Lars’s Law – I blame the ECB

My colleague Arne Rasmussen put it well in a comment on Facebook today:

”…you have Godwin’s law and then you have Lars’s law…sooner or later he will blame it (everything) on the ECB…”

Arne is of course right. I just have to admit it – I do tend to blame the ECB for everything bad in this world.

—–

PS if you forgot what Godwin’s law then this what Wikipedia is tellng us: “As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches 1”

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European central bankers are obsessing about everything else than monetary policy

While it is becoming increasingly clear that Europe is falling into a Japanese style deflationary trap European central bankers continue to refuse to talk about the need for monetary easing to curb deflationary pressures. Instead they seem to be focused on everything else. We have been through it all – the ECB has concerned itself with who was Prime Minister in Greece and Italy about Spanish fiscal policy, rising oil prices in 2011 and about “financial stability”. And believe it or not it has become fashionable for European central bankers to call for higher wages in Germany!

This is from Reuters (on Sunday):

The European Central Bank supports Germany‘s Bundesbank in its appeals for higher wage deals in Germany, Der Spiegel magazine quoted ECB Chief Economist Peter Praet as saying on Sunday.

Low wage agreements were needed in some crisis-hit countries in the euro zone to bolster competitiveness, the magazine quoted Praet as saying.

By contrast, in countries like Germany where “inflation is low and the labour market is in good shape”, higher earnings increases were appropriate, Der Spiegel reported him to have said.

This would help bring average wage developments in the euro zone in line with the ECB’s inflation target of close to 2 percent, his argument continued, said Der Spiegel.

The Bundesbank historically has been a strong advocate of wage restraint, but with euro zone inflation stuck below 1 percent and consumer prices rising just 1.0 percent in June in Germany, Europe’s biggest economy, some fear deflation.

Bundesbank Chief Economist Jens Ulbrich has been widely reported by German media to have encouraged German trade unions to take a more aggressive stance in wage negotiations given low levels of inflation.

First of all one should ask the question why European central bankers in this way would interfere in the determination of prices (wages). The job of the central bank is to provide a nominal anchor – not to have a view on relative prices.

Second you got to wonder what textbook European central bank economists have been reading. It seems like they have completely missed the difference between the supply side and the demand side of the economy.

We know from earlier that ECB Chief Economist Praet seems to have a bit of a problem differentiating between supply and demand shocks. Apparently this is a general problem for Eureopan central bankers – or at least Bundesbank’ Jens Ulbrich suffers from the same problem.

What Ulbrich seems to be arguing is that we should solve Europe’s deflationary problem by basically engineering a negative supply shock to the German economy. The same kind of logic has been used as an argument for the recent misguided increase in German minimum wages.

Hence, it seems like both Praet and Ulbrich actually acknowledge that there is a deflationary problem in Europe, but at the same time they very clearly fail to understand that this is a monetary phenomenon. As a consequence they come up with very odd “solutions” for the problem.

This can be easily demonstrated in a simple Cowen-Tabarak style AS/AD framework – see the graph below.

wage shock

ECB’s overly tight monetary policy has caused aggregate demand to drop shifting the AD curve from AD to AD’, which has caused a drop in inflation to below 2% (likely also soon below 0%).

The Bundesbank now wants to deal with this problem not by doing the obvious – easing monetary policy aggressive – but instead by causing a negative supply shock. Obviously if German labour unions are given further monopoly powers and/or the German minimum wage is increased then that is a negative supply shock – wages increase without an increase in productivity or demand for labour. This causes the AS curve to shift left from AS to AS’.

The result of course would be higher inflation, but real GDP growth would drop further (to y” in the graph). Or said in another way it seems like the Bundebank are advocating “solving” Europe deflationary problem by increasing the structural problems on the German labour market.

Obviously Jens Ulbrich likely would argue that this is not what he means (his reasoning seems to follow a typical 1970s style “Keynesian” macroeconometric model where there is no money and no supply side – higher wage growth cause demand to increase), but that doesn’t matter as the outcome of an exogenous negative supply shock to the German economy would be bad news for Europe rather than good news.

Stop micromanaging the European economy – and do monetary easing

It is about time that European central bankers stop obsessing about matters that have nothing to do with monetary policy – whether it is fiscal policy, financial stability or labour market conditions. They can and not should try to influence these matters. The ECB should just take these matters as given when they conduct monetary policy, but it not for them to influence these matters.

