PBoC governor Zhou Xiaochuan should give Jeff Frankel a call (he is welcome to call me as well)

Jeffrey Frankel of course is a long-term advocate of NGDP targeting, but recently he has started to advocate that if central banks continue to target inflation then they should target producer prices (the GDP deflator) rather than consumer prices. As anybody who reads this blog knows I tend to agree with this position.

Jeff among other places has explained his position in his 2012 paper “Product Price Targeting—A New Improved Way of Inflation Targeting”In this paper Jeff explains why it makes more sense for central banks to target product prices rather than consumer prices.

Terms of trade volatility poses a serious challenge to the inflation targeting (IT) approach to monetary policy. IT had been the favoured monetary regime in many quarters. But the shocks of the last five years have shown some serious limitations to IT, much as the currency crises of the late 1990s showed some serious limitations to exchange rate targeting. There are many variations of IT: focusing on headline versus core CPI, price level versus inflation, forecasted inflation versus actual, and so forth. Some interpretations of IT are flexible enough to include output in the target at relatively short horizons. But all orthodox interpretations focus on the CPI as the choice of price index. This choice may need rethinking in light of heightened volatility in prices of commodities and, therefore, in the terms of trade in many countries.

A CPI target can lead to anomalous outcomes in response to terms of trade fluctuations. Textbook theory says it is helpful for exchange rates to accommodate terms-of-trade shocks. If the price of imported oil rises in world markets, a CPI target induces the monetary authority to tighten money
enough to appreciate the currency—the wrong direction for accommodating an adverse movement in the terms of trade. If the price of the export commodity rises in world markets, a CPI target prevents monetary tightening consistent with appreciation as called for in response to an improvement in the terms of trade. In other words, the CPI target gets it exactly backward.

An alternative is to use a price index that reflects a basket of goods that the country in question produces, including those exported, in place of an index that reflects the basket of goods consumed, including those imported. It could be an index of export prices alone or a broader index of all goods produced domestically. I call the proposal to use a broad output-based price index as the anchor for monetary policy Product Price Targeting (PPT).

It is clear that Jeff’s PPT proposal is related to his suggestion that commodity exporters should target export prices – what he calls Peg-the-Export-Price (PEP) and I have termed the Export Price Norm (EPN). A PPT or PEP/EPN is obviously closer to the the Market Monetarist ideal of targeting the level of nominal GDP than a “normal” inflation target based on consumer prices is. In that regard it should be noted that the prices in nominal GDP is the GDP deflator, which is the price of goods produced in the economy rather than the price of goods consumed in the economy.

The Chinese producer price deflation

The reason I am writing about Jeff PPT’s proposal this morning is that I got reminded of it when I saw an article on CNBC.com on Chinese producer prices today. This is from the article:

The deflationary spiral in China’s producer prices that has plagued factories in the mainland for 16 consecutive months highlights the weakening growth momentum in the world’s second largest economy, said economists…

…The producer price index (PPI) dropped 2.7 percent in June from the year ago period, official data showed on Tuesday, compared to a fall of 2.9 percent in May. Producer prices in China have been declining since February 2012, weighed down by falling commodity prices, overcapacity and weakening demand.

…China’s consumer inflation, however, accelerated in June, driven by a rise in food prices.

China’s consumer price index (CPI) rose 2.7 percent in June from a year earlier, slightly higher than a Reuters forecast of 2.5 percent, and compared to a 2.1 percent tick up in the previous month. However, June’s reading is well under the central bank’s 3.5 percent target for 2013.

This I think pretty well illustrates Jeff’s point. If the People’s Bank of China (PBoC) was a traditional – ECB style – inflation target’er focusing solely on consumer prices then it would be worried about the rise in inflation, while if the PBoC on the other hand had a producer price target then it would surely now move to ease monetary policy.

Measuring Chinese monetary policy “tightness” based on PPT

In the pre-crisis period from 2000 to 2007 Chinese producer prices on average grew 2.3% y/y. Therefore, lets say that the PBoC de facto has targeted a 2-2.5% level path for producer prices. The graph below compares the actual level of producer prices in China (Index 2000=100) with a 2% and a 2.5% path respectively.  We can see that producer prices started to decline during the second part of 2011 and dropped below the 2.5% path more or less at the same time and dropped below the 2% path in the last couple of months. So it is probably safe to say that based on a PPT measure Chinese monetary policy has become tighter over the past 18 months or so and have become excessively tight within the last couple of quarters.

PPI China

The picture that emerges from using a ‘Frankel benchmark’ for monetary policy “tightness” hence is pretty much in line with what we see from other indicators of monetary conditions – the money supply, NGDP, FX reserve accumulation and market indicators.

It therefore also seems fair to say that while monetary tightening probably was justified in early 2010 one can hardly justify further monetary tightening at this stage. In fact there are pretty good reasons – including PPT – that Chinese monetary policy has become excessive tight and I feel pretty confident that that is exactly what Jeff Frankel would tell governor Zhou if he gave him a call.

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Angola should adopt an ‘Export-Price-Norm’ to escape the ‘China shock’

It might be a surprise to most people but one of the fastest growing economies in the world over the last 10-15 years has been Angola. A combination of structural reforms and a commodity boom have boosted growth in the oil-rich African country. However, Angola is, however, at a crossroad and the future of the boom might very well now be questioned.

It is monetary tightening in China, which is now threatening the boom. The reason for this is that Angola has received significant direct investments from China over the past decade and the rising oil prices have fueled oil exports. However, as the People’s Bank of China continues to tighten monetary conditions in China it will likely have two effects. First, it is likely to reduce Chinese investments – also into Angola. Second, the slowdown in the Chinese economy undoubtedly is a key reason for the decline in oil prices. Both things are obviously having a direct negative impact on the Angolan economy.

Angola’s monetary policy is likely to exacerbate the ‘China shock’ 

This is how the IMF describes Angola’s monetary regime:

Angola’s de facto exchange arrangement has been classified as “other managed” since October 2009. The Banco Nacional de Angola (BNA) intervenes actively in the foreign exchange market in order to sterilize foreign currency inflows in the form of taxes paid by oil companies. Auctions were temporarily suspended from April 20 to October 1, 2009 leading to the establishment of a formal peg. Since the resumption of auctions, the kwanza has depreciated. However, the authorities maintain strong control over the exchange rate, which is the main anchor for the monetary policy. The BNA publishes a daily reference rate, which is computed as the transactionweighted average of the previous day’s rates negotiated with commercial banks. Banks and exchange bureaus may deal among themselves and with their customers at rates that can be freely negotiated provided they do not exceed the reference rate by more than 4 percent.

Hence Angola de facto operates a pegged exchange rate regime and it is pretty clear in my view that this regime is likely to exacerbate the negative impact from the ‘China shock’.

