Yet another year of asymmetrical monetary policy – revisiting the Weidmann rule

Nearly a year ago – January 2 – I wrote a blog post on what I termed the Weidmann rule. In the blog post I argued that the ECB is basically following a rule – named after Bundesbank boss Jens Weidmann – which is asymmetrical. The ECB will tighten monetary conditions in the event of a positive aggregate demand (velocity) shock, but will not ease in the event of a negative demand (velocity) shock to the euro zone economy.

This means that the ECB monetary policy set-up basically ensures that we are in a classical world when demand is picking (the budget multiplier is zero), but is in a basically keynesian world when we have negative demand shocks (the budget multiplier is positive). The world is not “naturally” keynesian, but the ECB’s policy regime makes the euro zone economy is essentially 50% keynesian.

A year ago I argued that the Weidman rule would be deflationary. Hence, “if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).”

This is of course exactly what we have seen over the past year – US NGDP remains on its 4% path, while euro zone has averaged less than 1% over the past year and the gap between US and euro zone NGDP is therefore growing larger and larger.

Add to that that euro zone has seen as least two negative demand shocks in 2014. First of all and likely most important the Russian (Ukrainian) crisis, which is likely to lead to a double-digit contraction in Russian real GDP in 2015 and second renewed concerns over the political situation in Greece and other Southern European countries (particularly separatist worries in Spain). These shocks are so far not major shocks and with a proper monetary policy set-up would like have very limited impact on the European economy. However, we do not have a proper monetary policy set-up and therefore every even smaller negative demand shock will just push Europe deeper and deeper into a deflationary spiral.

It is correct that the ECB has done a bit to offset these shocks – which in quantity theoretical context essentially are negative velocity shocks – by cutting interest rates and indicated that we will get some sort of quantitative easing in 2015.

However, with the euro zone money base basically still contracting, M3 growth being lacklustre, inflation expectations declining and NGDP growth being very weak it is hard to argue that the ECB has done a lot. In fact it has not really done anything to even offset the negative velocity/demand shocks we have seen in 2015.

Therefore, we unfortunately have to conclude that the Weidmann rule still the name of the game in Frankfurt and all indications are that the Bundesbank remains strongly opposed to any quantitative easing.

What the ECB needs to do is of course to once and for all to demonstrate that it will indeed offset any shock to velocity – both negative and positive to ensure nominal stability. A 4% NGDP target rule would do the job (see here) and would be fully within ECB’s mandate.

PS These days Jens Weidmann is arguing that things will be a lot better in the euro zone because the drop in oil prices is a positive demand shock (yes, this is basically what he is saying) and that monetary easing therefore is not needed. In 2011 the Bundesbank of course was eager to see interest rate hikes in response to increased oil prices because the risk of “second-round effects” (horrible expression!). It is hard to get any better illustration of the just how asymmetrical the Bundesbank’s preferred monetary policy rule is.

PPS Tim Worstall has an excellent post on Jens Weidmann and the Bundesbank here.

Mankiw rule tells the Fed to tighten

The most famous monetary policy rule undoubtedly is the so-called Taylor rule, which basically tells monetary policy makers to set the key monetary policy interest rates as a function of on the one hand the inflation rate relative to the inflation target and on the other hand the output gap.

The Taylor rule is rather simple and seems to at least historically have been a pretty good indicator of the actual policy followed by particularly the Federal Reserve. Often the Taylor rule is taken to be the “optimal” monetary policy rule. That of course is not necessarily the case. Rather one should see the Taylor rule as a empirical representation of actual historical Fed policy.

A similar rule which has gotten much less attention than the Taylor rule, but which essentially is the same thing is the so-called Mankiw rule. Greg Mankiw originally spelled out his rule in a paper on US monetary policy in the 1990s.

The beauty of the Mankiw rule is that it is extremely simple as it simply says that the Fed is setting the fed funds rate as function of the difference between core inflation (PCE) and the US unemployment rate (this of course is also the Fed’s “dual mandate”). Here is the original rule from Mankiw’s paper:

Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)

The graph below shows the original Mankiw rule versus actual Fed policy.

Mankiw rule

I have also added a Mankiw rule estimated on the period 2000-2007: Federal funds rate = 9.9 + 2.1 (Core inflation – Unemployment)

We see the Mankiw rule more or less precisely captures the actual movements up and down in the Fed funds rate from 2000 to 2008. Then in 2008 we of course hit the Zero Lower Bound. From the Autumn of 2008 the Mankiw rule told us that interest rates should have been cut to somewhere between -4% (the original rule) and -8% (the re-estimated rule). This is of course is what essentially have justified quantitative easing.

