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.

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Certainly not perfect, but Fed policy is not worse than during the Great Moderation (an answer to Scott Sumner)

Scott Sumner has replied to my previous post in which I argued that the Federal Reserve de facto has implemented a 4% NGDP level targeting regime (without directly articulating it).

Scott is less positive about actual Fed policy than I am. This is Scott answering my postulate that he would have been happy about a 4% NGDP growth path had it been announced in 2009:

Actually I would have been very upset, as indeed I was as soon as I saw what they were doing.  I favored a policy of level targeting, which meant returning to the previous trend line.

Now of course if they had adopted a permanent policy of 4% NGDP targeting, I would have had the satisfaction of knowing that while the policy was inappropriate at the moment, in the long run it would be optimal.  Alas, they did not do that.  The recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.

I most admit that I am a bit puzzled by Scott’s comments. Surely one could be upset in 2009 – as both Scott and I were – that the Fed did not do anything to bring back the nominal GDP level back to the pre-crisis trend and it would likely also at that time have been a better policy to return to a 5% trend rather than a 4% trend. However, I would also note that that discussion is mostly irrelevant for present day US monetary policy and here I would note two factors, which I find important:

  1. We have had five years of supply side adjustments – five years of “internal devaluation”/”wage moderation” so to speak. It is correct that the Fed didn’t boost aggregate demand sufficiently to push down US unemployment to pre-crisis levels, but instead it has at least kept nominal spending growth very stable (despite numerous shocks – see below), which has allowed for the adjustment to take place on the supply side of the economy and US unemployment is now nearly back at pre-crisis levels (yes employment is much lower, but we don’t know to what extent that is permanent/structural or not).
  2. Furthermore, we have had numerous changes to supply side policies in the US – mostly negative such as Obamacare and an increase in US minimum wages, but also some positive such as the general general reduction in defense spending and steps towards ending the “War on Drugs”.

Given these supply side factors – both the adjustments and the policy changes – it would make very little sense in my view to try to bring the NGDP level back to the pre-2008 trend-level and I don’t think Scott is advocating this even though his comments could leave that impression. Furthermore, given that expectations seem to have fully adjusted to a 4% NGDP level-path there would be little to gain from targeting a higher NGDP growth rate (for example 5%).

The Fed is more credible today than during the Great Moderation

Furthermore, I would dispute Scott’s claim that the Fed’s policy is not credible. Or rather while the monetary policy regime is not well-articulated by the Fed it is nonetheless pretty well-understood by the markets and basically also by the Fed itself (even though that from time to time could be questioned).

Hence, both the markets and the Fed fully understand today that there effectively is no liquidity trap. There might be a Zero Lower Bound on interest rates but if needed the Fed can ease monetary policy through quantitative easing. This is clearly well-understood by the Fed system today and the markets fully well knows that if a new shock to for example money-velocity where to hit the US economy then the Fed would most likely once again step up QE. This is contrary to the situation prior to 2008 where the Fed certainly had not articulated a policy of how to conduct monetary policy at the Zero Lower Bound and this of course was a key reason why the monetary policy stance became so insanely tight in 2008.

This does in no way mean that monetary policy in the US is perfect. It is certainly not – just that it is no less credible than monetary policy was during the Greenspan years and that the Fed today is better prepared to conduct monetary policy at the ZLB than prior to 2008.

NGDP has been more stable since 2009/2010 than during the Great Moderation

If we look at the development in nominal GDP it has actually been considerably more stable – and therefore also more predictable – than during the Great Moderation. The graph below illustrates that.

NGDP gap New Moderation

It is particularly notable in the graph that the NGDP gap – the percentage difference between the actual NGDP level and the NGDP trend – has been considerably smaller in the period from July 2009 and until today than during the Great Moderation (here said to be from 1995 until 2007). In fact the average absolute NGDP gap (the green dotted lines) was nearly three times as large during the Great Moderation than it has been since July 2009. Similarly inflation expectations has been more stable since July 2009 than during the Great Moderation and there unlike in the euro zone there are no signs that inflation expectations have become unanchored.