The Bundesbank or the ECB should not have a view on what the level of the public deficit in Spain is or the how much German wages should increase. The first is for the Spanish government to decide on and the second is for German employers and labour unions to negotiate. It is becoming very hard to argue for central bank independence when central bankers (mis)use this independence to interfere in non-monetary matters.

The ECB is failing badly on this at the moment has the risk of falling into a deflationary trap is increase day by day. So why do the Bundesbank and the ECB just not focus on solving that issue? Depressingly the problem is very easy to solve – also without worsening German labour market conditions.

PS The argument for higher wage growth and tight money is very similar to what caused the so-called Recession in the Depression in the US in 1937. The Roosevelt administration got increasingly concerned in 1936-37 that inflation was picking up while wage growth remained weak. The Roosevelt administration feared this would cause real wage to drop, which would cause private consumption to drop and unemployment to increase. This obviously is a very primitive form of Keynesianism (but something Keynes did in fact advocate) and today it should be clear to everybody that political attempts to cause real wages to outpace productivity will lead to higher rather than lower unemployment. And this is what happened in 1937 – the FDR administration troed push up real wages by increasing nominal wage growth and tightening monetary policy caused the recession in 1937.

PPS Unfortunately the Abe government in Japan seems to suffering from the same illusion that “engineering” a rise in real wage – without a similar rise in productivity – can help the Japanese economy.

 

The stock market has reached “a permanently high plateau” (if the Fed does not mess up again…)

Last week I wrote a post criticizing Fed chair Janet Yellen for apparently becoming a stock picker. Later later in the week she spoke before the US House Financial Services Committee in Washington she seemed to tone down a bit her “stock picking” comments, but she nonetheless commented on the general valuation of the US stock market.

I am still critical about the idea that the Fed has a view at all on the valuation of the US stock market, but lets for a second forget that and instead address the issue of US stock market valuation. I am certainly no equity analyst and the normal disclaimer applies – this is not investment advice. This is an quasi-academic excise.

Last week Yellen said that in her assessment US asset values “aren’t out of line with norms“. Said in another way – the US stock market is basically fairly valued.

Equity strategists and investors have many different methods to evaluate stock market valuation. An often used method is what has become known as the so-called Fed-model (named by the legendary equity strategist Ed Yardeni).

An alternative Fed-model

The Fed-model basically says that there is a close historical relationship between the so-called earnings yield (the inverse of the P/E ratio) and US Treasury bond yields. While there certainly is good theoretical reason to discuss the model there is no doubt that over time the “model” as fitted the development in the US stock market fairly.

I will here use a slightly altered version of the Fed-model. Instead of using the earning yields I look at the ratio between on the one hand Private consumption expenditure (as a monthly proxy for nominal spending/NGDP) and stock prices (I use the Wilshire 5000 index here). I compare that not with US Treasury yields but instead with the yield on Aaa corporate bonds. I have “calibrated” my “earnings yield”  (PCE/Wilshire5000) so it is in January 1980 was exactly equal to the corporate bond yield. This obviously is an ad hoc assumption, but it ensures that the average “valuation” of the stock markets is more or less zero for the period since 1975.

The graph below shows that there is a quite close historical correlation between the “earnings yield” and the yield on US corporate bonds.

Fed model

We can show basically the same thing by looking at the Wilshire 5000 in level versus what I below call “fundamentals”. “Fundamentals” I here define as the ratio of Private Consumption Expenditure to the corporate bond yield. Also here I have calibrated the “model” so January 1980 is our “starting point”.

Wilshare 5000

Both graphs above illustrate Yellen’s argument that stocks are not overvalued. In fact US stock prices exactly seem to reflect “fundamentals” – at least if we use my version of the Fed-model.

There is no bubble – it is easy to explain what have happened since 2009  

Some central bankers and a lot of internet-Austrians are eager to claim that the development in stock prices since 2009 in some way reflect monetary policy “manipulation” of the stock market. Obviously we cannot understand the development in stock prices without understanding monetary policy, but there is nothing “unnatural” about what have happened and as the graphs above illustrates it doesn’t really look like there is a US stock market bubble.