The China shock is likely to lead to depreciation pressures on the Angolan kwanza in two ways. First the drop in global oil prices is likely to push down Angolan export prices – more or less by a one-to-one ratio. Second, the expected drop in Chinese investment activity is likely to also reduce Chinese direct investments into Angola. The depreciation pressures could potentially become very significant. However, if the Angolan central bank tries to maintain a quasi-pegged exchange rate then these depreciation pressures will automatically translate into a significant monetary tightening. The right thing to do is therefore obvious to allow (if needed) the kwanza to depreciate to adjust to the shock.

There are two ways of ensuring such depreciation. The first one is to simply to allow the kwanza to float freely. That however, would necessitate serious reforms to deepen the Angolan capital markets and the introduction of an nominal target – such as either an inflation target or an NGDP target. Even though financial markets reforms undoubtedly are warranted I have a hard time seeing that happening fast. Therefore, an alternative option – the introduction of a Export Price Norm (EPN) is – is clearly something the Angolan authorities should consider. What I call EPN Jeff Frankel originally termed Peg-the-Export-Price (PEP).

I have long been a proponent of the Export Price Norm for commodity exporting economies such as Russia, Australia or Angola (or Malaysia for that matter). The idea with EPN is that the commodity exporting economy pegs the currency to the price of the commodity it exports such as oil in the case of Angola. Alternatively the currency should be pegged to a basket of a foreign currency (for example the dollar) and the oil price. The advantage of EPN is that it will combine the advantages of both a floating exchange (an “automatic” adjustment to external shocks) and of a pegged exchange rate (a rule based monetary policy). Furthermore, for a country like Angola where nearly everything that is being produced in the country is exported the EPN will effectively be an quasi-NGDP target as export growth and aggregate demand growth (NGDP growth) will be extremely highly correlated. So by stabilizing the export price in local currency the central bank will effectively be stabilizing aggregate demand and NGDP.

Operationally it would be extremely simple for the Angolan central bank to implement an EPN regime as al it would take would be to target a basket of for example oil and US dollars, which would not be very different operationally than what it is already doing. Without having done the ‘math’ I would imagine that a 20% oil and 80% US dollar basket would be fitting. That would provide a lot of projection against the China shock.

And if it turns out that China is not slowing and oil prices again will rise an EPN will just lead to an ‘automatic’ appreciation of the kwanza and monetary tightening of Angolan monetary conditions and in that way be a very useful tool in avoiding that skyrocketing oil prices and booming inward investments do not lead to the formation of for example property bubbles (many would argue that there already is a huge property bubble in the Angola economy – take a look here).

Russia’s slowdown – another domestic demand story

Today I am in to Moscow to do a presentation on the Russian economy. It will be yet another chance to tell one of my pet-stories and that is that growth in nominal GDP in Russia is basically determined by the price of oil measured in rubles. Furthermore, I will stress that changes in the oil price feeds through to the Russian economy not primarily through net exports, but through domestic demand. This is what I earlier have termed the petro-monetary transmission mechanism.

The Russian economy is slowing – it is mostly monetary

In the last couple of quarters the Russian economy has been slowing. This is a direct result of a monetary contraction caused by lower Russian export prices (measured in rubles). Hence, even though the ruble has been “soft” it has not weakened nearly as much as the drop in oil prices and this effectively is causing a tightening of Russian monetary conditions.

oil price rub

This is how the petro-monetary transmission mechanism works. What happens is that when the oil price drops it puts downward pressure on the ruble. If the Russian central bank had been following what I have called Export Price Norm the ruble would have weakened in parallel with the drop in the oil price.

However, the Russian central bank is not allowing the ruble to weaken enough to keep the price of oil measured in rubles stable and as a consequence we effectively are seeing a drop in the Russian foreign exchange reserves (compared to what otherwise would have happened). There of course is a direct (nearly) one-to-one link between the decline in the FX reserve and the decline in the Russian money base. Hence, due to the managed float of the ruble – rather than a freely floating RUB (and a clear nominal target) – we are getting an “automatic”, but unnecessary, tightening of monetary conditions.

This means that there is a fairly close correlation between changes in oil prices measured in rubles and the growth of nominal GDP. The graph below illustrates this quite well.

NGDP russia oil price

I should of course stress that the slowdown in NGDP growth not necessarily a problem. Unemployment has continued to decline in Russia since 2010 and is now at fairly low levels, while inflation recently have been picking up to around 7%. Hence, it is hard to argue that there is a massive demand side problem in Russia. Yes, both nominal and real GDP is slowing, but it is certainly not catastrophic and I strongly believe that the Russian central bank should target 5-8% NGDP growth rather than 20 or 30% NGDP growth (which is what we saw prior to the crisis erupting in 2008-9). In that sense the gradual tightening of monetary conditions we have seen over the last 2 years might have been warranted. The problem, however, is that the Russian central banks is not very clear on want it wants to achieve with its policies.

It is all about domestic demand rather than net exports

Many would instinctively, but wrongly, conclude that the recent drop in oil prices is a drop in net exports and that is the reason for the slowdown in economic activity. However, that is far from right. In fact net export growth has remained fairly stable with Russian exports and imports growing more or less by the same rate. Hence, there has basically been only a small negative impact on GDP growth from the development in net exports.

What of course is happening is that even though export growth has slowed so has import growth as a result of a fairly sharp slowdown in domestic demand – particularly investment growth.

In that sense the present slowdown is quite similar to the massive collapse in economic activity in 2008-9. The difference is of course that what we are seeing now is not a collapse, but simply a slowdown in growth, but the mechanism is the same – monetary conditions have become tighter as the ruble has not weakened enough to “accommodate” the drop in the oil price.

It should be noted that the ruble today is significantly more freely floating than prior and during the 2008-9 crisis. As a result the ruble has moved much more in sync with the oil price than was the case in 2008-9. So while the oil price has gradually declined since the highs of 2011 the ruble has also weakened moderately against the US dollar in this period. However, the net result has nonetheless been that the price of oil measured in ruble has declined by 25-30% since the peak in 2011. Furthermore, the drop in the oil price measured in rubles has further accelerated since March. As a consequence we are likely to see the slowdown in economic activity continue towards the end of the year.

Overall I believe that the  gradual and moderate tightening of monetary conditions in 2010-12 was warranted. However, it is also clear that what we have see in the last couple of months likely is an excessive tightening of monetary conditions.

 The Export Price Norm is still the best solution for Russia

I have earlier argued that the Russian central bank should implement a variation of what I have termed an Export Price Norm (EPN) and what Jeff Frankel calls Peg-the-Export-Price (PEP) to ensure a stable growth rate in nominal GDP.

I think simplest way of doing this would be to include the oil price in the basket of currencies that the Russian central bank is now shadowing (dollars and euros). Hence, I believe that if the Russian central bank announced that it would shadow a basket of 20% oil prices and 40% dollars and 40% euros to ensure stable NGDP growth for example 7% and allowed for a +/-15% fluctuation band around the basket then I believe that you would get a monetary regime that automatically and without policy discretion would provide tremendous nominal stability and fairly low inflation (2-4%). In such a regime most of the changes in monetary policy would be implemented by market forces. Hence, if the oil price dropped the ruble would automatically be depreciated and equally important if the NGDP growth slowed due to other factors – for example a fiscal tightening or financial distress – then the ruble would automatically weak relative to the basket within the fluctuation band. Obviously there might be – rare – occasions where the “mid-point” of the fluctuation band could be changed and market participants should obviously be made aware that the purpose of the regime is not exchange rate stability but nominal stability. In such a set-up the central bank’s policy instrument would be the level for the mid-point for the fluctuation band around the basket.

