economic outlook. Job gains that beat expectations in June have helped firm market projections of a September start for the Federal Reserve to begin reducing its unprecedented $85 billion in monthly asset purchases, indicating confidence that growth is sustainable without record levels of monetary stimulus.

This is exactly what Market Monetarists said would happen if the Federal Reserve eased monetary policy within a rule based framework. This in my view is a pretty clear demonstration of how the monetary transmission mechanism works.

This is how I in 2011 explained it would work:

Lets assume that the economy is in “bad equilibrium”. For some reason money velocity has collapsed, which continues to put downward pressures on inflation and growth and therefore on NGDP. Then enters a new credible central bank governor and he announces the following:

“I will ensure that a “good equilibrium” is re-established. That means that I will ‘print’ whatever amount of money is needed so to make up for the drop in velocity we have seen. I will not stop the expansion of the money base before market participants again forecasts nominal GDP to have returned to it’s old trend path. Thereafter I will conduct monetary policy in such a fashion so NGDP is maintained on a 5% growth path.”

Lets assume that this new central bank governor is credible and market participants believe him. Lets call him Ben Volcker.

By issuing this statement the credible Ben Volcker will likely set in motion the following process:

1) Consumers who have been hoarding cash because they where expecting no and very slow growth in the nominal income will immediately reduce there holding of cash and increase private consumption.
2) Companies that have been hoarding cash will start investing – there is no reason to hoard cash when the economy will be growing again.
3) Banks will realise that there is no reason to continue aggressive deleveraging and they will expect much better returns on lending out money to companies and households. It certainly no longer will be paying off to put money into reserves with the central bank. Lending growth will accelerate as the “money multiplier” increases sharply.
4) Investors in the stock market knows that in the long run stock prices track nominal GDP so a promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% path growth rule for NGDP investors will expect a much less volatile earnings and dividend flow from companies. That will reduce the “risk premium” on equities, which further will push up stock prices. With higher stock prices companies will invest more and consumers will consume more.

I think that is exactly what is now happening in the US economy. The fed’s de facto announcement back in September last year of the Bernanke-Evans rule is moving the US economy from a “bad equilibrium” to a “good equilibrium”.

Hence, it is not only in the increase in the money base, which is lifting the US economy out of the crisis, but also a marked shift in expectations among US investors and consumers. It is the Chuck Norris effect. At least that is what the survey mentioned above indicates.

Furthermore, this is a clear demonstration of the Sumner Critique – the fiscal multiplier will be zero if the fed follows a clear nominal target. Hence, any fiscal tightening will be offset by monetary easing and/or expected monetary easing. So while fiscal policy contracts investments and private consumption is expanding.

I am still puzzled that it took the fed four years to figure this out and I should say that the Chuck Norris effect could have been much more powerful had the Federal Reserve been a lot more clear about its objectives. Now investors and consumers are still to a large extent guessing what the fed is targeting. Had the fed announced an NGDP level target then I am sure we would have seen an even stronger recovery in US capital spending.

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The monetary transmission mechanism in a ‘perfect world’

I fundamentally think that what really sets Market Monetarism aside from other macroeconomic schools it how we see the monetary transmission mechanism. I this blog post I will try to describe how I think the monetary transmission mechanism would look like in a ‘perfect world’ and how in such a perfect world the central bank basically would do nothing at all and changes in monetary conditions would be nearly 100% determined by market forces.

Futures based NGDP level targeting – the perfect world

No monetary regime is perfect, but I think the regime that get closest to perfection (leaving out Free Banking) is a regime where the central bank targets the nominal GDP level and implement this target with the use of an NGDP-linked bond.

How would this work? Well imagine that the government – lets say the US government – issues bonds linked to the NGDP level. So if the market expectation for the future NGDP level increases the price of the bond increased (and yields drop) and similarly if the NGDP expectation drops the bond price will decline.

Now imagine that the central bank announces that it will always buy or sell these bonds to ensure that the expected NGDP level is equal to the targeted NGDP level.

Then lets now imagine that the price of the bond rise is reflecting expectations for a higher NGDP level. If the expected NGDP level increases above the targeted NGDP level then the central bank will “automatically” go out and sell NGDP-linked bonds until the price is pushed down so the expected NGDP level is equal to the targeted level. This means that the central bank will automatically reduce the money base by a similar amount as the amount of bond selling. The drop in the money base obviously in itself will contribute to pushing back the NGDP level to the targeted level.

It don’t take a genius to see that the mechanism here is very similar to a fixed exchange rate policy, but the outcome of the policy is just much better than what you would get under a fixed exchange rate policy.

And similarly to under a fixed exchange rate regime the money base is endogenous in the sense that it is changed automatically to hit the NGDP target. There is no discretion at all.

Changes in money demand will do most of the job  

It is not only the supply of money, which will be endogenous in a perfect world – so will the demand for money be. In fact it is very likely that most of the adjustments in this world will happen through changes in money demand rather than through changes in the money base.

