All posts tagged ECB

Lower (supply) inflation is NOT a reason to ease US monetary policy

Here are two news stories from today:

“U.S. import prices fell in April due to a drop in oil costs, a positive sign for household finances that also pointed to benign inflation pressures.

Import prices slipped 0.5 percent last month, the biggest decline since December, the Labor Department said on Tuesday. March’s data was revised to show a 0.2 percent decline instead of the previously reported 0.5 percent drop.”

And the second one:

“U.S. producer prices recorded their largest drop in three years in April while a reading of manufacturing in New York indicated contraction.

Producer prices slid as gasoline and food costs tumbled, pointing to weak inflation pressures that should give the Federal Reserve latitude to keep monetary policy very accommodative.”

Now some might of course think that this would make Market Monetarists scream for the Federal Reserve to step up monetary easing. However, that would be extremely wrong. There are certainly good reasons for the fed to ease monetary policy, but a drop in inflation caused by a positive supply shock – lower import prices – is certainly not one of them.

At the core of Market Monetarist thinking is that central banks should not react to supply shock – positive or negative. Hence, we are arguing that central banks should target the level of nominal GDP – not inflation.

Therefore, imagine that the fed indeed was targeting the the NGDP level and NGDP was “on track” and a positive supply shock hit. Then the fed would maintain monetary conditions completely unchanged – keeping NGDP on track – and allowed the positive supply shock to feed through to lower inflation (and higher real GDP). This is benign inflation and as such very welcomed as it do not reflect a deflationary and recessionary demand shock. Furthermore, some Market Monetarists like David Beckworth and myself also believe that monetary easing in response to positive supply shocks risks leading to economic misallocation and what Austrian economists call relative inflation.

Lower (supply) inflation is no reason for more QE
…but the fed needs to focus on defining its target

One can certainly argue that NGDP growth is too weak to catch up with the pre-crisis NGDP trend, but on the other hand it is also pretty clear that US NGDP growth is fairly robust. So instead of stepping up quantitative easing in response to lower import prices the fed instead should focus on becoming much more clear on what it wants to achieve. Hence, there is still considerable uncertainty about what the fed really wants to achieve.

Therefore, the fed should become more clear on its target. Preferably of course the fed should adopt an NGDP level target and decide whether the present growth rate of the money base is strong enough to achieve that or not. Regarding that I don’t think that the present policy with a not clearly defined target and the present growth rate of the money base is enough to return NGDP to the pre-crisis trend, but it is nonetheless likely to keep NGDP growing 4-5% and that is likely enough to maintain the present speed of recovery in real GDP and the US labour market. I think that is far too unambitious, but it is certainly better than what we are seeing in Europe.

The paradox – the positive supply shock is “pushing” central banks to do the right thing for the wrong reasons

The paradox, however, is that the recent drop in global commodity prices have pushed down headline inflation around the world and central banks have over the last couple of weeks been responding by cutting interest rates. Hence, Central banks in the eurozone, India, Australia, South Korea, Poland and Israel have all cut rates in recent weeks. While there certainly is very good reasons for monetary easing in nearly all of these countries it a paradox that these central banks now seem to have been “shocked” into easing monetary policy in response to a positive supply shock rather than in response to weak demand growth.

It would clearly be wrong to criticize these central banks for doing the right thing – easing monetary policy – but I also believe that it is important to stress that had monetary policy in these countries been “right” then these central banks would likely have been making a policy mistakes by easing monetary policy at the moment.

In that regard it is of course also important that central banks’ (apparent mental) inability to differentiate between supply and demand shocks often has lead central banks to tight monetary policy in response to negative supply. The ECB’s catastrophic rate hikes in 2011 is a very good example of this. Paradoxically we might be happy at the moment that the ECB’s tendency to react to supply shocks might push the ECB into stepping up monetary easing.

Finally I should stress that the recent decline in inflation globally is certainly not only caused by a positive supply. In fact I have long argued that we are likely heading for deflation in the euro zone due to excessively tight monetary policy. So my discussion above should mostly be seen as an attempt to stress the need for understanding the difference between demand and supply for the conduct of monetary policy. Unfortunately many central bankers seem unable to understand these important difference.

