‘The Myth of Currency War’

I know that most of my readers must be sick and tired of reading about my view on ‘currency war’. Unfortunately I have more for you. My colleague Jens Pedersen and I have written an article for the Danish business daily Børsen. The piece was published in today’s edition of Børsen. It is in Danish, but you can find an English translation of the article here.

Regular readers of this blog will not be surprised by the main message in the article: The talk of a “dangerous” ‘currency war’ is just silly. It is not really a ‘currency war’, but rather global monetary easing. Global monetary easing even helps the euro zone despite the ECB’s extreme reluctance to ease monetary policy.

Jens has recently also written an extremely interesting paper on the consequence of the ‘currency war’ for the Danish economy. Jens concludes that the currency war – or rather global monetary easing – is good news for Danish exporters despite the fact that the Danish krone has been strengthening in line with the euro (remember the krone is pegged to the euro). The reason is that global monetary easing is boosting global growth and that is outweighing any negative impact on exports from the strengthening of the krone.

Take a look at Jens’ paper here.

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Guest post: Yes Lars, inflation is always and everywhere a monetary phenomenon (By Jens Pedersen)

Guest post: Yes Lars, inflation is always and everywhere a monetary phenomenon
By Jens Pedersen

The host of this blog, my good friend and colleague, on a daily basis reminds me “inflation is always and everywhere a monetary phenomenon” – and even more so this week where we have celebrated Milton Friedman’s birthday. I certainly do not need any convincing. On the contrary with this blog post I will present evidence that this is has indeed also been the case during the “The Great Recession”.

Following the general New Keynesian Phillips curve formulation current inflation depends on the expected future inflation and the gap between current output and the natural level of output. If a larger share of prices is adjusted every period then current inflation will depend more strongly on the current output gap and vice versa.

Using the New Keynesian framework it is possible to show that monetary policy during “The Great Recession” has had leverage over the development of prices both in the short run and the long run. Atlanta Fed’s monthly sticky price index will serve helpful in this. The sticky price index basically comprises the price components in the US consumer price index that are adjusted infrequently. Atlanta Fed furthermore publishes a flexible counterpart comprising the components in the US consumer price index that are adjusted frequently.

The first chart below depicts the development in US flexible core price inflation since 2008. I have used the three-month annual inflation rate only to get a smoother trend – it does not affect the main points of the analysis. I have marked seven turning points in the flexible core inflation that coincides with significant monetary policy shocks. 1) ECB surprises with a 0.25 %-point increase in interest rates, 2) Fed launches first round of QE, signals extended period of low rates, other major central bank cuts rates, Fed open dollar swap line, 3) Fed ends dollar swap line, 4) Bernanke mentions QE2, Fed launches QE2, 5) Trichet signals “strong vigilance”, ECB raises the interest rate twice, 6) ECB implements 3 year LTRO, 7) ECB tightens collateral rules.

What this brief analysis shows is that frequently adjusted prices do react to changes in monetary policy. When monetary policy is eased, demand increases and subsequently prices increase and vice versa.

In contrast, sticky price inflation does not only reflect the reaction to current monetary policy shocks, but also the expectations of the future development in demand. If demand is expected to increase then the sticky price inflation will increase as well.

The second chart below illustrates US sticky core price inflation since 2008. What the sticky core price inflation chart shows is that the monetary policy shocks in the end of 2008 (QE1 and extended period language) briefly improved the outlook for the US economy, but it was not before Fed launched QE2 in the second half of 2010 that sticky core inflation started increasing reflecting expectations of increasing demand. The chart further shows that sticky core inflation has started declining since the end of 2011. Hence, recently monetary policy has not done enough to maintain expectations of increasing demand.

The above analysis shows that consumer prices do contain substantial information on the effects of monetary policy. And to sum up, yes Lars, you are certainly right – inflation is always and everywhere a monetary phenomenon!

PS The Flexible and sticky prices series come from Federal Reserve Bank of Atlanta’s Inflation Project.

Guest post: Why “Integral” is wrong about Price Level Targeting (by J. Pedersen)

I have always said that my blog should be open to debate and I am happy to have guest posts from clever and inlighted economists (and non-economists) about monetary matters. I am therefore delighted that my good friend and colleague Jens Pedersen (I used to be his boss…) has offered to write a reply to “Integral’s” post on price level targeting versus NGDP level targeting. Jens who recently graduated from University of Copenhagen. His master thesis was about Price Level Targeting.

Jens, take it away…

Lars Christensen

Guest post: Why “Integral” is wrong about Price Level Targeting

by Jens Pedersen

The purpose of this comment is two-fold. First, I argue that ”Integral” in his guest post ”Measuring the stance of monetary policy through NGDP and prices” is wrong when he concludes that the Federal Reserve has done a fine job in achieving price level path stability and by this measure does maintain a tight stance on monetary policy. Second, I present a way of evaluating the Fed’s monetary policy stance based on the theory of optimal monetary policy.