The reason for this is that if the NGDP targeting policy is credible then investors and consumers will adjust the demand for money to ‘pre-empt’ future changes in monetary policy.

Hence, let imagine a situation where NGDP growth for some reason start to slow down. This initially pushes market expectations for future NGDP below the targeted level. However, this will only be short-lived as forward-looking investors will realise that the central bank will start buying NGDP-linked bonds and hence increase the money base. As investors realise this they will expect the value of money to go down and as forward-looking investors they will re-allocate their portfolios – buying assets that go up in value when NGDP increases and selling assets that go down in value when this happens.

Assets that go up in value when NGDP expectations increase includes shares, real estate and of course NGDP-linked bond and also the national currency, while regular bonds will drop in value when NGDP expectations increase.

This is key to the monetary transmission mechanism in the ‘perfect world’ – it is all about consumers and investors anticipating the central bank’s future actions and the impact this is having on portfolio reallocation.

Similarly there is also an impact on macroeconomic variables due to this portfolio reallocation. Hence, if NGDP drops below the targeted level then rational consumers and investors will realise that the central bank will ease monetary policy to bring NGDP back on track. That would mean that the value of cash should be expected to decline relative to other assets. As a consequence consumers and investors will reduce their cash holdings – and instead increase consumption and investment. Similarly as monetary easing is expected this will tend to weaken the national currency, which will boost exports. Hence, the “NGDP anchor” will have a stabilizing impact on the macro economy.

Therefore, if the central bank’s NGDP targeting regime is credible it will effectively be the market mechanism that automatically through a portfolio reallocation mechanism will ensure that NGDP continuously tend to return the targeted NGDP level.

We can see in the ‘perfect world’ the money base would likely not change much and probably be closed the ideal of a ‘frozen money base’ and the continuously adjustment in monetary conditions would happens by changes in the money demand and hence in money-velocity.

It should also be noted that the way I describe the transmission mechanism above interest rates play no particularly important role and the only thing we can say is that interest rates and bond yields will tend to move up and down with NGDP expectations. However, the interest rate is not the policy instrument and interest rate is just one of many prices that adjust to changes in NGDP expectations.

The Great Moderation was close to the ‘perfect world’

The discussion above might seem somewhat like science fiction, but in fact I believe the way I describe the transmission mechanism above is very similarly to how the transmission mechanism actually was working during the Great Moderation from the mid-1980s to 2007/8 particularly in the US.

Effectively the Fed during this period targeted 5-5½% NGDP growth and that “target” was highly credible – even though it was never precisely defined. Furthermore, the NGDP “target” was not implemented by utilizing NGDP-linked bonds and officially the fed’s used the fed funds target rate to implement monetary policy. However, the reality was that it was the market that determined what level of interest rates that was necessary to hit the “target”.

Hence, only very rarely did the fed surprised the market expectation for changes in the fed fund target rate during that period. Furthermore, it was basically a portfolio reallocation mechanism that ensured NGDP stability – not changes in the fed funds target rate. So when NGDP was above ‘target’ investors would expect monetary tightening – that would cause market interest rates rise, stock prices to drop and the dollar to strengthen as future monetary tightening was priced in. In this process the demand for money would also increase and hence the velocity of money would decline.

So the real achievement of monetary policy in the US during the Great Moderation was effectively to create a credible NGDP targeting regime where monetary policy basically was market determined. The problem of course was, however, that this was never acknowledged and equally problematic was the reliance on the fed funds target as the key monetary policy instrument. This of course turned out to be catastrophic defects in the system in 2008.

In 2008 it was very clear that NGDP expectations were declining – stock prices was declining, bond yields dropped, the dollar strengthened and money velocity declined. Had there been a futures based NGDP targeting regime in place this would likely have lead to the price of NGDP linked-bonds to drop already in 2006 as US property prices peaked. As the fed would have pledged to keep NGDP expectations on track this would have led to an automatic increase in the money base as the fed would have been buying NGDP-linked bonds. That would have sent a clear signal to consumers and investors that the fed would not let the NGDP level drop below target for long. As a consequence we would not have seen the massive increase in money demand we saw and even if it that had happened the supply of money would have been completely elastic and the supply of dollars would have risen one-to-one with the increase in money demand. There would hence have been no monetary contraction at all.

Instead the system ‘broke down’ as the fed funds target rate effectively hit the Zero Lower Bound (ZLB) and the fed effectively became unable to ease monetary policy with its preferred monetary policy instrument – the fed funds target rate. Obviously in the ‘perfect world’ there is no ZLB problem. Monetary policy can always – and will always – be eased if NGDP expectations drop below the targeted NGDP level.

Fiscal consolidation in the ‘perfect world’

In the ‘perfect world’ the fiscal multiplier will always be zero. To understand this try to imagine the following situation. The US government announces that government spending will be cut by 10% of GDP next year. It is pretty obvious that the initial impact of this would for aggregate demand to drop. Hence, the expectation for next year’s NGDP level would drop.

