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.

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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.

HAWKISH Market Monetarists

Over the past five years Market Monetarists have gotten a reputation for always being dovish in terms of monetary policy. The Market Monetarists have day-in and day-out been pushing for monetary easing in the US, the UK and the euro zone. So our reputation is correct in the sense that we – the Market Monetarists – in general have favoured a more dovish monetary stance both in the US and in Europe than has been implemented by central banks.

However, one might notice that the Market Monetarist bloggers have been surprisingly calm in recent months despite the sharp decline in inflation we have see in particularly Europe. Overall, we have obviously maintained that monetary policy in the euro zone is far too tight and that we are heading for deflation as a result of this. But the primary cause of the sharp decline in headline inflation in the euro zone has been lower commodity prices and to some extent also a result of an “austerity pause” (no indirect tax hikes).

Hence, Market Monetarists do not think a decline in inflation due a positive supply shock in itself should trigger interest rate cuts (or other forms of monetary policy easing). Remember Market Monetarists favour nominal GDP targeting and a supply shock will not impact nominal GDP – only composition of nominal GDP growth between inflation and real GDP growth.

As a result Market Monetarists actually tend to be somewhat less alarmed by the recent inflation decline in the euro zone than for example the ECB and in that sense you can argue that the Market Monetarists actually are more “hawkish” than the ECB presently is when it comes to the need for monetary easing in response to the recent decline in euro zone inflation. When Market Monetarists are calling for monetary easing in the euro zone it is hence for a somewhat different reason than the ECB.

Monetary policy remains overly tight in the euro zone and we are likely heading for deflation – even disregarding the recent supply side driven drop in inflation – and that is why we – the Market Monetarists are advocating monetary easing in the euro zone. Just a look at the dismail growth of nominal GDP in the euro zone – there is no better indication than that of the ECB’s failure to ease monetary policy appropriately. So we shouldn’t be too sad if the ECB moves to ease monetary policy – even if Market Monetarists think it is for the wrong reasons.

In 3-5 years the Market Monetarists will be among the biggest hawks

If we are lucky we continue to see supply side conditions improve both in the US and the euro zone in the coming years. I am personally particular optimistic about the outlook for the US economy, where I do expect a number of factors to give a welcomed lift to US potential growth. The end of the so-called commodity super cycle and fracking might hopefully to reduce oil prices. This is a positive supply shock to the US economy.

Furthermore, as I am optimistic that the US is in the process of ending two wars – the War on Drugs and the War on Terror. I will return to that issue in a later blog post, but I overall think that this is the direction we are moving in and that will be tremendously positive for the US labour supply (and public finances for that matter).

Finally, as the US economy continues to improve the present anti-immigration sentiment in the US will hopefully be reversed – after all Americans are more happy to welcome Mexicans to join the labour force when the economy is doing good rather than bad.

Add to that that US unemployment is still high so there is really no labour market constrains to growth at the moment in the US. So overall, I think we with a bit of luck could be in for a couple of years of fairly high real GDP growth driven by positive supply side factors. In such a scenario we could easily have 4% or even 5% real GDP growth for some years without any substantial pick-up in inflation. This would be very similar to mid-1990s.

Such a scenario would likely in 3-5 years time turn the Market Monetarist bloggers into proponents of Fed tightening – before most other economists would favour it. This would particularly be the case if the Fed overdo it on monetary easing in a scenario where positive supply side factors keep inflation low and hence we see a sharp pick-up in nominal GDP growth. This would of course be what Austrians call relative inflation.

So no, Market Monetarists are not always dovish. We advocate clear monetary policy rules and these rules sometimes leads us to advocate a dovish stance on monetary (as presently), but also to a hawkish stance if needed. For now I have no big fears that US monetary policy is becoming too easy, but if I am right about my “supply side optimism” then a Fed too focused on headline inflation might overdo it on the easy side down the road.

There is of course only one way to avoid such a monetary policy mistake – spell out a clear NGDP level targeting rule today.

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PS The ECB today did NOTHING to avoid deflation in the euro zone. No comments on that other than the ECB missed yet another opportunity to do the right thing.

PPS My best guess is that Scott Sumner will be a ultra hawk on US monetary policy in 2018-9.

