Chuck Norris beats Wolfgang Schäuble

So far it is has been a remarkable week in the global financial markets. The ’deposit grab’ in Cyprus undoubtedly has shocked international investors and confidence in the ability of euro zone policy makers has dropped to an all-time low.

Despite of the ‘Cyprus shock’ global stock markets continue to climb higher – yes, yes we have seen a little more volatility, but the overall picture is that of a continued global stock market rally. That is surely remarkable when one takes into account the scale of the policy blunder committed by the EU in Cyprus and the likely long-lasting damage done to the confidence in EU policy makers.

I therefore think it is fair to conclude that so far Chuck Norris has beaten German Finance Minister Wolfgang Schäuble. Or said, in another way the Chuck Norris effect has been at work all week and that has clearly been a key reason why we have not (yet?) seen global-wide or even European-wide contagion from the disaster in Cyprus.

Just to remind my readers – the Chuck Norris effect of course is the effect that monetary policy not only works through expanding the money base, but also through guiding expectations.

When I early this week expressed my worries (or rather mostly my anger) over the EU’s handling of the situation in Cyprus a fixed income trader who is a colleague of mine comforted me by saying “Lars, you have now for half a year been saying that the Fed and the Bank of Japan are more or less doing the right thing so shouldn’t we expect the Fed and BoJ to offset any shock from the euro zone?” (I am paraphrasing a little – after all we were talking on a trading floor)

The message from the trader was clear. Yes, the EU is making a mess of things, but with the Bernanke-Evans rule in place and the Bank of Japan’s newfound commitment to a 2% inflation target we should expect that any shock from the euro zone to the US and Japanese economies would be ‘offset’ by the Fed and the BoJ by stepping up quantitative easing.

The logic is basically is that if an European shock pushes up US unemployment up we should expect the Fed to do even more QE and if that same shock leads to a strengthening of the yen (that mostly happens when global risk aversion increases) then the BoJ would also do more QE to try to meet its 2% inflation target. Said in another way any increase in demand for US dollar and yen is likely to be met by an increase in the supply of dollars and yen. In that sense the money base is ‘elastic’ in a similar sense as it would be under NGDP targeting. It is less perfect, but it nonetheless seems to be working – at least for now.

The fact that markets now expect the supply of dollars and yens to be at least quasi-elastic in itself means that the markets are not starting to hoard dollars and yen despite the ‘Cyprus shock’. This is the Chuck Norris effect at work – the central banks doesn’t have to do anything else that to reaffirm their commitment to their targets. This is exactly what the Federal Reserve did yesterday and what the new governor of Bank of Japan Kuroda is expected to do later today at his first press conference.

So there is no doubt – Chuck Norris won the first round against Wolfgang Schäuble and other EU policy makers. Thank god for that.

 

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Fed NGDP targeting would greatly increase global financial stability

Just when we thought that the worst was over and that the world was on the way safely out of the crisis a new shock hit. Not surprisingly it is once again a shock from the euro zone. This time the badly executed bailout (and bail-in) of Cyprus. This post, however, is not about Cyprus, but rather on importance of the US monetary policy setting on global financial stability, but the case of Cyprus provides a reminder of the present global financial fragility and what role monetary policy plays in this.

Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster 

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity.

Hence, lets for example imagine that a sovereign default in an euro zone country shocks investors, who run for cover and starts buying ‘safe assets’. Among other things that would be the US dollar. This would obviously be similarly to what happened in the Autumn of 2008 then US monetary policy became ‘adaptive’ when interest rates effectively hit zero. As a consequence the US dollar rallied strongly. The ill-timed interest rates hikes from the ECB in 2011 had exactly the same impact – a run for safe assets caused the dollar to rally.

In that sense under an ‘adaptive’ monetary policy the Fed is effective allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

As the Fed is a ‘global monetary superpower’ a tightening of US monetary conditions by default leads to a tightening of global monetary conditions due to the dollar’s role as an international reserve currency and due to the fact that many central banks around the world are either pegging their currencies to the dollar or at least are ‘shadowing’ US monetary policy.

In that sense a negative financial shock from Europe will be ‘escalated’ as the fed conducts monetary policy in an adaptive way and fails to offset negative velocity shocks.

This also means that under an ‘adaptive’ policy regime the risk of contagion from one country’s crisis to another is greatly increased. This obviously is what we saw in 2008-9.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity as Fed policy automatically would counteract the shock to US money-velocity. As a consequence there would be no reason to expect any major negative impact on for example the overall performance of US stock markets. Furthermore, as a ‘global monetary policy’ the automatic increase in the US money base would curb the strengthening of the dollar and hence curb the tightening of global monetary conditions, which great would reduce the global financial fallout from the euro zone sovereign default.