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Update: Market Monetarists think alike – I just realized that Marcus Nunes did a post yesterday that made the exact same argument as me.

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3 Comments
by Lars Christensen on May 15, 2013  •  Permalink
Posted in Deflation, ECB, Federal Reserve, Supply shock
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Posted by Lars Christensen on May 15, 2013

http://marketmonetarist.com/2013/05/15/lower-supply-inflation-is-not-a-reason-to-ease-us-monetary-policy/

Dear Northern Europeans – Monetary easing is not a bailout

If we want to explain the Market Monetarist position on banking crisis then it would probably be that banking crisis primarily is a result of monetary policy, but also that moral hazard should be avoided and a strict ‘no bailout’ policy should be implemented. However, the fact that Market Monetarists now for example favour aggressive monetary easing in the euro zone, but at the same time are highly skeptical about bailouts of countries and banks might confuse some.

I have noticed that there generally is a problem for a lot of people to differentiate between monetary easing and bailouts. Often when one argues for monetary easing the reply is “we should stop bailing out banks and countries and if we do it we will just create an even bigger bubble”. The problem here is that Market Monetarists certainly do not favour bailouts – we favour nominal stability.

I think that at the core of the problem is that people have a very hard time figuring out what monetary policy is. Most people – including I believe most central bankers – think that credit policy is monetary policy. Just take the Federal Reserve’s attempt to distort relative prices in the financial markets in connection with QE2 or the ECB’s OMT program where the purpose is to support the price of government bonds in certain South European countries without increasing the euro zone money base. Hence, the primary purpose of these policies is not to increase nominal GDP or stabilise NGDP growth, but rather to change market prices. That is not monetary policy. That is credit policy and worse – it is in fact bailouts.

As the ECB’s OMT and Fed’s QE2 to a large extent have been focused on changing relative prices in the financial markets they can rightly be – and should be – criticized for leading to moral hazard. When the ECB artificially keeps for example Spanish government bond yields from increasing above a certain level then the ECB clearly is encouraging excessive risk taking. Spanish bond yields have been rising during the Great Recession because investors rightly have been fearing a Spanish government default. This is an entirely rational reaction by investors to a sharp deterioration of the outlook for the Spanish economy. Obviously if the ECB curb the rise in Spanish bond yields the ECB are telling investors to disregard these credit risks. This clearly is moral hazard.

The problem here is that a monetary authority – the ECB – is engaged in something that is not monetary policy, but people will not surprisingly think of what a central bank do as monetary policy, but the ECB’s attempts to distort relative prices in the financial markets have very little to do with monetary policy as it do not lead to a change in the money base or to a change in the expectation for future changes in the money base.

That is not to say that the ECB’s credit policies do not have monetary impact. They likely have. Hence, it is clear that the so-called OMT has reduced financial distress in the euro zone, which likely have increased the money-multiplier and money-velocity in the euro zone, but it has also (significantly?) increased moral hazard problems. So the paradox here is that the ECB really has done very little to ease monetary policy, but a lot to increase moral hazard problems.

Unfortunately many of those policy makers who rightly are very fearful of moral hazard – normally Northern European policy makers – fail to realise the difference between monetary policy and credit policy. German, Finnish and Dutch policy makers are right in opposing a credit based bailout of South European “sinners”, but they are equally wrong in opposing an monetary expansion.

The paradox here is that Northern European policy markets by opposing monetary easing in the euro zone actually are increasing the problem with moral hazard and bailouts. Hence, when monetary policy is too tight nominal GDP (and likely also real GDP) collapses. As a result debt ratios increase – and this goes for both private and public debt. That will cause both sovereign debt crisis and banking crisis, which is perceived to threaten the future of the euro. The threat to the future of the euro so far has convinced Northern European policy makers to going along with bailouts and implicit and explicit guarantees to banks and countries around the euro zone. Hence, the ECB’s overly tight monetary policy likely have INCREASED moral hazard problems.

