Mike Darda tells it as it is – The ECB’s deflationary failure

This is my good friend Michael Darda speaking on Bloomberg TV about the ECB – needless to say I agree with everything he says.

PS this is Mike talking about commodity prices – is it a demand or a supply story?Again I agree with Mike – it is both.

PPS This is myself on FOX Business’ Opening Bell with Maria Bartiromo last week commenting on the Bank of Japan’s latest action.

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Milton, Melamed and Me

Earlier this week Leo Melamed and myself spoke about Milton Friedman and markets at the Danish free market think thank CEPOS. See the show here

The Brilliant Nick Rowe

This is our own Nick Rowe on “Boom-Bust”.

Nick is a brilliant monetary thinker – and very entertaining. I would so hope that the likes of the ECB and the Riksbank would listen to people like Nick.

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.

 

 

Tighter monetary conditions – not lower oil prices – are pushing down inflation expectations

Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong.

Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future.

2y2y BEI euro zone

But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward.

Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market.

brent 1-year foreard

Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year.

Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices – because the market actual expects higher oil prices – more than 2.5% higher oil prices over the coming year.

So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions.

Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow.

As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now.

Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down.

I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not.

Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening.

We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad.

PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future.

PPS This post was greatly inspired by clever young colleague Jens Pedersen.

Soon everybody will be scared about ‘currency war’ again – we should be celebrating

With the dollar continuing to strengthen and now the Japanese yen starting to take off as well central bankers in the US and Japan are likely increasingly becoming worried about the deflationary tendencies of stronger currencies and recent comments from both countries’ central banks indicate that they will not allow their currencies to strengthen dramatically if it where to become deflationary.

This has in recent days caused some to begin to talk about the “risk” of a new global “currency war” where central banks around the world compete to weaken their currencies. Most commentators seem to think this would be horrible, but I would instead argue – as I have often done in recent years – that a global race to ease monetary policy is exactly what we need in a deflationary world.

If we lived in the high-inflation days of the 1970s we should be very worried, but we live in deflationary times so global monetary easing should be welcome and unlike most commentators I believe a global currency war would be a positive sum game.

Over the last couple of years I have written a number of posts on the topic of currency war. The main conclusions are the following:

  1. Currency war is a GREAT THING and is VERY POSITIVE – if indeed we think of it as a global competition to print money. This is what we need in a deflationary world.
  2. As long as we are seeing commodity prices decline and inflation expectations we can’t really say that the currency war is on yet.
  3. Currency war is NOT a zero sum game. It is a positive sum game in a deflationary world.
  4. Don’t think of monetary easing/currency depreciation to primarily work through a “competitiveness channel”, but rather through a boost to domestic demand. Therefore, we are likely to actually see the trade balance WORSEN for countries, which undertakes aggressive monetary easing. The US in 1933 is a good example. So is Argentina in 2001-2 and Japan recently. Sweden versus Denmark since 2008.

I don’t have much time to write more on the topic this morning, but I am sure I will return to the topic soon again. Until then have a look at my previous posts on the topic (and related topics):

Bernanke knows why ‘currency war’ is good news – US lawmakers don’t

‘The Myth of Currency War’

Don’t tell me the ‘currency war’ is bad for European exports – the one graph version

The New York Times joins the ‘currency war worriers’ – that is a mistake

The exchange rate fallacy: Currency war or a race to save the global economy?

Is monetary easing (devaluation) a hostile act?

Fiscal devaluation – a terrible idea that will never work

Mises was clueless about the effects of devaluation

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

The luck of the ‘Scandies’

The Fed was targeting the Labor Market Conditions Index 30 years before it was invented

Today the Federal Reserve published its much-hyped new Labor Market Conditions Index (LMCI).

This is how the Fed describes the Index:

The U.S. labor market is large and multifaceted. Often-cited indicators, such as the unemployment rate or payroll employment, measure a particular dimension of labor market activity, and it is not uncommon for different indicators to send conflicting signals about labor market conditions. Accordingly, analysts typically look at many indicators when attempting to gauge labor market improvement. However, it is often difficult to know how to weigh signals from various indicators. Statistical models can be useful to such efforts because they provide a way to summarize information from several indicators…

…A factor model is a statistical tool intended to extract a small number of unobserved factors that summarize the comovement among a larger set of correlated time series.