Alternatively the Russian central bank could also opt for a completely freely floating exchange rate with NGDP targeting or flexible inflation targeting. I, however, would be skeptical about such solution as the domestic Russian financial markets are still quite illiquid and underdeveloped which complicates the conduct of monetary policy. Furthermore, an EPN solution would actually be more rule based than a freely floating ruble regime as a freely floating ruble regime would necessitate regular changes in for example the interest rate (or the money base) to be announced by the central bank. That opens the door for monetary policy to become unnecessarily discretionary.

Russia’s biggest problems are not monetary

It is correct that Market Monetarists seem to be obsessed with talking about monetary policy, but in the case of Russia I would also argue that even though there is a significant need for monetary policy reform monetary policy is not Russia’s biggest problem. In fact I believe the conduction of monetary policy has improved greatly in the last couple of years.

Russia’s biggest problem is structural. The country is struggling with massive overregulation, lack of competition and widespread corruption. There are very esay solutions to this: Deregulation and privatization. Every sane economist would tell you that, but the political reality in Russia means that reforms are painfully slow. In fact if anything corruption seems to have become even more widespread over the past decade.

Russian policy makers need to deal with these issues if they want to boost real GDP growth over the medium term. The Russian central bank can ensure nominal stability but it can do little else to increase real GDP growth. That is a case for the Russian government. On that I am unfortunately not too optimistic, but hope I will be proven wrong.

Ease of doing business russia

PS My story that the drop in oil prices measured in ruble is about domestic demand rather than export growth is of course very similar to the point I have been making about Japanese monetary stimulus. Monetary easing in Japan might be weakening the currency, but it is not about lifting exports, but about boosting domestic demand. That be the way seem to be exactly what is happening in the Japan. See for example this story from Bloomberg from earlier today.

A modest proposal for post-Chavez monetary reform in Venezuela

Let’s just say it as it is – I was very positively surprised by the massive response to my post on the economic legacy of Hugo Chavez. However, as somebody who primarily wants to blog about monetary policy it is a bit frustrating that I attract a lot more readers when I write about dead authoritarian presidents rather than about my favourite topic – monetary policy.

So I guess I have to combine the two themes – dead presidents and monetary policy. Therefore this post on my modest proposal for post-Chavez monetary reform in Venezuela.

It is very clear that a key problem in Venezuela is the high level of inflation, which clearly has very significant negative economic and social implications. Furthermore, the high level of inflation combined with insane price controls have led to massive food and energy shortages in Venezuela in recent years.

Obviously the high level of inflation in Venezuela is due to excessive money supply growth and there any monetary reform should have the purpose of bringing money supply growth under control.

A Export Price Norm will bring nominal stability to Venezuela

Market Monetarists generally speaking favour nominal GDP targeting or what we also could call nominal demand targeting. For large economies like the US that generally implies targeting the level of NGDP. However, for a commodity exporting economy like Venezuela we can achieve nominal stability by stabilizing the price of the main export good – in the case of Venezuela that is the price of oil measured in Venezuelan bolivar. The reason for this is that aggregate demand in the economy is highly correlated with export revenues and hence with the price of oil.

I have therefore at numerous occasions suggested that commodity exporting countries implement what I have called an Export Price Norm (EPN) and what Jeff Frankel has called a Peg-the Export-Price (PEP) policy.

The idea with EPN is basically that the central bank should peg the country’s currency to the price of the main export good. In the case of Venezuela that obviously would be the price of oil. However, it is not given that an one-to-one relationship between the bolivar and the oil price will ensure nominal stability.

My suggestion is therefore that the bolivar should be pegged to basket of 75% US dollars and 25% oil price. That in my view would view would ensure a considerable degree of nominal stability in Venezuela. So in periods of stable oil prices the Venezuelan bolivar would be more or less “fixed” against the US dollar and that likely would lead to nominal GDP growth in Venezuela that would be slightly higher than in the US (due to catching up effects in Venezuelan productivity), but in periods of rising oil prices the bolivar would strengthen against the dollar, but keep nominal GDP growth fairly stable.

 EPN is preferable to a purely fixed exchange rate regime

My friend Steve Hanke has suggested that Venezuela implements a currency board against the dollar and permanently peg the Venezuelan bolivar to the dollar. However, that in my view could have a rather destabilizing impact on the economy.

Imagine a situation where oil prices increase by 30% in a year (that is not usual given what we have seen over the past decade). In that scenario the appreciation pressures on the bolivar would be significant, but as the central bank was pegging the exchange rate money supply growth would increase significantly to curb the strengthening of the currency. That would undoubtedly be inflationary and could potentially lead to a bubble tendencies and an increase the risk of a boom-bust in the economy.

If on the other hand the bolivar had been pegged to 75-25% basket of US dollars and oil then an 30% increase in the oil prices would lead to an appreciation of the bolivar by 7.5% (25% of 30%). That would counteract the inflationary tendencies from the rise in oil prices. Similar in the case of a sharp drop in oil prices then the bolivar would “automatically” weaken as if the bolivar was freely floating and that would offset the negative demand effects of falling oil prices – contrary to what happened in Venezuela in 2008-9 where the authorities tried to keep the bolivar overly strong given the sharp drop in oil prices. This in my view is one of the main cause for the slump in Venezuelan economic activity in 2008-9. That would have been avoided had the Venezuelan central bank operated EPN style monetary regime.

I should stress that I have not done detailed work on what would be the “optimal” mixed between the US dollar and the oil price in a potential bolivar basket. However, that is not the important thing with my proposal. The important thing is that such a policy would provide the Venezuelan economy with an stable nominal anchor while at the time reduce the risk of boom-bust in the Venezuelan economy – contrary to what have been the case in the Chavez years.

Time to get rid of currency and price controls

The massively unsustainable fiscal and monetary policy since 1999 have “forced” the Venezuelan government and central bank to implement draconian measures to control prices and the exchange rate. The currency controls have lead to a large black market for foreign currency in Venezuela and at the same time the price controls have led to massive energy and food shortages in Venezuela.

Obviously one cannot fight inflation and currency depreciation with interventionist policies. Therefore, this policies will have to be abandoned sooner rather than later as the cost of these policies are massive. Furthermore, it is obvious that the arguments for these policies will disappear once monetary policy ensures nominal stability.

End monetary funding of public finances

A key reason for the high level of inflation in Venezuela since 1999 undoubtedly has to be explained by the fact that there is considerable monetary financing of public finances in Venezuela. To end high-inflation it is therefore necessary to stop the central bank funding of fiscal policy. That obviously requires to bring the fiscal house in order. I will not touch a lot more on that issue here, but obviously there is a lot of work to be undertaken here. A place to start would obviously be to initiate a large scale (re)privatization program.