Finally and most importantly the financial markets would under a system of a credible Fed NGDP target figure all this out on their own. That would mean that investors would not necessarily run for safe assets in the event of an euro zone country defaulting – or some other major financial shock happening – as investors would know that the supply of the dollar effectively would be ‘elastic’. Any increase in dollar demand would be meet by a one-to-one increase in the dollar supply (an increase in the US money base). Hence, the likelihood of a ‘global financial panic’ (for lack of a better term) is massively reduced as investors will not be lead to fear that we will ‘run out of dollar’ – as was the case in 2008.

The Bernanke-Evans rule improves global financial stability, but is far from enough

We all know that the Fed is not operating an NGDP targeting regime today. However, since September last year the Fed clearly has moved closer to a rule based monetary policy in the form of the Bernanke-Evans rule. The BE rule effective mean that the Fed has committed itself to offset any shock that would increase US unemployment by stepping up quantitative easing. That at least partially is a commitment to offset negative shocks to money-velocity. However, the problem is that the fed policy is still unclear and there is certainly still a large element of ‘adaptive’ policy (discretionary policy) in the way the fed is conducting monetary policy.  Hence, the markets cannot be sure that the Fed will actually fully offset negative velocity-shocks due to for example an euro zone sovereign default. But at least this is much better than what we had before – when Fed policy was high discretionary.

Furthermore, I think there is reason to be happy that the Bank of Japan now also have moved decisively towards a more rule based monetary policy in the form of a 2% inflation targeting (an NGDP targeting obviously would have been better). For the past 15 year the BoJ has been the ‘model’ for adaptive monetary policy, but that hopefully is now changing and as the yen also is an international reserve currency the yen tends to strengthen when investors are looking for safe assets. With a more strict inflation target the BoJ should, however, be expected to a large extent to offset the strengthening of the yen as a stronger yen is push down Japanese inflation.

Therefore, the recent changes of monetary policy rules in the US and Japan likely is very good news for global financial stability. However, the new regimes are still untested and is still not fully trusted by the markets. That means that investors can still not be fully convinced that a sovereign default in a minor euro zone country will not cause global financial distress.

The ultimate sign of recovery – no reason to freak out about higher bond yields

This is from CNBC.com:

U.S. Treasurys prices eased for a second day after jobless claims data suggested solid improvement in the labor market, while stocks’ gains undermined the appeal of lower-risk government debt.

The Treasury Department auctioned $13 billion of reopened 30-year bonds on Thursday at a high yield of 3.248 percent. The bid-to-cover ratio, an indicator of demand, was 2.43, the lowest level since August.

In the when-issued market, considered a proxy for where the bonds will price at auction, 30-year bonds were yielding about 3.24 percent. The auction followed solid demand in the sales of $21 billion of reopened 10-year notes on Wednesday and $32 billion of three-year notes on Tuesday.

US bond yields continue to inch higher. To me that is the ultimate sign that easier monetary conditions is pushing up nominal GDP (and very likely also real GDP).

But I am afraid that we will soon hear somebody warn us that higher bond yields will kill the recovery. But we of course know that when bond yields and equity prices are rising in parallel then it is normally a very good sign of higher aggregate demand and that is of course exactly what we need.

So if we avoid the biggest fallacy in economics and ask why bond yields are rising then we should find a lot of comfort in the fact that US stock prices are rising as well.

And finally there is some Keynesians out there that can explain to me why global stock prices continue to inch up, bond yields are rising and the US consumer seems completely unaffected despite of the fiscal cliff (I told you so!) and the sequester. Market Monetarists of course have an answer – it is monetary policy dominance – monetary policy can always offset any impact on aggregate demand from a fiscal shock. It is very simple – and is the positive spin on the Sumner Critique. (Here is a model textbook Keynesian should be able to understand).

PS yes you got it right – I am very optimistic both on the markets and on the recovery at least in the US (I have been optimistic for a while – see here and here). My only two fears are that the ECB once again will do something stupid or that we will have a repeat of the mistakes of 19367-37 – premature monetary tightening from the fed. Italian politics is, however, not keeping me awake at night.