In fact we can use the Fed-model to explain the development in stock prices fairly well since Wilshire 5000 hit rock bottom in 2009. Since then Private Consumption Expenditure has rebounded and Corporate bond yields have come down. Both factors are obviously bullish for stock prices according to my adjusted Fed-model. Furthermore, stocks became significantly undervalued in 2008-9 and this in fact seems to most important in terms of the stock market valuation.

Looking at the adjusted Fed-model Wilshire 5000 is now basically at “fair value” levels. So going forward we need either to see Private Consumption Expenditure to increase or Corporate bond yields to drop to see further (fundamentally driven) stock market gains.

I should again stress that this is not the work of an equity strategist and I am not providing investment advice here. My only concern is to discuss whether or not we can say that actions from the Federal Reserve have manipulated stock prices in such away that we can say there is a bubble in the US stock market.

 The stock market has reached “a permanently high plateau” – until the Fed once again mess up things…

Famously Irving Fisher shortly before the stock market crashed in 1929 announced that the US stock market had reached “a permanently high plateau”. I might be repeating this mistake by argueing that we are now basically trading at “fair value” levels for the US stock. So let me hedge my position (quite) a bit – unless the Federal Reserve will make another policy mistake then US stocks are at a permanently high plateau. Other central banks like the PBoC or the ECB might also very well mess up things.

And yes monetary policy failure is the biggest risk at the moment as I see it. The US economy is in recovery, stock prices continue to inch up and financial market volatility is low.

Why? Exactly because monetary policy in the US in general has returned to what Bob Hetzel has called a Lean-Against-the-Wind with credibility-regime. While Fed policy is far from perfect we broadly-speaking can say the Fed has returned to a (quasi) rule-based monetary policy where the markets in general are able to predict changes to the monetary policy stance. If anything the Fed is probably expected to deliver 4% nominal GDP growth – and this is exactly what the Fed has done in recent years.

However, if the Fed for some reason where to change cause (or change the implicit target) for example because it is becoming preoccupied with asset prices as in 1928-29 we could see the Fed trigger a negative shock to the US economy and that surely would send the US stock market down.

The Fed should certainly not worry about stock market valuation, but if it delivers a stable and predictable monetary policy regime then it will also create the best environment for a stable development in stock markets. In fact a predictable and strictly rule based monetary policy would make it extremely boring to be an equity strategist…

Stock picker Janet Yellen

If you are looking for a new stock broker look no further! This is Fed chair Janet Yellen at her testimony in the US Senate yesterday:

“Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

This is quite unusual to say the least that the head of most powerful central bank in the world basically is telling investors what stocks to buy and sell.

Unfortunately it seems to part of a growing tendency among central bankers globally to be obsessing about “financial stability” and “bubbles”, while at the same time increasingly pushing their primary nominal targets in the background. In Sweden an obsession about household debt and property prices has caused the Riksbank to consistently undershot its inflation target. Should we now start to think that the Fed will introduce the valuation of biotech and social media stocks in its reaction function? Will the Fed tighten monetary policy if Facebook stock rises “too much”? What is Fed’s “price target” in Linkedin?

I believe this is part of a very unfortunate trend among central bankers around the world to talk about monetary policy in terms of “trade-offs”. As I have argued in a recent post in the 1970s inflation expectations became un-anchored exactly because central bankers refused to take responsibility for providing a nominal anchor and the excuse was that there are trade-offs in monetary policy – “yes, we can reduce inflation, but that will cause unemployment to increase”.

Today the excuse for not providing a nominal anchor is not unemployment, but rather the perceived risk of “bubbles” (apparently in biotech and social media stocks!)  The result is that inflation expectations again are becoming un-anchored – this time the result, however, is not excessively high inflation, but rather deflation. The impact on the economy is, however, the same as the failure to provide a nominal anchor will make the working of the price system less efficient and therefore cause a general welfare lose.

I am not arguing that there is not misallocation of credit and capital. I am just stating that it is not a task for central banks to deal with these problems. In think that moral hazard problems have grown significantly since 2008 – particularly in Europe. Therefore governments and international organisations like the EU and IMF need to reduce implicit and explicit guarantees and subsidies to (other) governments, banks and financial institutions to a minimum. And central banks should give up credit policies and focus 100% on monetary policy and on providing a nominal anchor for the economy and leave the price mechanism to allocate resources in the economy.

