2008 was a large negative demand shock – also in Canada

Scott Sumner has a follow-up post on Nick Rowe’s post about whether a supply shock or a demand shock caused the Canadian recession in 2008-9. Both Nick and Scott seem to think that the recession in some way was caused by a supply shock.

I must admit that I really don’t understand what Scott and Nick are saying. It is pretty clear to me that the shock in 2008-9 was negative aggregate demand shock.

Lets start with the textbook version of a negative aggregate demand (AD) shock). Here is how a negative demand shock looks in AS/AD model (the growth rate version):

Demand shock

So what happened in Canada? Here is a look at inflation measured by headline CPI and by the price deflator for final domestic sales.

CAD inflation

Both measures of inflation were running higher than the Bank of Canada’s official 2% inflation target when the crisis hit in the autumn of 2008.

However, it is pretty clear that inflation slowed sharply and dropped well-below the 2% inflation target in 2009 as the Canadian economy went into recession (real GDP contracted). It is hard to say that this is anything other than a rather large negative AD shock.

Obvioulsy inflation increased above 2% in 2011, but we all know that a major negative supply shock hit in 2011 as global oil prices spiked. In the case of Canada this in fact is both a negative supply shock and a positive demand shock (remember Canada is an oil exporter). That said, the rise in inflation was certainly not dramatic and since 2012 inflation has once again dropped well-below 2% indicating that monetary policy in Canada has become overly tight given the BoC’s 2% inflation target.

I might add that different measures of inflation expectations (both survey and market data) are telling the exact same story. Inflation and inflation expectations eased significantly in 2008-9 and once again in 2012.  

And we can tell the same story if we look at the price level. The graph below compares the two measures of prices (CPI and the final domestic demand deflator) with an 2% price path starting in Q3 2008.

Canada Price Level

Again the picture is clear. The price level – for both measures – are lower than a hypothetical 2% price level path – indicating that Mark Carney and his colleagues in the Bank of Canada have kept monetary conditions too tight over the past 4-5 years – maybe because of a preoccupation with the risk of “bubbles”. Mark Carney might be talking about NGDP level targeting, but he is certainly also speaking quite a bit about “macroprudential indicators” (modern central bank lingo for bubble risk).

Concluding, it is very clear that the Canadian economy was hit by a large negative demand shock in 2008 and initially the BoC has kept monetary policy overly tight and the recent tightening of monetary conditions certainly also looks problematic.

Once again it is monetary policy failure and it is certainly not a negative supply shock, which is to blame for the Canadian recession and sub-trend growth since 2008. Needless to say NGDP tells the exact same story. I should add that the size of this “monetary policy failure” is fairly small compared to for example for example what we have seen in the euro zone.

Reminding Scott about the Sumner Critique

Given the very clear evidence of a negative demand shock I find this comment from Scott somewhat puzzling:

Let’s suppose that the BOC had been targeting NGDP in 2008, when global trade fell off a cliff.  How would the Canadian economy have been affected?  Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports.  In fact, it would be an adverse supply shock.  Even if the BOC had been targeting NGDP, output would have probably fallen.  Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions.  That’s a real shock.  No (plausible) amount of price flexibility would move those transmissions during a recession.  If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions.  If the US stops building houses, then we don’t want Canadian lumber.  That’s a real shock to Canada, i.e. an AS shock.

I simply don’t understand Scott’s argument. A negative shock to exports obviously is a negative demand shock. From the perspective of nominal spending a negative shock to exports is a negative shock to money-velocity in the exact same way as a tightening of fiscal policy. Therefore, if the BoC had been targeting NGDP (it actually also goes for inflation targeting) the Sumner Critique would apply – the BoC would offset any negative shock to exports by easing monetary policy (increasing M to offset the drop in V). As a consequence domestic demand would rise and offset the drop in exports. And this obviously applies even if prices are sticky. Yes, the production of transmissions in Ontario drops, but that is offset by an increase in construction of apartments in Vancouver.