Update: I wrote above my worry was the ECB. I should have said the EU/IMF. The terms for the EU/IMF bail out of Cyprus scare me quite a bit. So much for the rule of law…

It’s Frankfurt that should be your worry – not Rome

This week investors have been spooked by the election outcome in Italy, but frankly speaking is there anything new in that shady characters are doing well in an Italian election? Is there anything new in a hung parliament in Italy? Nope, judging from post-WWII Italian political history this is completely normal. Ok, Italian public finances is a mess, but again that not really news either.

So if all this is ‘business-as-usual’ why are investors suddenly so worried? My explanation would be that investors are not really worrying about what is going on in Rome, but rather about what is going on in Frankfurt.

Last year I argued that the ECB had introduced ‘political outcomes’ in its reaction function:

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

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

And this is really what concerns investors. The logic is that a ‘bad’ political outcome in Italy will lead the ECB to become more hawkish and effectively tighten monetary conditions by signaling that the ECB is not happy about the ‘outcome’ in Italy and therefore will not ease monetary policy going forward even if economic conditions would dictate that. This is exactly what happened in 2011-12 in the euro zone, where the political ‘outcomes’ in Greece, Italy and Spain clearly caused the ECB to become more hawkish.

The problems with introducing political outcomes into the monetary reaction function are obvious – or as I wrote last year:

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

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

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

Therefore investors are likely to watch comments from the ECB on the Italian elections as closely as the daily political show in Rome. However, there might be reasons to be less worried now than in 2011-12. The reason is not Europe, but rather what has been happening with US and Japanese monetary policy since August-September last year.

Hence, with the Fed effective operating the Bernanke-Evans rule and the Bank of Japan having introduced a 2% inflation target these two central banks effective have promised to offset any negative spill-over to aggregate demand from the euro zone to the US and the Japanese economy (this is basically the international financial version of the Sumner Critique – there is no global spill-over if the central banks have proper nominal targets).

Hence, if Italian political jitters spark financial jitters that threaten to push up US unemployment then the Fed will “automatically” step up monetary easing to offset the shock and investors should full well understand that. Hence, the Bernanke-Evans rule and the BoJ’s new inflation target are effective backstops that reduces the risk of spill-over from Italy to the global markets and the global economy.

However, investors obviously still worry about the possible reaction from the ECB. If the ECB – and European policy makers in general – uses political events in Italy to tighten monetary conditions then we are likely to see more unrest in the European markets. Hence, the ECB can end market worries over Italy today by simply stating that the ECB naturally will act to offset any spill-over from Italy to the wider European markets that threatens nominal stability in the euro zone.

Related posts:
News of Berlusconi once again slipped into the financial section
Spanish and Italian political news slipped into the financial section
Greek and French political news slipped into the financial section
Political news kept slipping into the financial section – European style
“…political news kept slipping into the financial section”

Jeff Cox is puzzled – maybe because he never asked anybody about monetary policy

This is CNBC’s Jeff Cox:

Investors who fled in fear over potentially massive tax increases associated with the “fiscal cliff” have barely broken a sweat over corresponding spending cuts that are only two weeks away.

The so-called sequestration of $110 billion a year in discretionary spending will happen March 1 if Congress does not come to an agreement.

With little indication that Washington is anywhere near a compromise similar to the one that avoided the full brunt of the fiscal cliff, markets could be expected to be in full panic mode.

But the post-cliff rally has shown no signs of letting up and the topic has gained little traction around Wall Street.

It is clear that Jeff never read any Market Monetarist blogs. If he had he would have known that monetary policy always overrules fiscal policy – there is monetary policy dominance and therefore financial markets should not be worried about a sizable fiscal tightening.

With the Bernanke-Evans rule the Fed has committed itself to continuing and escalating – if necessary – monetary easing until there is a substantial improvement of US labour market conditions – essentially this is a commitment to increasing aggregate demand. Hence, the Fed is also committed to counteract any negative impact on aggregate demand from a potential tightening of fiscal policy.

I have explained earlier that there is no reason to fear the fiscal cliff as long as there is a ‘monetary backstop’ in the form of the Bernanke-Evans rule:

Even if the fiscal cliff would be a negative shock to private consumption and public spending it is certainly not given that that would lead to a drop in overall aggregate demand. As I have discussed in earlier posts if the central bank targets NGDP or inflation for that matter then the central bank tries to counteract any negative demand shock (for example a fiscal tightening) by a similarly sized monetary expansion.

Even if we assume that we are in a textbook style IS/LM world with sticky prices and where the money demand is interest rate sensitive the budget multiplier will be zero if the central bank follows a rule to stabilize aggregate demand/NGDP.