Immigration is saving the US economy – some telling graphs

Apparently monetary theory is not sexy – or at least when I write about something else than monetary issues then I get more comments and activity on my blog than when I focus on what I really care about (monetary policy as you know…)

Recently I wrote a piece on why I think the best immigration policy is “Open Borders” and that got a bit of attention and interestingly enough some of my readers who normally tend to agree with me – disagreed with me.

I do not exactly seek controversy (some would say I do), but I simply have to write another post on immigration. Bloomberg chief economist Mike McDonough yesterday shared some very interesting graphs on Twitter on the demographic outlook for Japan, China and the US.

The graphs are extremely telling – while Japan and China are facing sharply declining work age populations in the coming decades the US is likely to more or less maintain its present demographic structure.

Demographics

Joe Weisenthal at the Businessinsider explains how this is possible:

The best looking, really, is the US, which has a nice evenly distributed population. The shape of the pyramid isn’t changing much, in part because our immigration policy keeps the population from getting too old.

Joe is of course right – the US is still attracting people from all around the world to come to the US to work and live and my bet (and hope) is that that will continue to be the case in the future. Immigration is part of the American success story and will continue to be so for decades to come.

PS I am in London today speaking at the CAMP Alphaville. I am on a panel on “Central banks and their jedi mind tricks”  (they stole that title from Matt O’Brien) with Lorcan Roche Kelly, Josh Ryan-Collins and Paul Woolley. The Session starts at 12.30pm London time (so I better get moving…)

HT Niels Westy

 

Sticking to its Knitting: Central bankers should forget about “financial stability”

These days central bankers seem more concerned about “financial stability” than ever before – and even more concerned about financial stability than nominal stability. These things go in cycles. After 1929 central bankers became terribly concerned about financial stability. Then again in the 1990s after the Mexican crisis in 1994 and the Asian crisis in 1997 and then after the bursting of the “IT bubble” in 2001.

But should central bankers really concern themselves with “financial stability” as a monetary policy goal? The great David Laidler gave the answer in a paper 10 years ago – This is from the abstract to “Sticking to its Knitting”:

It has become painfully evident that low inflation is not, in and of itself, sufficient to guarantee overall stability to the financial system. The bursting of the high-tech stock market bubble of the late 1990s in North America is sufficient evidence of this, but there were echoes here of the collapse of Japan’s bubble economy at the beginning of the decade, and even of the stock market crash of 1929 that marked the onset of the Great Depression of the 1930s. All of these episodes occurred at time when inflation was low and stable. At the same time, the Bank of Canada’s success in controlling inflation has been matched in many countries, to the point that monetary policy appears almost routine.

This combination of circumstances has led to a new interest in financial stability among central bankers, and a debate is beginning about what they might do to enhance it. No serious commentator is suggesting that inflation targeting should be abandoned for more ambitious goals, but there are those who suggest that existing regimes ought to be modified at least to the point of taking more notice of asset price behaviour, and others who argue that, sometimes it might be appropriate to trade off a little short term inflation stability in order to pre-empt financial market problems before they become acute.

This Commentary argues that monetary policy makers should think several times before becoming more ambitious in their goals. It notes that central banks already have all the powers they need to prevent financial market collapses getting out of hand in the wake of asset-price bubbles. In their role as lenders of last resort, they can and should be ready to provide ample liquidity to markets in such circumstances, measures which the Bank of Japan failed to take in the early 1990s. The Bank of Canada should stick to the single basic task of targeting inflation, while always holding lender-of-last-resort powers in reserve.

The Riksbank’s Stefan Ingves and the Bank of England’s Mark Carney should read David’s paper before talking more about macroprudential instruments and credit bubbles.

HT David Laidler

PS Tomorrow I will be speaking at the Financial Times’s CAMP Alphaville conference. See the programme here.

The Fisher-Hetzel Standard: A much improved “gold standard”

Anybody who follow my blog will know that I am not a great fan of the gold standard or any other form of fixed exchange rate policy. However, I am a great fan of policy rules that reduce monetary policy discretion to an absolute minimum.

Central bankers’ discretionary powers should be constrained and I fundamentally share Milton Friedman’s ideal that the central bank should be replaced by a “computer” – an automatic monetary policy rule.

Admittedly a gold standard or for that matter a currency board set-up reduce monetary policy discretion to a minimum. However, the main problem in my view is that different variations of a fixed exchange rate regime tend to be pro-cyclical. Imagine for example that productivity growth picks up for whatever reason (for example deregulation or a wave of new innovations).