Europe needs to return to a system where insolvent banks and countries are allowed to default. We need to end the bailouts. The Northern Europeans are completely right about that. However, we also need to end the deflationary policies of the ECB, which greatly increases public debt and banking problems.

It is certainly not given that even if the ECB brought the NGDP level back to the pre-crisis trend everything would be fine. I am fairly convinced that the removal of implicit and explicit guarantees would force banks and countries to deleverage further.  Moral hazard problems and bailouts have led to excessive risk taking. There is no doubt about that, but if the ECB (and the Fed!) focuses on maintaining nominal stability we can get an orderly return to a market based financial system where credit risks are correctly priced.

And finally solvency problems should not be dealt with through monetary or credit policy. If a country is insolvent then the only answer is an orderly debt restructuring. Similarly if banks are insolvent orderly bank resolution is needed. Monetary policy at the same time should ensure that bank resolution and debt restructuring do not lead to a negative shock to monetary conditions. The best way to do that is to keep NGDP on track.

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Update: This is a greeting to the University of Chicago Monetary Policy Reading Group. This week the group is reading and discussing Ben Bernanke’s classic 1983 paper “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. In this paper Bernanke discusses his creditist view of the Great Depression. I believe that  these views are what led the Bernanke Fed to initially response to the Great Depression with credit policies (trying to “fix” the banks) rather than through a focused increase in the money base and the money supply.

My challenge to the UoC Monetary Policy Reading Group they should discuss how Fed policy has evolved from initially to be strongly focused on credit policies (QE2) to moving towards a monetary expansion (the Bernanke-Evans rule) and comparing the Bank of Japan’s new policy which is much more focused on an expansion of the money base rather than an attempt to distort relative prices in the financial markets. This is Friedman versus Bernanke.

20 Comments
by Lars Christensen on April 22, 2013  •  Permalink
Posted in Banking crisis, ECB, euro crisis, Moral Hazard
Tagged , ,

Posted by Lars Christensen on April 22, 2013

http://marketmonetarist.com/2013/04/22/dear-northern-europeans-monetary-easing-is-not-a-bailout/

15 years too late: Reviving Japan (the ECB should watch and learn)

After 15 years of deflationary policies the Bank of Japan now clearly is changing course. That should be clear to everybody after today’s policy announcement from the Bank of Japan. I don’t have a lot of writing here other than I will say this is extremely good news. Good for Japan and good for the global economy and what the BoJ is doing is nearly textbook style monetary easing. The only minus is that the BOJ is targeting inflation and not the NGDP level, but anyway I am pretty convinced this will work and work soon.

Anyway lets pay tribute to Milton Friedman. This is Uncle Milty in 1998 in his article “Reviving Japan”:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

This is what the BoJ announced today:

Under this guideline, the monetary base — whose amount outstanding was 138 trillion yen at end-2012 — is expected to reach 200 trillion yen at end-2013 and 270 trillion yen at end-2014.

The monthly flow of JGB (Japanese Government Bonds) purchases is expected to become 7+ trillion yen on a gross basis.

The Bank will achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. In order to do so, it will enter a new phase of monetary easing both in terms of quantity and quality. It will double the monetary base and the amounts outstanding of Japanese government bonds (JGBs) as well as exchange-traded funds (ETFs) in two years, and more than double the average remaining maturity of JGB purchases.

After 15 years the BoJ is finally listening to Friedman’s advice and I am sure it will do a lot to revive the Japanese economy. In fact the BoJ is doing more than listening to Milton Friedman. The BoJ is also listening to the Market Monetarist message of using the Chuck Norris Effect by guiding market expectations. Good work Kuroda.

And finally a message to ECB boss Mario Draghi. If you want to end the euro crisis just copy-paste today’s BoJ statement. You have the same inflation target anyway. It is not really that hard to do.

