“God forbid that our policy should ever work”

This is Mario Draghi at the ECB’s press conference yesterday:

“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring.”

You got to ask yourself why you would ease monetary policy if you don’t want inflation expectations to increase. And ask yourself if the market will believe this will work if the ECB is so eager to say that the policy will not increase inflation expectations.

It all just feel so Japanese – pre-Kuroda…

HT Nicolas Goetzmann

 

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The ECB is way behind the curve (the one graph version)

The ECB is today widely expected to introduce a number of measures to ease monetary conditions in the euro zone and it seems like the ECB is finally beginning to recognize the serious deflationary risks facing the euro zone.

But how far behind the curve is the ECB? There are a lot of measures of that, but if we look at the ECB’s own stated goal of 2% inflation then we will see that the ECB has basically failed consistently since 2008.

Below I look at the the level of the GDP deflator (which I believe is a better indicator of inflation than the ECB’s prefered measure – the HCIP inflation).

Price gap ECB

I think the graph very well illustrates just how big the ECB’s policy failure has been since 2008. From 1999 to 2008 the ECB basically kept the actual price level on a straight 2% path in line with its stated policy goal. However, since 2008 GDP deflator-inflation has consistently been well-below the 2%. As a result what I here call the price gap - the percentage difference between the actual price level and the 2% path – has kept on widening so the gap today is around 4%.

This is a massive policy mistake – and this is why the euro zone remains in crisis – and given the fact that we are basically not seeing any broad money supply growth at the moment the price gap is very likely to continue to widen. In fact outright deflation seems very likely if the ECB once again fails to take decisive action.

What should be done? It is really easy, but the ECB is likely to make it complicated 

At the ECB in Frankfurt they are happy to repeat Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon. So it should be really simple – if you have less than 2% inflation and want to ensure 2% inflation then you need to create more money. Unfortunately the ECB seems to think that it is in someway ‘dirty’ to create money and therefore we are unlikely to see any measures today to actually create money.

Most analysts expect a cut in ECB’s deposit rate to negative territory and maybe a new LTRO and even some kind of lending scheme to European SMEs. But all of that is basically credit policies and not monetary policy. Credit policy has the purpose of distorting market prices – and that shouldn’t really be the business of central banks – while monetary policy is about hitting nominal variables such as the price level or nominal spending by controlling the money base (money creation).

The ECB needs to stop worrying about credit markets and instead focus on ensuring nominal stability. So to me it is very simple. Today Mario Draghi simply should announce that the ECB has failed since 2008, but that that will now change.

He should pre-commit to bringing back the price level to the ‘old’ trend within the next two years and do that he should keep expanding the euro zone money base (by buying a basket of GDP weight euro zone government bonds) until he achieves that goal and he should make is completely clear that there will be no limits to the expansion of the money base. The sole purpose of his actions will be to ensure that the price level is brought back on track as fast as possible.

Once the price level is brought back to the old trend it should be kept on this 2% trend path.

How hard can it be?

PS Yes, I fundamentally would like the ECB to target the nominal GDP level, but targeting the GDP deflator price level would be pretty close to my preferred policy.

Follow me on Twitter here.

“Whatever it takes to get deflation” (Stealing two graphs from Marcus Nunes)

Marcus Nunes has two extremely illustratative graphs in his latest blog post. Just take a look here:

 

 I don’t think any other comments are needed…

Mr. Draghi you have not delivered price stability. Now please do!

The ECB is very proud of its 2% inflation target. The problem is just that it is not hitting it.

According to the ECB price stability is defined as “inflation rates below, but close to, 2% over the medium term”.

Today the ECB published it’s new inflation and growth forecasts. The ECB now forecasts 1.4% inflation in 2013 and 1.3% in 2014. That might be below, but it is certainly not close to 2%. In fact inflation has been nowhere close to 2% for five years (!) if you look at the GDP deflator rather than HCIP inflation.

So how does the ECB response to its own forecast that it will fail in deliver price stability in both 2013 and 2014? Well, by saying everything is just fine and no monetary easing is needed.