Tick tock…here comes the Zero Lower Bound again

This week have brought even more confirmation that we are still basically in a deflationary world – particularly in Europe. Hence, inflation numbers for October in a number of European countries published this week confirm that that inflation is declining markedly and that we now very close to outright deflation in a number of countries. Just take the case of the Czech Republic where the so-called monetary policy relevant inflation dropped to 0.1% y/y in October or even worse Sweden where we now have outright deflation – Swedish consumer prices dropped by 0.1% in October compared to a year ago.

And the picture is the same everywhere – even a country like Hungary where inflation notoriously has been above the central bank’s 3% inflation target inflation is now inching dangerously close to zero.

Some might say that there is no reason to worry because the recent drop in inflation is largely driven by supply side factors. I would agree that we shouldn’t really worry about deflation or disinflation if it is driven by a positive supply shocks and central banks would not react to such shocks if they where targeting nominal GDP rather than headline consumer price inflation. In fact I think that we are presently seeing a rather large positive supply shock to the global economy and in that sense the recent drop in inflation is mostly positive. However, the fact is that the underlying trend in European prices is hugely deflationary even if we strip out supply side factors.

Just the fact that euro zone money supply growth have averaged 0-3% in the past five years tells us that there is a fundamental deflationary problem in the euro zone – and in other European countries. The fact is that inflation has been kept up by negative supply shocks in the past five years and in many countries higher indirect taxes have certainly also helped kept consumer price inflation higher than otherwise would have been the case.

So yes supply side factors help drag inflation down across Europe at the moment – however, some of this is due to the effect of earlier negative supply side shocks are “dropping out” of the numbers and because European governments are taking a break from the austerity measures and as a result is no longer increasing indirect taxes to the same extent as in earlier years in the crisis. Hence, what we are no seeing is to a large extent the real inflation picture in Europe and the fact is that Europe to a very large extent is caught in a quasi-deflatonary trap not unlike what we had in Japan for 15 years.

Here comes the Zero Lower Bound

Over the past five years it is not only the ECB that stubbornly has argued that monetary policy was easy, while it in fact was über tight. Other European central banks have failed in a similar manner. I could mention the Polish, the Czech central banks and the Swedish Riksbank. They have all to kept monetary policy too tight – and the result is that in all three countries inflation is now well-below the central bank’s inflation targets. Sweden already is in deflation and deflation might very soon also be the name of the game in the Czech Republic and Poland. It is monetary policy failure my friends!

In the case of Poland and Sweden the central banks have had plenty of room to cut interest rates, but both the Polish central bank and the Swedish Riksbank have been preoccupied with other issues. The Riksbank has been busy talking about macro prudential indicators and the risk of a property market bubble, while the economy has slowed and we now have deflation. In fact the Riksbank has consistently missed its 2% inflation target on the downside for years.

In Poland the central bank for mysteries reasons hiked interest rates in early 2012 and have ever since refused to acknowledged that the Polish economy has been slowing fairly dramatically and that inflation is likely to remain well-below its official 2.5% inflation target. In fact yesterday the Polish central bank published new forecasts for real GDP growth and inflation and the central bank forecasts inflation to stay well-below 2.5% in the next three years and real GDP is forecasted to growth much below potential growth.

If a central bank fails to hit its inflation target blame the central bank and if a central bank forecasts three years of failure to hit the target something is badly wrong. Polish monetary policy remains overly tight according to it own forecasts!

The stubbornly tight monetary stance of the Polish, the Czech and the Swedish central banks over the past couple of years have pushed these countries into a basically deflationary situation. That mean that these central banks now have to ease more than would have been the case had they not preoccupied themselves with property prices, the need for structural reforms and fiscal policy in recent years. However, as interest rates have been cut in all three countries – but too late and too little – we are now inching closer and closer to the Zero Lower Bound on interest rates.

In fact the Czech central bank has been there for some time and the Polish and the Swedish central bank might be there much earlier than policy makers presently realise. If we just get one “normal size” negative shock to the European economy and then the Polish and Swedish will have eventually to cut rates to zero. In fact with Sweden already in deflation one could argue that the Riksbank already should have cut rates to zero.