It is easy to be critical about the Fed’s conduct of monetary policy in recent years, but I find it very hard to argue that monetary policy has been worse than during the Great Moderation. 2008-9 was the catastrophic period, but since 2009/10 the Fed has re-established a considerable level of nominal stability and the Fed should be given some credit for that.

In this regard it is also notable that financial market volatility in the US today is at a historical low point – lower than during most of the Great Moderation period. This I believe to a large extent reflects a considerable level of “nominal predictability”.

No less sensitive to shocks than during the Great Moderation

Scott argues “(t)he recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.” 

It is obviously correct that the Fed has failed to spell out that it is actually targeting a 4% NGDP level path and I agree with Scott that this is a major problem and that means that the US economy is much more sensitive to shocks than otherwise would be the case. However, I would also stress that first of all during the Great Moderation the Fed had an even less clear target officially than is the case today.

Second, we should not forget that we have actually seen considerable shocks to the global and to the US economy since 2009/10. Just think of the massive euro crisis, Greece’s de facto default, the Cyprus crisis, the “fiscal cliff” in the US, a spike in oil prices 2010-12 and lately a sharp rise in global geopolitical tensions. Despite of all these shocks US NGDP has stayed close to the 4% NGDP path started in July 2009.

This to me is a confirmation that the Fed has been able to re-establish a considerable level of nominal stability. It has not been according to Market Monetarist game plan, but it is hard to be critical about the outcome.

In regard to the so-called “fiscal cliff” – the considerable tightening of fiscal policy in 2013 – it is notable that Scott has forcefully and correctly in my view argued that it had no negative impact on total aggregate nominal demand exactly because of monetary policy – or rather the monetary policy regime – offset the fiscal shock.

This is of course the so-called Sumner critique. For the Sumner critique to hold it is necessary that the monetary policy regime is well-understood by the markets and that the regime is credible. Hence, when Scott argues that 2013 confirmed the Sumner critique then he is indirectly saying that the monetary policy regime was credible in 2013. Had the monetary policy regime not been credible then the fiscal tightening likely would have led to a sharp slowdown in US growth.

It is time to let bygones be bygones

Nearly exactly a year ago I argued in a post that it is time to let bygones be bygones in US monetary policy:

Obviously even though the US economy seems to be out of the expectational trap there is no guarantee that we could not slip back into troubled waters once again, (but)…

… it is pretty clear to most market participants that the Fed would likely step up quantitative easing if a shock would hit US aggregate demand and it is fairly clear that the Fed has become comfortable with using the money base as a policy instrument…

… I must admit that I increasingly think – and most of my Market Monetarist blogging friends will likely disagree – that the need for a Rooseveltian style monetary positive shock to the US economy is fairly small as expectations now generally have adjusted to long-term NGDP growth rates around 4-5%. So while additional monetary stimulus very likely would “work” and might even be warranted I have much bigger concerns than the lack of additional monetary “stimulus”.

Hence, the focus of the Fed should not be to lift NGDP by X% more or less in a one-off positive shock. Instead the Fed should be completely focused on defining its monetary policy rule. A proper rule would be to target of 4-5% NGDP growth – level targeting from the present level of NGDP. In that sense I now favour to let bygones to be bygones as expectations now seems to have more or less fully adjusted and five years have after all gone since the 2008 shock.

Therefore, it is not really meaningful to talk about bringing the NGDP level back to a rather arbitrary level (for example the pre-crisis trend level). That might have made sense a year ago when we clearly was caught in an expectations deflationary style trap, but that is not the case today. For Market Monetarists it was never about “monetary stimulus”, but rather about ensuring a rule based monetary policy.  Market Monetarists are not “doves” (or “hawks”). These terms are only fitting for people who like discretionary monetary policies.

This remains my view. Learn from the mistakes of the past, but lets get on with life and lets instead focus fully on get the Fed’s target well-defined.

PS I hate being this positive about the Federal Reserve. In fact I am really not that positive. I just argue that the Fed is no worse today than during the Great Moderation.

The Fed’s un-announced 4% NGDP target was introduced already in July 2009

Scott Sumner started his now famous blog TheMoneyIllusion in February 2009 it was among other things “to show that we have fundamentally misdiagnosed the nature of the recession, attributing to the banking crisis what is actually a failure of monetary policy”.

