An intra-European hot-pot effect

This morning I feel like qouting myself:

Over the past month, CEE and other non-euro European currencies have indeed been strengthening. This is ‘forcing’ central banks from the Swedish Riksbank to the Polish central bank to cut interest rates. So, we are getting a double effect of European monetary policy. The ECB is easing monetary policy, which on its own is stimulating Central and Eastern European growth through an export channel and at the same time the CEE central banks is moving towards further monetary easing, which is directly stimulating CEE domestic demand. This is good news for the CEE fixed income and equity markets particularly and for the CEE economies in general. As a result, we are becoming more upbeat on the outlook for growth in Poland, Hungary and the Czech Republic.

This is essentially what we call an intra-Europe hot-potato effect. The ECB is creating liquidity, some of which is spreading across Europe, like a hot potato being passed along. It is basically all part of a European portfolio rebalancing, combined with a monetary reaction in countries such as Poland.

We think this hot-potato effect will force CEE central banks to cut interest rates further to curb the appreciation of their currencies. This is likely to push the key policy rates of countries such as Poland, Hungary and Romania closer to the zero lower bound and, ultimately, this could force the central banks to use other policy instruments than the interest rate such as quantitative easing or currency intervention. The Czech Republic is already at the zero lower bound and the Czech central bank (CNB) has put a floor under EUR/CZK at 27. It has recently inched close to this floor and it is becoming increasingly likely that the CNB will be forced to intervene in the FX market to defend it. This is likely to cause increased focus on the underlying appreciation pressure on all of the CEE currencies.

And yes, this is an intra-European currency war and I believe it is good news for European growth. In a deflationary, slow growth scenario you should celebrate when central banks competie to ease monetary policy.

The Open Borders Manifesto

Today is Open Borders day. As I wholeheartedly believe in the free global movement of goods, capital and labour I encourage my readers to have a look at the Open Borders Manifesto.

This is from the Manifesto:

Freedom of movement is a basic liberty that governments should respect and protect unless justified by extenuating circumstances. This extends to movement across international boundaries.
International law and many domestic laws already recognise the right of any individual to leave his or her country…

We believe international and domestic law should similarly extend such protections to individuals seeking to enter another country…The border enforcement status quo is both morally unconscionable and economically destructive. Border controls predominantly restrict the movement of people who bear no ill intentions. Most of the people legally barred from moving across international borders today are fleeing persecution or poverty, desire a better job or home, or simply want to see the city lights.

The border status quo bars ordinary people from pursuing the life and opportunity they desire, not because they lack merit or because they pose a danger to others. Billions of people are legally barred from realising their full potential and ambitions purely on the basis of an accident of birth: where they were born. This is both a drain on the economic and innovative potential of human societies across the world, and indefensible in any order that recognises the moral worth and dignity of every human being.

We seek legal and policy reforms that will reduce and eventually remove these bars to movement for billions of ordinary people around the world…

How to choose a ”good” monetary regime

My recent trip to Iceland and my discussions there about the possible future changes to Iceland’s monetary regime have inspired me a great deal in terms of organising some of my views on monetary matters in general.

Market Monetarists are known for our advocacy of nominal GDP level targeting, but it is also well-known that we have argued this primarily for countries like the US or UK rather than as a “one-size-fits” all regime. In fact Scott Sumner again and again has stressed that he does not think NGDP targeting necessarily is fitting for small-open economies like Denmark or Hong Kong.

Similarly I have myself suggested other rules for small-open economies such as my suggestion that commodity exporting countries like Russia should peg the export exchange to the price of its main export. This of course is what I have termed an Export Price Norm (EPN).

Similarly while Milton Friedman generally favoured floating exchange rates he also noted that different variations of pegged exchange rate regimes might be preferable for certain countries. Friedman often highlighted the apparent success of Hong Kong’s currency board system as a good monetary regime.

One can of course see this as pragmatism or realism and I am sure Scott would have no problem with that. However, I would rather stress the crucial different between what we want to achieve with our choice of monetary regime and how we are trying to achieve it.