In our model, these factors are assumed to summarize overall labor market conditions. What we call the LMCI is the primary source of common variation among 19 labor market indicators. One essential feature of our factor model is that its inference about labor market conditions places greater weight on indicators whose movements are highly correlated with each other. And, when indicators provide disparate signals, the model’s assessment of overall labor market conditions reflects primarily those indicators that are in broad agreement.

The included indicators are a large but certainly not exhaustive set of the available data on the labor market, covering the broad categories of unemployment and underemployment, employment, workweeks, wages, vacancies, hiring, layoffs, quits, and surveys of consumers and businesses.

So is there really anything new in all this? Well, not really. To me it is just another indicator for the US business cycle. The graph below illustrates this.

LMCI FF rate

The graph shows the relationship between on the one hand the cumulative Labor Market Conditions Index and on the other hand the year-on-year change in the real Fed Funds rate. I have deflated the Fed Funds rate with the core PCE deflator.

The picture is pretty clear – since the mid-1980s the Fed has tended to increase real rates, when “Labor Market Conditions” have improved and cut rates when labor market conditions have worsened. There is really nothing new in this – it is just another version of the Taylor rule or the Mankiw rule, which capture the Fed’s Lean-Against-the-Wind regime during the Great Moderation. I am hence sure that you could estimate a nice rule for the Fed funds rate for period 1985-2007 based on the LMCI and PCE core inflation. I might return to that in a later post…

That said, there seems to have been a “structural” break in the relationship around 2001/2. Prior to that the relationship was quite close, but since then the relationship has become somewhat weaker.

Anyway that is not really important. My point is just that the LMCI is not really telling us much new. That said, the LCMI might help the Fed to communicate better about it policy rule (I hope), but why bother when a NGDP level target would be so much better than trying to target real variables (fancy or not)?

PS don’t be fooled by the graph into concluding the Fed Funds rate should be hiked. To conclude that you at the least need an estimate relationship between the LMCI and the Fed Funds rate.

Leland Yeager at 90 – happy birthday

Today Leland Yeager is turning 90. Happy birthday!

Leland Yeager is an amazing scholar. My friend Peter Kurrild-Klitgaard put it very well in a comment on Facebook:

Such a good scholar and a very nice man. Who speaks Danish. And 10-20 other languages.”

Yes, Pete is right – Yeager speaks an incredible number of languages – but I of course mostly appreciates Yeager’s contribution to monetary thinking.

Leland_Yeager

I consider Yeager (with Clark Warburton) to have been one of the founding father of what we could call Disequilibrium Monetarism and I think that Yeager has written the best ever monetarist “textbook”. As I have put it earlier:

One could of course think I would pick something by Friedman and I certainly would recommend reading anything he wrote on monetary matters, but in fact my pick for the best monetarist book would probably be Leland Yeager’s “Fluttering Veil”.

In terms of something that is very readable I would clearly choose Friedman’s “Money Mischief”, but that is of course a collection of articles and not a textbook style book. Come to think of it – we miss a textbook style monetarist book.

I actually think that one of the most important things about a monetarist (text)book should be a description of the monetary transmission mechanism. The description of the transmission mechanism is very good in (Keynes’) Tract, but Yeager is even better on this point.

Friedman on the other hand had a bit of a problem explaining the monetary transmission mechanism. I think his problem was that he tried to explain things basically within a IS/LM style framework and that he was so focused on empirical work. One would have expected him to do that in “Milton Friedman’s Monetary Framework: A Debate with His Critics”, but I think he failed to do that. In fact that book is is probably the worst of all of Friedman’s books. It generally comes across as being rather unconvincing.

Yeager not only provides very good insight into understanding the monetary transmission mechanism, but he also in my view provides a key insight to understanding what happened in 2008. This is from The Fluttering Veil: (David Beckworth has earlier used the same quote)

Say’s law, or a crude version of it, rules out general overproduction: an excess supply of some things in relation to the demand for them necessarily constitutes an excess demand for some other things in relation to their supply…

The catch is this: while an excess supply of some things necessarily mean an excess demand for others, those other things may, unhappily, be money. If so, depression in some industries no longer entails boom in others…

[T]the quantity of money people desire to hold does not always just equal the quantity they possess. Equality of the two is an equilibrium condition, not an identity. Only in… monetary equilibrium are they equal. Only then are the total value of goods and labor supplied and demanded equal, so that a deficient demand for some kinds entails and excess demand for others.