Said in another way the Federal Reserve was to blame for the Great Recession and there was only one way out and that was monetary easing within a regime of nominal GDP level targeting (NGDP targeting).

NGDP targeting is of course today synonymous Scott Sumner. He more or less single-handedly “re-invented” NGDP targeting and created an enormous interest in the topic among academics, bloggers, financial sector economists and even policy makers.

The general perception is that NGDP targeting and Market Monetarism got the real break-through in 2013 when the Federal Reserve introduced the so-called Evans rule in September 2012 (See for example Matt Yglesias’ tribute to Scott from September 2012).

This has also until a few days ago been my take on the story of the success of Scott’s (and other’s) advocacy of NGDP targeting. However, I have now come to realize that the story might be slightly different and that the Fed effectively has been “market monetarist” (in a very broad sense) since July 2009.

The Fed might not have followed the MM game plan, but the outcome has effectively been NGDP targeting

Originally Scott basically argued that the Fed needed to bring the level nominal GDP back to the pre-crisis 5% trend path in NGDP that we had known during the so-called Great Moderation from the mid-1980s and until 2007-8.

We all know that this never happened and as time has gone by the original arguments for returning to the “old” NGDP trend-level seem much less convincing as there has been considerable supply side adjustments in the US economy.

Therefore, as time has gone by it becomes less important what is the “starting point” for doing NGDP targeting. Therefore, if we forgive the Fed for not bringing NGDP back to the pre-crisis trend-level and instead focus on the Fed’s ability to keep NGDP on “a straight line” then what would we say about the Fed’s performance in recent years?

Take a look at graph below – I have used (Nominal) Private Consumption Expenditure (PCE) as a monthly proxy for NGDP.

PCE gap

If we use July 2009 – the month the 2008-9 recession officially ended according to NBER – as our starting point (rather than the pre-crisis trend) then it becomes clear that in past five years PCE (and NGDP) has closely tracked a 4% path. In fact at no month over the past five years have PCE diverged more than 1% from the 4% path. In that sense the degree of nominal stability in the US economy has been remarkable and one could easily argue that we have had higher nominal stability in this period than during the so-called Great Moderation.

In fact I am pretty sure that if somebody had told Scott in July 2009 that from now on the Fed will follow a 4% NGDP target starting at the then level of NGDP then Scott would have applauded it. He might have said that he would have preferred a 5% trend rather than a 4% trend, but overall I think Scott would have been very happy to see a 4% NGDP target as official Fed policy.

The paradox is that Scott has not sounded very happy about the Fed’s performance for most of this period and neither have I and other Market Monetarists. The reason for this is that while the actual outcome has looked like NGDP targeting the Fed’s implementation of monetary policy has certainly not followed the Market Monetarist game plan.

Hence, the Market Monetarist message has all along been that the Fed should clearly announce its target (a NGDP level target), do aggressive quantitative easing to bring NGDP growth “back on track”, stop focusing on interest rates as a policy instrument and target expected NGDP rather than present macroeconomic variables. Actual US monetary policy has gradually moved closer to this ideal on a number of these points – particularly with the so-called Evan rule introduced in September 2012, but we are still very far away from having a Market Monetarist Fed when it comes to policy implementation.

However, in the past five years the implementation of Fed policy has been one of trial-and-error – just think of QE1, QE2 and QE3, two times “Operation Twist” and all kinds of credit policies and a continued obsession with using interest rates rates as the primary policy “instrument”.

I believe we Market Monetarists rightly have been critical about the Fed’s muddling through and lack of commitment to transparent rules. However, I also think that we today have to acknowledge that this process of trail-and-error actually has served an important purpose and that is to have sent a very clear signal to the financial markets (and others for that matter) that the Fed is committed to re-establishing some kind of nominal stability and avoiding a deflationary depression. This of course is contrary to the much less clear commitment of the ECB.

The markets have understood it all along (and much better than the Fed)

Market Monetarists like to say that the markets are better at forecasting and the collective wisdom of the markets is bigger than that of individual market participants or policy makers and something could actually indicate that the markets from an early point understood that the Fed de facto would be keeping NGDP on a straight line.