However, if NGDP expectations drop below the targeted level the fed would automatically expand the money base to ‘offset’ the shock to NGDP expectations. The fed would likely have to do very little ‘offsetting’ as the market would probably do most of the work. Hence, as the fiscal tightening is announced this would be an implicit signal to the market that the fed would ease monetary policy. The expectation of monetary easing obviously would lead to a weakening of the dollar and push up stock prices and property prices. As a consequence most of the ‘offsetting’ of the fiscal tightening would be market determined.

We should therefore, expect money demand to drop and velocity increase in response to an announcement of fiscal tightening. As an aside it should be noticed at this is the opposite of what would be the case in a paleo-keynesian world. Here a tightening of monetary policy would lead to a drop in money-velocity. I plan to return to this issue in a future post.

The important point here is that in the ‘perfect world’ there is no room or reason for using fiscal policy for cyclical purposes. As a consequence the there are no argument as consolidating fiscal policy is long-term considerations necessitate this.

Market Monetarism is not about ‘stimulus’ and QE, but above rules

I think my conclusion above clearly demonstrates what is the ‘core’ of Market Monetarist thinking. So while Market Monetarism often wrongly is equated with ‘monetary stimulus’ and advocacy of ‘quantitative easing’ the fact is that this really has nothing to do with Market Monetarism. Instead what we are arguing is that monetary policy should be ‘market determined’ by the use of targeting the price of NGDP-linked bonds. In such a world there would be no ‘stimulus’ in the sense that there would be no need for discretionary changes in monetary policy. Monetary conditions would change completely automatically to always ensure NGDP stability. As a consequence monetary conditions would likely mostly change through changes in money demand rather than through changes in the money base. Therefore we can hardly talk about ‘QE’ in such a regime.

So why have Market Monetarists then seemly supported quantitative easing in for example the US. Well, the point is first and foremost that the fed’s monetary policy regime over the past five years have not been entirely credible – we are getting closer, but we are very far away from the ‘perfect world’. Hence, the fed needs to undertake quantitative easing to demonstrate first of all that it can indeed ease monetary policy even with interest rates basically at zero. Secondly since monetary policy is not credible (countercyclical) changes in money demand will not happen automatically so the fed will instead have to change the money base.

Obviously these measures would not be necessary if the US Treasury issue NGDP-linked bonds and the fed at the same time announced an NGDP level target and utilized the NGDP-linked bonds to hit this target. If such a system were credibly announced then it would be very hard to argue for ‘monetary stimulus’ and quantitative easing in the discretionary sense.

It might be that the discussion above is pure fantasy and it is pretty clear that we are very, very far away from such a monetary policy regime anywhere, but I nonetheless think that the discussion illustrates how important it is for monetary policy to be rule based rather than to be conducted in a discretionary fashion. Both the Bank of Japan and the Federal Reserve have within the last six months moved (a little) closer to the ‘perfect world’ in the sense that their policies have become a lot more rule based than used to be the case and there is no doubt that the policies are ‘working’. Especially in the case of Japan it seems clear that ‘automatic’ adjustments in money demand is going to play a very key role in achieve BoJ’s 2% inflation target. Hence, it is likely that it will not be the expansion of the money base that will do it for BoJ, but rather the likely sharp increase in money-velocity that will ensure that BoJ’s hits its target.

Finally, I would argue that my discussion above also demonstrates why a proper NGDP level targeting regime is a true free market alternative as the system relies heavy on market forces for the implementation of monetary policy and is strictly rule base.

The Kuroda recovery will be about domestic demand and not about exports

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

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.

The weaker yen is an indicator of monetary easing – but not the main driver of growth

I think that the way we should think about the weaker yen is as a 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.

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expect the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate. So it is no wonder that equity analysts feel more optimistic about Japanese companies’ earnings.

Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

The focus on competitiveness is completely misplaced

I have in numerous earlier posts argued that when a country is going through a “devaluation” as a consequence of monetary easing the important thing is not competitiveness, but the impact on domestic demand.

I have for example earlier demonstrated that Swedish growth outpaced Danish growth in 2009-10 not because the Swedish krona depreciated strongly against the Danish krone (which is pegged to the euro), but because the Swedish Riksbank was able to ease monetary policy, while the Danish central bank effectively tightened monetary conditions due to the Danish fixed exchange rate policy. As a consequence domestic demand did much better in Sweden in 2009-10 than in Denmark, while – surprise, surprise – Swedish and Danish exports more or less grew at the same pace in 2009-10 (See graphs below).

Similarly I have earlier shown that when Argentina gave up its currency board regime in 2002 the major boost to growth did not primarly come from exports, but rather from domestic demand. Let me repeat a quote from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

And if we want to go further back in history we can look at what happened in the US after FDR gave up the gold standard in 1933. Here the story was the same – it was domestic demand and not net exports which was the driver of the sharp recovery in growth during 1933.