However, the point is that the BoC failed to offset the shock to exports and as a consequence prices have been growing slower than implied by BoC’s official inflation target.

There is absolutly nothing special about Canada – its monetary policy failure – the failure is just (a lot) smaller than in the euro zone or the US.

PS I could also have used the GDP deflator as well in my examples above. The story is the same. In fact it is worse! The GDP deflator dropped by more than 4% during 2009. The primary reason for the massive drop in the GDP deflator is that the price of oil measured in Canadian dollars dropped sharply in 2008-9. As drop in the oil price obviously is a negative demand shock as Canada is a oil exporter. The story in that sense is completely the same as what happened to the Russian economy in 2008-9. Had the BoC had followed a variation of an “Export Price Norm” as the Reserve Bank of Australia is doing then the negative shock would likely have been much smaller as was the case in Australia.

GDP deflator Canada

PPS JP Irving also comments on the Canadian story.

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Sweden, Poland and Australia should have a look at McCallum’s MC rule

Sweden, Poland and Australia all managed the shock from the outbreak of Great Recession quite well and all three countries recovered relatively fast from the initial shock. That meant that nominal GDP nearly was brought back to the pre-crisis trend in all three countries and as a result financial distress and debt problems were to a large extent avoided.

As I have earlier discussed on my post on Australian monetary policy there is basically three reasons for the success of monetary policy in the three countries (very broadly speaking!):

1)     Interest rates were initially high so the central banks of Sweden, Poland and Australia could cut rates without hitting the zero lower bound (Sweden, however, came very close).

2)     The demand for the countries’ currencies collapsed in response to the crisis, which effectively led to “automatic” monetary easing. In the case of Sweden the Riksbank even seemed to welcome the collapse of the krona.

3)     The central banks in the three countries chose to interpret their inflation targeting mandates in a “flexible” fashion and disregarded any short-term inflationary impact of weaker currencies.

However, recently the story for the three economies have become somewhat less rosy and there has been a visible slowdown in growth in Poland, Sweden and Australia. As a consequence all three central banks are back to cutting interest rates after increasing rates in 2009/10-11 – and paradoxically enough the slowdown in all three countries seems to have been exacerbated by the reluctance of the three central banks to re-start cutting interest rates.

This time around, however, the “rate cutting cycle” has been initiated from a lower “peak” than was the case in 2008 and as a consequence we are once heading for “new lows” on the key policy rates in all three countries. In fact in Australia we are now back to the lowest level of 2009 (3%) and in Sweden the key policy rate is down to 1.25%. So even though rates are higher than the lowest of 2009 (0.25%) in Sweden another major negative shock – for example another escalation of the euro crisis – would effectively push the Swedish key policy rate down to the “zero lower bound” – particularly if the demand for Swedish krona would increase in response to such a shock.

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? he discusses a new policy rule that could be highly relevant for the central banks in Sweden, Poland and Australia – and for matter a number of other central banks that risk hitting the zero lower bound in the event of a new negative demand shock (and of course for those who have ALREADY hit the zero lower bound as for example the Czech central bank).

What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target. Therefore we could also formulate the rule for example in terms of commodity prices (that would basically be Irving Fisher’s Compensated dollar standard) or for that matter stock prices (See my earlier post on how to use stock prices as a monetary policy instrument here). That is not really important. The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

Implementing a MC rule would be easy, but very effective

So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank or the Polish central bank (NBP) should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

You might object that in for example in Poland the key policy rate is still way above zero so why worry now? Yes, that is true, but the experience over the last four years shows that when you hit the zero lower bound and there is no pre-prepared operational framework in place then it is much harder to come up with away around the problem. Furthermore, by announcing such a rule the risk that it will have to “kick in” is in fact greatly reduced – as the exchange rate automatically would start to weaken as interest rates get closer to zero.

Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank, the Polish central bank and the Australian Reserve Bank could all avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

PS it should be noted that this post is not meant as a discussion about what the central bank ultimately should target, but rather about what instruments to use to hit the given target. McCallum in his 2005 paper expresses his MC as a Taylor style rule, but one could obviously also think of a MC rule that is used to implement for example a price level target or even better an NGDP level rule and McCallum obviously is one of the founding father of NGDP targeting (I have earlier called McCallum the grandfather of Market Monetarism).

The “Export Price Norm” saved Australia from the Great Recession

Milton Friedman once said never to underestimate the importance of luck of nations. I believe that is very true and I think the same goes for central banks. Some nations came through the shock in 2008-9 much better than other nations and obviously better policy and particularly better monetary policy played a key role. However, luck certainly also played a role.

I think a decisive factor was the level of key policy interest rate at the start of the crisis. If interest rates already were low at the start of the crisis central banks were – mentally – unable to ease monetary policy enough to counteract the shock as most central banks did operationally conduct monetary policy within an interest rate targeting regime where a short-term interest rate was the key policy instrument. Obviously there is no limits to the amount of monetary easing a central bank can do – the money base after all can be expanded as much as you would like – but if the central bank is only using interest rates then they will have a problem as interest rates get close to zero. Furthermore, it played a key role whether demand for a country’s currency increased or decreased in response to the crisis. For example the demand for US dollars exploded in 2008 leading to a “passive tightening” of monetary policy in the US, while the demand for for example Turkish lira, Swedish krona or Polish zloty collapsed.

As said, for the US we got monetary tightening, but for Turkey, Sweden and Poland the drop in money was automatic monetary easing. That was luck and nothing else. The three mentioned countries in fact should give reason to be careful about cheering too much about the “good” central banks – The Turkish central bank has done a miserable job on communication, the Polish central bank might have engineered a recession by hiking interest rates earlier this year and the Swedish central bank now seems to be preoccupied with “financial stability” and household debt rather than focusing on it’s own stated inflation target.

In a recent post our friend and prolific writer Lorenzo wrote an interesting piece on Australia and how it has been possible for the country to avoid recession for 21 years. Lorenzo put a lot of emphasis on monetary policy. I agree with that – as recessions are always and everywhere a monetary phenomena – the key reason has to be monetary policy. However, I don’t want to give the Reserve Bank of Australia (RBA) too much credit. After all you could point to a number of monetary policy blunders in Australia over the last two decades that potentially could have ended in disaster (see below for an example).

I think fundamentally two things have saved the Australian economy from recession for the last 21 years.

First of all luck. Australia is a commodity exporter and commodity prices have been going up for more than a decade and when the crisis hit in 2008 the demand for Aussie dollars dropped rather than increased and Australia’s key policy rate was relatively high so the RBA could ease monetary policy aggressively without thinking about using other instruments than interest rates. The RBA was no more prepared for conducting monetary policy at the lower zero bound than the fed, the ECB or the Bank of England, but it didn’t need to be as prepared as interest rates were much higher in Australia to begin with – and the sharp weakening of the Aussie dollar obviously also did the RBA’s job easier. In fact I think the RBA is still completely unprepared for conducting monetary policy in a zero interest rate environment. I am not saying that the RBA is a bad central bank – far from it – but it is not necessarily the example of a “super central bank”. It is a central bank, which has done something right, but certainly also has been more lucky than for example the fed or the Bank of England.

Second – and this is here the RBA deserves a lot of credit – the RBA has been conducting it’s inflation targeting regime in a rather flexible fashion so it has allowed occasional overshooting and undershooting of the inflation target by being forward looking and that was certainly the case in 2008-9 where it did not panic as inflation was running too high compared to the inflation target.

One of the reasons why I think the RBA has been relatively successful is that it effectively has shadowed a policy of what Jeff Frankel calls PEP (Peg the currency to the Export Price) and what I (now) think should be called an “Export Price Norm” (EPN). EPN is basically the open economy version of NGDP level targeting.