An example is the US stock market bottomed out a few months before we started to establish the new 4% trend in US NGDP and the US stock markets have essentially been on an upward trend ever since, which is fully justified if you believe the Fed will keep this de facto NGDP target in place. Then we should basically be expecting US stock prices to increase more or less in line with NGDP (disregarding changes to interest rates).

Another and even more powerful example in my view is what the currency markets have been telling us. I  (and other Market Monetarists) have long argued that market expectations play a key role in the in the implementation of monetary policy and in the monetary policy transmission mechanism.

In a situation where the central bank’s NGDP level target is credible rational investors will be able to forecast changes in the monetary policy stance based on the actual level of NGDP relative to the targeted level of NGDP. Hence, if actual NGDP is above the targeted level then it is rational to expect that the central bank will tighten the monetary policy stance to bring NGDP back on track with the target. This obviously has implications for the financial markets.

If the Fed is for example targeting a 4% NGDP path and the actual NGDP level is above this target then investors should rationally expect the dollar to strengthen until NGDP is back at the targeted level.

And guess what this is exactly how the dollar has traded since July 2009. Just take a look at the graph below.

NGDP gap dollar index 2

We are looking at the period where I argue that the Fed effectively has targeted a 4% NGDP path. Again I use PCE as a monthly proxy for NGDP and again the gap is the gap between the actual and the “targeted” NGDP (PCE) level. Look at the extremely close correlation with the dollar – here measured as a broad nominal dollar-index. Note the dollar-index is on an inverse axis.

The graph is very clear. When the NGDP gap has been negative/low (below target) as in the summer of 2010 then the dollar has weakened (as it was the case from from the summer of 2010under spring/summer of 2011. And similarly when the NGDP gap has been positive (NGDP above target) then the dollar has tended to strengthen as we essentially has seen since the second half of 2011 and until today.

I am not arguing that the dollar-level is determining the NGDP gap, but I rather argue that the dollar index has been a pretty good indicator for the future changes in monetary policy stance and therefore in NGDP.

Furthermore, I would argue that the FX markets essentially has figured out that the Fed de facto is targeting a 4% NGDP path and that currency investors have acted accordingly.

It is time for the Fed to fully recognize the 4% NGDP level target

Just because there has a very clear correlation between the dollar and the NGDP gap in the past five years it is not given that that correlation will remain in the future. A key reason for this is – and this is a key weakness in present Fed policy – that the Fed has not fully recognize that it is de facto targeting a 4%. Therefore, there is nothing that stops the Fed from diverging from the NGDP rule in the future.

Recognizing a 4% NGDP level target from the present level of NGDP in my view should be rather uncontroversial as this de facto has been the policy the Fed has been following over the past five years anyway. Furthermore, it could easily be argued as compatible  with the Fed’s (quasi) official 2% inflation target (assuming potential real GDP growth is around 2%).

In my previous post I argued that the ECB should introduce a 4% NGDP target. The Fed already done that. Now it is just up to Fed Chair Janet Yellen to announce it officially. Janet what are you waiting for?

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.

Stock picker Janet Yellen

If you are looking for a new stock broker look no further! This is Fed chair Janet Yellen at her testimony in the US Senate yesterday:

“Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

This is quite unusual to say the least that the head of most powerful central bank in the world basically is telling investors what stocks to buy and sell.

Unfortunately it seems to part of a growing tendency among central bankers globally to be obsessing about “financial stability” and “bubbles”, while at the same time increasingly pushing their primary nominal targets in the background. In Sweden an obsession about household debt and property prices has caused the Riksbank to consistently undershot its inflation target. Should we now start to think that the Fed will introduce the valuation of biotech and social media stocks in its reaction function? Will the Fed tighten monetary policy if Facebook stock rises “too much”? What is Fed’s “price target” in Linkedin?

I believe this is part of a very unfortunate trend among central bankers around the world to talk about monetary policy in terms of “trade-offs”. As I have argued in a recent post in the 1970s inflation expectations became un-anchored exactly because central bankers refused to take responsibility for providing a nominal anchor and the excuse was that there are trade-offs in monetary policy – “yes, we can reduce inflation, but that will cause unemployment to increase”.