These examples in my view clearly shows that 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.

Finally if anybody still worry about “currency war” they might want to rethink how they see the impact of monetary easing. When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

HT Jonathan Cast

—-

PS Scott Sumner also comments on Japan.

PPS An important non-competitiveness impact of the weaker yen is that it is telling consumers and investors that inflation is likely to increase. Again the important thing is the signal about monetary policy, which is rather more important than the impact on competitiveness.

The Fed’s easing is working…in Mexico

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

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

The Bernanke-Evans rule boosts the Mexican stock market

MXN stock market

Mexican consumers get a boost from Bernanke

conconfMEX

Mexican industrialists are falling in love with Bernanke

PMI mexico

The US-Mex monetary transmission mechanism

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

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

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

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

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

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

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

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

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

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

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

Causality, econometrics and beautiful Saint Pete

I am going to Russia next week. It will be good to be back in wonderful Saint Petersburg. In connection with my trip I have been working on some econometric models for Russia. It is not exactly work that I enjoy and I am deeply skeptical about how much we can learn from econometric studies. That said, econometrics can be useful when doing practical economics – such as trying to forecast Russian growth and inflation.

So I have been working on this model for the Russian economy. The main purpose of the model is to learn about what I would would call the petro-monetary transmission mechanism in the Russian economy. It is my thesis that the primary channel for how oil prices are impacting the Russian economy is through the monetary transmission mechanism rather than through net exports.

Here is my theory in short: The Russian central bank (CBR) dislikes – or at least used to dislike – a freely floating exchange rate. Therefore the CBR will intervene to keep the ruble stable. These days the CBR manages the ruble within a band against a basket of the US dollar and the euro. Today the ruble is much more freely floating than it used to be, but nonetheless the ruble is still tightly managed and the ruble is certainly not a freely floating currency.

So why is that important for my econometric models for Russia? Well, it is important because it means quite a bit to the causality I assume in the model. Lets look at two examples. One where the ruble is completely pegged against another currency or a basket of currencies and another example where the ruble is freely floating and the central bank for example targets inflation or nominal GDP.

Pegged exchange rate: Causality runs from oil to money supply and NGDP 

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

Now lets look at the case where we assume a freely floating ruble.

Floating ruble: Oil prices and monetary policy will be disconnected

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

Do I have to forget about econometrics? Not necessarily

So what do that mean for my little econometric exercise on the Russian economy? Well, basically it means that I have to be extremely careful when I interpret the econometric output. The models I have been playing around with I have estimated from 2000 and until today. I have done what is called Structural VAR analysis (with a lot of help from a clever colleague who knows econometrics much better than me). Some of the results we get are surely interesting, however, we got one major problem and that is that during the 12 years we are looking Russian monetary policy has changed significantly.

In the early part of the estimation period the Russian central bank basically maintained a quasi-pegged exchange for the ruble against the dollar. Later, however, the CBR started to manage the ruble against a basket of dollars and euros and at the same time the CBR would “adjust” the ruble rate to hit changing nominal targets – for example an inflation target. The CBR have had multiple and sometimes inconsistent targets during the past decade. Furthermore, the CBR has moved gradually in the direction of a more freely floating ruble by allowing for a wider “fluctuation band” around the euro-dollar basket.

So basically we would expect that causality in the Russian economy in 2000 would be pretty much as described in the pegged exchange rate case, while it today should be closer to the floating exchange rate case. That of course means that we should not expect the causality in our model to be stable causal structure. Econometricians hate that – to me it is just a fact of life or as Ludwig von Mises used to say “there are no constants in economics” (I am paraphrasing von Mises from my memory). This of course is also know as the Lucas Critique. Some would of course argue that we could take this into account when we do our econometric work, but regime changes do not necessarily happen from day to day. Often regime change is gradual, which makes it impossible to really to take into account in econometric studies.

And this is one of my problems with econometrics – or rather with how econometric studies often are conducted. They do not take into account regime change and therefore do not take into account expectations. As a result well-known correlations tend to breakdown. The best example is of course the disappearance of the Phillips curve relationship in the 1970s and 1980s. Another example is the breakdown of the causal relationship between money supply growth and inflation in 1990s.

So what do I do? Should I give up on my little econometric venture? No, I don’t think so. Econometrics can clearly be useful in determining the magnitude and importance of different shocks in the economy and surely some of our econometric results on the Russian economy seems to be pretty robust. For example over the estimation period it seems like a 10% increase in the oil prices have increased the M2 and nominal GDP by around 2%. That is nice to know and is useful information when you want to do forecasting on the Russian economy. But it would be completely naive to expect this relationship to be constant over time. Rather the Russian central bank is clearly moving in the direction of a more and more freely floating ruble so we should expect the correlation between oil prices one the one hand and M2 and NGDP on the other hand to decrease going forward.