The Swedish and the Polish central banks are not unique in this sense. Most central banks in the developed world are very close to the ZLB or will get there if we get another negative shock to the global economy. However, most of them seem to be completely unprepared for this. Yes, the Federal Reserve now have a fairly well-defined framework for conducting monetary policy at the Zero Lower Bound, but it is still very imperfect. Bank of Japan is probably closer to having a operational framework at the ZLB. For the rest of the central banks you would have to say that they seem clueless about monetary policy at the Zero Lower Bound. In fact many central bankers seem to think that you cannot ease monetary policy more when you hit the ZLB. We of course know that is not the case, but few central bankers seem to be able to answer how to conduct monetary policy in a zero interest rate environment.

It is mysteries how central banks in apparently civilised and developed countries after five years of crisis have still not figured out how to combat deflation with interest rates at the Zero Lower Bound. It is a mental liquidity trap and it is telling of the serious institutional dysfunctionalities that dominate global central banking that central bankers are so badly prepared for dealing with the present situation.

But it is nonetheless a fact and it is hard not to think that we could be heading for decades of deflation in Europe if something revolutionary does not happen to the way monetary policy is conducted in Europe – not only by the ECB, but also by other central banks in Europe. In that sense the track record of the Swedish Riksbank or the Polish and Czech central banks is not much better than that of the ECB.

We can avoid deflation – it is easy!

Luckily there is a way out of deflation even when interest rates are stuck at zero. Anybody reading the Market Monetarists blogs know this and luckily some central bankers know it as well. BoJ chief Kuroda obviously knows what it takes to take Japan out of deflation and he is working on it. As do Czech central bank chief Miroslav Singer who last week – finally  - moved to use the exchange rate as policy instrument and devalued the Czech kurona by introducing a floor on EUR/CZK of 27. By doing this he copied the actions of the Swiss central bank. So there is hope.

Some central bankers do understand that there might be an Zero Lower Bound, but there is no liquidity trap. You can always avoid deflation. It is insanely easy, but mentally it seems to be a big challenge for central bankers in most countries in the world.

I am pretty optimistic that the Fed’s actions over the past year is taking the US economy out of the crisis. I am optimistic that the Bank of Japan will win the fight against deflation. I am totally convinced that the Swiss central bank is doing the right thing and I am hopeful that Miroslav Singer in the Czech Republic is winning the battle to take the Czech economy out of the deflationary trap. And I am even optimistic that the recent global positive supply shock will help lift global growth.

However, the ECB is still caught in its own calvinist logic and seems unable to realise what needs to be done to avoid a repeat of the past failures of the Bank of Japan. The Swedish central bank remains preoccupied with macro prudential stuff and imaginary fears of a property market bubble, while the Swedish economy now caught is in a deflationary state. The Polish central bank continues to forecast that it will fail to meet its own inflation target, while we are inching closer and closer to deflation. I could mention a number of other central banks in the world which seem trapped in the same kind of failed policies.

Ben Bernanke once argued that the Bank of Japan should show Rooseveltian resolve to bring Japan out of the deflationary trap. Unfortunately very few central bankers in the world today are willing to show any resolve at all despite the fact that we at least Europe is sinking deeper and deeper into a deflationary trap.

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Update: Former Riksbank deputy governor Lars E. O. Svensson comments on the Swedish deflation. See here.

No tapering, but no rule either. Net, net that is bad

I just arrived in New York and I will spend the next couple of days in the New York and Boston. For once my timing is good – the Federal Reserve just announce that there is not going to be any tapering.

Scott Sumner is happy, but I must admit that I for once disagree with the Fed on the hawkish side (kind of). Not that I am not favouring monetary easing, but I don’t really think that the important thing is the amount of quantitative easing the Fed is doing in the sense of 10 or 20 billion dollars more or less per month relative to Fed communication.

Blackrock’s Larry Fink is speaking on CNBC as I am writing this. He is saying that minor tapering with better guidance would have been better. I agree on that. I would much more have liked to see the Fed coming out today spelling out its monetary policy much more clearly. The fact is that the US economy is getting better – slowly, but surely so tapering is justified sooner or latter.

After all the Fed has now spend months getting the markets ready for the tapering and now it didn’t “deliver”. Not that I want tightening US monetary policy, but I want much better communication and better rules. The Fed didn’t move in that direction today. That is a missed opportunity. Today the fed could have tapered by 10 or 20 billion dollars, but at the same time clearly spelled out a rule for money base growth. It didn’t do tapering, but didn’t spell out a rule. Remember – Market Monetarism is not about monetary “stimulus”. It is about a rule based monetary policy. And remember the Fed could actually have eased today with a clear rule AND done tapering at the same time.