A modest proposal for monetary reform

We can therefore sum up my proposal for monetary reform in Venezuela in the following four points:

1) Introduce an Export Price Norm – peg the Bolivar to a basket of 75% US dollars and 25% oil prices

2) Liberalize capital and currency controls completely

3) Get rid of all price and wage controls

4) Separate fiscal policy and monetary policy – stop monetary funding of the public budget

I doubt that this post will be popular as my latest post on Venezuela, but I think that this post is significantly more important for the future well-being of the Venezuelan economy and a post-Chavez regime should move as fast as possible to implement monetary reform because without monetary reform the Venezuelan economy is unlikely to fully recover from its present crisis.

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Jeffrey Frankel has made a similar proposal for the Gulf States. Have a look at Jeff’s proposal here.

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Update: Steve Hanke has a comment on his suggestion for full dollarization in Venezuela. Even though I prefer my own EPN proposal I must say that Steve’s idea has a lot of appeal given the obvious weakness of public institutions in Venezuela and a very long history (pre-dating Chavez) of monetary mismanagement.

Jeff Frankel repeats his call for NGDP targeting

Here is Jeff Frankel on Project Syndicate:

“Monetary policymakers in some countries should contemplate a shift toward targeting nominal GDP – a switch that could be phased in gradually in such a way as to preserve credibility with respect to inflation. Indeed, for many advanced economies, in particular, a nominal-GDP target is clearly superior to the status quo….

…A nominal-GDP target’s advantage relative to an inflation target is its robustness, particularly with respect to supply shocks and terms-of-trade shocks. For example, with a nominal-GDP target, the ECB could have avoided its mistake in July 2008, when, just as the economy was going into recession, it responded to a spike in world oil prices by raising interest rates to fight consumer price inflation. Likewise, the Fed might have avoided the mistake of excessively easy monetary policy in 2004-06 (when annual nominal GDP growth exceeded 6%)…

…The idea of targeting nominal GDP has been around since the 1980’s, when many macroeconomists viewed it as a logical solution to the difficulties of targeting the money supply, particularly with respect to velocity shocks. Such proposals have been revived now partly in order to deliver monetary stimulus and higher growth in the US, Japan, and Europe while still maintaining a credible nominal anchor. In an economy teetering between recovery and recession, a 4-5% target for nominal GDP growth in the coming year would have an effect equivalent to that of a 4% inflation target.

Monetary policymakers in some advanced countries face the problem of the “zero lower bound”: short-term nominal interest rates cannot be pushed any lower than they already are. Some economists have recently proposed responding to high unemployment by increasing the target for annual inflation from the traditional 2% to, say, 4%, thereby reducing the real (inflation-adjusted) interest rate. They like to remind Fed Chairman Ben Bernanke that he made similar recommendationsto the Japanese authorities ten years ago…

…Shortly thereafter, projections for nominal GDP growth in the coming three years should be added – higher than 4% for the US, UK, and eurozone (perhaps 5% in the first year, rising to 5.5% after that, but with the long-run projection unchanged at 4-4.5%). This would trigger much public speculation about how the 5.5% breaks down between real growth and inflation. The truth is that central banks have no control over that – monetary policy determines the total of real growth and inflation, but not the relative magnitude of each.

A nominal-GDP target would ensure either that real growth accelerates or, if not, that the real interest rate declines automatically, pushing up demand. The targets for nominal GDP growth could be chosen in a way that puts the level of nominal GDP on an accelerated path back to its pre-recession trend. In the long run, when nominal GDP growth is back on its annual path of 4-4.5%, real growth will return to its potential, say 2-2.5%, with inflation back at 1.5-2%.

Phasing in nominal-GDP targeting delivers the advantage of some stimulus now, when it is needed, while respecting central bankers’ reluctance to abandon their cherished inflation target.

Marcus Nunes also comments on Jeff.

Malaysia should peg the renggit to the price of rubber and natural gas

The Christensen family arrived in Malaysia yesterday. It is vacation time! So since I am in Malaysia I was thinking I would write a small piece on Malaysian monetary policy, but frankly speaking I don’t know much about the Malaysian economy and I do not follow it on a daily basis. So my account of how the Malaysian economy is at best going to be a second hand account.

However, when I looked at the Malaysian data something nonetheless caught my eye. Looking at the monetary policy of a country I find it useful to compare the development in real GDP (RGDP) and nominal GDP (NGDP). I did the same thing for Malaysia. The RGDP numbers didn’t surprise me – I knew that from the research I from time to time would read on the Malaysian economy. However, most economists are still not writing much about the development in NGDP.

In my head trend RGDP growth is around 5% in Malaysia and from most of the research I have read on the Malaysian economy I have gotten the impression that inflation is pretty much under control and is around 2-3% – so I would have expected NGDP growth to have been around 7-8%. However, for most of the past decade NGDP growth in Malaysia has been much higher – 10-15%. The only exception is 2009 when NGDP growth contracted nearly 8%!

How could I be so wrong? Well, the most important explanation is that I don’t follow the Malaysian economy very closely on a daily basis. However, another much more important reason is the difference between how inflation is measured. The most common measure of inflation is the consumer price index (CPI). However, another measure, which is much closer to what the central bank controls is the GDP deflator – the difference between NGDP and RGDP.

In previous posts I have argued that if one looks at the GDP deflator rather than on CPI then monetary policy in Japan and the euro zone has been much more deflationary than CPI would indicate and the fact that the Bank of Japan and the ECB have been more focused on CPI than on the GDP deflator have  led to serious negative economic consequences. However, it turns out that the story of Malaysian inflation is exactly the opposite!

While Malaysian inflation seems well-behaved and is growing around 2% the GDP deflator tells a completely different story. The graph below illustrates this.

As the graph shows inflation measured by the GDP deflator averaged nearly 7% in the 2004-2008 period. In the same period CPI inflation was around 3%. So why do we have such a massive difference between the two measures of inflation? The GDP deflator is basically the price level of domestically produced goods, while CPI is the price level of domestically consumed goods. The main difference between the two is therefore that CPI includes indirect taxes and import prices.

However, another difference that we seldom talk about is the difference between the domestic price and the export price of the same good. Hence, if the price of a certain good – for example natural gas - increased internationally, but not domestically then if the country is an natural gas producer – as Malaysia is – then the GDP deflator will increase faster than CPI.

I think this explains the difference between CPI and GDP deflator inflation Malaysia in the last 10-12 years – there is simply a large difference between the domestic price and the international price development of a lot of goods in Malaysia and the reason is price controls. The Malaysian government has implemented price controls on a number of goods, which is artificially keeping prices from rising on these goods.

The difference between CPI and the GDP deflator therefore is a reflection of a massive misallocation of economic resources in the Malaysian economy and inflation is in reality much larger than indicated by CPI. While the inflation is not showing up in CPI – due to price controls – it is showing up in shortages. As any economist knows if you limit prices from rising when demand outpaces supply then you will get shortages (Bob Murphy explains that quite well).