Today the excuse for not providing a nominal anchor is not unemployment, but rather the perceived risk of “bubbles” (apparently in biotech and social media stocks!)  The result is that inflation expectations again are becoming un-anchored – this time the result, however, is not excessively high inflation, but rather deflation. The impact on the economy is, however, the same as the failure to provide a nominal anchor will make the working of the price system less efficient and therefore cause a general welfare lose.

I am not arguing that there is not misallocation of credit and capital. I am just stating that it is not a task for central banks to deal with these problems. In think that moral hazard problems have grown significantly since 2008 – particularly in Europe. Therefore governments and international organisations like the EU and IMF need to reduce implicit and explicit guarantees and subsidies to (other) governments, banks and financial institutions to a minimum. And central banks should give up credit policies and focus 100% on monetary policy and on providing a nominal anchor for the economy and leave the price mechanism to allocate resources in the economy.

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.

—-

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.

The monetary transmission mechanism – causality and monetary policy rules

Most economists pay little or no attention to nominal GDP when they think (and talk) about the business cycle, but if they had to explain how nominal GDP is determined they would likely mostly talk about NGDP as a quasi-residual. First real GDP is determined – by both supply and demand side factors – and then inflation is simply added to get to NGDP.

Market Monetarists on the other hand would think of nominal GDP determining real GDP. In fact if you read Scott Sumner’s excellent blog The Money Illusion – the father of all Market Monetarist blogs – you are often left with the impression that the causality always runs from NGDP to RGDP. I don’t think Scott thinks so, but that is nonetheless the impression you might get from reading his blog. Old-school monetarists like Milton Friedman were basically saying the same thing – or rather that the causality was running from the money supply to nominal spending to prices and real GDP.

In my view the truth is that there is no “natural” causality from RGDP to NGDP or the other way around. I will instead here argue that the macroeconomic causality is fully dependent about the central bank’s monetary policy rules and the credibility of and expectations to this rule.

In essenssens this also means that there is no given or fixed causality from money to prices and this also explains the apparent instability between the lags and leads of monetary policy.

From RGDP to NGDP – the US economy in 2008-9?

Some might argue that the question of causality and whilst what model of the economy, which is the right one is a simple empirical question. So lets look at an example – and let me then explain why it might not be all that simple.

The graph below shows real GDP and nominal GDP growth in the US during the sharp economic downturn in 2008-9. The graph is not entirely clearly, but it certainly looks like real GDP growth is leading nominal GDP growth.

RGDP NGDP USA 2003 2012

Looking at the graph is looks as if RGDP growth starts to slow already in 2004 and further takes a downturn in 2006 before totally collapsing in 2008-9. The picture for NGDP growth is not much different, but if anything NGDP growth is lagging RGDP growth slightly.

So looking at just at this graph it is hard to make that (market) monetarist argument that this crisis indeed was caused by a nominal shock. If anything it looks like a real shock caused first RGDP growth to drop and NGDP just followed suit. This is my view is not the correct story even though it looks like it. I will explain that now.

A real shock + inflation targeting => drop in NGDP growth expectations

So what was going on in 2006-9. I think the story really starts with a negative supply shock – a sharp rise in global commodity prices. Hence, from early 2007 to mid-2008 oil prices were more than doubled. That caused headline US inflation to rise strongly – with headline inflation (CPI) rising to 5.5% during the summer of 2008.

The logic of inflation targeting – the Federal Reserve at that time (and still is) was at least an quasi-inflation targeting central bank – is that the central bank should move to tighten monetary condition when inflation increases.

Obviously one could – and should – argue that clever inflation targeting should only target demand side inflation rather than headline inflation and that monetary policy should ignore supply shocks. To a large extent this is also what the Fed was doing during 2007-8. However, take a look at this from the Minutes from the June 24-25 2008 FOMC meeting:

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards. In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation… 

…Conditions in some financial markets had improved… the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen. Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. 