Towards a “good” monetary regime
In my presentations in Iceland I stressed that I don’t think there is such a thing as an “optimal” monetary policy regime. What is the best regime might change over time and between different countries depending on numerous factors.

Hence, the choice of monetary regime to some extent will have to be a purely empirical matter. We fore example can’t say a priori that floating exchange rates are preferable to pegged exchange rate regimes under all circumstances even though some of us tend to think that variations of floating exchange rates in general are preferable to fixed exchange rate regime.

However, I believe that we a priori can establish certain criterion for what outcome we would like see a certain monetary regime produce.

Overall, I believe that the overriding goal of the monetary regime must be to ensure the highest possible level of nominal stability.

I see nominal stability as a situation where the monetary regime does not generally distort the allocation of goods, labour and capital both across sectors and across different time periods. Hence, my ideal monetary regime is one that we can think of as “neutral” in the sense it does not impact relative prices in the economy.

This basically means that the monetary regime should ensure an outcome similar to a batter economy with no transaction costs – an outcome where Say’s Law rules or an outcome where we cannot make any Pareto improvements by adjusting or changing the monetary regime.

Furthermore, I would argue that a good monetary regime is transparent, predictable and well understood by the general public. Hence, rules are preferable to discretion as a general principle.

And finally the monetary regime should be robust. That implies that the risk of a “highjacking” or a politicization of the monetary system should be as small as possible. Hence, a certain regime might produce a good outcome today, but if the same regime tomorrow is likely to be taken over by certain political interests then we cannot say that the regime is “good”.

Furthermore, a robust monetary regime will ensure a “good” outcome under different shocks to the economy, changes in the political climate or even changes to political institutions. Therefore a regime cannot be said to be robust if it only “performance” well under demand shocks, but not under demand shocks or is overly sensitive to political uncertainty and crisis.

Finally, I would argue that a robust monetary regime is as little dependent on human judgement and data as possible. Hence, we can imagine a perfect monetary regime, which ensures an extremely high degree of nominal stability, but it can only be implemented by Alan Greenspan. Such a regime certainly would not be robust.

Concluding, a good monetary regime ensures a high degree of nominal stability, is transparent, predictable and is robust economically, political and institutionally.

It isn’t hard to see that no monetary regime will always be good across countries and time. Hence, I think that NGDP targeting regime as advocated by Market Monetarists would approximately be a “good” monetary regime for the US, but it would likely not work as well as alternatives in low-income countries with weak economic and political institutions.

Monetary regime trade-offs

The choice of monetary regime therefore ultimately is about trade-offs between how well different regimes “score” on the overall criterion for a “good” monetary regime.

Overall I have no doubt that two regimes – in the textbook form – can described as being “good” regimes and that is Free Banking and NGDP level targeting. Similarly I would argue that in the strict theoretical form inflation targeting and a fixed exchange rate regime cannot a priori be considered as being good monetary regimes as both regimes will distort relative prices and hence not ensure nominal stability.

However, these are textbook examples. In the real-world (an expression I hate…) we are facing the choice between imperfect systems. For example it is clear that a George Selgin style textbook Free Banking system would ensure nominal stability. However, we can also historical conclude that Free Banking systems have tended not to survive for long. Not because they didn’t ensure nominal stability – they to a large extent did – but they just didn’t turn out to be robust enough.

On the other hand some monetary regimes have been very robust even though they have been less optimal from a nominal stability perspective. The Danish pegged exchange regime, which essentially has been in place since 1982 has been very robust. It has survived numerous domestic and external shocks, financial crisis and political uncertainty. However, it is not hard to argue that at least in theory a NGDP targeting regime with a floating krone would give more nominal stability than the pegged exchange rate regime. But the crucial question is that if the improvement in terms of nominal stability is relative small would it then be worthwhile experimenting with more than 30 years of robust and high-predictable rule based monetary policy regime?

Finally and this is what got me to think more deeply about these issues is the experience with monetary policy in Iceland since the country became independent in 1944. Hence, Iceland has only have short periods of nominal stability, while we again and again have seen episodes of high inflation, banking crisis and general monetary and exchange rate instability.