There is still good arguments for monetary easing in the US, but relative to the need for spelling a clear monetary policy rule that it unimportant.

Unfortunately I don’t have more time for blogging now – I am off to dinner with a good friend who happens to be another Market Monetarist. Try to guess who it is…

PS Larry Fink is also talking on CNBC about the debt celling. I don’t care about that. Lets just ignore it. Phew Larry Fink thinks Larry Summers would be a great Fed chairman. I don’t.

Rules vs central bank superheros

I have a new piece in today’s City AM on central bankers as (pretend) superheros versus rules based monetary policy:

LARRY Summers is out of the race to succeed Ben Bernanke as Fed chair. After months of debate, with politicians and media picking over Summers’s personality and background, the spotlight has returned to Janet Yellen, deputy Fed chairwoman. Is she now a certainty? Or is another monetary superhero about to emerge?

All of this recalls the moment when George Osborne announced that Mark Carney would be governor of the Bank of England. Carney was described by both the chancellor and the media as a superstar. It’s hard to miss the parallel with the hubbub around Gareth Bale’s £85.3m switch to Real Madrid.

But it’s a problem when monetary policy becomes viewed as uniquely dependent on a single “personality”. Central bankers should not be seen as star footballers. At best, they are referees. This is partly a problem of job description. What should the governor do? Should he or she fly about, putting out fires as they erupt in the economy? Or should he or she follow clearly defined monetary policy rules?

Over the past five years, we have grown increasingly used to the idea of the fire-fighting central banker. Even in 1999, Time magazine described Alan Greenspan, Robert Rubin and Summers as “The Committee to Save the World” for their role in the Asian crisis, the Russian crisis and the collapse of long-term capital management. Summers’s reputation nearly landed him the top job at the Fed.

Read the rest here.

Chuck Norris is back in the running

I seldom agree with Joseph Stiglitz on anything, but I agree with him that it would be a bad idea to name Larrry Summers new Fed chairman. So both Stiglitz and I should be happy today as Summers has redrawn his candidacy for new Fed chairman.

This is Summers’ letter to president Obama:

Dear Mr. President,

I am writing to withdraw my name for consideration to be Chairman of the Federal Reserve.

It has been a privilege to work with you since the beginning of your Administration as you led the nation
through a severe recession into a sustained economic recovery built on policies to promote employment
and strengthen the middle class.

This is a complex moment in our national life. I have reluctantly concluded that any possible
confirmation process for me would be acrimonious and would not serve the interests of the Federal
Reserve, the Administration, or ultimately, the interests of the nation’s ongoing economic recovery.

I look forward to continuing to support your efforts to strengthen our national economy by creating a
broad based prosperity and to reform our financial system so that no President ever again faces what you
and your economic team faced upon taking office in 2009.

Sincerely yours,

Lawrence Summers

And the market reaction? Well, the US stock market is up, the dollar weaker and yields are lower. Said in another way US monetary conditions are easier today than on Friday.

So by redrawning from the Fed race Summers has done more for a “sustaine economic recovery”  and more “to promote employment” than by staying in the race.  That is not my verdict, but the verdict of the markets.

Don’t ever mess with Chuck Norris!

It is time to let bygones be bygones

US bond yields continue to rise. To some this is a major risk for the global economy. However, I continue to think that there is no reason to worry about rising US bond yields – at least not from the perspective of the US economy.

Many have highligthed that the rise in US yields have been caused by the Federal Reserve’s plans to scale back quantatively easing. The fear of “tapering” is certainly a market theme and I would certainly not rule out that the tapering talk has contributed to the rise in bond yields. However, we don’t know that and a lot of other factors certainly also have contributed to the rise in yields and I do certainly not think that the recent rise in yields in itself is likely to derail the US economy. The Fed might still fail by prematurely tighten monetary conditions, but bond yields are not telling us much in that regard. Or rather if the market really feared premature monetary tightening then yields would probably have collapsed rather than continued to rise.