No further comments are needed – its just depressing…

PS don’t tell me that euro zone inflation is low because of a positive supply shock. In 2011 the ECB nearly killed the euro by hiking interest rates twice in response to a negative supply shock.

PPS with M3 growth just above 3% is it pretty easy to conclude that the euro zone is heading for deflation sooner or later.

15 years too late: Reviving Japan (the ECB should watch and learn)

After 15 years of deflationary policies the Bank of Japan now clearly is changing course. That should be clear to everybody after today’s policy announcement from the Bank of Japan. I don’t have a lot of writing here other than I will say this is extremely good news. Good for Japan and good for the global economy and what the BoJ is doing is nearly textbook style monetary easing. The only minus is that the BOJ is targeting inflation and not the NGDP level, but anyway I am pretty convinced this will work and work soon.

Anyway lets pay tribute to Milton Friedman. This is Uncle Milty in 1998 in his article “Reviving Japan”:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

This is what the BoJ announced today:

Under this guideline, the monetary base — whose amount outstanding was 138 trillion yen at end-2012 — is expected to reach 200 trillion yen at end-2013 and 270 trillion yen at end-2014.

The monthly flow of JGB (Japanese Government Bonds) purchases is expected to become 7+ trillion yen on a gross basis.

The Bank will achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. In order to do so, it will enter a new phase of monetary easing both in terms of quantity and quality. It will double the monetary base and the amounts outstanding of Japanese government bonds (JGBs) as well as exchange-traded funds (ETFs) in two years, and more than double the average remaining maturity of JGB purchases.

After 15 years the BoJ is finally listening to Friedman’s advice and I am sure it will do a lot to revive the Japanese economy. In fact the BoJ is doing more than listening to Milton Friedman. The BoJ is also listening to the Market Monetarist message of using the Chuck Norris Effect by guiding market expectations. Good work Kuroda.

And finally a message to ECB boss Mario Draghi. If you want to end the euro crisis just copy-paste today’s BoJ statement. You have the same inflation target anyway. It is not really that hard to do.

Time to end discretionary monetary policy!

This week has been nearly 100% about monetary policy in the financial markets and in the international financial media. In fact since 2008 monetary policy has been the main driver of prices in basically all asset classes. In the markets the main job of investors is to guess what the ECB or the Federal Reserve will do next. However, the problem is that there is tremendous uncertainty about what the central banks will do and this uncertainty is multi-dimensional. Hence, the question is not only whether XYZ central bank will ease monetary policy or not, but also about how it will do it.

Just take Mario Draghi’s press conference last week – he had to read out numerous different communiqués and he had to introduce completely new monetary concepts – just take OMT. OMT means Outright Monetary Transactions – not exactly a term you will find in the monetary theory textbook. And he also had to come up with completely new quasi-monetary institutions – just take the ESM. The ESM is the European Stability Mechanism. This is not really necessary and it just introduce completely unnecessary uncertainty about European monetary policy.

In reality monetary policy is extremely simple. Central bankers can fundamentally do two things. First, the central bank can increase or decrease the money base and second it can guide expectations. It is really simple. There is no reason for ESM, OMT, QE3 etc. The problem, however, is that central banks used to control the money base and expectations with interest rates, but with interest rates close to zero central bankers around the world seem to have lost the ability to communicate about what they want to do. As a result monetary policy has become extremely discretionary in both Europe and the US.

That need to change as this discretion is at the core the uncertainty about monetary policy. Central bankers therefore have to do two things to get back on track and to create some kind of normality. First, central banks should define very clear targets of what the want to achieve – preferably the ECB and the Fed should announce nominal GDP targets, but other target might do as well. Second, the central banks should give up communicating about monetary policy in terms of interest rates and rather communicate in terms of how much they want to change the money base.