Say’s law overlooks monetary disequilibrium. If people on the whole are trying to add more money to their total cash balances than is being added to the total money stock (or are trying to maintain their cash balances when the money stock is shrinking), they are trying to sell more goods and labor than are being bought. If people on the whole are unwilling to add as much money to their total cash balances as is being added to the total money stock (or are trying to reduce their cash balances when the money stock is not shrinking), they are trying to buy more goods and labor than are being offered.

The most striking characteristic of depression is not overproduction of some things and underproduction of others, but rather, a general “buyers’ market,” in which sellers have special trouble finding people willing to pay more for goods and labor. Even a slight depression shows itself in the price and output statistics of a wide range of consumer-goods and investment-goods industries. Clearly some very general imbalance must exist, involving the one thing–money–traded on all markets. In inflation, an opposite kind of monetary imbalance is even more obvious.

This is exactly what happened in 2008 – dollar demand rose sharply, but the Federal Reserve failed to ensure monetary equilibrium by not sufficiently increasing the supply of base money. That caused the Great Recession.

Finally I would also note that Yeager in his article (with Robert Greenfield)  Money and Credit confused: An Appraisal of Economic Doctrine and Federal Reserve Procedure explained the very crucial difference between money and credit. 

In a great tribute (published yesterday) to Yeager Bill Woolsey – Market Monetarist and student of Yeager – explains:

Yeager was certainly aware that a banking system might respond to depressed economic conditions by reducing the quantity of money rather than holding it steady.    This points to an additional major emphasis of his work–the distinction between money and credit.   For Yeager, money is the medium of exchange.   The quantity is the amount that exists and the demand is the amount that people would like to hold.   Credit, on the other hand, involves borrowing and lending.   Banks can lend money into existence, expanding the quantity of money even if there is no one who wants to hold the additional balances.   And those wishing to hold additional money balances have no directly reason to show up at a bank seeking to borrow.   The interest rate that clears credit markets does not necessarily keep the quantity of money equal to the demand to hold it.    It is the price level for goods and services, along with the prices of resources, including nominal wages, that must adjust to keep the real quantity  of money equal to the demand to hold it.

One could only hope that the central bankers in Frankfurt would study Yeager (and Woolsey!) to understand this crucial difference between money and credit and then we might get monetary easing – to ensure monetary equilibrium rather than the numerous odd credit policies we have seen in recent years. The problem is not a “broken transmission mechanism”, but monetary disequilibrium. No one explains that better than Leland Yeager.

I could – and should – write a lot more on Leland Yeager (for example on his contribution to international trade and international monetary theory), but I will leave it for that for now.

But you shouldn’t stop reading yet. Kurt Schuler over at freebanking.org has collected a number of excellent tributes to Leland Yeager from a number of his friends, colleagues and former students. Here is the impressive list:

Thomas D. Willett
David Tuerck
Roger Koppl
Warren Coats
Kenneth Elzinga
Jim Dorn
Robert Greenfield
Kurt Schuler

Did Scotland avoid a Puerto Rican style crisis by voting “No” to independence?

I just read the latest depressing news about the Puerto Rican economy:

Puerto Rico’s economic activity has slumped to its lowest level in two decades, according to an index released by the commonwealth’s Government Development Bank (GDB), which also showed a sharp drop in electric power generation and cement sales.

The bank’s economic activity index fell 1.1 percent in August year-over-year, putting the headline index at the lowest level since 1994.

As I was reading it I realized that this is that the “No” campaign should have scared the Scottish people with at the recent vote on Scottish independence.

What Puerto Rico has is a monetary union, but not a full fiscal union, with the US. This is exactly what the Scottish independence proponents were favouring – continued monetary union with the UK, but complete fiscal sovereignty.

I am not sure that this makes sense (I have not been thinking too much about it…), but maybe the Scottish National Party should send a couple of observers to Puerto Rico to study the drawbacks to having a monetary union without full fiscal union before the next referendum.

PS There is a solution for Scotland that might solve this challenge. See here.