Thinking about Iceland’s historical monetary dysfunctionality is increasingly leading me to think that there simply is a near-natural impossibility of ever ensuring nominal stability in Iceland as long as country maintains monetary sovereignty and the best way to solve this problem of lack of robustness in the monetary system would simply be to “outsource” the monetary regime – either by introducing a currency or even better through dollarization (for example by introducing the Canadian dollar or the Norwegian krone).

However, getting rid of monetary sovereignty in Iceland comes with a trade-off. Hence, by giving up the króna would likelu get less nominal stability on for example a textbook NGDP targeting regime.

However, by comparing a less than perfect dollarization regime for Iceland with a textbook NGDP targeting regime would be what Harold Demsetz termed a Nirvana Fallacy. Hence, Demsetz would have told us to choose between different economic institutions (here monetary regimes) based on real institutions arrangements rather than comparing an “ideal norm” and an “imperfect” regime.

Such a comparative-institutionalist approach would make us choose among imperfect alternatives – for example in the case of Iceland the present not very robust sovereign monetary regime and for example a regime with dollarization of some form.

Monetary revolution, monetary evolution and windows-of-opportunity

Such an approach also tends to make us more humble when we discuss different alternatives to real exiting monetary regimes. That does certainly not mean that the status quo is preferable. Far from it, however, it does mean that some times we should simply accept exiting monetary institutions and arrangements as the best we can get – at least until we get a window-of-opportunity to change things. Such window-of-opportunity could be economic, financial or political crisis or a change in political sentiment. In the case of Iceland I think that we might be approaching such a window-of-opportunity in the next couple of years.

So even though I feel somewhat uncomfortable with being this pragmatic and feel I sound like Hayek I will have to say that monetary evolution often will make more sense than monetary revolution.

However, that does not mean that we should not advocate change. We certainly should, but maybe it makes most sense to focus on ideas of monetary reform rather than throwing ourselves into discussions about minor changes in actually “calibration” of monetary policy in a given monetary set-up. Frankly speaking who cares whether the Federal Reserve should hike interest rates in May or in August? Isn’t the important question how we can change the monetary setting to ensure nominal stability for the longer run?

I remain a proud advocate of NGDP targeting, but I would like to think of NGDP targeting as a “ideal regime” that might or might not be possible to implement in different countries. We can hence, use NGDP targeting (and Free Banking) as a benchmark for both how present monetary policy is calibrated and as benchmark to compare different real-lift monetary institutions.

Differences in central banker pay illustrates why the euro is not an “optimal currency area”

Bloomberg has a great story on differences in the pay of different central bank governors within the euro area.

This graph is from the Bloomberg story:

cb pay

As the graph illustrates there is a massive difference between how much the different euro zone central bank governors are paid. These differences probably very well reflect the general differences in income levels within the euro area.

Normally we would say that a core condition for being a “Optimal Currency Area” is that the income (productivity) level of different countries/regions within the currency area should be on a fairly similar level. The pay differences of euro zone central bankers illustrates quite well that this core condition is not fulfilled within the euro area.

PS  This is from the Bloomberg story: “The economic turmoil has also crimped earnings at the Greek central bank. Governor Yannis Stournaras gets 7,342 euros a month after taxes following two rounds of voluntary cuts by his predecessor, by 20 percent and 30 percent.”

Merry Christmas

Dear friends and readers,

Christmas is family time – also in the Christensen family so this will be a short post.

I just want to thank all my loyal readers and followers for following and commenting on my blog (and following me on Twitter and Facebook).

It gives me lots of joy writing my blog and it is getting me in contact with interesting people from all over the world. I am grateful for that. For those of you who are celebrating Christmas these days I wish you a Merry Christmas.

See you all soon!

PS I have the same wish-list as George Selgin (just replace George’s “Bitdollar” protocol with a NGDP futures market and add a wish number 11 that I want the ECB to do this)

Christmas_tree

Importing monetary tightening – the case of Belarus

Everybody has been following events in the Russian markets this week, but fewer have kept an eye on Russia’s smaller neighbour Belarus, but the small country is seeing some serious contagion from Russia.