If the primary factor in nominal demand changes in the economy is exports – as it tend to be in small open economies and in commodity exporting economies – then if the central bank pegs the price of the currency to the price of the primary exports then that effectively could stabilize aggregate demand or NGDP growth. This is in fact what I believe the RBA – probably unknowingly – has done over the last couple of decades and particularly since 2008. As a result the RBA has stabilized NGDP growth and therefore avoided monetary shocks to the economy.

Under a pure EPN regime the central bank would peg the exchange rate to the export price. This is obviously not what the RBA has done. However, by it’s communication it has signalled that it would not mind the Aussie dollar to weaken and strengthen in response to swings in commodity prices – and hence in swings in Australian export prices. Hence, if one looks at commodity prices measured by the so-called CRB index and the Australian dollar against the US dollar over the last couple of decades one would see that there basically has been a 1-1 relationship between the two as if the Aussie dollar had been pegged to the CRB index. That in my view is the key reason for the stability of NGDP growth over the past two decade. The period from 2004/5 until 2008 is an exception. In this period the Aussie dollar strengthened “too little” compared to the increase in commodity prices – effectively leading to an excessive easing of monetary conditions – and if you want to look for a reason for the Australian property market boom (bubble?) then that is it.

This is how close the relationship is between the CRB index and the Aussie dollar (indexed at 100 in 2008):

However, when the Great Recession hit and global commodity prices plummet the RBA got it nearly perfectly right. The RBA could have panicked and hike interest rates to curb the rise in headline consumer price inflation (CPI inflation rose to around 5% y/y) caused by the weakening of the Aussie dollar. It did not do so, but rather allowed the Aussie dollar to weaken significantly. In fact the drop in commodity prices and in the Aussie dollar in 2008-9 was more or less the same. This is in my view is the key reason why Australia avoided recession – measured as two consecutive quarters of negative growth – in 2008-9.

But the RBA could have done a lot better

So yes, there is reason to praise the RBA, but I think Lorenzo goes too far in his praise. A reason why I am sceptical is that the RBA is much too focused on consumer price inflation (CPI) and as I have argued so often before if a central bank really wants to focus on inflation then at least the central bank should be focusing on the GDP deflator rather on CPI.

In my view Australia saw what Hayekian economists call “relative inflation” in the years prior to 2008. Yes, inflation measured by CPI was relatively well-behaved, but looking at the GDP deflator inflationary pressures were clearly building and because the RBA was overly focused on CPI – rather than aggregate demand/NGDP growth or the GDP deflator – monetary policy became excessively easy and the had the RBA not had the luck (and skills?) it had in 2008-9 then the monetary induced boom could have turned into a nasty bust. The same story is visible from studying nominal GDP growth – while NGDP grew pretty steadily around 6% y/y from 1992 to 2002, but from 2002 to 2008 NGDP growth escalated year-by-year and NGDP grew more than 10% in 2008. That in my view was a sign that monetary policy was becoming excessive easy in Australia. In that regard it should be noted that despite the negative shock in 2008-9 and a recent fairly marked slowdown in NGDP growth the actual level of NGDP is still somewhat above the 1992-2002 trend level.

George Selgin has forcefully argued that there is good and bad deflation. Bad deflation is driven by negative demand shocks and good deflation is driven by positive supply shocks. George as consequence of this has argued in favour of what he has called a “productivity norm” – effectively an NGDP target.

I believe that we can make a similar argument for commodity exporters. However, here it is not a productivity shock, but a “wealth shock”. Higher global commodity prices is a positive “wealth shock” for commodity exporters (Friedman would say higher permanent income). This is similar to a positive productivity shock. The way to ensure such “wealth shock” is transferred to the consumers in the economy is through benign consumer price deflation (disinflation) and you get that through a stronger currency, which reduces import prices. However, a drop in global commodity prices is a negative demand shock for a commodity exporting country and that you want to avoid. The way to do that is to allow the currency to weaken as commodity prices drop. This is why the Export Price Norm makes so much sense for commodity exporters.

