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

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

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

2y2y BEI euro zone

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

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

brent 1-year foreard

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

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

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

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

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

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

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

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

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

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

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

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End Europe’s deflationary mess with a 4% nominal GDP (level) target

From the onset of the Great Recession in 2008 the ECB has been more afraid of doing “too much” rather than too little. The ECB has been obsessing about fiscal policy being too easy in the euro zone and about that too easy monetary policy would create bubbles. As a consequence the ECB was overly eager to hike interest rates in 2011 – way ahead of the Federal Reserve started to talk about monetary tightening.

The paradox is that the ECB now is in a situation where nobody can imagine that interest rates should be hiked anytime soon exactly because the ECB’s über tight monetary stance has created a deflationary situation in the euro zone. As a consequence the ECB under the leadership (to the extent the Bundesbank allows it…) of Mario Draghi is trying to come up with all kind of measures to fight the deflationary pressures. Unfortunately the ECB doesn’t seem to understand that what is needed is open-ended quantitative easing with proper targets to change the situation.

Contrary to the situation in Europe the financial markets are increasing pricing in that a rate hike from the Federal Reserve is moving closer and the Fed will be done doing quantitative easing soon. Hence, the paradox is that the Fed is “normalizing” monetary policy much before the ECB is expected to do so – exactly because the Fed has been much less reluctant expanding the money base than the ECB.

The tragic difference between monetary policy in the US and Europe is very visible when we look at the difference in the development in nominal GDP in the euro zone and the US as the graph below shows.

NGDP EZ US

The story is very simple – while both the euro zone and the US were equally hard hit in 2008 and the recovery was similar in 2009-10 everything went badly wrong when the ECB prematurely started to hike interest rates in 2011. As a result NGDP has more or less flat-lined since 2011. This is the reason we are now seeing outright deflation in more and more euro zone countries and inflation expectations have dropped below 2% on most relevant time horizons.

While the Fed certainly also have failed in many ways and monetary policy still is far from perfect in the US the Fed has at least been able to (re)create a considerable degree of nominal stability – best illustrated by the fact that US NGDP basically has followed a straight line since mid-2009 growing an average of 4% per year. This I believe effectively is the Fed’s new target – 4% NGDP level targeting starting in Q2 of 2009.

The ECB should undo the mistakes of 2011 and copy the Fed

I believe it is about time the ECB fully recognizes the mistakes of the past – particularly the two catastrophic “Trichet hikes” of 2011. A way forward could be for the ECB to use the performance of the Fed over the last couple of years as a benchmark. After all the Fed has re-created a considerable level of nominal stability and this with out in any having created the kind of runaway inflation so feared in Frankfurt (by both central banks in the city).

So here is my suggestion. The ECB’s major failure started in April 2011 –  so let that be our starting point. And now lets assume that we want a 4% NGDP path starting at that time. With 2% potential real GDP growth in the euro zone this should over the cycle give us 2% euro zone inflation.

The graph below illustrate the difference between this hypothetical 4% path and the actual level of euro zone NGDP.

EZ NGDP path 4pct

The difference between the 4% path and the actual NGDP level is presently around 7.5%. The only way to close this gap is by doing aggressive and open-ended quantitative easing.

My suggestion would be that the ECB tomorrow should announce the it will close ‘the gap’ as fast as possible by doing open-ended QE until the gap has been closed. Lets pick a number – lets say the ECB did EUR 200bn QE per month starting tomorrow and that the ECB at the same time would announce that it every month would monitor whether the gap was closing or not. This of course would necessitate more than 4% NGDP growth to close the gap – so if for example expected NGDP growth dropped below for example 6-8% then the ECB would further step up QE in steps of EUR 50bn per month. In this regard it is important to remember that it would take as much as 8% yearly NGDP growth to close the gap in two years.