In terms of changes in the money base the central banks should clarify how the money base is changed. The central bank can increase the money base, by buying different assets such as government bonds, foreign currencies, commodities or stocks. The important thing is that the central banks do not try to affect relative prices in the financial markets. When the Fed is conducting it “twist operations” it is trying to distort relative prices, which essentially is a form of central planning and has little to do with monetary policy. Therefore, the best the central banks could do is to define a clear basket of assets it will be buying or selling to increase or decrease the money base. This could be a fixed basket of bonds, currencies, commodities and stocks – or it could just be short-term government bonds. The important thing is that the central bank define a clear instrument.

This would remove the “instrument uncertainty” and the ECB or the Fed would not have to come up with new weird instruments every single month. Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.” 

In this world there would be no discretion at all – the central bank would be strictly rule following. It would use its well-defined policy instrument to always hit the policy target and there would be no problems with zero bound interest rates. But most important it would allow the financial markets to do most of the lifting as such set-up would be tremendously more transparent than what they are doing today.

Today we will see whether Ben Bernanke want to continue distorting relative prices and maintaining policy uncertainty by keeping the Fed’s highly discretionary habits or whether he want to ensure a target and rules based monetary policy.

PS a possibility would of course also be to use NGDP futures to conduct monetary policy as Scott Sumner has suggested, but that nearly seems like science fiction given the extreme conservatism of the world’s major central banks.

“Conditionality” is ECB’s term for the Sumner Critique

Some time ago Scott Sumner did a number of blog posts on fiscal policy and why he believes that the budget multiplier is zero. At the time I was somewhat frustrated that the amount of time Scott was using to focus on an issue that I found quite obvious. However, I now found myself doing exactly the same thing – I can’t let go of the game played by central banks against governments and impact this has on the economic policy mix. This is maybe because I find empirical evidence for the so-called Sumner Critique popping up everywhere.

The Sumner Critique basically says that the central bank can always overrule any impact of expansionary fiscal policy on aggregate demand by tightening monetary policy and if the central bank is targeting for example inflation or nominal GDP then it will do so. Therefore, under inflation targeting or NGDP targeting the budget multiplier will always be zero even if the world is Keynesian.

Last week’s policy announcement from the ECB gives further (quasi) empirical support for the Sumner Critique. Hence, the ECB announced that it would conduct what it calls “Outright Monetary Transactions” (OMT) – that is it would (or rather could) buy euro government bonds.

But see here what the ECB said about the conditions for OMT:

“A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.

The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.

Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.”

The important term here is “conditionality”. The ECB’s condition for buying government bonds is that the individual euro zone country has a EFSF/ESM macroeconomic adjustment programme. Such a programme is basically a pledge of a given government to tighten fiscal policy. In other words – the ECB could buy for example Spanish government bonds, but the condition would be that the Spanish government should tighten fiscal policy.

Therefore, what the ECB is doing is basically asking the Spanish government and other euro zone governments to be the “Stackelberg leader”: First you tighten fiscal policy and then we will ease monetary policy.

As a consequence the ECB has basically said that the fiscal multiplier should be zero – the ECB will “neutralize” any impact on aggregate demand of changes in fiscal policy. This is better news than it might sound. Obviously European monetary policy is much too tight in the euro zone and I would have liked to see a lot more action from the ECB. However, one could understand “conditionality” to mean that the ECB will fill the possible hole in aggregate demand from fiscal consolidation in euro zone – monetary policy will be eased in response to fiscal tightening. That is good news.

However, the crucial problem of course is that the euro zone needs higher aggregate demand and therefore I would have been much happier if the ECB had announced a clear plan to increase aggregate demand (or rather nominal GDP) – it did not do that. However, if the ECB at least will try to counteract the possible negative impact on aggregate demand from fiscal consolidation then that is good news. One could of course say that this is a completely natural consequence of the ECB’s inflation targeting regime – if fiscal tightening reduces aggregate demand then the ECB should ease monetary policy to avoid inflation undershooting the inflation targeting.

Concluding, “conditionality” is another term for the Sumner Critique and it is in my view yet another illustration that expansionary fiscal policy is unlikely to bring us out of this crisis if central banks is not playing along.