17 Comments
by Lars Christensen on April 4, 2013  •  Permalink
Posted in Bank of Japan, ECB, euro crisis, Japan
Tagged , , , ,

Posted by Lars Christensen on April 4, 2013

http://marketmonetarist.com/2013/04/04/15-years-too-late-reviving-japan-the-ecb-should-watch-and-learn/

The damage done by ECB’s rate hikes in 2011 (the 3-graph version)

Since the failure of the Cyprus “bailout” the euro crisis has once again flared up and investors are once again have become nervous about that future of Europe’s common currency. I believe most of the present problems dates back to ECB’s fatal decision to hike interest rates twice in 2011.

The three graphs below illustrate this - while the US is slowly getting out of the crisis things have in fact gotten worse and not better since ECB’s first rate hike in April 2011.

First from the perspective nominal GDP growth.

NGDP US euro zone

Second the horrific euro zone labour market situation versus the gradual improvement in the US.

unemp euro US

Finally the price level – the deflationary environment in Europen is becoming in clear

Relative price level US euro

It is time for the ECB to end its deflationary policies and take action sooner rather than later.

5 Comments
by Lars Christensen on April 2, 2013  •  Permalink
Posted in ECB, euro crisis
Tagged ,

Posted by Lars Christensen on April 2, 2013

http://marketmonetarist.com/2013/04/02/the-damage-done-by-ecbs-rate-hikes-in-2011-the-3-graph-version/

“The Euro: Monetary Unity To Political Disunity?”

The re-eruption of the euro crisis as sparked not only economic and financial concerns, but maybe even more important the crisis is now very clearly leading to serious political disunity exemplified by an article the Spanish newspaper El País in, which Chancellor Merkel (somewhat unjustly) was compared to Hitler. And it is pretty clear that Germans are unlikely to get the same level of service if they go on vacation in Spain, Greece or Cyprus this year.

The political disunity in Europe should hardly be a surprised to anybody who have read anything Milton Friedman ever wrote on monetary union and fixed exchange rate regime. His article “The Euro: Monetary Unity To Political Disunity?” from 1997 has turned out to have been particularly prolific.

Here is Friedman on why the euro just is a bad idea:

By contrast, Europe’s common market exemplifies a situation that is unfavorable to a common currency. It is composed of separate nations, whose residents speak different languages, have different customs, and have far greater loyalty and attachment to their own country than to the common market or to the idea of “Europe.” Despite being a free trade area, goods move less freely than in the United States, and so does capital.

The European Commission based in Brussels, indeed, spends a small fraction of the total spent by governments in the member countries. They, not the European Union’s bureaucracies, are the important political entities. Moreover, regulation of industrial and employment practices is more extensive than in the United States, and differs far more from country to country than from American state to American state. As a result, wages and prices in Europe are more rigid, and labor less mobile. In those circumstances, flexible exchange rates provide an extremely useful adjustment mechanism.

If one country is affected by negative shocks that call for, say, lower wages relative to other countries, that can be achieved by a change in one price, the exchange rate, rather than by requiring changes in thousands on thousands of separate wage rates, or the emigration of labor. The hardships imposed on France by its “franc fort” policy illustrate the cost of a politically inspired determination not to use the exchange rate to adjust to the impact of German unification. Britain’s economic growth after it abandoned the European Exchange Rate Mechanism a few years ago to refloat the pound illustrates the effectiveness of the exchange rate as an adjustment mechanism.

Note how Friedman rightly notes that downward rigidities in price and wages are likely to cause problems in the euro zone in the event of a negative shock to one or more of the euro countries.

These problems cannot be ignored and if they are ignored it will likely lead to political disunity – if not indeed political disintegration. As Friedman express it:

The drive for the Euro has been motivated by politics not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.

Friedman unfortunately once again has been proven right by events over the past couple of weeks.