Mankiw rule is telling the Fed to hike rates 

Since early 2011 the Mankiw rule – both versions – has been saying that interest rates should become gradually less negative (mostly because the US unemployment rate has been declining) and maybe most interestingly both the original and the re-estimated Mankiw rule is now saying that the Fed should hike interest rates. In fact the re-estimated rule has just within the past couple of months has turned positive for the first time since 2008 and this is really why I am writing the this post.

Maybe we can use the Mankiw rule to understand why the Fed now seems to be moving in a more hawkish direction – we will know more about that later this week at the much anticipated FOMC meeting.

BUT the Mankiw rule is not an optimal rule

I have to admit I like the Mankiw rule for its extreme simplicity and because it is useful in understanding historical Fed policy actions. However, I do certainly not think of the Mankiw rule as an optimal monetary policy rule. Rather my regular readers will of course know that I would prefer that the Fed was targeting the nominal GDP level (something by the way Greg Mankiw also used to advocate) and I would like the Fed to use the money base rather than the Fed funds rate as its primary monetary policy instrument, but that is another story. The purpose here is simply to use the Mankiw rule to understand why the Fed – rightly or wrongly – might move in a move hawkish direction soon.

PS One could argue that the Mankiw rule needs to be adjusted for changes in the natural rate of unemployment, for discourage worker effects and for the apparent “drift” downward in the US core inflation rate since 2008. Those are all valid arguments, but again the purpose here is not to say what is “optimal” – just to use the simple Mankiw rule to maybe understand why the Fed is moving closer to rate hikes.

PPS One could also think of the Mankiw rule a simplistic description of the Evans rule, which the Fed basically announced in September 2012.

The fiscal cliff is not the end of the world

Today is supposed to be the end of the world – at least according to classic Mayan accounts (and Hollywood?). But so far we are still here and there are not really any signs that the world really is coming to an end today. However, judging from media reports the world might be coming to an end at least in economic terms as the feared “fiscal cliff” is drawing closer after U.S. House of Representatives Speaker John Boehner yesterday failed to get support for his so-called “plan B”.

The fear is that on January 1 we will get a massive US fiscal tightening unless a compromise to avoid it is reached. However, as I earlier have argued the fiscal cliff might not be as bad as it commonly is said to be. The fact is that no matter what US policy makers will have to tighten fiscal policy in the coming years as the size of the budget deficit clearly is unsustainable. Hence, it is just really a timing issue about when fiscal policy will have to be tightened. Fiscal tightening is unavoidable.

The Permanent Income Hypothesis and the Sumner Critique
– two reasons why the fiscal cliff is not the end of the world

Said in another way whether or not there is a compromise made on the fiscal cliff or not – this time around – it will have no impact on the average American’s Permanent Income. Hence, the average American will have to pay for the US budget deficit in some way or another today or tomorrow. There is really no way around it.

In his brilliant book “A Theory of the Consumption Function” Milton Friedman distinguished between permanent and transitory changes in income and he argued – contrary to the prevailing Keynesian dogma at the time – that only permanent changes in income would have an impact on private consumption.

This also means that if tax payers are given a tax break today, but are told that they will have to pay it all back in the form of higher taxes tomorrow then it will have no impact on private consumption today as the income increase is only transitory and will have no impact on the tax payers’ permanent income.

This would obviously also mean that if US tax rates are indeed increased in 2013 and that the revenue is used to reduce the US budget deficit then that will have no negative impact on the US tax payers’ permanent income as higher taxes today basically just mean that taxes will not have to be increased in the future.  This result of course is a variation of the so-called Ricardian Equivalence Theorem as formulated by Robert Barro in his classic article “Are government bonds net wealth?” from 1974.

Hence, if you believe in the fundamental truth of Friedman’s Permanent Income Hypothesis then you would expect the impact of a tax increase to cut the budget deficit and public debt to be much smaller than what the paleo-Keynesian textbook models would indicate.

One can of course debate whether the Permanent Income Hypothesis is correct or not and discuss especially the empirical validity of the Ricardian Equivalence Theorem (RET). Personally I am somewhat skeptical about assuming that RET will always hold.

However, on the other hand if the budget deficit is not reduced then sooner or later I certainly would expect some kind of RET style effect to kick in. That would naturally trigger consumers to cut spending on the expectation of higher taxes. The budget deficit will have to be cut – either through higher taxes or lower public spending – whether or not the fiscal cliff (if it happens).