Such policy would course be a very powerful signal to the markets and we would likely get the reaction very fast. First of all the euro would weaken sharply and euro equity prices would shoot up. Furthermore, inflation expectations – particularly near-term inflation expectations would shoot up. This in itself would have a dramatic impact on nominal demand in the European economy and it would in my opinion be possible to close the NGDP gap in two years. When the gap is closed the ECB would just continue to target 4% NGDP growth and start “tapering” and then gradual rate hikes in the exact same way the Fed has done. But first we need to see some action from the ECB.

So Draghi what are you waiting for? Just announce it!

PS some would argue that the ECB is not allowed to do QE at all. I believe that is nonsense. Of course the ECB is allowed to issue money – after all if a central bank cannot issue money what is it then doing? The ECB might of course not be allowed to buy government bonds, but then the ECB could just buy something else. Buy covered bonds, buy equities, buy commodities etc. It is not about what to buy – it is about increasing the money base permanently and stick to the plan.

PPS Yes, yes I fully realize that my suggestion is completely unrealistic in terms of the ECB actually doing it, but not doing something like what I have suggested will condemn the euro zone to Japan-style deflationary pressures and constantly returning banking and public finances problems. Not to mention the risk of nasty political forces becoming more and more popular in Europe.

Three terrible Italian ‘gaps’

Yesterday we got confirmation that Italy feel back to recession in the second quarter of the year (see more here). In this post I will take a look at three terrible ‘gaps’ – the NGDP gap, the output gap and the price gap –  which explains why the Italian economy is so deeply sick.

It is no secret that I believe that we can understand most of what is going on in any economy by looking at the equation of exchange:

(1) M*V=P*Y

Where M is the money supply, V is money-velocity, P is the price level and Y is real GDP.

We can – inspired by David Eagle – of course re-write (1):

(1)’ N=P*Y

Where N is nominal GDP.

From N, P and Y we can construct our gaps. Each gap is the percentage difference between the actual level of the variable – for example nominal GDP – and the ‘pre-crisis trend’ (2000-2007).

The NGDP gap – massive tightening of monetary conditions post-2008 

We start by having a look at nominal GDP.

NGDP gap Italy

We can make numerous observations based on this graph.

First of all, we can see the Italian euro membership provided considerable nominal stability from 2000 to 2008 – nominal GDP basically followed a straight line during this period and at no time from 2000 to 2008 was the NGDP gap more than +/- 2%. During the period 2000-2007 NGDP grew by an average of 3.8% y/y.

Second, there were no signs of excessive NGDP growth in the years just prior to 2008. If anything NGDP growth was fairly slow during 2005-7. Therefore, it is hard to argue that what followed in 2008 and onwards in anyway can be explained as a bubble bursting.

Third, even though Italy obviously has deep structural (supply side) problems there is no getting around that what we have seen is a very significant drop in nominal spending/aggregate demand in the Italian economy since 2008. This is a reflection of the significant tightening of Italian monetary conditions that we have seen since 2008. And this is the reason why the NGDP gap no is nearly -20%!

Given this massive deflationary shock it is in my view actually somewhat of a miracle that the political situation in Italy is not a lot worse than it is!

An ever widening price gap

The scale of the deflationary shock is also visible if we look at the development in the price level – here the GDP deflation – and the price gap.

Price gap Italy

The picture in terms of prices is very much the same as for NGDP. Prior to 2007/8 we had a considerable level of nominal stability. The actual price level (the GDP deflator) more or less grew at a steady pace close to the pre-crisis trend. GDP deflator-inflation averaged 2.5% from 2000 to 2008.

However, we also see that the massive deflationary trends in the Italian economy post-2008. Hence, the price gap has widened significantly and is now close to 7%.

It is also notable that we basically have three sub-periods in terms of the development in the price gap. First, the ‘Lehman shock’ in 2008-9 where the price gap widened from zero to 4-5%. Then a period of stabilisation in 2010 (a similar pattern is visible in the NGDP gap) – and then another shock caused by the ECB’s two catastrophic interest rate hikes in 2011. Since 2011 the price gap has just continued to widen and there are absolutely no signs that the widening of the price gap is coming to an end.