Here is an 2010 Malaysian news story:

PETALING JAYA: There is an acute shortage of sugar in the country.

Consumers and traders in several states have voiced their frustration in getting supply of the essential commodity, describing the shortage as the “worst so far”.

A check at several grocery shops here revealed that no sugar had been on sale for over a week…

…Fomca secretary-general Muhd Sha’ani Abdullah said it had received complaints in various areas including Kuantan, Muar, Klang and Temerloh since a month ago.

He said the problem was not due to retailers hoarding sugar but the smuggling of the item to other countries, especially Thailand.

Federation of Sundry Goods Merchants president Lean Hing Chuan said the shortage nationwide was caused by manufacturers halving production, adding that its members started noticing the slowdown in April.

“Factories might be slowing down their production to keep their costs down until subsidies for sugar are withdrawn,” Lean said.

I got this from the excellent local blog “Malaysia Economics” in which the economics of price controls is explained very well (See this post). By the way the author of Malaysia Economics has a lot of sympathy for Market Monetarism – so I am happy to quote his blog.

So while the problem in Japan and the euro zone is hidden deflation the problem in Malaysia is hidden inflation. The consequence of hidden inflation is always problems with shortages and as it is always the case with such shortages you will get problems with a ever increasing black economy with smuggling and corruption. This is also the case in Malaysia.

I believe the source of these problems has to be found in the Malaysian authorities response to the 1997 Asian crisis. Malaysia came out of the Asian crisis faster than most of other South East Asian countries due to among other things fairly aggressive monetary policy easing. Any Market Monetarist would tell you that that probably was the right response – however, the problem is that the Malaysian central bank (BNM) kept easing monetary policy well after the Malaysian economy had recovered from the crisis by keeping the Malaysian ringgit artificially weak.

The graph below clearly shows how the price level measured with the GDP deflator and CPI started to diverge in 1997-98.

As global commodity prices started to rise around a decade ago the price of a lot of Malaysia’s main export goods – such as rubber, petroleum and liquified natural gas – started to rise strongly. However, until 2005 the BNM kept the Malaysian ringgit more less fixed against the US dollar. Therefore, to keep the renggit from strengthen the BNM had to increase the money supply as Malaysian export prices were increasing. This obviously is inflationary.

There are to ways to curb such inflationary pressures. Either you allow your currency to strengthen or you introduce price controls. The one is the solution of economists – the other is the solution of politicians. After 2005 the BNM has moved closer to a floating renggit, but it is still has fairly tightly managed currency and the renggit has not strengthened nearly as much as the rise in export prices would have dictated. As a consequence inflationary pressures have remained high.

Two possible monetary policy changes for Malaysia

Overall I believe the the combination of price controls and overly easy monetary policy is damaging the for the Malaysian economy. As I see it there are two possible changes that could be made to Malaysian monetary policy. Both solutions, however, would have to involve a scrapping of price controls and subsidies in the Malaysian economy. The Malaysian government has been moving in that direction in the last couple of years and there clearly are fewer price controls today than just a few years ago.

The fact that price controls are being eased is having a positive effect (and GDP deflator inflation and CPI inflation also is much more in line with each other than earlier). See for example this recent news story on how easing price controls on sugar has led to a sharp drop in smuggling of sugar. It is impossible to conduct monetary policy in a proper fashion if prices are massively distorted by price controls and regulations. The liberalization of price in Malaysia is therefore good news for monetary reform in Malaysia.

The first option for monetary reform is simply to allow the renggit to float completely freely and then target some domestic nominal variable like inflation (the GDP deflator!), the price level or preferably the NGDP level. This is more or less the direction BNM has been moving in since 2005, but we still seems to be far away from a truly freely floating renggit.

Another possibility is to move closer to policy closer to Jeff Frankel’s idea of Pegging the exchange rate to the Export Price (PEP). In many ways I think such a proposal would be suitable for Malaysia – especially in a situation where price controls have not been fully liberalized and where the authorities clearly are uncomfortable with a freely floating renggit.

A major advantage of PEP compared to a freely floating currency is that the central bank needs a lot less macroeconomic data to conduct monetary policy. This obviously would be an advantage in Malaysia where macroeconomic data still is distorted by price controls and subsidies. Second, PEP also means that monetary policy automatically would be rule based. Third, compared to a strict FX peg a variation of PEP would not lead to boom-bust cycles when export prices rise and fall as the currency would “automatically” appreciate and depreciate in line with changes in export prices.

Another reason why a variation of PEP might be a good solution for Malaysia is that the prices of the country’s main export goods such as rubber, petroleum and liquified natural gas are highly correlated with internationally traded commodity prices. Hence, it would be very easy to construct a real-time basket of international traded commodity prices that would be nearly perfectly correlated with Malaysian export prices.

The BNM is already managing the renggit against a basket of currencies. It would be very simply to include a basket of international traded commodity prices – which is correlated with Malaysian export prices (I have made a similar suggestion for Russia – see here). This I believe would give the same advantage as a floating exchange rate, but with less need for potentially distorted macroeconomic data while at the same time avoiding the disadvantages of a fixed exchange rate.

Had the BNM operated such a PEP style monetary policy over the last decade the renggit would had strengthened significantly more than was the case from 2000 until 2008. However, the renggit would have weaken sharply in 2008 when commodity prices plummeted at the onset of the Great Recession. Since 2009 the renggit would then had started strengthening again (more than has been the case). This in my view would have lead to a significantly more stable development in nominal GDP (and real GDP).

And price controls would not have been “needed”. Hence, while commodity prices were rising the renggit would also have been strengthening significantly more than actually was the case and as a consequences import prices would have dropped sharply and therefore push down consumer prices (CPI). Hence, the Malaysian consumers would have been the primary beneficiaries of rising export prices. In that sense my suggestion would have been a Malaysian version of George Selgin’s “productivity norm” – or rather a “export price norm” (maybe we should call PEP that in the future?).

But now I should be heading back to the pool – I am on vacation after all…

PS I got a challenge to my clever readers: Construct a basket of US dollars and oil prices (or rubber and natural gas) against the renggit that would have stabilized NGDP growth in Malaysia at 5-7% since 2000. I think it is possible…

Causality, econometrics and beautiful Saint Pete

I am going to Russia next week. It will be good to be back in wonderful Saint Petersburg. In connection with my trip I have been working on some econometric models for Russia. It is not exactly work that I enjoy and I am deeply skeptical about how much we can learn from econometric studies. That said, econometrics can be useful when doing practical economics – such as trying to forecast Russian growth and inflation.

So I have been working on this model for the Russian economy. The main purpose of the model is to learn about what I would would call the petro-monetary transmission mechanism in the Russian economy. It is my thesis that the primary channel for how oil prices are impacting the Russian economy is through the monetary transmission mechanism rather than through net exports.