Concluding, econometrics can be useful in doing “practical” economics like macroeconomic forecasting, but one should never forget to do the homework on the institutional structures of the economy and one should never ever forget about the importance of expectations. Economic reasoning is much more important than any statistical results.

Related posts:
Next stop Moscow
International monetary disorder – how policy mistakes turned the crisis into a global crisis
Fear-of-floating, misallocation and the law of comparative advantages
PEP, NGDPLT and (how to avoid) Russian monetary policy failure
Should small open economies peg the currency to export prices?

Please keep “politics” out of the monetary reaction function

During the Great Moderation it was normal to say that the Federal Reserve and the ECB (and many other central banks for that matter) was following a relatively well-defined monetary policy reaction function. It is debatable what these central banks where actually targeting, but there where is no doubt that both the Fed and the ECB overall can be descripted to have conducted monetary policy to minimize some kind of loss function which included both unemployment and inflation.

In a world where the central bank follows a Taylor rule style monetary policy reaction function, targets the NGDP level, do inflation targeting or have pegged the exchange rate the markets will tend to ignore political news. The only important thing will be how the actual economic development is relative to the target and in a situation with a credible nominal target the Chuck Norris effect will ensure that the markets do most of the lifting to achieve the nominal target.  The only things that could change that would be if politicians decided to take away the central bank’s independence and/or change the central bank’s target.

When I 12 years ago joined the financial sector from a job in the public sector I was hugely surprised by how little attention my colleagues in the bank was paying to political developments. I, however, soon learned that both fiscal policy and monetary policy in most developed countries had become highly rule based and therefore there was really no reason to pay too much attention to the nitty-gritty of day-to-day politics. The only thing one should pay attention to was whether or not given monetary targets where on track or not. That was the good old days of the Great Moderation. Monetary policy was rule based and therefore highly predictable and as a result market volatility was very low.

This have all changed in the brave new world of Great Recession (failed) monetary policy and these days it seems like market participants are doing nothing else than trying to forecast what will be the political changes in country X, Y and Z. The reason for that is the sharp increase in the politician of monetary policy.

In the old days – prior to the Great Moderation – market participants were used to have politicians messing up monetary policies. Central banks were rarely independent and did not target clear nominal targets. However, today the situation is different. Gone are the days of rule based monetary policy, but the today it is not the politicians interfering in the conduct of monetary policy, but rather the central bankers interfering in the conduct of other policies.

This particularly is the case in the euro zone where the ECB now openly is “sharing” the central bank’s view on all kind of policy matters – such as fiscal policy, bank regulation, “structural reforms” and even matters of closer European political integration. Furthermore, the ECB has quite openly said that it will make monetary policy decisions conditional on the “right” policies being implemented. It is for example clear that the ECB have indicated that it will not ease monetary policy (enough) unless the Greek government and the Spanish government will “deliver” on certain fiscal targets. So if Spanish fiscal policy is not “tight enough” for the liking of the ECB the ECB will not force down NGDP in the euro zone and as a result increase the funding problems of countries such as Spain. The ECB is open about this. The ECB call it to use “market forces” to convince governments to implement fiscal tightening. It of course has nothing to do with market forces. It is rather about manipulating market expectations to achieve a certain political outcome.

Said in another way the ECB has basically announced that it does not only have an inflation target, but also that certain political outcomes is part of its reaction function. This obviously mean that forward looking financial markets increasingly will act on political news as political news will have an impact of future monetary policy decisions from the ECB.

Any Market Monetarist will tell you that the expectational channel is extremely important for the monetary transmission mechanism and this is particularly important when a central bank start to include political outcomes in it’s reaction function.

Imaging a central bank say that it will triple the money supply if candidate A wins the presidential elections (due to his very sound fiscal policy ideas), but will cut in halve the money supply if candidate B wins (because he is a irresponsible bastard). This will automatically ensure that the opinion polls will determine monetary policy. If the opinion polls shows that candidate A will win then that will effectively be monetary easing as the market will start to price in future monetary policy easing. Hence, by announce that political outcomes is part of its reaction function will politics will make monetary policy endogenous. The ECB of course is operating a less extreme version of this set-up. Hence, it is for example very clear that the ECB’s monetary policy decisions in the coming months will dependent on the outcome of the Greek elections and on the Spanish government’s fiscal policy decisions.

The problem of course is that politics is highly unpredictable and as a result monetary policy becomes highly unpredictable and financial market volatility therefore is likely to increase dramatically. This of course is what has happened over the past year in Europe.

Furthermore, the political outcome also crucially dependents on the economic outcome. It is for example pretty clear that you would not have neo-nazis and Stalinists in the Greek parliament if the economy were doing well. Hence, there is a feedback from monetary policy to politics and back to monetary policy. This makes for a highly volatile financial environment.  In fact it is hard to see how you can achieve any form of financial or economic stability if central banks instead of targeting only nominal variables start to target political outcomes.