With the Belarusian rouble effectively pegged to the US dollar and the Russian rouble in a free fall speculation has been mounting in Belarus that the Belarusian rouble (BYR) could be devalued.

And then on Friday Belarusian central bank reacted to these pressures and hiked its key policy rate to 50%! Furthermore, the authorities tightened currency controls by imposing a 30 per cent tax on buying foreign currency.

Nothing is of course forcing the Belarusian authorities to do this other than the desire to keep the BYR pegged to the dollar. That commitment now means that we will get a very significant tightening of monetary conditions in Belarus and as nearly always when such a tightenning happens you will get a sharp drop in economic activity. Once again it seems like the Belarusian authorities are importing a crisis from Russia.

I am not saying that I am advocating a Belarusian devaluation, but it is also clear that given the huge dependence on Russia it is hard for Belarus to maintain a peg to the US dollar when the Russian rouble is in a free fall.

It looks like 2015 will be an “interesting” year for Belarus – we will have presidential elections in November 2015.

Commodity prices, currencies and monetary policy

It has been a busy year for me – it has especially been the Russian-Ukrainian crisis, which has kept me busy. However, I thought that this week would be fairly calm – I didn’t have any traveling planned, not a lot a meetings scheduled and I had not expected to be too busy.

However, things turned out very differently thanks to the spectacular collapse of the Russian rouble and a massive rate hike from the Russian central bank. After 15 years in the financial markets this is absolutely up there among the wildest things I have ever experienced.

So frankly speaking I am a bit tired and not really up to the task of writing a major blog post. However, I have a lot on my mind nonetheless so I want share a bit of that anyway.

First, in relationship to what have played out in the Russian markets recently I must say that I actually have been impressed with the Russian central bank. Yes, Monday’s 650bp rate hike in my clearly is a major policy mistake and the decision has brought more uncertainty and more financial distress rather than stability and the rate hike will just send the already badly damaged Russian economy into a even deeper recession.

But one have to see the actions of the Russian central bank in the light of political pressures the central bank is under and that is the reason I am impressed. Russian monetary policy is far from great, but other Emerging Markets central banks would probably have made significantly worse decisions in a similar political and financial environment.

Second, while Market Monetarists advocate NGDP level targeting we have been less outspoken on our support for (N)GDP-linked bonds (in fact I am not sure the other MM bloggers like NGDP linked bonds as much as I do). However, I think the logic of market monetarism also implies that we should be advocating that governments should issue bonds linked to nominal GDP.

This would not only be a useful tools for monitoring market expectations for NGDP growth, but equally it would be helpful in “synchronizing” fiscal policy with monetary policy in the sense that fiscal policy would be automatically eased then the NGDP target is undershot and tightened when the target is overshot. This would also be helpful for countries where monetary policy is in different ways restricted for example by a fixed exchange rate regime.

Third, the Russia crisis “story” and the topic of NGDP-linked bonds can be combined to a discussion of whether the Russian government should issue government bonds linked to oil prices – so when oil prices decline then debt servicing costs also decline.

Just imagine what that would have done to reduce Russian default worries in the present situation. And this of course is linked to my favourite monetary framework for commodity exporters – the Export Price Norm. Hence, had all Russian government debt been linked to oil prices and had the rouble been pegged to a basket of US dollar (80%) and oil prices (20%) then I believe there would have been a much less spectacular crisis in Russia right now.

I hope to return to all these topics in the coming weeks, but until then I want to draw my readers’ attention to a recent blog post by my friend “Hishamh” over at Economics Malaysia on the topic of Commodities and Currencies. Here is Hishamh:

There’s quite a bit of gloom in the air these last few weeks. The plunge in oil and other commodity prices, capital pulling out of emerging markets, and currency turmoil, have people getting very worried about growth prospects next year. There doesn’t appear to be a bottom yet on oil prices, and it’s anybody’s guess where all this will end up.

In Malaysia’s case, oil price depreciation and Ringgit depreciation seems like one piling on the other – the latter is making things worse (Malaysians feel relatively poorer), on top of the drop in oil and gas revenues. But conflating the two like this is wrong. The depreciation of the currency is in fact a required and necessary result of the drop in oil prices.

