Belka-gate – the Polish version of the Sumner Critique?

A key Market Monetarist insight (it is New Keynesian insight as well…) is that budget multiplier is zero if the central bank says it is so. Or rather it the central bank targets inflation, the price level or nominal GDP then the central and will offset any shock – positive or negative – to nominal spending (aggregate demand) from changes in fiscal policy.

This means that the central bank – rather than the ministry of finance – has the full control of aggregate demand in the economy. No matter what the government does with fiscal policy the central bank has the instruments to fully offset this. This is the so-called Sumner Critique.

A major scandal involving the Polish central bank governor Marek Belka that has developed over the last couple of days is a powerful illustration of the Sumner Critique.

This is from Reuters:

A Polish magazine said on Saturday it had a recording of a private conversation in which the central bank chief told a minister the bank would be willing to help rescue the government from economic troubles on condition the finance minister was removed.

The weekly Wprost news magazine said it had a recording of a meeting in a Warsaw restaurant last July between central bank governor Marek Belka and Interior Minister Bartlomiej Sienkiewicz. It did not say who recorded their conversation, or how it had obtained the recording.

According to extracts of the audio recording posted on the Internet by the magazine, which have been heard by Reuters reporters, and were also emailed to Reuters by Wprost in transcript form, the minister sets out a possible future scenario in which the government could not meet its financial commitments and faced election defeat.

The man identified in the transcript as Sienkiewicz refers in vague terms to monetary policy action carried out elsewhere in Europe – an apparent reference to central bank stimulus.

“Is that precisely the moment for launching this sort of solution, or not?” Sienkiewicz asks Belka.

Belka replies, according to the transcript: “My condition would be the removal of the finance minister.”

The finance minister at the time, Jacek Rostowski, was removed last November as part of a cabinet reshuffle.

There you go. Central bankers have the power to control nominal spending in the economy. They might even have the power to have finance ministers removed. Never ignore the Sumner Critique.

PS the Polish central bank has said that the recordings are authentic, but that they have been manipulated and that Belka’s comments regarding the removal of the Finance Minister were taken out of context.

PPS It has been – and still is – my view that Polish monetary policy has been far too tight since early 2012. Maybe an explanation to the overly tight stance could be – and I am speculating – dissatisfaction with the Polish government’s fiscal stance.

PPPS for game theoretical based discussion of the Sumner Critique see my earlier posts here and here.

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Tick tock…here comes the Zero Lower Bound again

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

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

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

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

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

Here comes the Zero Lower Bound

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

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

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

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

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

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

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

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

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

We can avoid deflation – it is easy!

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

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

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

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

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

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

The antics of FX intervention – the case of Turkey

I have often been puzzled by central banks’ dislike of currency flexibility. This is also the case for many central banks, which officially operating floating exchange rate regimes.

The latest example of this kind of antics is the Turkish central bank’s recent intervention to prop as the Turkish lira after it has depreciated significantly in connection with the recent political unrest. This is from cnbc.com:

“On Monday, the Turkish central bank attempted to stop the currency’s slide by selling a record amount of foreign-exchange reserves in seven back-to-back auctions. The bank sold $2.25 billion dollars, or around 5 percent of its net reserves, to shore up its currency – the most it has ever spent to do so”

A negative demand shock in response to a supply shock

I have earlier described the political unrest in Turkey as a negative supply shock and it follows naturally from currency theory that a negative supply shock is negative for the currency and in that sense it shouldn’t be a surprise that the political unrest has caused the lira to weaken. One can always discuss the scale of the weakening, but it is hard to dispute that increased ‘regime uncertainty’ should cause the lira to weaken.

It follows from ‘monetary theory 101′ that central banks should not react to supply shocks – positive or negative. However, central banks are doing that again and again nonetheless and the motivation often is that central banks see market moves as “excessive” or “irrational” and therefore something they need to “correct”. This is probably also the motivation for the Turkish central bank. But does that make any sense economically? Not in my view.

We can illustrate the actions of the Turkish central bank in a simple AS/AD framework.