What should be noted, however, is that the price gap is considerably smaller than the NGDP gap (7% vs 20% in 2014). This is an indication of considerably downward rigidity in Italian prices. Hence, had there been full price flexibility the NGDP gap and the price gap would have been of a similar size. We can therefore conclude that the Italian Aggregate Supply (AS) curve is fairly flat (the short-run Phillips curve is not vertical).

The Great Recession has caused a massive output loss in Italy

In a world of full price flexibility the AS curve is vertical and as a result a drop in nominal GDP should be translated fully into a drop in prices, while the output should be unaffected. However, as the difference between the NGDP gap and the price indicates the Italian AS curve is far from vertical. Therefore we should expect a major negative demand shock to cause a drop in prices (relative to the pre-crisis trend), but also a a drop in output (real GDP). The graph below shows that certainly also has been the case.

Output gap Italy

 

The graph confirms the story from the two first graphs – from 2000 to 2007 there was considerably nominal stability and that led to real stability as well. Hence, during that period real GDP growth consistently was fairly close to potential growth. However, the development in real GDP since 2008 has been catastrophic. Hence, real GDP today is basically at the same level today as 15 years ago!

The extremely negative development in real GDP means that the output gap (based on this simple method) today is -14%! And worse – there don’t seems to be any sign of stabilisation (yesterday’s GDP numbers confirmed that).

And it should further be noted that even before the crisis Italian RGDP growth was quite weak. Hence, in the period 2000-2007 real GDP grew by an average of only 1.2% y/y – strongly indicating that Italy not only has to struggle with a massive negative demand problem, but also with serious structural problems.

Without monetary easing it could take a decade to close the output gap  

The message from the graphs above is clear – the Italian economy is suffering from a massive demand short-fall due to overly tight monetary conditions (a collapse in nominal GDP).

One can obviously imagine that the Italian output gap can be closed without monetary easing from the ECB. That would, however, necessitate a sharp drop in the Italian price level (basically 14% relative to the pre-crisis trend – the difference between the NGDP gap and the price gap).

A back of an envelop calculation illustrates how long this process would take. Over the last couple of years the GDP deflator has grown by 1-1.5% y/y compared a pre-crisis trend-growth rate around 2.5%. This means that the yearly widening of the price gap at the present pace is 1-1.5%. Hence, at that pace it would take 9-14 years to increase the price gap to 20%.

However, even if this was political and socially possible we should remember that such an “internal devaluation” would lead to a continued rise in both public and private debt ratios as it would means that nominal GDP growth would remain extremely low even if real GDP growth where to pick up a bit.

Concluding, without a monetary easing from the ECB Italy is likely to remain in a debt-deflation spiral within things that follows from that – banking distress, public finances troubles and political and social distress.

PS An Italian – Mario Draghi – told us today that the ECB does not think that there is a need for monetary easing right now. Looking at the “terrible gaps” it is pretty hard for me to agree with Mr. Draghi.

European central bankers are obsessing about everything else than monetary policy

While it is becoming increasingly clear that Europe is falling into a Japanese style deflationary trap European central bankers continue to refuse to talk about the need for monetary easing to curb deflationary pressures. Instead they seem to be focused on everything else. We have been through it all – the ECB has concerned itself with who was Prime Minister in Greece and Italy about Spanish fiscal policy, rising oil prices in 2011 and about “financial stability”. And believe it or not it has become fashionable for European central bankers to call for higher wages in Germany!

This is from Reuters (on Sunday):

The European Central Bank supports Germany‘s Bundesbank in its appeals for higher wage deals in Germany, Der Spiegel magazine quoted ECB Chief Economist Peter Praet as saying on Sunday.

Low wage agreements were needed in some crisis-hit countries in the euro zone to bolster competitiveness, the magazine quoted Praet as saying.