Back in May I wrote the following:

Greenspan was thinking that the Federal Reserve should (or actually did) target NGDP growth of 4.5%. Furthermore, he (indirectly) said that that would correspond to 30-year US Treasury yields being around 5.5%.

This is more or less also what we had all through the Great Moderation – or rather both 5% 30-year yields and 5% NGDP growth. However, the story is different today. While, NGDP growth expectations for the next 1-2 years are around 4-5% (ish) 30-year bond yields are around 3.3%. This in my view is a pretty good illustration that while the US economy is in recovery market participants remain very doubtful that we are about to return to a New Great Moderation of stable 5% NGDP growth.

That said, with yields continuing to rise faster than the acceleration in NGDP growth we can say that we are seeing a gradual return to something more like the Great Moderation. That obviously is great news.

In fact I would argue that when US 30-year hopefully again soon hit 5% then I think that we at that time will have to conclude that the Great Recession finally has come to an end. Last time US 30-year yields were at 5% was in the last year of the Great Moderation – 2007.

We are still very far away from 5% yields, but we are getting closer than we have been for a very long time – thanks to the fed’s change of policy regime in September last year.

Finally, when US 30-year bond yields hit 5% I will stop calling for US monetary easing. I will, however, not stop calling for a proper transparent and rule-based NGDP level targeting regime before we get that.

Since then US yields have continued to rise and even though 30-year yields are still someway away from 5% we getting closer on another measure, which is probably more relavant. Take a look at the graph below.

30yearyield

This is the market expectation for 30-year yields in five years. Since May we have seen a more 100bp increase in yields and we are now closing in on my “target” of 5%.

Historically there has been a very close relationship between nominal GDP growth and 30 year yields and it is reasonable to assume that when the market is expecting close to 5% yields in five years then it is a pretty strong indication that the market no longer expects a “Japanese scenario” of 10-15 years of deflation and no NGDP growth. In fact the market now more or less seem to expect that we are heading back towards nominal GDP growth rates similarly to what we had during the Great Moderation prior to 2008. Said in another way – we have moved out of the “expectational trap”. Investors no longer see weak nominal GDP growth as a permanent situation.

Therefore, I think it is safe to conclude that we effectively are at the end of the Great Recession in terms of market expectations. That, however, do not mean that we are out of the Great Recession in terms of the macroeconomic situation. Unemployment in the US likely is well-above the structural level of unemployment and the economy is certainly not working at full capacity. But judging from the bond market we are no longer caught in an expectational trap.

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. In fact as the graph above shows that in 2009  5-year ahead 30-year yields swiftly recovered back to Great Moderation levels around 5%, but then fell back to “depression levels” in 2010 and then again in 2011/12 – both times seemingly driven primarily by the euro crisis.

It should, however, be stressed that the set-backs in 2010 and 2011/2012 happened at a time when the Fed had not clearly defined a monetary policy rule nor had the Fed defined a clear alternative monetary policy instrument to the interest rate tool. Now however, it is pretty clear to most market participants that the Fed would likely step up quantitative easing if 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. The Evans rule is far from perfect, but it is certainly better than what we had in 2010 or 2011.

In that regard it is notable that yields started the  up-trend around September last year then the Fed basically announced the Evans rule, cf. the graph above. It is also notable that there probably has been a “recognition lag” – the markets did not immediately priced in 4-5% future NGDP growth. This has only happened gradually (indicating the Fed did not explain its target well enough), but we now seem to be quite close to having fully priced in longer-term growth rates in NGDP similar to what we had during the Great Moderation.

And finally, 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.

PS Just because I now argue that we should let bygones be bygones I certainly do not plan to let the Fed of the hook. Rather the opposite, but my concern is not that monetary policy is too tight in the US. My concern is that monetary policy still is far too discretionary.

PPS If the Fed once again “slips” and let monetary conditions become excessively tight as in 2011/12 I would certainly scream about that.

PPPS My worries that Larry Summers might become the next Fed chairman certain have influenced my thinking about these issues. I don’t fear that Summers will be too hawkish or too dovish. I fear that we will go back to an ultra-discretionary monetary policy in the US. The result of this could be catastrophic.

Helmut Reisen on the “China as monetary superpower” hypothesis

I have in a number of blog posts argued that China is a global or at least an Asian monetary superpower, which is exporting monetary tightening across Asia.