“Integral” assumes that the Federal Reserve has targeted an implicit linear path for the price level since the beginning of the Great Moderation. Following Pedersen (2011) using the deviation in the price level from a linear trend (or the deviation in nominal GDP) to evaluate the stance of monetary policy needs to take into account the potential breaks and shifts in the trend following changes in the monetary policy regime. Changes in the monetary policy committee, changes in the mandate, targets etc. may lead to a shift or break in the targeted trend. Hence, the current implicit targeted trend for the price level (or nominal GDP) should correctly be estimated from February 2006 to take into account the change in president of the FOMC, or alternatively take account of this possible shift or break.

Changing the estimation period changes the conclusions of “Integral’s” analysis. Below, I illustrate the deviation in the log core PCE index from the estimated linear trend over the period 2006:2-2006:12. As the figure show Fed has significantly undershoot its implicit price level target and has not achieved price level path stability during the Great Recession. Currently, the price level gap is around 3% and increasing. Hence, looking at the deviation in the price level from the implicit price level trend does indeed suggest that monetary policy should be eased.

Following, Clarida et. al. (1999), Woodford (2003) and Vestin (2006) optimal monetary policy is a dual mandate which requires the central bank to be concerned with the deviation in output from its efficient level and the deviation in the price level from its targeted level. The first-best way of evaluating Fed’s monetary policy stance should be relative to the optimal solution to monetary policy.

However, this method requires a clear reference to the output gap. Common practice has been to calculate the output gap as the deviation in real output from its HP-filtered trend. This practice is by all means a poor consequence of the RBC view of economic fluctuations. Theoretically it fails to take account of the short run fluctuations in the efficient level of output. Empirically it does a poor job at estimating the potential output near the end points of the sample.

Fortunately, Jordi Galí in Galí (2011) shows how to circumvent these problems and derive a theoretical consistent output gap defined as the deviation in real output from its efficient counterpart. The efficient level of output corresponds to the first-best allocation in the economy, i.e. the output achieved when there are no nominal rigidities or imperfections present. Galí further shows how this output gap can be derived using only the observed variables of the unemployment rate and the labour income share.

The chart below depicts the efficiency gap in the US economy. Note, that this definition does not allow positive values. It is clear from the figure that at present there is significant economic slack in the US economy of historic dimension. The US output gap is currently almost 6.5% and undershoots its natural historical mean by more than 1.5%-points.

Hence, the present price level gap and output gap reveal that the Federal Reserve has not conducted optimal monetary policy during the Great Recession. Furthermore, the analysis suggest that Fed can easily increase inflation expectations by committing to closing the price level gap. This should give the desired boost to demand and spending and further close the output gap.

References:

Clarida, et al. (1999), “The Science of Monetary Policy: A New Keynesian Perspective”

Galí (2011), “Unemployment Fluctuations and Stabilization Policies: A New Keynesian Perspective”

Pedersen (2011), “Price Level Targeting: Optimal Anchoring of Expectations in a New Keynesian Model”

Vestin (2006), “Price Level Targeting versus Inflation Targeting

Woodford (2003), “Interest and Prices”

Pedersen on Price Level Targeting

My good colleague Jens N. Pedersen has today successfully defended his master thesis at the Department on Economics at the University of Copenhagen.

 Jens’ thesis should be of interest to Market Monetarists.

 Here is a bit from the introduction of Jens’ thesis “Price Level Targeting –  Optimal anchoring of expectations in a New Keynesian model”:

 “The recent experience of the Financial Crisis has highlighted the potential drawbacks of a policy targeting the changes and not the level of the prices. When the zero lower bound on the nominal interest rate binds, the inflation target presents a lower constraint on the real interest rate because inflation expectations are anchored at the target. Following the crisis, a number of major central banks have been forced to keep the policy rate close to zero and in the mean time use unconventional tools to keep monetary policy effective. Price level targeting, however, presents the optimal way of anchoring expectations by increasing inflation expectations in a deflationary environment and vice versa. This improves monetary policy in general and in a zero interest rate environment, which keeps the conventional interest rate operating procedure effective. This thesis attempts to study, how the central bank can optimally utilise the expectational channel, when setting monetary policy, by announcing a price level target. The investigation will take on both a theoretical and an empirical stand point. The theoretical part of the thesis revisits the arguments for and against adopting price level targeting. The empirical part of the thesis attempts to evaluate the optimality of monetary policy by inspecting the statistical properties of the price level.”

I am grateful to Jens for always challenging some of my views on monetary policy and Jens is always an excellent sparring partner not only on monetary issues but also on such interesting subjects as sportometrics and fine dining.

So dear readers please have a look at Jens’ excellent thesis. And to Jens – Congratulations! It is well-deserved and you can truly be proud of your thesis.

 

 

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