As I have shown in an earlier post the LM curve becomes vertical if the monetary policy rule targets a certain level of unemployment or aggregate demand. This is exactly what the Bernanke-Evans rule implies. Effectively that means that if the fiscal cliff were to push up unemployment then the Fed would simply step up quantitative easing to force back down unemployment again.

Obviously the Fed’s actual conduct of monetary policy is much less “automatic” and rule-following than I here imply, but it is pretty certain that a 3, 4 or 5% of GDP tightening of fiscal policy in the US would trigger a very strong counter-reaction from the Federal Reserve and I strongly believe that the Fed would be able to counteract any negative shock to aggregate demand by easing monetary policy. This of course is the so-called Sumner Critique.

So Jeff the reason the markets are so relaxed about the so-called sequestration might very well be that the Fed has regained some credibility that it actually is controlling aggregate demand/NGDP. I know it is hard to understand that it is not important what is going on in the US Congress, but the markets really don’t care as long as the Fed is doing its job.

The Fed’s easing is working…in Mexico

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

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

The Bernanke-Evans rule boosts the Mexican stock market

MXN stock market

Mexican consumers get a boost from Bernanke

conconfMEX

Mexican industrialists are falling in love with Bernanke

PMI mexico

The US-Mex monetary transmission mechanism

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

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

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

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

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

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

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

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

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

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

Our pal George tells us not to rest on our laurels

Even though George Selgin never said he was a Market Monetarists – he dislikes labels like that – he is awfully close to being a Market Monetarist and many of us are certainly Selginians. So when George speaks we all tend to listen.

Now George is telling us not to rest on our laurels after the Federal Reserve took “a giant leap” after it effectively announced an Evans style policy rule. I have called the Fed’s new rule the Bernanke-Evans rule. There is no doubt that the Market Monetarist bloggers welcomed fed’s latest policy announcement, but George is telling us not be carried away.

Here is George:

In the title of a recent post Scott Sumner jokingly wonders whether, having been credited by the press for badgering Ben Bernanke’s Fed until it at last cried “uncle!” by announcing QE3, he now needs to worry about going down in history as the guy who gave the U.S. its first episode of hyperinflation.

Well, probably not. But if Scott and the rest of the Market Monetarist gang don’t start changing their tune, they may well go down in history as the folks responsible for our next boom-bust cycle.

I’m saying that, not because, like some monetary hawks, I’m dead certain that no substantial part of today’s unemployment is truly cyclical in the crucial sense of being attributable to slack demand. I have my doubts about the matter, to be sure: I think it’s foolish, first of all, to assume that 8.1% must include at least a couple percentage points of cyclical unemployment just because it’s more than that much higher than the postwar average… Still, for for the sake of what I wish to say here, I’m happy to concede that some more QE, aimed at further elevating the level of nominal GDP to restore it to some higher long-run trend value to which the recession itself and overly tight monetary policy have so far prevented it from returning, might do some good.

But although QE3 is in that case something that might do some real good up to a point, it hardly follows that Market Monetarists should treat it as a vindication of their beliefs. On the contrary: if they aim to be truly faithful to those beliefs, they ought to find at least as much to condemn as to praise in the FOMC’s recent policy announcement. And yes, they should be worried–very worried–that if they don’t start condemning the bad parts people will blame them for the consequences. What’s more, they will be justified in doing so.

So what are the bad parts? Two of them in particular stand out. First, the announcement represents a clear move by the Fed toward a more heavy emphasis on employment or “jobs” targeting:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Yes, there’s that bit about fighting unemployment “in a context of price stability,” and yes, it’s all perfectly in accord with the Fed’s “dual mandate.” But monetarists have long condemned that mandate, and have done so for several good reasons, chief among which is the fact that it may simply be beyond the Fed’s power to achieve what some may regard as “full employment” if the causes of less-than-full employment are structural rather than monetary. The Fed should, according to this view, focus on targeting nominal values only, which can serve as direct indicators of whether money is or is not in short supply. Many old-fashioned monetarists favor a strict inflation target because they view inflation as such an indicator. Market Monetarists are I think quite right in favoring treating the level and growth rate of NGDP as better indicators. But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don’t start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.

So what is George saying? Well, it is really quite obvious. Monetary policy should focus on nominal targets – such a price level target or a NGDP level target – rather than on real target like an unemployment target (as the fed now is doing). This is George’s position and it is also the position of traditional monetarists and more important it has always been the position of Market Monetarists like Sumner, Beckworth and myself.