That would tend to push the country’s currency stronger. However, as the central bank is keeping the currency pegged a positive supply shock will cause the central bank to “automatically” increase the money base to offset the appreciation pressures (from the positive supply shock) on the currency.

Said in another way under any form of pegged exchange rate policy a supply shock leads to an “automatic” demand shock. A gold standard will stabilize the currency, but might very well destabilize the economy.

Hence, the problem with a traditional gold standard is not that it is rule based, but that the rule is the wrong rule. We want a rule that provides nominal stability – not a rule, which is pro-cyclical.

Merging Fisher and Hetzel

Irving Fisher more than a 100 years ago came up with a good alternative to the gold standard – his so-called Compensated Dollar Plan. Fisher’s idea was that the Federal Reserve – he was writing from a US perspective – basically should keep the US price level stable by devaluing/revaluing the dollar against the gold price dependent on whether the price level was above or below the targeted level. This would be a fully automatic rule and it would ensure nominal stability. The problem with the rule, however, is that it not necessarily was forward-looking.

I suggest that we can “correct” the problems with Compensated Dollar Plan by learning a lesson from Bob Hetzel. Has I have explained in my earlier blog post Bob Hetzel has suggested that the central bank should target market expectations for inflation based on inflation-linked bonds (in the US so-called TIPS).

Now imagine that we that we merge the ideas of Fisher and Hetzel. So our intermediate target is the gold price in dollars and our ultimate monetary policy goal is for example 2-year/2-year break-even inflation at for example 2%.

Under this Fisher-Hetzel Standard the Federal Reserve would announce that it would buy or sell gold in the open market to ensure that 2-year/2-year break-even inflation is always at 2%. If inflation expectations for some reason moves above 2% the Fed would sell gold and buy dollars.

By buying dollars the Fed automatically reduces the money base (and import prices for that matter). This will ultimately lead to lower money supply growth and hence lower inflation. Similarly if inflation expectations drop below 2% the Fed would sell dollar (print more money), which would cause actual inflation to increase.

One could imagine that the Fed implemented this rule by at every FOMC meeting – instead of announcing a target for the Fed funds rate – would announce a target range for the dollar/gold price. The target range could for example be +/- 10% around a central parity. Within this target range the dollar (and the price of gold) would fluctuate freely. That would allow the market to do most of the lifting in terms of hitting the 2% (expected) inflation target.

Of course I would really like something different, but…

Obviously this is not my preferred monetary policy set-up and I much prefer NGDP level targeting to any form of inflation targeting.

Nonetheless a Fisher-Hetzel Standard would first of all seriously reduce monetary policy discretion. It would also provide a very high level of nominal stability – inflation expectations would basically always be 2%. And finally we would completely get rid of any talk about using interest rates as an instrument in monetary policy and therefore all talk of the liquidity trap would stop. And of course there would be no talk about the coming hyperinflation due to the expansion of the money base.

And no – we would not “manipulate” any market prices – at least not any more than in the traditional gold standard set-up.

Now I look forward to hearing why this would not work. Internet Austrians? Gold bugs? Keynesians?

PS I should say that this post is not part of my series on Bob Hetzel’s work and Bob has never advocated this idea (as far as I know), but the post obviously has been inspired by thinking about monetary matters from a Hetzelian perspective – as most of my blog posts are.

PPS Obviously you don’t have to implement the Fisher-Hetzel Standard with the gold price – you can use whatever commodity price or currency.

Bob Hetzel’s great idea

As I have promised earlier I will in the coming weeks write a number of blog posts on Robert Hetzel’s contribution to monetary thinking celebrating that he will turn 70 on July 3. Today I will tell the story about what I regard to be Bob’s greatest and most revolutionary idea. An idea which I think marks the birth of Market Monetarism.

I should in that regard naturally say that Bob doesn’t talk about himself as market monetarist, but simply as a monetarist, but his ideas are at the centre of what in recent years has come to be known at Market Monetarism (I coined the phrase myself in 2011).