Here is my theory in short: The Russian central bank (CBR) dislikes – or at least used to dislike – a freely floating exchange rate. Therefore the CBR will intervene to keep the ruble stable. These days the CBR manages the ruble within a band against a basket of the US dollar and the euro. Today the ruble is much more freely floating than it used to be, but nonetheless the ruble is still tightly managed and the ruble is certainly not a freely floating currency.

So why is that important for my econometric models for Russia? Well, it is important because it means quite a bit to the causality I assume in the model. Lets look at two examples. One where the ruble is completely pegged against another currency or a basket of currencies and another example where the ruble is freely floating and the central bank for example targets inflation or nominal GDP.

Pegged exchange rate: Causality runs from oil to money supply and NGDP 

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

Now lets look at the case where we assume a freely floating ruble.

Floating ruble: Oil prices and monetary policy will be disconnected

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

Do I have to forget about econometrics? Not necessarily

So what do that mean for my little econometric exercise on the Russian economy? Well, basically it means that I have to be extremely careful when I interpret the econometric output. The models I have been playing around with I have estimated from 2000 and until today. I have done what is called Structural VAR analysis (with a lot of help from a clever colleague who knows econometrics much better than me). Some of the results we get are surely interesting, however, we got one major problem and that is that during the 12 years we are looking Russian monetary policy has changed significantly.

In the early part of the estimation period the Russian central bank basically maintained a quasi-pegged exchange for the ruble against the dollar. Later, however, the CBR started to manage the ruble against a basket of dollars and euros and at the same time the CBR would “adjust” the ruble rate to hit changing nominal targets – for example an inflation target. The CBR have had multiple and sometimes inconsistent targets during the past decade. Furthermore, the CBR has moved gradually in the direction of a more freely floating ruble by allowing for a wider “fluctuation band” around the euro-dollar basket.

So basically we would expect that causality in the Russian economy in 2000 would be pretty much as described in the pegged exchange rate case, while it today should be closer to the floating exchange rate case. That of course means that we should not expect the causality in our model to be stable causal structure. Econometricians hate that – to me it is just a fact of life or as Ludwig von Mises used to say “there are no constants in economics” (I am paraphrasing von Mises from my memory). This of course is also know as the Lucas Critique. Some would of course argue that we could take this into account when we do our econometric work, but regime changes do not necessarily happen from day to day. Often regime change is gradual, which makes it impossible to really to take into account in econometric studies.

And this is one of my problems with econometrics – or rather with how econometric studies often are conducted. They do not take into account regime change and therefore do not take into account expectations. As a result well-known correlations tend to breakdown. The best example is of course the disappearance of the Phillips curve relationship in the 1970s and 1980s. Another example is the breakdown of the causal relationship between money supply growth and inflation in 1990s.

So what do I do? Should I give up on my little econometric venture? No, I don’t think so. Econometrics can clearly be useful in determining the magnitude and importance of different shocks in the economy and surely some of our econometric results on the Russian economy seems to be pretty robust. For example over the estimation period it seems like a 10% increase in the oil prices have increased the M2 and nominal GDP by around 2%. That is nice to know and is useful information when you want to do forecasting on the Russian economy. But it would be completely naive to expect this relationship to be constant over time. Rather the Russian central bank is clearly moving in the direction of a more and more freely floating ruble so we should expect the correlation between oil prices one the one hand and M2 and NGDP on the other hand to decrease going forward.

Concluding, econometrics can be useful in doing “practical” economics like macroeconomic forecasting, but one should never forget to do the homework on the institutional structures of the economy and one should never ever forget about the importance of expectations. Economic reasoning is much more important than any statistical results.

Related posts:
Next stop Moscow
International monetary disorder – how policy mistakes turned the crisis into a global crisis
Fear-of-floating, misallocation and the law of comparative advantages
PEP, NGDPLT and (how to avoid) Russian monetary policy failure
Should small open economies peg the currency to export prices?

Jeff Frankel restates his support for NGDP targeting

It is no secret that I have been fascinated by some of Havard professor Jeff Frankel’s ideas especially his idea for Emerging Markets commodity exporters to peg the currency to the price of their main export (PEP). I have written numerous posts on this (see below) However, Frankel is also a long-time supporter of NGDP target and now he has restated is his views on NGDP targeting.

Here is Jeff:

“In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT), much as the currency crises of the 1990s dramatized the vulnerability of exchange rate targeting and the velocity shocks of the 1980s killed money supply targeting.   But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations?

The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting.  It has gained popularity rather suddenly, over the last year.  But the idea is not new.  It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to shifts in money demand.  Under certain conditions, it dominates not only a money target (due to velocity shocks) but also an exchange rate target  (if exchange rate shocks are large) and a price level target (if supply shocks are large).   First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean(1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein & Jim Stock (1994), Bob Hall & Greg Mankiw (1994), Ben McCallum (1987, 1999), and others.

Nominal GDP targeting was not adopted by any country in the 1980s.  Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy.  (They ended up with a “two pillar approach,” of which one pillar was supposedly the money supply.)” 

So far so good…and here is something, which will make all of us blogging Market Monetarists happy:

“But now nominal GDP targeting is back, thanks to enthusiastic blogging by ScottSumner (at Money Illusion), LarsChristensen (at Market Monetarist), David Beckworth (at Macromarket Musings),Marcus Nunes (at Historinhas) and others.  Indeed, the Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere.”

This is a great endorsement of the Market Monetarist “movement” and it is certainly good news that Jeff so clearly recognize the work of the blogging Market Monetarists. Anyway back to the important points Jeff are making.

“Fans of nominal GDP targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks.    Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy.  An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.

In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target).   But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity?  Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world:  Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.”

Exactly! The great advantage of NGDP level targeting compared to other monetary policy rules is that it handles both velocity shocks and supply shocks. No other rules (other than maybe Jeff’s own PEP) does that. Furthermore, I would add something, which is tremendously important to me and that is that unlike any other monetary policy rule NGDP level targeting does not distort relative prices. NGDP level targeting as such ensures the optimal and unhampered working of a free market economy.

Back to Jeff:

“Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential.  It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent.   (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap.)  But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s.  Of course one could declare that the shift from a 2 % target to 4 % would be temporary.  But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number.   An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year – which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target – and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor.”

I completely agree. I have always found the idea of temporary changing the inflation target to be very odd. The problem is not whether to target 2,3 or 4% inflation. The problem is the inflation targeting itself. Inflation targeting tends to create bubbles when the economy is hit by positive supply shocks. It does not fully response to negative velocity shocks and it leads to excessive tightening of monetary policy when the economy is hit by negative supply shocks (just have look at the ECB’s conduct of monetary policy!)
Market Monetarists advocate a clear rule based monetary policy exactly because we think that expectations is tremendously important in the monetary transmission mechanism. A temporary change in the inflation target would completely undermining the effectiveness of the monetary transmission mechanism and we would still be left with a bad monetary policy rule.
Let me give the final word to Jeff:
Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.
_______
Some of my earlier posts on Jeff’s ideas:

Next stop Moscow
International monetary disorder – how policy mistakes turned the crisis into a global crisis
Fear-of-floating, misallocation and the law of comparative advantages
Exchange rates are not truly floating when we target inflation
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
PEP, NGDPLT and (how to avoid) Russian monetary policy failure
Should small open economies peg the currency to export prices?