Related posts:

In New Zealand the Sumner Critique is official policy
Policy coordination, game theory and the Sumner Critique
The fiscal cliff and why fiscal conservatives should endorse NGDP targeting
The Bundesbank demonstrated the Sumner critique in 1991-92
“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy

Greece is not really worse than Germany (if you adjust for lack of growth)

Market Monetarists have stressed it again and again – the European crisis is primarily a monetary crisis rather than a financial crisis and a debt crisis. Tight monetary conditions is reason for the so-called debt crisis. Said in another way it is the collapse in nominal GDP relative to the pre-crisis trend that have caused European debt ratios to skyrocket in the last four years.

That is easily illustrated – just see the graph below:

I have simply plotted the change in public debt to GDP from 2007 to 2012 (2012 are European Commission forecasts) against the percentage change in nominal GDP since 2007.

The conclusion is very clear. The change in public debt ratios across the euro zone is nearly entirely a result of the development in nominal GDP.

The “bad boys” the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain (and Slovenia) are those five (six) countries that have seen the most lackluster growth (in fact decline) in NGDP in the euro zone. These countries are obviously also the countries where debt has increased the most and government bond yields have skyrocketed.

This should really not be a surprise to anybody who have taken Macro 101 – public expenditures tend to increase and tax revenues drop in cyclical downturns. So higher budget deficits normally go hand in hand with weaker growth.

The graph interestingly enough also shows that the debt development in Greece really is no different from the debt development in Germany if we take the difference in NGDP growth into account. Greek nominal GDP has dropped by around 10% since 2007 and that pretty much explains the 50%-point increase in public debt since 2007. Greece is smack on the regression line in the graph – and so is Germany. The better debt performance in Germany does not reflect that the German government is more fiscally conservative than the Greek government. Rather it reflects a much better NGDP growth performance. So maybe we should ask the Bundesbank what would have happened to German public debt had NGDP dropped by 10% as in Greece. My guess is that the markets would not be too impressed with German fiscal policy in that scenario. It should of course also be noted that you can argue that the Greek government really has not anything to reduce the level of public debt – if it had than the Greece would be below to the regression line in the graph and it is not.

There are two outliers in the graph – Ireland and Estonia. The increase in Irish debt is much larger than one should have expected judging from the size of the change in NGDP in Ireland. This can easily be explained – it is simply the cost of the Irish banking rescues. The other outlier is Estonia where the increase in public debt has been much smaller than one should have expected given the development in nominal GDP. In that sense Estonia is really the only country in the euro zone, which have improved its public finances in any substantial fashion compared to what would have been the case if fiscal austerity had not been undertaken. The tightening of fiscal policy measured in this way is 20-25% of GDP. This is a truly remarkable tightening of fiscal policy.

Imagine, however, for one minute that Greece had undertaken a fiscal tightening of a similar magnitude as Estonia and assume at the same time that it would have had no impact on NGDP (the keynesians are now screaming) then the Greek budget situation would still have been horrendous – public debt would have not increase by 50% %-point of GDP but “only” by 30%-point. Greece would still be in deep trouble. This I think demonstrates that it is near impossible to undertake any meaningful fiscal consolidation when you see the kind of collapse in NGDP that you have seen in Greece.

Concluding, the European debt crisis is not really a debt crisis. It is a monetary crisis. The ECB has allowed euro zone nominal GDP to drop well-below its pre-crisis trend and that is the key reason for the sharp rise in public debt ratios. I am not saying that Europe do not have other problems. In fact I think Europe has serious structural problems – too much regulation, too high taxes, rigid labour markets, underfunded pension systems etc. However, these problems did not cause the present crisis and even though I think these issues need to be addressed I doubt that reforms in these areas will be enough to drag us out of the crisis. We need higher nominal GDP growth. That will be the best cure. Now we are only waiting on Draghi to deliver.