Hence, not only did some FOMC members (the majority?) believe monetary policy was easy, but they even wanted to move to tighten monetary policy in response to a negative supply shock. Hence, even though the official line from the Fed was that the increase in inflation was due to higher oil prices and should be ignored it was also clear that that there was no consensus on the FOMC about this.

The Fed was of course not the only central bank in the world at that time to blur it’s signals about the monetary policy response to the increase in oil prices.

Notably both the Swedish Riksbank and the ECB hiked their key policy interest rates during the summer of 2008 – clearly reacting to a negative supply shock.

Most puzzling is likely the unbelievable rate hike from the Riksbank in September 2008 amidst a very sharp drop in Swedish economic activity and very serious global financial distress. This is what the Riksbank said at the time:

…the Executive Board of the Riksbank has decided to raise the repo rate to 4.75 per cent. The assessment is that the repo rate will remain at this level for the rest of the year… It is necessary to raise the repo rate now to prevent the increases in energy and food prices from spreading to other areas.

The world is falling apart, but we will just add to the fire by hiking interest rates. It is incredible how anybody could have come to the conclusion that monetary tightening was what the Swedish economy needed at that time. Fans of Lars E. O. Svensson should note that he has Riksbank deputy governor at the time actually voted for that insane rate hike.

Hence, it is very clear that both the Fed, the ECB and the Riksbank and a number of other central banks during the summer of 2008 actually became more hawkish and signaled possible rates (or actually did hike rates) in reaction to a negative supply shock.

So while one can rightly argue that flexible inflation targeting in principle would mean that central banks should ignore supply shocks it is also very clear that this is not what actually what happened during the summer and the late-summer of 2008.

So what we in fact have is that a negative shock is causing a negative demand shock. This makes it look like a drop in real GDP is causing a drop in nominal GDP. This is of course also what is happening, but it only happens because of the monetary policy regime. It is the monetary policy rule – where central banks implicitly or explicitly – tighten monetary policy in response to negative supply shocks that “creates” the RGDP-to-NGDP causality. A similar thing would have happened in a fixed exchange rate regime (Denmark is a very good illustration of that).

NGDP targeting: Decoupling NGDP from RGDP shocks 

I hope to have illustrated that what is causing the real shock to cause a nominal shock is really monetary policy (regime) failure rather than some naturally given economic mechanism.

The case of Israel illustrates this quite well I think. Take a look at the graph below.

NGDP RGDP Israel

What is notable is that while Israeli real GDP growth initially slows very much in line with what happened in the euro zone and the US the decline in nominal GDP growth is much less steep than what was the case in the US or the euro zone.

Hence, the Israeli economy was clearly hit by a negative supply shock (sharply higher oil prices and to a lesser extent also higher costs of capital due to global financial distress). This caused a fairly sharp deceleration real GDP growth, but as I have earlier shown the Bank of Israel under the leadership of then governor Stanley Fischer conducted monetary policy as if it was targeting nominal GDP rather than targeting inflation.

Obviously the BoI couldn’t do anything about the negative effect on RGDP growth due to the negative supply shock, but a secondary deflationary process was avoid as NGDP growth was kept fairly stable and as a result real GDP growth swiftly picked up in 2009 as the supply shock eased off going into 2009.

In regard to my overall point regarding the causality and correlation between RGDP and NGDP growth it is important here to note that NGDP targeting will not reverse the RGDP-NGDP causality, but rather decouple RGDP and NGDP growth from each other.

Hence, under “perfect” NGDP targeting there will be no correlation between RGDP growth and NGDP growth. It will be as if we are in the long-run classical textbook case where the Phillips curve is vertical. Monetary policy will hence be “neutral” by design rather than because wages and prices are fully flexible (they are not). This is also why we under a NGDP targeting regime effectively will be in a Real-Business-Cycle world – all fluctuations in real GDP growth (and inflation) will be caused by supply shocks.

This also leads us to the paradox – while Market Monetarists argue that monetary policy is highly potent under our prefered monetary policy rule (NGDP targeting) it would look like money is neutral also in the short-run.