Here is how Bob describes his great idea in his book “The Monetary Policy of the Federal Reserve”:

“In February 1990, Richmond Fed President Robert Black testified before Congress on Representative Stephen Neal’s Joint Resolution 4009 mandating that the Fed achieved price stability with five years. Bob Black was a monetarist, and he recommend multiyear M2 targets. As an alternative, I had suggested Treasury issuance of matched-maturity securities half of which would be nominal and half indexed to the price level.  The yield difference, which would measure expected inflation, would be a nominal anchor provided that the Fed committed to stabilizing it.

The idea came from observing how exchange-rate depreciation in small open economies constrained central banks because of the way it passed through immediately to domestic inflation. With a market measure of expected inflation, monetary policy seen by markets as inflationary would immediately trigger an alarm even if inflation were slow to respond. I mentioned my proposal to Milton Friedman, who  encouraged me to write a Wall Street Journal op-ed piece, which became Hetzel (1991).”

Bob developed his idea further in a number of papers published in the early 1990s. See for example here and here.

I remember when I first read about Bob’s idea I thought it was brilliant and was fast convinced that it would be much preferable to the traditional monetarist idea of money supply targeting. Milton Friedman obviously for decades advocated money supply targeting, but he also became convinced that Bob’s idea was preferable to his own idea.

Hence, in Friedman’s book Money Mischief (1992) he went on to publicly endorse Bob’s ideas. This is Friedman:

“Recently, Robert Hetzel has made an ingenious proposal that may be more feasible politically than my own earlier proposal for structural change, yet that promises to be highly effective in restraining inflationary bias that infects government…

…a market measure of expected inflation would make it possible to monitor the Federal Reserve’s behavior currently and to hold it accountable. That is difficult at present because of the “long lag” Hetzel refers to between Fed’s actions and the market reaction. Also, the market measure would provide the Fed itself with information to guide its course that it now lacks.”

In a letter to then Bank of Israel governor Michael Bruno in 1991 Friedman wrote (quoted from Hetzel 2008):

“Hetzel has suggested a nominal anchor different from those you or I may have considered in the past…His proposal is…that the Federal Reserve be instructed by Congress to keep that (nominal-indexed yield) difference below some number…It is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply. Clearly it is far better than a price level anchor which…is always backward looking.”

The two versions of Bob’s idea

It was not only Friedman who liked Hetzel’s ideas. President Clinton’s assistant treasury secretary Larry Summers also liked the idea – or at least the idea about issuing bonds linked to inflation. This led the US Treasury to start issuing so-called Treasury Inflation Protected Securities (TIPS) in 1997. Since then a number of countries in the world have followed suit and issued their own inflation-linked bonds (popularly known as linkers).

However, while Bob succeed in helping the process of issuing inflation-linked bonds in the US he was less successfully in convincing the Fed to actually use market expectations for inflation as a policy goal.

In what we could call the strict version of Bob’s proposal the central bank would directly target the market’s inflation expectations so they always were for example 2%. This would be a currency board-style policy where monetary policy was fully automatic. Hence, if market expectations for, for example inflation two years ahead were below the 2% target then the central bank would automatically expand the money base – by for example buying TIPS, foreign currency, equities or gold for that matter. The central bank would continue to expand the money base until inflation expectations had moved back to 2%. The central bank would similarly reduce the money base if inflation expectations were higher than the targeted 2%.

In this set-up monetary policy would fully live up to Friedman’s ideal of replacing the Fed with a “computer”. There would be absolutely no discretion in monetary policy. Everything would be fully rule based and automatic.

In the soft version of Bob’s idea the central bank will not directly target market inflation expectations, but rather use the market expectations as an indicator for monetary policy. In this version the central bank would likely also use other indicators for monetary policy – for example money supply growth or surveys of professional forecasters.

One can argue that this is what the Federal Reserve was actually doing from around 2000-3 to 2008. Another example of a central bank that de facto comes close to conducting monetary policy in way similar to what has been suggested by Hetzel is the Bank of Israel (and here there might have been a more or less direct influence through Bruno, but also through Stanley Fisher and other University of Chicago related Bank of Israel officials). Hence, for more than a decade the BoI has communicated very clearly in terms of de facto targeting market expectations for inflation and the result has been a remarkable degree of nominal stability (See here).

Even in the soft version it is likely that the fact that the central bank openly is acknowledging market expectations as a key indicator for monetary policy will likely do a lot to provide nominal stability. This is in fact what happened in the US – and partly in other places during the 2000s – until everything when badly wrong in 2008 and inflation expectations were allowed to collapse (more on that below).