If the Ringgit had stayed where it had been (about MYR3.20-3.30 to the USD), the full drop in oil prices would have been transmitted directly and with full force into the domestic economy. The approximate 8% depreciation of the Ringgit over the past few months partially mitigates that income shock. Since sales of oil (and gas) are denominated in USD terms on the international markets, a cheaper Ringgit partially cushions the revenue drop in local currency terms.

Consider that oil & gas make up about 20% of Malaysian exports; commodities as a whole about a third. That means that the drop in oil prices and the depreciation of the Ringgit have been nearly symmetrical. If anything, the Ringgit hasn’t dropped far enough – my estimate is that it should be at least 3%-5% weaker.

…That suggests the last few months currency action has largely been a USD movement rather than weakness in the MYR.

There’s also the flip side that the lower Ringgit should in theory provide a boost to non-commodity exports. In this case though, I’m a bit leery of depending on this as global demand growth outside the US and UK is pretty weak, and because again this is largely a case of Dollar strength more than Ringgit weakness.

…Some have been interpreting …central bank intervention to support the Ringgit value…My view is a little more nuanced – the drop in reserves is just too small to make that conclusion.

Contrasted with the pegged FX regime of the early ‘00s, reserve movements over the past four years are just too minor to affect the FX market. Rather, what I think is going on here is that BNM is simply trying to ensure that there’s enough USD (and other currency) liquidity in the interbank market to ensure, in their words, “orderly” market conditions.

…The bottom line is that BNM is not and will not be “defending” any level of the Ringgit. And if they’re not willing to spend reserves on it, you can forget the interest rate defense (which doesn’t work anyway).

Said in another way – the Malaysian central bank (BNM) has moved closer to my ideal of an Export Price Norm and that is benefiting the Malaysian economy. This is in fact what I suggested back in 2012 that the BNM should do.

 

H. L. Mencken on the Russian central bank

 H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”

See also here – What the Turkish central bank did a year ago the Russian central bank is doing today. Not good.

HT Josh

Turning the Russian petro-monetary transmission mechanism upside-down

Big news out of Moscow today – not about the renewed escalation of military fighting in Eastern Ukraine, but rather about Russian monetary policy. Hence, today the Russian central bank (CBR) under the leadership of  Elvira Nabiullina effectively let the ruble float freely.

The CBR has increasing allowed the ruble to float more and more freely since 2008-9 within a bigger and bigger trading range. The Ukrainian crisis, negative Emerging Markets sentiments and falling oil prices have put the ruble under significant weakening pressures most of the year and even though the CBR generally has allowed for a significant weakening of the Russian currency it has also tried to slow the ruble’s slide by hiking interest rates and by intervening in the FX market. However, it has increasingly become clear that cost of the “defense” of the ruble was not worth the fight. So today the CBR finally announced that it would effectively float the ruble.

It should be no surprise to anybody who is reading my blog that I generally think that freely floating exchange rates is preferable to fixed exchange rate regimes and I therefore certainly also welcome CBR’s decision to finally float the ruble and I think CBR governor Elvira Nabiullina deserves a lot of praise for having push this decision through (whether or not her hand was forced by market pressures or not). Anybody familiar with Russian economic-policy decision making will know that this decision has not been a straightforward decision to make.

Elvira has turned the petro-monetary transmission mechanism upside-down

The purpose of this blog post is not necessarily to specifically discuss the change in the monetary policy set-up, but rather to use these changes to discuss how such changes impact the monetary transmission mechanism and how it changes the causality between money, markets and the economy in general.

Lets first start out with how the transmission mechanism looks like in a commodity exporting economy like Russia with a fixed (or quasi fixed) exchange rate like in Russia prior to 2008-9.

When the Russian ruble was fixed against the US dollar changes in the oil price was completely central to the monetary transmission – and that is why I have earlier called it the petro-monetary transmission mechanism. I have earlier explained how this works:

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).

This effectively means that in such a set-up the CBR will have given up monetary sovereignty and instead will “import” monetary policy via the oil price and the exchange rate. In reality this also means that the global monetary superpower (the Fed and PBoC) – which to a large extent determines the global demand for oil indirectly will determine Russian monetary conditions.