By contrast, in countries like Germany where “inflation is low and the labour market is in good shape”, higher earnings increases were appropriate, Der Spiegel reported him to have said.

This would help bring average wage developments in the euro zone in line with the ECB’s inflation target of close to 2 percent, his argument continued, said Der Spiegel.

The Bundesbank historically has been a strong advocate of wage restraint, but with euro zone inflation stuck below 1 percent and consumer prices rising just 1.0 percent in June in Germany, Europe’s biggest economy, some fear deflation.

Bundesbank Chief Economist Jens Ulbrich has been widely reported by German media to have encouraged German trade unions to take a more aggressive stance in wage negotiations given low levels of inflation.

First of all one should ask the question why European central bankers in this way would interfere in the determination of prices (wages). The job of the central bank is to provide a nominal anchor – not to have a view on relative prices.

Second you got to wonder what textbook European central bank economists have been reading. It seems like they have completely missed the difference between the supply side and the demand side of the economy.

We know from earlier that ECB Chief Economist Praet seems to have a bit of a problem differentiating between supply and demand shocks. Apparently this is a general problem for Eureopan central bankers – or at least Bundesbank’ Jens Ulbrich suffers from the same problem.

What Ulbrich seems to be arguing is that we should solve Europe’s deflationary problem by basically engineering a negative supply shock to the German economy. The same kind of logic has been used as an argument for the recent misguided increase in German minimum wages.

Hence, it seems like both Praet and Ulbrich actually acknowledge that there is a deflationary problem in Europe, but at the same time they very clearly fail to understand that this is a monetary phenomenon. As a consequence they come up with very odd “solutions” for the problem.

This can be easily demonstrated in a simple Cowen-Tabarak style AS/AD framework – see the graph below.

wage shock

ECB’s overly tight monetary policy has caused aggregate demand to drop shifting the AD curve from AD to AD’, which has caused a drop in inflation to below 2% (likely also soon below 0%).

The Bundesbank now wants to deal with this problem not by doing the obvious – easing monetary policy aggressive – but instead by causing a negative supply shock. Obviously if German labour unions are given further monopoly powers and/or the German minimum wage is increased then that is a negative supply shock – wages increase without an increase in productivity or demand for labour. This causes the AS curve to shift left from AS to AS’.

The result of course would be higher inflation, but real GDP growth would drop further (to y” in the graph). Or said in another way it seems like the Bundebank are advocating “solving” Europe deflationary problem by increasing the structural problems on the German labour market.

Obviously Jens Ulbrich likely would argue that this is not what he means (his reasoning seems to follow a typical 1970s style “Keynesian” macroeconometric model where there is no money and no supply side – higher wage growth cause demand to increase), but that doesn’t matter as the outcome of an exogenous negative supply shock to the German economy would be bad news for Europe rather than good news.

Stop micromanaging the European economy – and do monetary easing

It is about time that European central bankers stop obsessing about matters that have nothing to do with monetary policy – whether it is fiscal policy, financial stability or labour market conditions. They can and not should try to influence these matters. The ECB should just take these matters as given when they conduct monetary policy, but it not for them to influence these matters.

The Bundesbank or the ECB should not have a view on what the level of the public deficit in Spain is or the how much German wages should increase. The first is for the Spanish government to decide on and the second is for German employers and labour unions to negotiate. It is becoming very hard to argue for central bank independence when central bankers (mis)use this independence to interfere in non-monetary matters.

The ECB is failing badly on this at the moment has the risk of falling into a deflationary trap is increase day by day. So why do the Bundesbank and the ECB just not focus on solving that issue? Depressingly the problem is very easy to solve – also without worsening German labour market conditions.