Scott Sumner also comments on Jeff’s blogpost.

The discretionary decision to introduce rules

At the core of Market Monetarists thinking is that monetary policy should be conducted within a clearly rule based framework. However, as Market Monetarists we are facing a dilemma. The rules or rather quasi-rules that is presently being followed by the major central banks in the world are in our view the wrong rules. We are advocating NGDP level targeting, while most of the major central banks in the world are instead inflation targeters.

So we have a problem. We believe strongly that monetary policy should be based on rules rather than on discretion. But to change the wrong rules (inflation targeting) to the right rules (NGDP targeting) you need to make a discretionary decision. There is no way around this, but it is not unproblematic.

The absolute strength of the way inflation targeting – as it has been conducted over the past nearly two decades – has been that monetary policy a large extent has become de-politicised. This undoubtedly has been a major progress compared to the massive politicisation of monetary policy, which used to be so common. And while we might be (very!) frustrated with central bankers these days I think that most Market Monetarists would strongly agree that monetary policy is better conducted by independent central banks than by politicians.

That said, I have also argued that central bank independence certainly should not mean that central banks should not be held accountable. In the absence of a Free Banking system, where central banks are given a monopoly there need to be very strict limits to what central banks can do and if they do not fulfil the tasks given to them under their monopoly then it should have consequences. For example the ECB has clear mandate to secure price stability in the euro zone. I personally think that the ECB has failed to ensure this and serious deflationary threats have been allowed to develop. To be independent does not mean that you can do whatever you want with monetary policy and it does not mean that you should be free of critique.

However, there is a fine line between critique of a central bank (particularly when it is politicians doing it) and threatening the independence of the central banks. However, the best way to ensure central bank independence is that the central bank is given a very clear mandate on monetary policy. However, it should be the right mandate.

Therefore, there is no way around it. I think the right decision both in the euro zone and in the US would be to move to change the mandate of the central banks to a very clearly defined NGDP level target mandate.

However, when you are changing the rules you are also creating a risk that changing rules become the norm and that is a strong argument for maintain rules that might not be 100% optimal (no rule is…). Latest year it was debated whether the Bank of Canada should change it’s flexible inflation targeting regime to a NGDP targeting. It was decided to maintain the inflation targeting regime. I think that was too bad, but I also fully acknowledge that the way the BoC has been operating overall has worked well and unlike the ECB the BoC has understood that ensuring price stability does not mean that you should react to supply shocks. As consequence you can say the BoC’s inflation targeting regime has been NGDP targeting light. The same can be said about the way for example the Polish central bank (NBP) or the Swedish central banks have been conducting monetary policy.

Market Monetarists have to acknowledge that changing the rules comes with costs and the cost is that you risk opening the door of politicising monetary policy in the future. These costs have to be compared to the gains from introducing NGDP level targeting. So while I do think that the BoC, Riksbanken and the NBP seriously should consider moving to NGDP targeting I also acknowledge that as long as these central banks are doing a far better job than the ECB and the Fed there might not be a very urgent need to change the present set-up.

Other cases are much more clear. Take the Russian central bank (CBR) which today is operating a highly unclear and not very rule based regime. Here there would be absolutely not cost of moving to a NGDP targeting regime or a similar regime. I have earlier argued that could the easiest be done with PEP style set-up where a currency basket of currencies and oil prices could be used to target the NGDP level.

Concluding, we must acknowledge that changing the monetary policy set-up involve discretionary decisions. However, we cannot maintain rules that so obviously have failed. We need rules in monetary policy to ensure nominal stability, but when the rules so clearly is creating instability, economic ruin and financial distress there is no way out of taking a discretionary decision to get of the rules and replace them with better rules.

PS While writing this I am hearing George Selgin in my head telling me “Lars, stop this talk about what central banks should do. They will never do the right thing anyway”. I fear George is right…

PPS Jeffrey Frankel has a very good article on the Death of Inflation Targeting at Project Syndicate. Scott also comments on Jeff’s article. Marcus Nunes also comments on Jeff’s article.

PPPS It is a public holiday in Denmark today, but I have had a look at the financial markets today. When stock markets drop, commodity prices decline and long-term bond yields drop then it as a very good indication that monetary conditions are getting tighter…I hope central banks around the world realise this…

Next stop Moscow

I am writing this as I am flying to Moscow to spend a couple of days meeting clients in Moscow. It will be nice to be back. A lot of things are happing in Russia at the moment – especially politically. A new opposition has emerged to President Putin’s regime. However, even though politics always comes up when you are in Russia I do not plan to talk too much about the political situation. Everybody is doing that – so I will instead focus my presentations on monetary policy matters as I believe that monetary policy mistakes have been at the core of economic developments in Russia over the last couple of years. I hope to add some value as I believe that few local investors in Russia are aware of how crucial the monetary development is.

Here are my main topics:

1) The crucial link between oil prices, exchange rate developments and monetary policy. Hence, what we could call the petro-monetary transmission mechanism in the Russian economy

2) Based on the analysis of the petro-monetary transmission mechanism I will demonstrate that the deep, but short, Russian recession in 2008-9 was caused by monetary policy failure. This is what Robert Hetzel calls the “monetary disorder view” of recession

3) Why the Russian economy is in recovery and the role played by monetary easing

4) Changing the monetary regime: The Russian central bank (CBR) has said it wants to make the Russian ruble freely floating in 2013 (I doubt that will happen…). What could be the strategy for CBR to move in that direction?

The petro-monetary transmission mechanism
When talking about the Russian economy with investors I often find that they have a black-box view of the Russian economy. For most people the Russian economy seems very easy to understand – too easy I would argue. On the one hand the they see oil prices going up or down and on the other hand they see growth going up or down.

And it is also correct that if one has a look at real or nominal GDP growth of the past decade then one would spot a pretty strong correlation to changes in oil prices. That makes most people think that when oil prices increase Russian exports increase and as result GDP increases. However, this is the common mistake when doing economics based on a simple quasi-Keynesian national accounting identity Y=C+I+X+G+NX.

What most people believe is happening is that net exports (NX) increase when oil prices increase. As a result Y increases (everything else is just assumed to be a function of Y). However, a closer look at the Russian data will make you realise that this is not correct. In fact during the boom-years 2005-8 net exports was actually “contributing” negatively to GDP growth as import growth was outpacing export growth.

So what did really happen? Well, we have to study the crucial link between oil prices, the ruble exchange rate and money supply.

As I have described in an earlier post the Russian central bank (CBR) despite its stated goal of floating the ruble suffers from a distinct fear-of-floating. The CBR simply dislikes currency volatility. Therefore, when the ruble is strengthening the CBR would intervene in the FX market (printing ruble) to curb the strengthening. And it would also intervene (buying ruble) when the currency is weakening. In recent years it has been doing so by managing the ruble against a basket of euros (55%) and dollars (45%).