PS The graph above also illustrate how badly wrong Arthur Laffer got it on fiscal policy in his recent Wall Street Journal article – particular in his claim that Estonia had been got conducting keynesian fiscal stimulus. See here, here and here.

Draghi and European dollar demand – an answer to JP Irving’s puzzle

Yesterday, ECB chief Mario Draghi hinted quite clearly that monetary easing would be forthcoming in the euro zone. In fact he said the ECB would do everything to save the euro. However, something paradoxical happened on the back of Draghi’s comments. Here is JP Irving on his blog Economic Sophisms:

“Something interesting happened yesterday. The Euro strengthened  after Draghi hinted at easier policy. Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply.  I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.”

I can understand that JP is puzzled. Normally we would certainly expect monetary easing to mean that the currency should weaken. However, I think there is a pretty straightforward explanation to this and it has to do with the monetary linkages between the US and the euro zone. In my post Between the money supply and velocity – the euro zone vs the US from earlier in the week I described how I think the origin of the tightening of US monetary conditions in 2008 was a sharp rise in European dollar demand. When European investors in 2008 scrambled to increase their cash holdings they did not primarily demand euros, but US dollars. As a result US money-velocity dropped much more than European money-velocity, but at the same time the ECB failed to curb the drop in money supply growth. The sharp increase in dollar demand caused EUR/USD to plummet (the dollar strengthened).

What happened yesterday was exactly the opposite. Draghi effectively announced that he would increase the euro zone money supply and hence reduce the risk of crisis. With an escalation of the euro crisis less likely investors did move to reduce their demand for cash and since the dollar is the reserve currency of the world (and Europe) dollar demand dropped and as a result EUR/USD spiked. Hence, yesterday’s market action is fully in line with the mechanisms that came into play in 2008 and have been in play ever since. In that regard, it should be noted that Mario Draghi not only eased monetary policy in Europe yesterday, but also in the US as his comments led to a drop in dollar demand.

Finally this is a very good illustration of Scott Sumner’s point that monetary policy tends to work with long and variable leads. The expectational channel is extremely important in the monetary transmission mechanism, but so are – as I have often stressed – the international monetary linkages. In that regard it is paradoxical that University of Chicago (!!) economics professor Casey Mulligan exactly yesterday decided to publish a comment claiming that monetary policy does not have an impact on markets. Casey, did you see the reaction to Draghi’s comments? Or maybe it was just a technology shock?

—-
Related posts:

Between the money supply and velocity – the euro zone vs the US
International monetary disorder – how policy mistakes turned the crisis into a global crisis

The reason Mario Monti is beginning to sound (very) desperate

When the eurocrat Mario Monti became Prime Minister last year we were told that he was the man to turn around the Italian economy. We were told that technocrats would do the job rotten and incompetent politicians were not able to do. However, the eurocrat Papademos did not last long in Greece and now Mario Monti is beginning to sound rather desperate. On Thursday he told reporters that EU policy makers had one week to save the euro. That is somewhat of a stern warning from somebody who is supposed to be a cool-headed technocrat.

Why this sudden desperation from Monti? Well, it is pretty simple – Italian nominal GDP is declining sharply, while Italian funding costs are increasing sharply day-by-day. With NGDP declining rapidly the public debt-to-GDP ratio obviously is exploding and as investors know that the ECB has not shown any willingness to curb the decline in NGDP then Italian debt as share of GDP is likely to continue to increase no matter how many budget cuts and tax increases the Italian parliament passes. It is very simply – without growth in NGDP the Italian government will fast become insolvent.

Therefore, it is not really Angela Merkel Mario Monti should be asking for help to solve the crisis, but rather his namesake and countryman ECB chief Mario Draghi. The ECB can end this crisis by introducing a determined policy to curb the drop in euro zone NGDP (or rather to increase NGDP markedly). On the other hand if Draghi does not act then it might very well be that Monti is right about his warnings.

PS Meanwhile Monti’s predecessor is having other ideas (remember Italy never defaults – Italy inflates…) and it is not the first time.

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