PS The argument for higher wage growth and tight money is very similar to what caused the so-called Recession in the Depression in the US in 1937. The Roosevelt administration got increasingly concerned in 1936-37 that inflation was picking up while wage growth remained weak. The Roosevelt administration feared this would cause real wage to drop, which would cause private consumption to drop and unemployment to increase. This obviously is a very primitive form of Keynesianism (but something Keynes did in fact advocate) and today it should be clear to everybody that political attempts to cause real wages to outpace productivity will lead to higher rather than lower unemployment. And this is what happened in 1937 – the FDR administration troed push up real wages by increasing nominal wage growth and tightening monetary policy caused the recession in 1937.

PPS Unfortunately the Abe government in Japan seems to suffering from the same illusion that “engineering” a rise in real wage – without a similar rise in productivity – can help the Japanese economy.

 

Never reason from a price change – version #436552

This is ECB’s chief economist Peter Praet in an interview with Les Echos:

 “Normally, a fall in prices would be able to support purchasing power and, therefore, domestic demand. But demand has remained weak, including in the biggest euro area economies”

It seems like Praet is not entirely sure about the difference between supply and demand shocks, but let me just illustrate the dffference in two graphs (I don’t have much time so I did it by hand and with the help of an iPhone…)

ASAD

The European situation is the graph on the right.

The un-anchoring of inflation expectations – 1970s style monetary policy, but now with deflation

In country after country it is now becoming clear that we are heading for outright deflation. This is particularly the case in Europe – both inside and outside the euro area – where most central banks are failing to keep inflation close to their own announced inflation targets.

What we are basically seeing is an un-anchoring of inflation expectations. What is happening in my view is that central bankers are failing to take responsibility for inflation and in a broader sense for the development in nominal spending. Central bankers simply are refusing to provide an nominal anchor for the economy.

To understand this process and to understand what has gone wrong I think it is useful to compare the situation in two distinctly different periods – the Great Inflation (1970s and earlier 1980s) and the Great Moderation (from the mid-1980s to 2007/8).

The Great Inflation – “Blame somebody else for inflation”

Monetary developments were quite similar across countries in the Western world during the 1970s. What probably best describes monetary policy in this period is that central banks in general did not take responsibility for the development in inflation and in nominal spending – maybe with the exception of the Bundesbank and the Swiss National Bank.

In Milton Friedman’s wonderful TV series Free to Choose from 1980 he discusses how central bankers were blaming everybody else than themselves for inflation (see here)

As Friedman points out labour unions, oil prices (the OPEC) and taxes were said to have caused inflation to have risen. That led central bankers like then Fed chairman Arthur Burns to argue that to reduce inflation it was necessary to introduce price and wage controls.

Friedman of course rightly argued that the only way to curb inflation was to reduce central bank money creation, but in the 1970s most central bankers had lost faith in the fundamental truth of the quantity theory of money.

Said in another way central bankers in the 1970s simply refused to take responsibility for the development in nominal spending and therefore for inflation. As a consequence inflation expectations became un-anchored as the central banks did not provide an nominal anchor. The result was predictable (for any monetarist) – the price level driffed aimlessly, inflation increased, became highly volatile and unpredictable.

Another thing which was characteristic about monetary policy in 1970s was the focus on trade-offs – particularly the Phillips curve relationship that there was a trade-off between inflation and unemployment (even in the long run). Hence, central bankers used high unemployment – caused by supply side factors – as an excuse not to curb money creation and hence inflation. We will see below that central bankers today find similar excuses useful when they refuse to take responsibility for ensuring nominal stability.

The Great Moderation – “Inflation is always and everywhere monetary phenomenon” 

That all started to change as Milton Friedman’s monetarist counterrevolution started to gain influence during the 1970s and in 1979 the newly appointed Federal Reserve chairman Paul Volcker started what would become a global trend towards central banks again taking responsibility for providing nominal stability and in the early 1990s central banks around the world moved to implement clearly defined nominal policy rules – mostly in the form of inflation targets (mostly around 2%) starting with the Reserve Bank of  New Zealand in 1990.