This is really the reason for the link between oil prices and the GDP (both real and nominal) growth. Imagine that oil prices increases strongly as was the case in the years just prior to crisis hit in 2008. In such that situation oil exports revenues will be increasing (even if oil output in Russian is stagnated). With oil revenues increasing the ruble would tend to strengthen. However, the CBR is keeping the ruble more or less stable against the EUR-USD basket and it therefore will have to sell ruble (increase the money supply) to avoid the ruble strengthening (“too much” for CBR’s liking).

This is the petro-monetary link. Increased oil prices increase the money supply as a result of the CBR quasi-fixing of the ruble.

Therefore, it makes much more sense instead of a national account approach to go back to the most important equation in macroeconomics – the equation of exchange:

(1) MV=PY

Russian money-velocity (V) has been declining around a fairly stable trend over the past decade. We can therefore assume – to make things slightly easier that V has been growing (actually declining) at a fairly stable rate v’. We can then write (1) in growth rates:

(2) m+v’=p+y

As we know from above money supply growth (m) is a function of oil prices (oil) – if CBR is quasi-pegging the ruble:

(3) m=a*oil

a is a constant.

Lets also introduce a (very!) simple Phillips curve into the economy:

(4) p=by

p is of course inflation and y is real GDP growth. Equation 2,3 and 4 together is a very simple model of the Russian economy, but I frankly speaking think that is all you need to analyse the business cycle dynamics in the Russian economy given the present monetary policy set-up. (You could analyse the risk of bubbles in property market by introducing traded and non-trade goods, but lets look at that in another blog post).

If we assume oil prices (oil) and trend-velocity (v’) are exogenous it is pretty easy to solve the model for m, p and y.

Lets solve it for y by inserting (3) and (4) into (2). Then we get:

(2)’ a*oil+v’=(1+b)y

(2)’ y= a/(1+b)*oil+1/(1+b)*v’

So here we go – assuming sticky prices (the Phillips curve relationship between p and y) we get a relationship between real GDP growth and oil price changes similar to the “common man’s model” for the Russian economy. However, this link does only exist because of the conduct of monetary policy. The CBR is managing the float of the ruble, which creates the link between oil prices and real GDP growth. Had the CBR instead let the ruble float freely or linked the ruble in some way to oil prices then the oil price-gdp link would have broken down.

The CBR caused the 2009 crisis

You can easily use the model above to analyse what happen to the Russian economy in 2008-2009. I have already in a previous post demonstrated that the CBR caused the crisis in 2008-9 by not allowing the ruble to depreciate enough in the autumn of 2008.

Lets have a short look at the crisis through the lens of the model above. What happened in 2008 was that oil prices plummeted. As a consequence the ruble started to weaken. The CBR however, did not want to allow that so it intervened in the FX market – buying ruble and selling foreign currency. That is basically equation (3). Oil prices (oil) dropped, which caused the Russian money supply (m) to drop 20 % in October-November 2008.

As m drops it most follow from (2) that p and/or y will drop as well (remember we assume v’ to be constant). However, because p is sticky – that’s equation (4) – real GDP (y) will have to drop. And that is of course what happened. Russia saw the largest drop in real GDP (y) in G20.

It’s really that simple…and everything that followed – for example a relatively large banking crisis – was caused by these factors. Had the ruble been allowed to drop then the banking crisis would likely have been much smaller in scale.

Recovery time…

On to the next step. In early 2009 the Federal Reserve acted by moving towards more aggressive monetary easing and that caused global oil prices to rebound. As a result the ruble started to recover. Once again that CBR did not allow the ruble to be determined by market forces. Instead the CBR moved to curb the strengthening of the ruble. We are now back to equation (3). With oil prices (oil) increasing money supply growth (m) finally started to accelerate in 2009-10. With m increasing p and y would have to increase – we know that from equation (2) – and as p is sticky most of the initial adjustment would happen through higher real GDP growth (y). That is exactly what happened and that process has continued more or less until today.

It now seems like we have gone full cycle and that the Russian economy is operating close to full capacity and there are pretty clear signs that we now are moving back to an overly expansionary monetary policy. The question therefore is what is next for the CBR?

Time to move to a new monetary regime

The Russian central bank has announced that it wants to move to a freely floating ruble in 2013. That would make good sense as the discussion above in my view pretty clearly demonstrates that the CBR’s present monetary policy set-up has been extremely costly and lead to quite significant misallocation of economic resources.

Furthermore, as I have demonstrated above the link between economic activity and oil prices only exist in the Russian economy do to the conduct of monetary policy in Russia. If the ruble was allowed to fluctuate more freely, then we would get a much more stable development in not only inflation and nominal GDP (which is fully determined by monetary factors), but also in real GDP.

But how would you move from the one regime to the other. The simple solution would of course be to announce one day that from today the ruble is freely floating. That, however, would still beg the question what should the CBR then target and what instruments should it use to achieve this target?

Obviously as a Market Monetarist I think that the CBR should move towards a monetary regime in which relative prices are not distorted. A NGDP level targeting regime would clearly achieve that. That said, I am very sceptical about the quality of national account data in Russia and it might therefore in praxis be rather hard to implement a strict NGDP level targeting regime (at least given the present data quality). Second, even though I as a Friedmanite am strongly inclined to be in favour floating exchange rates I also believe that using the FX rate as a monetary instrument would be most practical in Russia given it’s fairly underdeveloped financial markets and (over) regulated banking sector.

Therefore, even though I certainly think a NGDP level target regime and floating exchange rates is a very good long-term objective for Russia I think it might make sense to move there gradually. The best way to do so would be for the CBR to announce a target level for NGDP, but implement this target by managing the ruble against a basket of euros and dollars (that is basically the present basket) and oil prices (measured in ruble).

Even though the CBR now is targeting a EUR-USD basket it allows quite a bit of fluctuations around the basket. These fluctuations to a large extent are determined by fluctuations in oil prices. Therefore, we can say that the CBR effective already has included oil prices in the basket. In my view oil prices effectively are somewhere between 5 and 10% of the “basket”. I think that the CBR should make that policy official and at the same time it should announce that it would increase the oil prices share of the basket to 30% in 1-2 years time. That I believe would more or less give the same kind of volatility in the ruble we are presently seeing in the much more freely floating Norwegian krone.

Furthermore, it would seriously reduce the link between swings in oil prices and in the economy. Hence, monetary policy’s impact on relative prices would be seriously reduced and as I have shown in my previous post there has been a close relationship between oil prices measured in ruble and nominal GDP growth. Hence, if the stability of oil prices measured in ruble is increased (which would happen if oil prices is included in the FX basket) then nominal GDP will also become much more stable. It will not be perfect, but I believe it would be a significant step in the direction of serious increasing nominal stability in Russia.

I am now finishing this blog post in the airport in Moscow waiting for a local colleague to pick me up, while talking to a very drunk ethic Russian Latvian who is on his way to Kazakhstan. He is friendly, but very drunk and not really interested in monetary theory…I hope the audience in the coming days

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