So just to make it completely clear….

…It is STUPID to target real variables such as the unemployment rate 

There is no doubt of my position in that regard and that is also why I and other Market Monetarists are advocating NGDP level targeting. The central bank is fully in control the level of NGDP, but never real GDP or the level of unemployment.

With sticky prices and wages the central bank can likely reduce unemployment in the short run, but in the medium term the Phillips curve certainly is vertical and as a result monetary policy cannot permanently reduce the level of unemployment – supply side problems cannot be solved with demand side measures. That is very simple.

As a consequence I am also tremendously skeptical about the Federal Reserve’s so-called dual mandate. To quote myself:

” …I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target.”

Is the glass half empty or half full?

It is clear that it has never been a Market Monetarists position to advocate that the Fed or any other central bank should target labour market conditions, but this is really a question about whether the glass is half full or half empty. George is arguing that the glass is half empty, while his Market Monetarist pals argue it is half full.

The reasons why the Market Monetarists are arguing the glass is half full are the following:

1) The fed has become much more clear on what it wants to achieve with its monetary policy actions – we nearly got a rule. One can debate the rule, but it is certainly better than nothing and it will do a lot to stabilise and guide market expectations going forward. That will also make fed policy much less discretionary. Victory number one for the Market Monetarists!

2) The fed has become much more clear on its monetary policy instrument – it is a about increasing (or decreasing) the money base by buying Mortgage Backed Securities (MBS). To Market Monetarists it is not really important what you buy to increase the money base – the point is the monetary policy is conducted though changes in the money base rather than through changes in interest rates. This I think is another major monetarist victory!

3) The fed’s policy actions will be open-ended – the focus will no long be on how much QE the fed will do, but on what it will do and the fed will – if it follows through on its promises – do whatever it takes to fulfill its policy target.  Victory number three!

It is certainly not perfect, but it certainly is a major change compared to how the fed has conducted monetary policy over the past four years. We can of course not know whether the fed will change direction tomorrow or in a month or in a year, but we are certainly heading in the right direction. I am sure that George would agree that these three points are steps in the right direction.

But lets get to the “half empty” part – the fed’s new unemployment target. George certainly worries about it as do I and other Market Monetarists. Bill Woolsey makes this point very clear in a recent blog post. However, I think there is an empirical difference in how George see the US economy and how most Market Monetarists see it. In George’s view it is not given that the present level of unemployment in the US primarily is a result of demand side factors. On the other hand while most Market Monetarists acknowledge that part of the rise in US unemployment is due to supply side factors such as higher minimum wages we also strongly believe that the rise in unemployment has been caused by a contraction in aggregate demand. As a consequence we are less worried that the fed’s new unemployment target will cause problems in the short to medium term in the US.

In that regard it should be noted that the so-called Evans rule mean that the fed will ease monetary policy until US unemployment drops below 7% or PCE core inflation increases above 3%. Fundamentally I think that is quite a conservative policy. In fact one could even argue that that will not be nearly enough to bring NGDP back to a level which in anyway is comparable to the pre-crisis trend.

We should listen to our pal George and continue advocacy of NGDP level targeting 

The fact that I personally is not overly worried about a conservative Evans rule (7%/3%) will lead to a new boom-bust as George seem to suggest does, however, not mean that we should stop our advocacy. While we seem to have won first round we should make sure to win the next round as well.

It is therefore obvious that we should continue to strongly advocate NGDP level targeting and we should certainly also warn against the potential dangers of unemployment targeting.

Finally I would also argue that Market Monetarists should step up our campaign against moral hazard. There is no doubt the failed monetary policies over the past four years have led to an unprecedented increase in explicit and implicit government guarantees to banks and other nations. These guarantees obviously should be scaled back as fast as possible. A rule based monetary policy is the best policy to avoid that the scaling back of such too-big-to-fail procedures will lead to unwarranted financial distress. This should do a lot to ease George’s fears of another boom-bust episode playing out as the US and the global economy start to recover. (See also my earlier post on moral hazard and the risk of boom-bust here.)

Similarly if we are so lucky that the fed’s new policy set-up will be start of the end of the slump then Market Monetarists should be as eager to fight excessive monetary easing as we have been in fighting overly tight monetary policy. In that regard I would argue that I personally have a pretty solid track record as I was extremely critical about what I saw as overly easy monetary policy in the years just prior to the crisis hit in 2007-8 in countries like Iceland and the Central and Eastern European countries.