Said in the other way from the mid-1980s or so central banks started to believe in Milton Friedman’s dictum that “Inflation is always and everywhere monetary phenomenon” and more importantly they started to act as if they believed in this dictum. The result was predictable – inflation came down dramatically and became a lot more predictable and nominal spending/NGDP growth became stable.

By taking responsibility for nominal stability central banks around the world had created an nominal anchor, which ensured that the price mechanism in general could ensure an efficient allocation of resources. This was the great success of the Great Moderation period.

The only problem was that few central bankers understood why and how this was working. Robert Hetzel obvious was and still is a notable exception and he is telling us that reason we got nominal stability is exactly because central banks took responsibility for providing a nominal anchor.

That unfortunately ended suddenly in 2008.

The Great Recession – back to the bad habits of the 1970s

If we compare the conduct of monetary policy around the world over the past 5-6 years with the Great Inflation and Great Moderation periods I think it is very clear that we to a large extent has returned to the bad habits of the 1970s. That particularly is the case in Europe, while there are signs that monetary policy in the US, the UK and Japan is gradually moving back to practices similar to the Great Moderation period.

So what are the similarities with the 1970s?

1) Central banks refuse to acknowledge inflation (and NGDP growth) is a monetary phenomenon.

2) Central banks are concerned about trade-offs and have multiple targets (often none-monetary) rather focusing on one nominal target. 

Regarding 1) We have again and again heard central bankers say that they are “out of ammunition” and that they cannot ease monetary policy because interest rates are at zero – hence they are indirectly saying that they cannot control nominal spending growth, the money supply and the price level. Again and again we have heard ECB officials say that the monetary transmission mechanism is “broken”.

Regarding 2) Since 2008 central banks around the world have de facto given up on their inflation targets. In Europe for now nearly two years inflation has undershot the inflation targets of the ECB, the Riksbank, the Polish central bank, the Czech central bank and the Swiss National Bank etc.

And to make matters worse these central banks quite openly acknowledge that they don’t care much about the fact that they are not fulfilling their own stated inflation targets. Why? Because they are concerning themselves with other new (ad hoc!) targets – such as the development in asset prices or household debt.

The Swedish Riksbank is an example of this. Under the leadership of Riksbank governor the Stefan Ingves the Riksbank has de facto given up its inflation targeting regime and is now targeting everything from inflation, credit growth, property prices and household debt. This is completely ad hoc as the Riksbank has not even bothered to tell anybody what weight to put on these different targets.

It is therefore no surprise that the markets no longer see the Riksbank’s official 2% inflation target as credible. Hence, market expectations for Swedish inflation is consistency running below 2%. In 1970s the Riksbank failed because it effectively was preoccupied with hitting an unemployment target. Today the Riksbank is failing – for the same reason: It is trying to hit another other non-monetary target – the level of household debt.

European central bankers in the same way as in the 1970s no longer seem to understand or acknowledge that they have full control of nominal spending growth and therefore inflation and as a consequence they de facto have given up providing a nominal anchor for the economy. The result is that we are seeing a gradual un-anchoring of inflation expectations in Europe and this I believe is the reason that we are likely to see deflation becoming the “normal” state of affairs in Europe unless fundamental policy change is implemented.

Every time we get a new minor or larger negative shock to the European economy – banking crisis in Portugal or fiscal and political mess in France – we will just sink even deeper into deflation and since there is nominal anchor nothing will ensure that we get out of the deflationary trap. This is of course the “Japanese scenario” where the Bank of Japan for nearly two decade refused to take responsibility for providing an nominal anchor.

And as we continue to see a gradual unchoring of inflation expectations it is also clear that the economic system is becomimg increasingly dysfunctional and the price system will work less and less efficiently – exactly as in the 1970s. The only difference is really that while the problem in 1970s was excessively high inflation the problem today is deflation. But the reason is the same – central banks refusal to take responsibility for providing a nominal anchor.

Shock therapy is needed to re-anchor inflation expectations

The Great Inflation came to an end when central banks around the world finally took responsibility for providing a nominal anchor for the economy through a rule based monetary policy based on the fact that the central bank is in full control of nominal spending growth in the economy. To do that ‘shock therapy’ was needed.