So I long for the days when politics was not market moves in the financial markets and I hope central banks around the world would soon learn that it is not part of their mandate to police the political process and punish governments (and voters!) for making the wrong decisions. Central banks should only target nominal targets and nothing else. If they diverge from that then things goes badly wrong and market volatility increases sharply.

Finally I should stress that I am not arguing in anyway that the ECB is wrong to be concerned about fiscal policy being unsustainable in a number of countries. I am deeply concerned about that state of fiscal policy in a number of countries and I think it is pretty clear to my regular readers that I do not favour easier fiscal policy to solve the euro zone crisis. I, however, is extremely sceptical about certain political results being included in the ECB’s reaction function. That is a recipe for increased market volatility.

PS this discussion is of course very similar to what happened during the Great Depression when politics kept slipping into the newspapers’ financial sector (See here and here)

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..

Who did most for the US stock market? FDR or Bernanke?

My post on US stock markets and monetary disorder led to some friendly but challenging comments from Diego Espinosa. Diego rightly notes that Market Monetarists including myself praises US president Roosevelt for taking the US off the gold standard and that similar decisive actions is needed today, but at the same time is critical of Ben Bernanke’s performance of Federal Reserve governor despite the fact that US share prices have performed fairly well over the last four years.

Diego’s point is basically that the Federal Reserve under the leadership of chairman Bernanke has indeed acted decisively and that that is visible if one look at the stock market performance. Diego is certainly right in the sense that the US stock market sometime ago broken through the pre-crisis peak levels and the stock market performance in 2009 by any measure was impressive. It might be worth noticing that the US stock market in general has done much better than the European markets.

However, it is a matter of fact that the stock market response to FDR’s decision to take the US off the gold standard was much more powerful than the Fed’s actions of 2008/9. I take a closer look at that below.

Monetary policy can have a powerful effect on share prices

To illustrate my point I have looked at the Dow Jones Industrial Average (DJIA) for the period from early 2008 and until today and compared that with the period from 1933 to 1937. Other stock market indices could also have been used, but I believe that it is not too important which of the major US market indices is used to the comparison.

The graph below compares the two episodes. “Month zero” is February 1933 and March 2009. These are the months where DJIA reaches the bottom during the crisis. Neither of the months are coincident as they coincide with monetary easing being implemented. In April 1933 FDR basically initiated the process that would take the US off the gold standard (in June 1933) and in March 2009 Bernanke expanded TAF and opened dollar swap lines with a number of central banks around the world.

As the graph below shows FDR’s actions had much more of a “shock-and-awe” impact on the US stock markets than Bernanke’s actions. In only four months from DJIW jumped by nearly 70% after FDR initiated the process of taking the US off the gold standard. This by the way is a powerful illustration of Scott Sumner’s point the monetary policy works with long and variable leads – you see the impact of the expected policy change even before it has actually been implemented. The announcement effects are very powerful. The 1933 episode illustrates that very clearly.

Over the first 12 months from DJIA reaches bottom in 1933 the index increases by more than 90%. That is nearly double of the increase of DJIA in 2009 as is clear from the graph.

Obviously this is an extremely crude comparison and no Market Monetarist would argue that monetary policy changes could account for everything that happened in the US stock market in 1993 or 2009. However, impact of monetary policy on stock market performance is very clear in both years.

NIRA was a disaster

A very strong illustration of the fact that monetary policy is not everything that is important for the US stock market is what happened from June 1933 to May 1935. In that nearly two year period the US stock market was basically flat. Looking that the graph it looks like the stock market rally paused to two years and then took off again in the second half of 1935.

The explanation for this “pause” is the draconian labour market policies implemented by the Roosevelt administration. In June 1933 the so-called National Industrial and Recovery Act was implemented by the Roosevelt administration (NIRA). NIRA massively strengthened the power of US labour unions and was effectively thought to lead to a cartelisation of the US labour market. Effectively NIRA was a massively negative supply shock to the US economy.

So while the decision to go off the gold standard had been a major positive demand shock that on it’s own had a massively positive impact on the US economy NIRA had the exact opposite impact. Any judgement of FDR’s economic policies obviously has to take both factors into account.

That is exactly what the US stock market did. The gold exit led to a sharp stock market rally, but that rally was soon killed by NIRA.

In May 1935 the US Supreme Court ruled that NIRA was unconstitutional. That ruling had a major positive impact positive impact as it “erased” the negative supply shock. As the graph shows very clearly the stock market took off once again after the ruling.

FDR was better for stocks than Bernanke, but…

Overall we have to conclude that FDR’s decision to take the US off the gold standard had an significantly more positive impact on the US stock markets than Ben Bernanke’s actions in 2008/9. However, contrary to the Great Depression the US has avoided the same kind of policy blunders on the supply side over the past four years. While the Obama administration certainly has not impressed with supply side reforms the damage done by his administration on the supply side has been much, much smaller than the disaster called NIRA.