Targeting market expectations and the monetary transmission mechanism

It is useful when trying to understand the implications of Bob’s idea to target the market expectations for inflation to understand how the monetary transmission mechanism would work in such a set-up.

As highlighted above thinking about fixed exchange rate regimes gave Bob the idea to target market inflation expectations, and fundamentally the transmission mechanism under both regimes are very similar. In both regimes both money demand and the money supply (both for the money base and broad money) become endogenous.

Both money demand and the money supply will automatically adjust to always “hit” the nominal anchor – whether the exchange rate or inflation expectations.

One thing that is interesting in my view is that both in a fixed exchange rate regime and in Bob’s proposal the actual implementation of the policy will likely happen through adjustments in money demand - or said in another way the market will implement the policy. Or that will at least be the case if the regime is credible.

Lets first look at a credible fixed exchange regime and lets say that for some reason the exchange rate is pushed away from the central bank’s exchange rate target so the actual exchange rate is stronger than the targeted rate. If the target is credible market participants will know that the central bank will act – intervene in the currency market to sell the currency – so to ensure that in the “next period” the exchange rate will be back at the targeted rate.

As market participants realize this they will reduce their currency holdings and that in itself will push back the exchange rate to the targeted level. Hence, under 100% credibility of the fixed exchange rate regime the central bank will actually not need to do any intervention to ensure that the peg is kept in place – there will be no need to change the currency reserve/money base. The market will effectively ensure that the pegged is maintained.

The mechanism is very much the same in a regime where the central bank targets the market’s inflation expectations. Lets again assume that the regime is fully credible. Lets say that the central bank targets 2% inflation (expectations) and lets assume that for some reason a shock has pushes inflation expectations above the 2%.

This should cause the central bank to automatically reduce the money base until inflation expectations have been pushed back to 2%. However, as market participants realize this they will also realize that the value of money (the inverse of the price level) will increase – as the central bank is expected to reduce the money base. This will cause market participants to increase money demand. For a given money base this will in itself push down inflation until the 2% inflation expectations target is meet.

Hence, under full credibility the central bank would not have to do a lot to implement its target – either a fixed exchange rate target or a Hetzel style target – the markets would basically take care of everything and the implementation of the target would happen through shifts in money demand rather than in the money base. That said, it should of course be noted that it is exactly because the central bank has full control of the money base and can always increase or decrease it as much as it wants that the money demand  taking care of the actual “lifting” so the central bank don’t actually have to do much in terms of changing the money base.

This basically means that the money base will remain quite stable while the broad money supply/demand will fluctuate – maybe a lot – as will money-velocity. Hence, under a credible Hetzel style regime there will be a lot of nominal stability, but it will look quite non-monetarist if one think of monetarism of an idea to keep money supply growth stable. Obviously there is nothing non-monetarist about ensuring a stable nominal anchor. The anchor is just different from what Friedman – originally – suggested.

Had the Fed listened to Bob then there would have been no Great Recession

Effectively during the Great Moderation – or at least since the introduction of TIPS in 1997 – the world increasingly started to look as if the Federal Reserve actually had introduced Bob’s proposal and targeted break-even inflation expectations (around 2.5%). The graph below illustrates this.

BE inflation

The graph shows that from 2004 to 2008 we see that the 5-year “break-even” inflation rate fluctuated between 2 and 3%. We could also note that we during that period also saw a remarkable stable growth in nominal GDP growth. In that sense we can say that monetary policy was credible as it ensured nominal stability – defined as stable inflation expectations.

However, in 2008 “something” happened and break-even inflation expectations collapsed. Said, in another way – the Fed’s credibility broke down. The markets no longer believed that the Fed would be able to keep inflation at 2.5% going forward. Afterwards, however, one should also acknowledge that some credibility has returned as break-even inflation particularly since 2011 has been very stable around 2%. This by the way is contrary to the ECB – as euro zone break-even inflation on most time horizons is well-below the ECB’s official 2% inflation target.

While most observers have been arguing that the “something”, which happened was the financial crisis and more specifically the collapse of Lehman Brothers Market Monetarists – and Bob Hetzel – have argued that what really happened was a significant monetary contraction and this is very clearly illustrated by the collapse in inflation expectations in 2008.