1 Comment
by Lars Christensen on April 1, 2013  •  Permalink
Posted in Cyprus, ECB, euro crisis, Germany, Milton Friedman, Slovenia, The Netherlands
Tagged , , , , , ,

Posted by Lars Christensen on April 1, 2013

http://marketmonetarist.com/2013/04/01/the-euro-monetary-unity-to-political-disunity/

A simple monetary policy rule to end the euro crisis

It is extremely depressing. After about half year of calm in Europe – mostly due to the efforts of the Federal Reserve and the Bank of Japan – European policy makers have once again messed up and the euro crisis is back on top of the headlines in the financial markets. It is time for the ECB to finally take bold actions and end this crisis once and for all. And no I don’t suggest anymore bailouts or odd credit policies and new weird policy instruments. I have a much simpler suggestion and I am pretty sure it would end the crisis very fast.

My suggestion is that the ECB immediately issues the following statement:

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

The ECB used to have a M3 reference rate. It is time to reintroduce it. In fact it is needed more than ever. So Mario Draghi what are you waiting for? And no you don’t have to ask the Bundesbank for permission.

PS See here to see why the M3 growth target should be 10%.

22 Comments
by Lars Christensen on March 29, 2013  •  Permalink
Posted in euro crisis, Mario Draghi
Tagged ,

Posted by Lars Christensen on March 29, 2013

http://marketmonetarist.com/2013/03/29/a-simple-monetary-policy-rule-to-end-the-euro-crisis/

The euro zone is heading for deflation

This is Daily Telegraph’s Ambrose Evans-Pritchard quoting me on the risk of deflation in the euro zone:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y

<=>

(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, the world is much more complicated than this, but I believe this is a pretty good illustration of the deflationary risks in the euro zone.

We still don’t have outright deflation in the euro zone, but we are certainly getting closer – and inflation is certainly well below the ECB’s 2% inflation target. The graph below clearly shows that.

GDP deflator inflation euro zone

So effectively the ECB has been undershooting it’s 2% inflation target since 2008 – at least if we use the GDP deflator rather than ECB’s preferred measure of inflation (HICP). See my earlier post on why the GDP deflator is a much better indicator of monetary inflation than HICP here.

The reason for these deflationary tendencies is obvious – overly tight monetary policy.

Just have a look at this graph – it is the level M3 versus a hypothetical 6.5% growth path for M3. (If you read this blog post you will see why I use 6.5% as a benchmark)

M3 eurozone

This is why I talk about the need to “boost” money supply growth. The ECB either needs to increase velocity growth (the fed and the BoJ is likely helping a bit on that at the moment) or money supply growth otherwise the euro zone is heading for deflation. It is pretty simple.

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Related posts:
Failed monetary policy – the one graph version
Failed monetary policy – (another) one graph version
Friedman’s Japanese lessons for the ECB

18 Comments
by Lars Christensen on March 12, 2013  •  Permalink
Posted in ECB, euro crisis
Tagged ,

Posted by Lars Christensen on March 12, 2013

http://marketmonetarist.com/2013/03/12/the-euro-zone-is-heading-for-deflation/

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”

7 Comments
by Lars Christensen on February 28, 2013  •  Permalink
Posted in Bank of Japan, Bernanke-Evans rule, ECB, euro crisis, Federal Reserve, Italy, Sumner Critique
Tagged , , , , , ,

Posted by Lars Christensen on February 28, 2013

http://marketmonetarist.com/2013/02/28/its-frankfurt-that-should-be-your-worry-not-rome/

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

It is said that Europe is the biggest “victim” in what is said to be an international ‘currency war’ (it is really no war at all, but global monetary easing) as the euro has strengthened significantly on the back of the Federal Reserve and Bank of Japan having stepped up monetary easing.

However, the euro zone is no victim – to claim so is to reason from a price change as Scott Sumner would say. The price here of course is the euro exchange rate. The ‘currency war worriers’ claim that the strengthening is a disaster for European exports. What they of course forget is to ask is why the euro has strengthened.

The euro is stronger not because of monetary tightening in the euro zone, but because of monetary easing everywhere else. Easier monetary policies in the US and Japan obviously boost domestic demand in those countries and with it also imports. Higher American and Japanese import growth is certainly good news for European exports and that likely is much more important than the lose of “competitiveness” resulting from the stronger euro.