 

When central banks ignore the Tinbergen rule – the case of RBNZ

The news from the global currency markets this morning:

New Zealand’s dollar was set for its biggest three-day drop since 2011 after the Reserve Bank said its sales of the currency in August were the most in seven years. The greenback headed for its best month since 2012

The kiwi dropped against all 31 major counterparts as Prime Minister John Key was reported as signaling that the currency needs to be weaker. Australia’s dollar declined below 87 U.S. cents for the first time since January. The Hong Kong dollar weakened along with equities in the Asian city amid the largest police crackdown on protesters since it returned to Chinese rule. The euro fell to its lowest in 22 months versus the greenback before the European Central Bank meets Oct. 2.

Everything is wrong about this. I normally think that the Reserve Bank of New Zealand (RBNZ) is doing a fairly good job, but over the past couple of years it has become increasingly erratic in its behaviour and seems to be having a problem focusing on its stated objective of keeping inflation close to its inflation target.

Hence, the RBNZ has in recent years had a pre-occopation with the development in the New Zealand property market and household debt etc. and now it is the level of the kiwi dollar, which is on the mind of the RBNZ. And maybe worse the Prime Minister is now also thinking that he should get involved in monetary policy decision making – at least indirectly.

You gotta ask yourself what monetary policy goal the RBNZ have? After all you cannot have the cake and it eat too. That is the Tinbergen rule – you can only have one policy objective for each policy instrument.

The intervention in the currency market seems particularly odd when we remember that the RBNZ is not unlike a lot of other central banks stuck at the Zero Lower Bound – RBNZ’s policy rate the Overnight Cash Rate is 3.5%. Said, in another way if the RBNZ thinks that the strengthening of the kiwi dollar in anyway was threatening its key policy objective (1-3% inflation) then it can just got the key policy rate.

Furthermore, the New Zealand economy does not exactly look like it needs monetary easing – real GDP growth is outpacing potential growth, inflation is within the inflation target range and inflation expectations seem to be quite close to the 2% mid-point of the inflation target range. And any Market Monetarist would of course also notice that nominal GDP growth has been extreme buoyant over the past year (admittedly it is slowing now).

NZ NGDP RGDP

The strong growth in nominal GDP during 2013 to a large extent reflected a sharp rise in New Zealand’s export prices particular higher dairy prices. That trend has changed significantly in 2014 and that has actually put considerable depreciation pressure on the kiwi dollar recently, but apparently there is enough pressure on the kiwi dollar if you listen to Prime Minister John Key and the RBNZ.

Just ask yourself the question what if the kiwi dollar remains “too strong” for the liking of the RBNZ and the Prime Minister and the RBNZ decides to intervene more what would then happen? What is currency intervention? It is money creation. The RBNZ would print kiwi dollar – expanding the money base.

That eventually will spur NGDP growth and with the economy operating at more or less full capacity utilisation this will spur inflation and increase inflation expectations above the RBNZ’s inflation target. So the question is how much higher inflation will the RBNZ be willing to accept to weaken the kiwi dollar? Will it be willing to jeopardize its inflation target?

This demonstrates that the RBNZ only permanently can weaken the kiwi dollar if it is compatible with the RBNZ’s inflation target. Unless of course the New Zealand government is willing to introduce capital and currency controls. That luckily that does not seem to be on the agenda.

If the RBNZ is targeting inflation then the RBNZ will have to accept the level for the kiwi dollar, which is determined by market forces. If it on the other hand wants to target the exchange rate then it fundamentally will have to give up its inflation target.

I don’t think that the RBNZ is going to mess up things dramatically, but the RBNZ’s pre-occopation with the level of the kiwi dollar is yet another example that central bankers around the world still fundamentally have a hard time accepting the logic of the Tinbergen rule. But there is no way around it – you can only have one monetary policy target – the inflation rate, the price level, the NGDP level or the exchange rate. You can’t do it all.

PS I have often argued that central banks in small open economies use the exchange rate as an way implement monetary policy if it is stuck at the Zero Lower Bound and if monetary easing is needed. However, that is not the case for the RBNZ.

PPS Maybe I am wrong and it might just be the case that the RBNZ knows better than the market – just see here (I don’t really think I am wrong…)

PPPS The RBNZ does not exactly have a good experience playing around with quasi-exchange rate targeting. See here.

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