Hence, the conclusion is clear – monetary easing is positive for the stock market, but any gains can be undermined by regulatory mistakes like NIRA. That is a lesson for today’s policy makers. Central banks should ensure stable growth in nominal GDP, while governments should implement supply side reforms to increase real GDP over the longer run. That would not undoubtedly be the best cocktail for the economy but also for stock markets.

Finally it should be noted that both FDR and Bernanke failed to provide a clear rule based framework for the conduct of monetary policy. That made the recovery much weaker in 1930s than it could have been and probably was a major cause why the US fell back into recession in 1937. Similarly the lack of a rule based framework has likely had a major negative impact on the effectiveness of monetary policy over the past four years.

PS this post an my two previous posts (see here and here) to a large degree is influenced by the kind of analysis Scott Sumner presents in his book on the Great Depression. Scott’s book is still unpublished. I look forward to the day it will be available to an wider audience.

Monetary disorder – not animal spirits – caused the Great Recession

If one follows the financial media on a daily basis as I do there is ample room to get both depressed and frustrated over the coverage of the financial markets. Often market movements are described as being very irrational and the description of what is happening in the markets is often based on an “understanding” of economic agents as somebody who have huge mood swings due to what Keynes termed animal spirits.

Swings in the financial markets created by these animal spirits then apparently impact the macroeconomy through the impact on investment and private consumption. In this understanding markets move up and down based on rather irrational mood swings among investors. This is what Robert Hetzel has called the “market disorder”-view. It is market imperfections and particularly the animal spirits of investors which created swings not only in the markets, but also in the financial markets. Bob obviously in his new book convincingly demonstrates that this “theory” is grossly flawed and that animal spirits is not the cause of neither the volatility in the markets nor did animal spirits cause the present crisis.

The Great Recession is a result of numerous monetary policy mistakes – this is the “monetary disorder”-view – rather than a result of irrational investors behaving as drunken fools. This is very easy to illustrate. Just have a look first at S&P500 during the Great Recession.

The 6-7 phases of the Great Recession – so far

We can basically spot six or seven overall phases in S&P500 since the onset of the crisis. In my view all of these phases or shifts in “market sentiment” can easy be shown to coincide with monetary policy changes from either the Federal Reserve or the ECB (or to some extent also the PBoC).

We can start out with the very unfortunate decision by the ECB to hike interest rates in July 2008. Shortly after the ECB hike the S&P500 plummeted (and yes, yes Lehman Brother collapses in the process). The free fall in S&P500 was to some extent curbed by relatively steep interest rate reductions in the Autumn of 2008 from all of the major central banks in the world. However, the drop in the US stock markets did not come to an end before March 2009.

March-April 2009: TAF and dollar swap lines

However, from March-April 2009 the US stock markets recovered strongly and the recovery continued all through 2009. So what happened in March-April 2009? Did all investors suddenly out of the blue become optimists? Nope. From early March the Federal Reserve stepped up its efforts to improve its role as lender-of-last resort. The de facto collapse of the Fed primary dealer system in the Autumn of 2008 had effective made it very hard for the Fed to function as a lender-of-last-resort and effectively the Fed could not provide sufficient dollar liquidity to the market. See more on this topic in George Selgin’s excellent paper  “L Street: Bagehotian Prescriptions for a 21st-Century Money Market”.

Here especially the two things are important. First, the so-called Term Auction Facility (TAF). TAF was first introduced in 2007, but was expanded considerably on March 9 2009. This is also the day the S&P500 bottomed out! That is certainly no coincidence.

Second, on April 9 when the Fed announced that it had opened dollar swap lines with a number of central banks around the world. Both measures significantly reduced the lack of dollar liquidity. As a result the supply of dollars effectively was increased sharply relatively to the demand for dollars. This effectively ended the first monetary contraction during the early stage of the Great Recession and the results are very visible in S&P500.

This as it very clear from the graph above the Fed’s effects to increase the supply of dollar liquidity in March-April 2009 completely coincides with the beginning of the up-leg in the S&P500. It was not animal spirits that triggered the recovery in S&P500, but rather easier monetary conditions.

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

The dollar swap lines expired February 1 2010. That could hardly be a surprise to the markets, but nonetheless this seem to have coincided with the S&P500 beginning to loose steam in the early part of 2010. However, it was probably more important that speculation grew in the markets that global central banks could move to tighten monetary conditions in respond to the continued recovery in the global economy at that time.

On January 12 2010 the People’s Bank of China increased reserve requirements for the Chinese banks. In the following months the PBoC moved to tighten monetary conditions further. Other central banks also started to signal future monetary tightening.

Even the Federal Reserve signaled that it might be reversing it’s monetary stance. Hence, on February 18 2010 the Fed increased the discount rate by 25bp. The Fed insisted that it was not monetary tightening, but judging from the market reaction it could hardly be seen by investors as anything else.

Overall the impression investors most have got from the actions from PBoC, the Fed and other central banks in early 2010 was that the central banks now was moving closer to initiating monetary tightening. Not surprisingly this coincides with the S&P500 starting to move sideways in the first half of 2010. This also coincides with the “Greek crisis” becoming a market theme for the first time.