Lets take the case of the People’s Bank of China (PBoC). If the PBoC ease monetary policy – increase monetary supply growth – then it will increase Chinese demand for oil and push up oil prices. Higher oil prices will push up currency inflows into Russia and will cause appreciation pressure on the ruble. If the ruble is pegged then the CBR will have to intervene to keep the ruble from strengthening. Currency intervention of course is the same as sell ruble and buying foreign currency, which equals an increase in the Russian money base/supply. This will push up Russian nominal GDP growth.

Hence, causality runs from the monetary policy of the monetary superpowers – Fed and the PBoC – to Russian monetary policy as long as the CBR pegs or even quasi-peg the ruble. However, the story changes completely when the ruble is floated.

I have also discussed this before:

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.

If today’s announced change in monetary policy set-up in Russia is taken to be credible (it is not necessary) then it would mean the completion of the transformation of the monetary transmission which essentially was started in 2008 – moving from a pegged exchange/manage float regime to a floating exchange rate.

This will also means that the CBR governor Elvira Nabiullina will have ensured full monetary sovereignty – so it will be her rather than the Federal Reserve and the People’s Bank of China, who determines monetary conditions in Russia.

Whether this will be good or bad of course fully dependent on whether Yellen or Nabiullina will conduct the best monetary policy for Russia.

One can of course be highly skeptical about the Russian central bank’s ability to conduct monetary policy in a way to ensure nominal stability – there is certainly not good track record, but given the volatility in oil prices it is in my view also hard believe that a fully pegged exchange rate would bring more nominal stability to the Russian economy than a floating exchange rate combined with a proper nominal target – either an inflation target or better a NGDP level target.

Today Elvira Nabiullina has (hopefully) finalized the gradual transformation from a pegged exchange to a floating exchange rate. It is good news for the Russian economy. It will not save the Russia from a lot of other economic headaches (and there are many!), but it will at least reduce the risk of monetary policy failure.

PS I still believe that the Russian economy is already in recession and will likely fall even deeper into recession in the coming quarters.

 

 

Time for the Fed to introduce a forward-looking McCallum rule

Earlier this week Boston Fed chief Eric Rosengreen in an interview on CNBC said that the Federal Reserve could introduce a forth round of quantitative easing – QE4 – since the beginning of the crisis in 2008 if the outlook for the US economy worsens.

I have quite mixed emotions about Rosengreen’s comments. I would of course welcome an increase in money base growth – what the Fed and others like to call quantitative easing – if it is necessary to ensure nominal stability in the US economy.

However, the way Rosengreen and the Fed in general is framing the use of quantitative easing in my view is highly problematic.

First of all when the fed is talking about quantitative easing it is speaking of it as something “unconventional”. However, there is nothing unconventional about using money base control to conduct monetary policy. What is unconventional is actually to use the language of interest rate targeting as the primary monetary policy “instrument”.

Second, the Fed continues to conduct monetary policy in a quasi-discretionary fashion – acting as a fire fighter putting out financial and economic fires it helped start itself.

The solution: Use the money base as an instrument to hit a 4% NGDP level target

I have praised the Fed for having moved closer to a rule based monetary policy in recent years, but the recent escalating distress in the US financial markets and particularly the marked drop in US inflation expectations show that the present monetary policy framework is far from optimal. I realize that the root of the recent distress likely is European and Chinese rather than American, but the fact that US inflation expectations also have dropped shows that the present monetary policy framework in the US is not functioning well-enough.

I, however, think that the Fed could improve the policy framework dramatically with a few adjustments to its present policy.

First of all the Fed needs to completely stop thinking about and communicating about its monetary stance in terms of setting an interest rate target. Instead the Fed should only communicate in terms of money base control.

The most straightforward way to do that is that at each FOMC meeting a monthly growth rate for the money base is announced. The announced monthly growth rate can be increased or decreased at every FOMC-meeting if needed to hit the Fed’s ultimate policy target.