Now imagine what would have happened if the Fed had implemented what I above called the strict version of Bob’s proposal prior to the collapse of Lehman Brother. And now lets say that Lehman Brothers collapses (out of the blue). Such a shock likely would cause a significant decline in the money-multiplier and a sharp decline in the broad money supply and likely also a sharp rise in money demand as investors run away from risky assets.

This shock on its own is strongly deflationary – and if the shock is big enough this potentially could give a shock to the Fed’s credibility and therefore we initially could see inflation expectations drop sharply as we actually saw in 2008.

However, had Bob’s regime been in place then the Fed would automatically have moved into action (not in a discretionary fashion, but following the rule). There would not have been any discussion within the FOMC whether to ease monetary policy or not. In fact there would not be a need for a FOMC at all – monetary policy would be 100% automatic.

Hence, as the shock hits and inflation expectations drop the Fed would automatically – given the rule to target for example 2.5% break-even inflation expectations – increase the money base as much as necessary to keep inflation expectations at 2.5%.

This would effectively have meant that the monetary consequences of Lehman Brothers’ collapse would have been very limited and the macroeconomic contraction therefore would have been much, much smaller and we would very likely not have had a Great Recession. In a later blog post I will return to Bob’s explanation for the Great Recession, but as this discussion illustrates it should be very clear that Bob – as I do – strongly believe that the core problem was monetary disorder rather than market failure.

Hetzel and NGDP targeting

There is no doubt in my mind that the conduct of monetary policy would be much better if it was implemented within a market-based set-up as suggested by Robert Hetzel than when monetary policy is left to discretionary decisions.

That said as other Market Monetarists and I have argued that central banks in general should target the nominal GDP level rather than expected inflation as originally suggested by Bob. This means that we – the Market Monetarists – believe that governments should issue NGDP-linked bonds and that central banks should use NGDP expectations calculated from the pricing of these bonds.

Of course that means that the target is slightly different than what Bob originally suggested, but the method is exactly the same and the overall outcome will likely be very similar whether one or the other target is chosen if implemented in the strict version, where the central bank effectively would be replaced by a “computer” (the market).

In the coming days and weeks I will continue my celebration of Robert Hetzel. In my next Hetzel-post I will look at “Bob’s model” and I will try to explain how Bob makes us understand the modern world within a quantity theoretical framework.

PS I should say that Bob is not the only economist to have suggested using markets and market expectations to implement monetary policy and to ensure nominal stability. I would particularly highlight the proposals of Irving Fisher (the Compensated Dollar Plan), Earl Thompson (nominal wage targeting “The Perfect Monetary System”) and of course Scott Sumner (NGDP targeting).

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Suggested further reading:

I have in numerous early posts written about Bob’s suggestion for targeting market inflation expectations. See for example here:

A few words that would help Kuroda hit his target
How to avoid a repeat of 1937 – lessons for both the fed and the BoJ
The cheapest and most effective firewall in the world

Sumner, Nunes and Christensen in London

Scott Sumner has been speaking at the Adam Smith Institute tonight. I had the honour to introduce Scott. Adam Smith Institute will surely post Scott’s presentation soon.

Here is, however, a historical picture. Three market monetarist bloggers and Adam Smith in a picture together: Scott Sumner, Marcus Nunes and myself.

Smith

An economist’s take on Brazil-Croatia – completely as expected

I just watched the opening match of the football World Cup between Brazil and Croatia. The model I helped develop with my colleagues in Danske Bank forecasted that Brazil would win by two goals. The model turned out to be right – Brazil won 3-1.

For the football commentators the match was a disappointment. Brazil didn’t play well and the referee seemed to have given a penalty – undeservingly – to Brazil. However, for the economist there was nothing surprising about the outcome.

Our World Cup model told us three things. 1) Brazil was a massive favourite. 2) Brazil’s Neymar would be important (we estimate his importance would be around +0.3 goals per match) and 3) the home-field advantage for Brazil would be +1 goal.

Neymar scored two goal and the home-field was clearly important (the referee was not exactly hostile to Brazil)-

So for now I can say – I told you so.

Luckily football is mostly about chance. So there is a good chance that we will be wrong in the next couple of matches.

PS most football commentators would say that Brazil disappointed and that Brazil therefore is less likely than previously thought. The economist would on the other hand notice that we now know that Brazil actually won today – compared to early were we didn’t know they would win.

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