But have a look at European exporters think. The graph below is the Purchasing Managers Index (PMI) for euro zone new export orders. The graph is clear – optimism is spiking! The boost from improved Japanese and American growth prospects is clearly what is on the mind of European exporters rather than the strong euro.

PMIexport euro zone

6 Comments
by Lars Christensen on February 19, 2013  •  Permalink
Posted in Bank of Japan, Currency war, ECB, euro crisis, Federal Reserve
Tagged , , , ,

Posted by Lars Christensen on February 19, 2013

http://marketmonetarist.com/2013/02/19/dont-tell-me-the-currency-war-is-bad-for-european-exports-the-one-graph-version/

Spanish and Italian political news slipped into the financial section

One of my favourite Scott Sumner blog posts is on the connection been monetary policy failure and the impact of political news on the financial markets. I have quoted Scott many times on this issue, but let me do it again:

I once read all the New York Times from the 1930s (on microfilm.)  You can’t even imagine how frustrating it was.  They knew they had a big problem.  Then knew that deflation had badly hurt the economy (including the capitalists.)  They knew that monetary policy could reflate.  And yet . . .

Weeks went by, then months, then years.  Somehow they never connected the dots.

“Monetary policy is already highly stimulative.”

“There’s a danger we’d overshoot toward too much inflation.”

“Maybe the problems are structural.”

“There are green shoots, things are getting worse at a slower pace.  The economy needs to heal itself.”

“Consumer demand is saturated.  Even workingmen can now afford iceboxes and automobiles.  We produced too much stuff in the 1920s.”

And the worst part was the way political news kept slipping into the financial section.  Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc.  In the 1930s the readers didn’t know what came next—but I did.

It has been a long time since political headlines really have been able to move the global financial markets (remember the fiscal cliff story never really did it). However, just take a look at these two stories from today:

 Ten-year Spanish government bond yields rose on Monday as the country’s opposition party called for the resignation of Prime Minister Mariano Rajoy over a corruption scandal.

…and here:

Ten-year Italian government bond yields also rose on concerns that a scandal involving Monte Paschi bank could see a rise in the popularity of the centre-right party in the polls, whose election charge is being led by former prime minister Silvio Berlusconi.

Since August-September the Federal Reserve and the Bank of Japan the have moved in the direction of easing monetary policy and a significantly more ruled basked monetary policy and even the ECB has eased up with ECB chief Draghi’s promising to do “whatever it takes” to save the euro. And Mark Carney has given investors hope that the Bank of England will move towards some form of NGDP level targeting. As a result the “euro crisis” has more or less disappeared from the headlines in the newspapers’ “financial section” (just take a look at what Google trends has to say).

Hence, it seems pretty clear that the markets’ “responsiveness” to political worries is a function of the tightness of global monetary conditions with tighter monetary conditions leading to a bigger impact of political jitters.

So where are we now? It to me all dependent on the ECB. If the ECB move towards a clearly rule based regime – in a similar fashion as the Fed and the BoE (and likely soon also the Bank of England) then we are likely to see markets becoming more immune to political jitters. On the other hand if the ECB moves back to the bad habit of conditioning monetary policy on political outcome then once again the markets will start worrying about the finer details of Italian and Spanish politics.

PS Some would argue that European monetary conditions have become tighter recently as a result of higher money market rates and yields. However, I don’t think that is the case. Higher yields and rates reflect growth optimism – just look at European stock markets and implied inflation expectations in the European fixed income markets. Market Monetarists don’t run for the door in panic when yields rise – rather we argue that you should not make the interest rate fallacy and confuse higher (lower) rates/yields with tighter (easier) monetary policy. As Milton Friedman reminds us rates and yields are high (low) when monetary policy has been easy (tight).

8 Comments
by Lars Christensen on February 4, 2013  •  Permalink
Posted in ECB, euro crisis, Italy, Spain
Tagged , , , ,

Posted by Lars Christensen on February 4, 2013

http://marketmonetarist.com/2013/02/04/spanish-and-italian-political-news-slipped-into-the-financial-section/

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