Using “the” interest rate as a policy “instrument” is not necessarily a major problem when the “natural interest rate” for example is 4 or 5%, but if the natural interest rate is for example 1 or 2% and there is major slack in the economy and quasi-deflationary expectations then you again and again will run into a problem that the Fed hits the Zero Lower Bound everything even a small shock hits the economy. That creates an unnecessary degree of uncertainly about the outlook for monetary policy and a natural deflationary bias to monetary policy.

I frankly speaking have a hard time understanding why central bankers are so obsessed about communicating about monetary policy in terms of interest rate targeting rather than money base control, but I can only think it is because their favourite Keynesian models – both ‘old’ and ‘new’ – are “moneyless”.

I have earlier argued that the Fed since the summer of 2009 effectively has target 4% nominal GDP growth (level targeting). One can obviously argue that that has been too tight a monetary policy stance, but we have now seen considerable real adjustments in the US economy so even if the US economy likely could benefit from higher NGDP growth for a couple of year I would pragmatically suggest that the time has come to let bygones-be-bygones and make a 4% NGDP level target an official Fed target.

Alternatively the Fed could once every year announce its NGDP target for the coming five years based on an estimate for potential real GDP growth and the Fed’s 2% inflation target. So if the Fed thinks potential real GDP growth in the US in the coming five years is 2% then it would target 4% NGDP growth. If it thinks potential RGDP growth is 1.5% then it would target 3.5% growth.

However, it is important that the Fed targets a path level rather than the growth rate. Therefore, if the Fed undershoots the targeted level one year it would have to bring the NGDP level back to the targeted level as fast as possible.

Finally it is important to realize that the Fed should not be targeting the present level of NGDP, but rather the future level of NGDP. Therefore, when the FOMC sets the monthly growth rate of the money base it needs to know whether NGDP is ‘on track’ or not. Therefore a forecast for future NGDP is needed.

The way I – pragmatically – would suggest the FOMC handled this is that the FOMC should publish three forecasts based on three different methods for NGDP two years ahead.

The first forecast should be a forecast prepared by the Fed’s own economists.

The second forecast should be a survey of professional forecasts.

And finally the third forecast should be a ‘market forecast’. Scott Sumner has of course suggested creating a NGDP future, which the Fed could target or use as a forecasting tool. This I believe would be the proper ‘market forecast’. However, I also believe that a ‘synthetic’ NGDP future can relatively easily be created with a bit of econometric work and the input from market inflation expectations, the US stock market, a dollar index and commodity prices. In fact it is odd no Fed district has not already undertaken this task.

An idealised policy process

To sum up how could the Fed change the policy process to dramatically improve nominal stability and reduce monetary policy discretion?

It would be a two-step procedure at each FOMC meeting.

First, the FOMC would look at the three different forecasts for the NGDP level two-years ahead. These forecasts would then be compared to the targeted level of NGDP in two year.

The FOMC statement after the policy decision the three forecast should be presented and it should be made clear whether they are above or below the NGDP target level. This would greatly increase policy-making discipline. The FOMC members would be more or less forced to follow the “policy recommendation” implied by the forecasts for the NGDP level.

Second, the FOMC would decide on the monthly money base growth rate and it is clear that it follows logically that if the NGDP forecasts are below (above) the NGDP level target then the money base growth rate would have to be increased (decreased).

It think the advantages of this policy process would be enormous compared to the present quasi-discretionary and eclectic process and it would greatly move the Fed towards a truly rule-based monetary policy.

Furthermore, the process would be easily understood by the markets and by commentators alike and it would in no way be in conflict with the Fed’s official dual mandate as I strongly believe that such a set-up would both ensure price stability – defined as 2% inflation over the cycle – and “maximum employment”.

And finally back to the headline – “Time for the Fed to introduce a forward McCallum rule”. What I essentially have suggested above is that the Fed should introduce a forward-looking version of the McCallum rule. Bennett McCallum obviously originally formulated his rule in backward-looking terms (and in growth terms rather than in level terms), but I am sure that Bennett will forgive me for trying to formulate his rule in forward-looking terms.

PS if the ECB followed the exactly same rule as I have suggested above then the euro crisis would come to an end more or less immediately.

 

 

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