The Friedmanite case of money (NGDP) causing RGDP

So while we under inflation targeting basically should expect causality to run from RGDP growth to NGDP growth we under NGDP targeting simply should expect that that would be no correlation between the two – supply shocks would causes fluctuations in RGDP growth, but NGDP growth would be kept stable by the NGDP targeting regime. However, is there also a case where causality runs from NGDP to RGDP?

Yes there sure is – this is what I will call the Friedmanite case. Hence, during particularly the 1970s there was a huge debate between monetarists and keynesians about whether “money” was causing “prices” or the other way around. This is basically the same question I have been asking – is NGDP causing RGDP or the other way around.

Milton Friedman and other monetarist at the time were arguing that swings in the money supply was causing swings in nominal spending and then swings in real GDP and inflation. In fact Friedman was very clear – higher money supply growth would first cause real GDP growth to pick and later inflation would pick-up.

Market monetarists maintain Friedman’s basic position that monetary easing will cause an increase in real GDP growth in the short run. (M, V and NGDP => RGDP, P). However, we would even to a larger extent than Friedman stress that this relationship is not stable – not only is there “variable lags”, but expectations and polucy rules might even turn lags into leads. Or as Scott Sumner likes to stress “monetary policy works with long and variable LEADS”.

It is undoubtedly correct that if we are in a situation where there is no clearly established monetary policy rule and the economic agent really are highly uncertain about what central bankers will do next (maybe surprisingly to some this has been the “norm” for central bankers as long as we have had central banks) then a monetary shock (lower money supply growth or a drop in money-velocity) will cause a contraction in nominal spending (NGDP), which will cause a drop in real GDP growth (assuming sticky prices).

This causality was what monetarists in the 1960s, 1970s and 1980s were trying to prove empirically. In my view the monetarist won the empirical debate with the keynesians of the time, but it was certainly not a convincing victory and there was lot of empirical examples of what was called “revered causality” – prices and real GDP causing money (and NGDP).

What Milton Friedman and other monetarists of the time was missing was the elephant in the room – the monetary policy regime. As I hopefully has illustrated in this blog post the causality between NGDP (money) and RGDP (and prices) is completely dependent on the monetary policy regime, which explain that the monetarists only had (at best) a narrow victory over the (old) keynesians.

I think there are two reasons why monetarists in for example the 1970s were missing this point. First of all monetary policy for example in the US was highly discretionary and the Fed’s actions would often be hard to predict. So while monetarists where strong proponents of rules they simply had not thought (enough) about how such rules (also when highly imperfect) could change the monetary transmission mechanism and money-prices causality. Second, monetarists like Milton Friedman, Karl Brunner or David Laidler mostly were using models with adaptive expectations as rational expectations only really started to be fully incorporated in macroeconomic models in the 1980s and 1990s. This led them to completely miss the importance of for example central bank communication and pre-announcements. Something we today know is extremely important.

That said, the monetarists of the times were not completely ignorant to these issues. This is my big hero David Laidler in his book Monetarist Perspectives” (page 150):

“If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

Macroeconomists to this day unfortunately still forget or ignore the wisdom of David Laidler.

HT DL and RH.

The Casselian-Mundelian view: An overvalued dollar caused the Great Recession

This is CNBC’s legendary Larry Kudlow in a comment to my previous post:

My friend Bob Mundell believes a massively over-valued dollar (ie, overly tight monetary policy) was proximate cause of financial freeze/meltdown.

Larry’s comment reminded me of my long held view that we have to see the Great Recession in an international perspective. Hence, even though I generally agree on the Hetzel-Sumner view of the cause – monetary tightening – of the Great Recession I think Bob Hetzel and Scott Sumner’s take on the causes of the Great Recession is too US centric. Said in another way I always wanted to stress the importance of the international monetary transmission mechanism. In that sense I am probably rather Mundellian – or what used to be called the monetary theory of the balance of payments or international monetarism.

Overall, it is my view that we should think of the global economy as operating on a dollar standard in the same way as we in the 1920s going into the Great Depression had a gold standard. Therefore, in the same way as Gustav Cassel and Ralph Hawtrey saw the Great Depression as result of gold hoarding we should think of the causes of the Great Recession as being a result of dollar hoarding.