For example example the Federal Reserve starting in 1979-82 fundamentally changed its policy and communication about its policy. It took responsibility for providing nominal stability. That re-anchored inflation expectations in the US and started a period of a very high level of nominal stability – stable and predictable growth in nominal spending and inflation.

To get back to a Great Moderation style regime central banks need to be completely clear that they take responsibility for for ensuring nominal stability and that they acknowledge that they have full control of nominal spending growth and as a consequence also the development in inflation. That can be done by introducing a clear nominal targeting – either restating inflation targets or even better introducing a NGDP targeting.

Furthermore, central banks should make it clear that there is no limits on the central bank’s ability to create money and controlling the money base. Finally central banks should permanently make it clear that you can’t have your cake and eat it – central banks can only have one target. It is the Tinbergen rule. There is one instrument – the money base – should the central bank can only hit one target. Doing anything else will end in disaster. 

The Federal Reserve and the Bank of Japan have certainly moved in that direction of providing a nominal anchor in the last couple of years, while most central banks in Europe – including most importantly the ECB – needs a fundamental change of direction in policy to achieve a re-anchoring of inflation expectations and thereby avoiding falling even deeper into the deflationary trap.

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PS This post has been greatly inspired by re-reading a number of papers by Robert Hetzel on the Quantity Theory of Money and how to understand the importance of central bank credibility. In that sense this post is part of my series of “Tribute posts” to Robert Hetzel in connection with his 70 years birthday.

PPS Above I assume that central banks have responsibility for providing a nominal anchor for the economy. After all if a central bank has a monopoly on money creation then the least it can do is to live up to this responsibility. Otherwise it seems pretty hard to argue why there should be any central bank at all.

Money and credit confused…again, again and again

The debate over the latest policy actions from the ECB has once again reminded me about one of the oldest failures in monetary debate – the confusion 0f  money and credit. This has been very visible in the discussion about monetary policy over the past six years both in Europe and the US.

The confusion of money and credit again and again has caused central banks to make the wrong decisions implementing credit policies and mistaking it for monetary easing.

I should really write a blog post on this, but it has already been done. Our friend and Market Monetarist blogger Bill Woolsey did it back in 2009. Bill used to be a student of Leland Yeager who back in 1986 wrote the ultimate paper on this issue with Robert Greenfield - Money and Credit confused: An Appraisal of Economic Doctrine and Federal Reserve Procedure.

I stole this from Bill’s 2009 post Money and Credit Confused. Bill explains the crucial differences between money and credit very well:

Money is the medium of exchange. The quantity of money is the amount of money that exists at a point in time.

The demand for money is the amount of money that people want to hold at a point in time. To hold money is to not spend it.

The supply of credit is the amount of funds people want to lend during a period of time.

The demand for credit is the amount of funds that people want to borrow during a period of time.

An increase in the demand for money is not the same thing as an increase in the demand for credit.

An increase in the demand for credit means that households and firms want to borrow more. While it is possible that they want to borrow money in order to hold it, the more likely scenario is that they borrow in order to increase spending on some good or service, including, perhaps some other financial asset.

An increase in the demand for money could result in an increase in the demand for credit. People might borrow money in order to hold it. However, the more likely scenario is that people demanding more money will reduce expenditure out of current income, purchasing fewer other assets, goods, or services. Of course, they could also sell other assets.

An increase in the supply of credit isn’t the same thing as an increase in the quantity of money. While it is possible that new money is lent into existence, raising the quantity of money over a period of time while augmenting the supply of credit, it is also possible for the supply of credit to rise without an increase in the quantity of money. Purchases of new corporate bonds by households or firms, for example, adds to the supply of credit without adding to the quantity of money.

Because shifts in the share of the total supply of credit associated with money creation are possible, the quantity of money can rise over a period of time when the supply of credit is shrinking.