I am not arguing that tax increases are good – certainly not. I think higher taxes have significantly negative supply side effects but I am very skeptical about the view that private consumption automatically will drop as much as the increase in taxes and even more skeptical that that would have an impact on aggregate demand (more on that below).

This discussion is similar to the discussion in a new paper by Matt Mitchell and Andrea Castillo. In their paper “What went wrong with the Bush tax cuts?” they discuss why the Bush tax cuts failed to spur growth.

I must admit I have not fully digested the paper yet (it just came out), but as I read it Mitchell and Castillo argue that the 2001 Bush tax cuts failed to have the intended economic impact primarily for two reasons. First, the tax cuts were announced to be temporary – and hence Milton Friedman would have told you that it would have no impact on permanent income and hence no impact on private consumption. Second, Mitchell and Castillo argue that since the tax cuts were not accompanied by similar budget cuts then consumers and investors would not expect the tax cuts to last – even if politicians had claimed they would.

I believe that if one argues that the Bush tax cuts failed to boost private consumption growth because of the reasons discussed above then you would have to think that there will be little impact on private consumption when the tax cuts expire. Again I am not talking about supply side effects, but the expected impact on private consumption and aggregate demand.

Aggregate demand is determined by monetary policy and not by fiscal policy

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.

The fiscal cliff is not going to be fun
…but it will certainly not be the end of the world

I am not arguing here that the fiscal cliff would be without problems. While the US certainly needs consolidation of public finances there are likely only small costs of postponing the fiscal adjustment and the uncertainty about the US tax code is certainly not good news from a supply side perspective. However, from a aggregate demand perspective I think there is much less reason to be worried than debate in the US would indicate.

Relax the world is not coming to an end…yet.

PS I admit that judging from the market action today we have to conclude that investors are likely not as relaxed about the fiscal cliff as I am. As a faithful Market Monetarist that leaves me with a bit of a dilemma – should I trust my own economic reasoning or should I trust the signals from the markets?

PPS this guy – my friend Martin – is well-prepared for an alien invasion (he is completely unprepared for the fiscal cliff)

MOH

Kocherlakota’s revelation

This is from Bloomberg:

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the central bank should hold the main interest rate near zero until unemployment falls below 5.5 percent, marking the first time he has linked policy to a specific economic goal.

“As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent,” Kocherlakota said today in the text of remarks prepared for a speech in Ironwood, Michigan, referring the policy-setting Federal Open Market Committee.

…Kocherlakota today embraced a proposal by Chicago Fed President Charles Evans to calibrate monetary policy based on specific economic goals. Evans advocates holding to near-zero rates until the jobless rate falls below 7 percent or inflation reaches 3 percent.

“My thinking has been greatly influenced by his,” Kocherlakota said, referring to Evans. “By increasing monetary accommodation, the Committee can better meet its employment mandate while still satisfying its price-stability mandate,” Kocherlakota said to business and community leaders at Gogebic Community College.

…”It’s an appropriate time to start thinking about when to begin the process of reversing the level of accommodation,” Kocherlakota said on May 9. “Six to nine months down the road, we should be thinking about initiating our exit strategy.”

Today, Kocherlakota said, “the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.”

Kocherlakota said today the central bank should give itself leeway by allowing inflation to deviate from its 2 percent target, saying the FOMC could contemplate raising rates if inflation rises above 2.25 percent. History suggests it’s unlikely inflation will rise above that point as long as the jobless rate remains above 5.5 percent, he said.

“The current economic impact of both forms of accommodation — low interest rates and asset purchases — depends on when the public believes that accommodation will be removed,” Kocherlakota said. Confident the Fed will keep the fed funds rate near zero until achieving 5.5 percent unemployment, “people will spend more today, and that will drive up economic activity,” he said.

This is pretty sensational – it seems like Kocherlakota finally understands. And it is it not only Kocherlakota. In fact it seems like there has been a completely transformation of the thinking at the Federal Reserve. I have no clue what happened at the Fed, but something happened. And it is good…

PS Just so it is 100% clear – I don’t think it is a good idea to target real variables like the unemployment rate and that it would make much more sense to introduce a proper NGDP level target, but at least variations of the Evans rules as suggested by Kocherlakota is much better than the status quo.

Update: See the entire speech here and a summary of Kocherlakota’s “liftoff plan”.

Update 2: Scott Sumner also comments on Kocherlakota.

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