In that sense I agree with Bob Mundell – the meltdown was caused by the sharp appreciation of the dollar in 2008 and the crisis only started to ease once the Federal Reserve started to provide dollar liquidity to the global markets going into 2009.

I have earlier written about how I believe international monetary disorder and policy mistakes turned the crisis into a global crisis. This is what I wrote on the topic back in May 2012:

In 2008 when the crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused by both a contraction in velocity and in the money supply, reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to meet the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss francs – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss francs will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over…

…I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also led to a monetary contraction in especially Europe. Not because of an increased demand for euros, lats or rubles, but because central banks tightened monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as members of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

So there you go – you have to see the crisis in an international monetary perspective and the Fed could have avoided the crisis if it had acted to ensure that the dollar did not become significantly “overvalued” in 2008. So yes, I am as much a Mundellian (hence a Casselian) as a Sumnerian-Hetzelian when it comes to explaining the Great Recession. A lot of my blog posts on monetary policy in small-open economies and currency competition (and why it is good) reflect these views as does my advocacy for what I have termed an Export Price Norm in commodity exporting countries. Irving Fisher’s idea of a Compensated Dollar Plan has also inspired me in this direction.

That said, the dollar should be seen as an indicator or monetary policy tightness in both the US and globally. The dollar could be a policy instrument (or rather an intermediate target), but it is not presently a policy instrument and in my view it would be catastrophic for the Fed to peg the dollar (for example to the gold price).

Unlike Bob Mundell I am very skeptical about fixed exchange rate regimes (in all its forms – including currency unions and the gold standard). However, I do think it can be useful for particularly small-open economies to use the exchange rate as a policy instrument rather than interest rates. Here I think the policies of particularly the Czech, the Swiss and the Singaporean central banks should serve as inspiration.

ECB: “We’re not sure we can get out of it”

When Milton Friedman turned 90 years back in 2002 Ben Bernanke famously apologized for the Federal Reserve’s role in the Great Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

On Twiiter Ravi Varghese has paraphrased Bernanke to describe the role of the ECB in the present crisis:

“You’re right, we did it. We’re very sorry. But we’re not sure we can get out of it.”

Brilliant…follow Ravi on Twiiter here (and follow me here).

Stanley Fischer – this guy can keep NGDP on a straight line

This is from Reuters:

Stanley Fischer, who led the Bank of Israel for eight years until he stepped down in June, has been asked to be the Federal Reserve’s next vice chair once Janet Yellen takes over as chief of the U.S. central bank, a source familiar with the issue said on Wednesday.

Fischer, 70, is widely respected as one of the world’s top monetary economists. At the Massachusetts Institute of Technology, he once taught current Fed Chairman Ben Bernanke and Mario Draghi, the European Central Bank president.

Yellen, the current Fed vice chair, is expected to win approval from the U.S. Senate next week to take the reins from Bernanke, whose term ends in January.

Fischer, as an American-Israeli, was widely credited with guiding Israel through the global economic crisis with minimal damage. For the Fed, he would offer the fresh perspective of a Fed outsider yet offer some continuity as well.

Good news! Stanley Fischer certainly is qualified for the job. He knows about monetary theory and policy. And even better he used to have some sympathy for nominal income targeting. Just take a look at this quote from his 1995 American Economic Review article “Central Bank Independence Revisited” (I stole this from Evan Soltas):

“In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run–albeit with long-run targets and consequences in mind. Nominal- income-targeting provides an automatic answer to the question of how to combine real income and inflation targets, namely, they should be traded off one-for-one…Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to implya better automatic response of monetary policy to supply shocks…I judge that inflation-targeting is preferable to nominal-income-targeting, provided the target is adjusted for supply shocks.”

While at the Bank of Israel Fischer certainly conducted monetary policy as if he was targeting the level of nominal GDP. Just take a look at the graph below and note the “missing” crisis in 2008.

NGDP Israel

Undoubtedly Fischer had some luck, while at the BoI, and I must also say that I think he from time to time had a problem with his “forward guidance”, but his track-record speaks for itself – while Bank of Israel  governor, Stanley Fischer provided unprecedented nominal stability, something very rare in Israeli economic history. Lets hope he will help do that at the Fed as well.
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