So George, there is no reason to worry – we don’t trust the fed more than you do…

PS I stole (paraphrased) my headline from one of George’s Facebook updates.

Update: Scott Sumner also comments on George’s post and George has a reply.

Josh Hendrickson has a related comment.

The fiscal cliff and the Bernanke-Evans rule in a simple static IS/LM model

Sometimes simple macroeconomic models can help us understand the world better and even though I am not uncritical about the IS/LM model it nonetheless has some interesting features which from time to time makes it useful for policy analysis (if you are careful).

However, a key problem with the IS/LM model is that the model does not take into account – in its basic textbook form – the central bank’s policy rule. However, it is easy to expand the model to include a monetary policy rule.

I will do exactly that in this post and I will use the Federal Reserve’s new policy rulethe Bernanke-Evans rule – to analysis the impact of the so-called fiscal cliff on a (very!) stylised version of the US economy.

We start out with the two standard equations in the IS/LM model.

The money demand function:

(1) m=p+y-α×r

Where m is the money supply/demand, p is prices and y is real GDP. r is the interest rate and α is a coefficient.

Aggregate demand is defined as follows:

(2) y=g-β×r

Aggregate demand y equals public spending and private sector demand (β×r), which is a function of the interest rate r. β is a coefficient. It is assumed that private demand drops when the interest rate increases.

This is basically all you need in the textbook IS/LM model. However, we also need to define a monetary policy rule to be able to say something about the real world.

I will use a stylised version of the Bernanke-Evans rule based on the latest policy announcement from the Fed’s FOMC. The FOMC at it latest meeting argued that it basically would continue to expand the money base (in the IS/LM the money base and the money supply is the same thing) to hit a certain target for the unemployment rate. That means that we can define a simple Bernanke-Evans rule as follows:

(3) m=λ×U

One can think of U as either the unemployment rate or the deviation of the unemployment rate from the Fed’s unemployment target. λ is a coefficient that tells you how aggressive the fed will increase the money supply (m) if U increases.

We now need to model how the labour market works. We simply assume Okun’s law holds (we could also have used a simple production function):

(4) U=-δ×y

This obviously is very simplified as we totally disregard supply side issues on the labour market. However, we are not interested in using this model for analysis of such factors.

It is easy to solve the model. We get the LM curve from (1), (3) and (4):

LM: r= y×(1+δ×λ)⁄α+(1/α)×p

And we get the IS curve by rearranging (2):

IS: r =(1/β)×g-(1/β)×y

Under normal assumptions about the coefficients in the model the LM curve is upward sloping and the IS curve is downward sloping. This is as in the textbook version.

Note, however, that the slope of the LM does not only depend on the money demand’s interest rate elasticity (α), but also on how aggressive  (λ) the fed will react to an increase in unemployment.

The Sumner Critique applies if λ=∞

The fact that the slope of the LM curve depends on λ is critical. Hence, if the fed is fully committed to its unemployment target and will do everything to fulfill (as the FOMC signaled when it said it would step up QE until it hit its target) then λ equals infinity (∞) .

Obviously, if λ=∞ then the LM curve is vertical – as in the “monetarist” case in the textbook version of the IS/LM model. However, contrary to the “normal” the LM curve we don’t need α to be zero to ensure a vertical LM curve.

Hence, under a strict Bernanke-Evans rule where the fed will not accept any diviation from its unemployment target (λ=∞) the (government) budget multiplier is zero and the so-called Sumner Critique therefore applies: Fiscal policy cannot increase or decrease output (y) or the unemployment (U) as any fiscal “shock” (higher or lower g) will be fully offset by the fed’s actions.

The Bernanke-Evans rule reduces risks from the fiscal cliff

It follows that if the fed actually follows through on it commitment to hit its (still fuzzy) unemployment target then in the simple model outlined above the risk from a negative shock to demand from the so-called fiscal cliff is reduced greatly.

This is good news, but it is also a natural experiment of the Sumner Critique. Imagine that we indeed get a 4% of GDP tightening of fiscal policy next year, but at the same time the fed is 100% committed to hitting it unemployment target (that unemployment should drop) then if unemployment then increases anyway then Scott Sumner (and myself) is wrong – or the fed didn’t do it job well enough. Both are obviously very likely…

I am arguing that I believe the model presented above is the correct model of the US economy. The purpose has rather been to demonstrate the critical importance of a the monetary policy rule even in a standard textbook keynesian model and to demonstrate that fiscal policy is much less important than normally assumed by keynesians if we take the monetary policy rule into account.

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