August 27 2010: Ben Bernanke announces QE2 and stock market takes off again

By mid-2010 it had become very clear that talk of monetary tightening had bene premature and the Federal Reserve started to signal that a new round of monetary easing might be forthcoming and on August 27 at his now famous Jackson Hole speech Ben Bernanke basically announced a new round quantitative easing – the so-called QE2. The actual policy was not implemented before November, but as any Market Monetarist would tell you – it is the Chuck Norris effect of monetary policy: Monetary policy mainly works through expectations.

The quasi-announcement of QE2 on August 27 is pretty closely connected with another up-leg in S&P500 starting in August 2010. The actual upturn in the market, however, started slightly before Bernanke’s speech. This is probably a reflection that the markets started to anticipate that Bernanke was inching closer to introducing QE2. See for example this news article from early August 2010. This obviously is an example of Scott Sumner’s point that monetary policy works with long and variable leads. Hence, monetary policy might be working before it is actually announced if the market start to price in the action beforehand.

April and July 2011: The ECB’s catastrophic rate hikes

The upturn in the S&P500 lasted the reminder of 2010 and continued into 2011, but commodity prices also inched up and when two major negative supply shocks (revolutions in Northern Africa and the Japanese Tsunami) hit in early 2011 headline inflation increased in the euro zone. This triggered the ECB to take the near catastrophic decision to increase interest rates twice – once in April and then again in July. At the same time the ECB also started to scale back liquidity programs.

The market movements in the S&P500 to a very large extent coincide with the ECB’s rate hikes. The ECB hiked the first time on April 7. Shortly there after – on April 29 – the S&P500 reached it’s 2011 peak. The ECB hiked for the second time on July 7 and even signaled more rate hikes! Shortly thereafter S&P500 slumped. This obviously also coincided with the “euro crisis” flaring up once again.

September-December 2011: “Low for longer”, Operation twist and LTRO – cleaning up your own mess

The re-escalation of the European crisis got the Federal Reserve into action. On September 9 2011 the FOMC announced that it would keep interest rates low at least until 2013. Not exactly a policy that is in the spirit of Market Monetarism, but nonetheless a signal that the Fed acknowledged the need for monetary easing. Interestingly enough September 9 2011 was also the date where the three-month centered moving average of S&P500 bottomed out.

On September 21 2011 the Federal Reserve launched what has come to be known as Operation Twist. Once again this is certainly not a kind of monetary operation which is loved by Market Monetarists, but again at least it was an signal that the Fed acknowledged the need for monetary easing.

The Fed’s actions in September pretty much coincided with S&P500 starting a new up-leg. The recovery in S&P500 got further imputes after the ECB finally acknowledged a responsibility for cleaning up the mess after the two rate hikes earlier in 2011 and on December 8 the ECB introduced the so-called 3-year longer-term refinancing operations (LTRO).

The rally in S&P500 hence got more momentum after the introduction of the 3-year LTRO in December 2011 and the rally lasted until March-April 2012.

The present downturn: Have a look at ECB’s new collateral rules

We are presently in the midst of a new crisis and the media attention is on the Greek political situation and while the need for monetary policy easing in the euro zone finally seem to be moving up on the agenda there is still very little acknowledgement in the general debate about the monetary causes of this crisis. But again we can explain the last downturn in S&P500 by looking at monetary policy.

On March 23 the ECB moved to tighten the rules for banks’ use of assets as collateral. This basically coincided with the S&P500 reaching its peak for the year so far on March 19 and in the period that has followed numerous European central bankers have ruled out that there is a need for monetary easing (who are they kidding?)

Conclusion: its monetary disorder and not animal spirits

Above I have tried to show that the major ups and downs in the US stock markets since 2008 can be explained by changes monetary policy by the major central banks in the world. Hence, the volatility in the markets is a direct consequence of monetary policy failure rather than irrational investor behavior. Therefore, the best way to ensure stability in the financial markets is to ensure nominal stability through a rule based monetary policy. It is time for central banks to do some soul searching rather than blaming animal spirits.

This in no way is a full account of the causes of the Great Recession, but rather meant to show that changes in monetary policy – rather than animal spirits – are at the centre of market movements over the past four years. I have used the S&P500 to illustrate this, but a similar picture would emerge if the story was told with US or German bond yields, inflation expectations, commodity prices or exchange rates.

Appendix: Some Key monetary changes during the Great Recession

July 2008: ECB hikes interest rates

March-April 2009: Fed expand TAF and introduces dollar swap lines

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

August 27 2010: Bernanke announces QE2

April and July 2011: The ECB hike interest rates twice

September-December 2011: Fed announces policy to keep rate very low until the end of 2013 and introduces “operation twist”. The ECB introduces the 3-year LTRO

March 2012: ECB tightens collateral rules

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