In a new very good blog post the former head of research at the OECD’s Development Centre Helmut Reisen discusses this hypothesis:

Usually, the current travails in emerging markets are blamed on expectations of slowing open market purchases by the US Federal Reserve System. Lars Christensen, head of emerging market research at Danske Bank, however, blames China´s monetary tightening as at least as important as the expected US Fed ´tapering´.  I have myself, with former colleagues, pointed to the growing impact that China´s growth has exerted since the last decade on GDP growth in middle- and low-income countries[1], pointing to the growing raw material, trade and production links of increasingly China centric emerging countries. So I shall have a lot of sympathy for Lars Christensen’s earlier proposition that China has also grown into a monetary superpower in a Sino monetary transmission mechanism with the rest of Asia. China´s monetary tightening, however, can hardly explain the current slump in Asian markets, on closer inspection.

So I nearly got Helmut convinced, but not quite. Here is Helmut again:

First, let us consider  the expected monetary stance in the US and in China. Graph 1 clearly shows that the market has formed expectations since May that the Fed would not continue open market purchases at the pace witnessed over the last years, partly fueled by Bernanke´s taper talk that month to US Congress. China´s monetary tightening, by contrast, occurred during late 2010 to early 2012 from when the Bank of China[2]. Since then, minimum reserve requirements were repeatedly reduced. Further, the PBC reduced its benchmark deposit and loan rates in June 2012. In addition, the PBC has also used a mix of monetary policy instruments to appropriately increase market liquidity. Even considering huge time lags, the current turmoil of Asia stock and bond markets cannot be blamed on China´s monetary tightening.

Hence, Helmut’s argument is that this is mostly caused by the Fed rather than by the People’s Bank of China. I do not disagree that the discussion of Fed tapering is having a negative impact on market sentiment in Asia. My view is just that that is not the whole story. China remains very important.

Furthermore, this is a good illustration of the Market Monetarist view of how to “measure” the monetary policy stance. While Helmut stresses that the PBoC has cut reserve requirements and interest rates recently Market Monetarists would instead focus on what markets are telling us about the monetary policy stance.

This discussion of course is similar to what happened in the euro zone and the US in 2008. Did the Fed ease or tighten monetary policy? Well, despite cutting nominal interest rates inflation expectations plummeted as did expectations for NGDP growth. That was indeed monetary tightening. And if we had good indicators for NGDP growth or inflation in China I would expect them to indicate a continued tightening of the Chinese monetary policy stance did the cut in official interest rates and reserve requirements.  The best market indicators for Chinese NGDP growth are probably copper and the Aussie dollar – and the Chinese stock market.

Hence, judging from for example the Chinese stock market monetary conditions have not become easier. Rather the opposite. And if the PBoC really had eased monetary conditions the Renminbi would have weakened significantly – it has not.

Furthermore, I would argue that communication about future changes in the money base is at least – in fact more – important than present changes to for example reserve requirements or interest rates. Hence, the communication from the Chinese authorities over the last couple of months has been decisively hawkish and if one wants to forecast the future path of the money base or the money supply in China one surely would have to conclude that the PBoC now plans a much slower rate of growth in the money supply than market participants had expected only a few months ago.

Furthermore, the PBoC’s rather clumsy handling of money market distress back in May-June left the impression that the Chinese authorities were quite happy about the impact it had on parts of the Chinese banking sector. In fact the turmoil gave reason to question that the PBoC really would act as lender-of-last-resort. That in my view was a very clear signal that the PBoC was quite happy with monetary conditions becoming tighter.

So yes, the PBoC has eased reserve requirements and cut official interest rates, but given the PBoC’s continued hawkish rhetoric market participants are not seeing the PBoC’s monetary policy stance becoming more accommodative – rather the opposite and judging from market pricing monetary contraction continues in China. That is having a clearly negative impact on the financial market sentiment across Asia.

That of course does not mean that Fed tapering is not important for what is going on in Asia at the moment. I think it is very important and it is for example clear that the sell-off in the Asian markets accelerated further this morning after the release yesterday of minutes from the latest FOMC meeting.

My point is just that the Fed is not the only monetary superpower in the world. The PBoC is also tremendously important. And on that I think Helmut and I are in total agreement.

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