The RBA effective acted as if it had an (variation of the) Export Price Norm in 2008-9, but certainly failed to do so in the boom years prior to the crisis. In those pre-crisis years the RBA should have tightened monetary policy conditions much more than it did and effectively allowed the Aussie dollar to strengthen more than it did. That would likely have pushed CPI inflation well-below the RBA’s official inflation (CPI) target of 2-3%. That, however, would have been just fine – there is no harm done in consumer price deflation generated by positive productivity shocks or positive wealth shocks. When you become wealthier it should show up in low consumer prices – or at least a slower growth of consumer price inflation.

So what should the RBA do now?

The RBA managed the crisis well, but as I have argued above the RBA was also fairly lucky and there is certainly no reason to be overly confident that the next shock will be handled equally well. I therefore think there are two main areas where the RBA could improve on it operational framework – other than the obvious one of introducing an NGDP level targeting regime.

First, the RBA should make it completely clear to investors and other agents in the economy what operational framework the RBA will be using if the key policy rate where to hit zero.

Second, the RBA should be more clear in it communication about the link between changes in commodity prices (measured in Aussie dollars) and aggregate demand/NGDP and that it consider the commodity-currency link as key element in the Australian monetary transmission mechanism – explicitly acknowledging the importance of the Export Price Norm.

The two points above could of course easily be combined. The RBA could simply announce that it will continue it’s present operational framework, but if interest rates where to drop below for example 1% it would automatically peg the Aussie dollar to the CRB index and then thereafter announce monetary policy changes in terms of the changes to the Aussie dollar-CRB “parity”.

Australian NGDP still remains somewhat above the old trend and as such monetary policy is too loose. However, given the fact that we have been off-trend for a decade it probably would make very little sense to force NGDP back down to the old trend. Rather the RBA should announce that monetary policy is now “neutral” and that it in the future will keep NGDP growth around a 5% or 6% trend (level targeting). Using the trend level starting in for example 2007 in my view would be a useful benchmark.

It is pretty clear that Australian monetary conditions are tightening at the moment, which is visible in both weak NGDP growth and the fact that commodity prices measured in Australian dollars are declining. Furthermore, it should be noted that GDP deflator growth (y/y) turned negative earlier in the year – also indicating sharply tighter monetary conditions. Furthermore, NGDP has now dropped below the – somewhat arbitrary – 2007-12 NGDP trend level. All that could seem to indicate that moderate monetary easing is warranted.

Concluding, the RBA did a fairly good job over the past two decades, but luck certainly played a major role in why Australia has avoided recession and if the RBA wants to preserve it’s good reputation in the future then it needs to look at a few details (some major) in the how it conducts its monetary policy.

PS I could obviously tell the same story for other commodity exporters such as Norway, Canada, Russia, Brazil or Angola for that matter and these countries actually needs the lesson a lot more than the RBA (maybe with the exception of Canada).

PPS Sometimes Market Monetarist bloggers – including myself – probably sound like “if we where only running things then everything would be better”. I would stress that I don’t think so. I am fully aware of the institutional and political constrains that every central banker in the world faces. Furthermore, one could easily argue that central banks by construction will never be able to do a good job and will always be doomed to fail (just ask Pete Boettke or Larry White). As everybody knows I have a lot of sympathy for that view. However, we need to have a debate about monetary policy and how we can improve it – at least as long as we maintain central banks. And I don’t think the answer is better central bankers, but rather I want better institutions. It is correct it makes a difference who runs the central banks, but the institutional framework is much more important and a discussion about past and present failures of central banks will hopefully help shape the ideas to secure more sound monetary systems in the future.

PPPS I should say this post was inspired not only by Lorenzo’s post and my long time thinking the that the RBA had been lucky, but also by Saturos’ comments to my earlier post on Malaysia. Saturos pointed out the difference between the GDP deflator and CPI in Australia to me. That was an important import to this post.

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