There are relationships between the supply and demand for money and the supply and demand for credit, both in disequilibrium and equilibrium. But money and credit are not the same thing.

As Bill notes – the first rule of monetary policy is not to confuse money and credit. Unfortunately central bankers do it all the time.

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Update: A friend of mine thinks the ultimate discussion is not Yeager, but this one: Currie, Lauchlin. “Treatment of Credit in Contemporary Monetary Theory.” Journal of Political Economy 41 (February 1933), 58-79.

The ECB should give Bob Hetzel a call

The ECB is very eager to stress that the monetary transmission mechanism in some way is broken and that the policy measures needed is not quantitative easing, but measures to repair the monetary transmission mechanism.

In regard to ECB’s position I find this quote from a excellent paper – What Is a Central Bank? – by Bob Hetzel very interesting:

For example, in Japan, the argument is common that the bad debts of banks have broken the monetary transmission mechanism. The central bank can acquire assets to increase the reserves of commercial banks, but the weak capital position of banks limits their willingness to engage in additional lending. As in the real bills world, the marketplace controls the ability of the central bank to create independent changes in money that change prices.

According to the quantity theory as opposed to the real bills view, a central bank exercises its control over the public’s nominal expenditure through money (monetary base) creation. That control does not derive from the central bank’s influence over financial intermediation. A commercial bank acquires assets by making its liabilities attractive to individuals who forego consumption to hold them. In contrast, a central bank acquires assets through the ability to impose a tax (seigniorage) that comes from money creation. It imposes the tax directly on holders of cash and indirectly on holders of bank deposits to the extent that banks hold reserves against deposits.

Bob wrote the paper while he was a visiting scholar at the Bank of Japan in 2003.

It is striking how the present position of the ECB is similar to the BoJ’s position at the time Bob spend time there. Maybe the ECB should invite Bob to pay a visit?

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See also Bob’s paper Japanese Monetary Policy and Deflation.

“God forbid that our policy should ever work”

This is Mario Draghi at the ECB’s press conference yesterday:

“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring.”

You got to ask yourself why you would ease monetary policy if you don’t want inflation expectations to increase. And ask yourself if the market will believe this will work if the ECB is so eager to say that the policy will not increase inflation expectations.

It all just feel so Japanese – pre-Kuroda…

HT Nicolas Goetzmann

 

The massively negative euro zone ‘money gap’ (another one graph version)

Earlier today I put out post with ‘one graph’ illustrating just how much behind the curve the ECB is in terms of needed monetary easing. At the core of that blog post was a graph of the ‘price gap’. I defined the price gap as the percentage difference between the actual price level (measured with the GDP deflator) and a 2% path.

David Laidler has asked me how the ‘two graph’ version of the post would have looked. The other graph of course being the (broad) money supply rather than price level.

David, take a look at this graph:

money gap euro zone

We know from my earlier post that the ECB prior to 2008 basically was able to keep the actual price level very close to the ‘targeted’ price level (the 2% path). Therefore, we will also have to conclude that the actual money supply (M3) level was more or less right. Hence, if we assume an unchanged trend in money-velocity then it reasonable to also assume that the pre-crisis trend is the trend in the money supply necessary to return the price level to the pre-2008 trend.

I define the ‘money gap’ the percentage difference between the actual M3 level and the pre-2008 trend-level. The graph is extremely scary – the ‘money gap’ is now -30%! Said in another way – the ECB needs to expand M3 by 30% to bring prices back to the pre-crisis trend level or the ECB needs to engineer a massive change in expectations to push up money-velocity.

Don’t tell me that the ECB doesn’t need to do massive QE to avoid deflation…

PS I have chosen to ignore commenting on ECB’s policy decision earlier today, but lets just say that today’s action is unlikely to do much about the deflationary risks in the euro zone. Outright QE is needed.

PPS I have earlier discussed the euro zone ‘money gap’. See for example here.

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