AS AD SRAS shock Turkey

The political unrest has increased ‘regime uncertainty’, which has shifted the short-run aggregate supply curve (SRAS) to the left. This push up inflation to P’ and output/real GDP drops to Y’.

In the case of a nominal GDP targeting central bank that would be it. However, in the case of Turkey the central bank (TCMB) has reacted by effectively tightening monetary conditions. After all FX intervention to prop up the currency is “reverse quantitative easing” – the TCMB has effectively cut the money base by its actions. This a negative demand shock.

In the graph this mean that the AD curve shifts  to the left from AD to AD’. This will push down inflation to P” and output to Y”.

In the example the combined impact of a supply shock and the demand shock is an increase in inflation. However, that is not necessarily given and dependent the shape of the SRAS curve and the size of the demand shock.

However, more importantly there is no doubt about the impact on real GDP growth – it will contract and the FX intervention will exacerbate the negative effects of the initial supply shock.

So why would the central bank intervene? Well, if we want to give the TCMB the benefit of the doubt the simple reason is that the TCMB has an inflation target. And since the negative supply shock increases inflation one could hence argue that the TCMB is “forced” by its target to tighten monetary policy. However, if that was the case why intervene in the FX market? Why not just use the normal policy instrument – the key policy interest rates?

My view is that this is a simple case of ‘fear-of-floating’ and the TCMB is certainly not the only central bank to suffer from this irrational fear. Recently the Polish central bank has also intervened to prop up the Polish zloty despite the Polish economy is heading for deflation in the coming months and growth is extremely subdued.

The cases of Turkey and Poland in my view illustrate that central banks are often not guided by economic logic, but rather by political considerations. Mostly central banks will refuse to acknowledge currency weakness is a result of for example bad economic policies and would rather blame “evil speculators” and “irrational” behaviour by investors and FX intervention is hence a way to signal to voters and others that the currency sell-off should not be blamed on bad policies, but on the “speculators”.

In that sense the central banks are the messengers for politicians. This is what Turkish Prime Minister Erdogan recently had to say about what he called the “interest rate lobby”:

“The lobby has exploited the sweat of my people for years. You will not from now on…

…Those who attempt to sink the bourse, you will collapse. Tayyip Erdogan is not the one with money on the bourse … If we catch your speculation, we will choke you. No matter who you are, we will choke you

…I am saying the same thing to one bank, three banks, all banks that make up this lobby. You have started this fight against us, you will pay the high price for it.

..You should put the high-interest-rate lobby in their place. We should teach them a lesson. The state has banks as well, you can use state banks.”

So it is the “speculators” and the banks, which are to blame. Effectively the actions of the TCMB shows that the central banks at least party agrees with this assessment.

Finally, when a central bank intervenes in the currency market in reaction to supply shocks it is telling investors that it effectively dislikes fully floating exchange rates and therefore it will effectively reduce the scope of currency adjustments to supply shocks. This effective increases in the negative growth impact of the supply shock. In that sense FX intervention is the same as saying “we prefer volatility in economic activity to FX volatility”. You can ask yourself whether this is good policy or not. I think my readers know what my view on this is.

Update: I was just reminded of a quote from H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”

Confused central banks and the need for an autopilot

For somewhat more than a decade I have regularly been watching monetary policy decisions from different central banks around the world. Most ‘modern’ central banks in the world announce changes to monetary policy once every month. Mostly these events are pretty much none-events – the central banks do not surprise markets much. However, over the last fives years it has certainly been harder to predict the outcome of these meetings compared to how relatively easy it was in the decade before the crisis.

The reason it has become harder to predict central banks is that we are no longer on ‘autopilot’ in monetary policy. One we are unsure about ‘where we are going’ – the central banks’ monetary targets have become less clear – and in some case the target has even changed. Second, especially central banks where interest rates have dropped to close to zero are unsure about what instruments to use in the conduct of monetary policy.

This uncertainty has created more volatility in financial markets as the markets have a very hard time “reading” the central banks. The monetary policy decision from the Bank of Japan this morning is instructive.

Yesterday the Nikkei was up around 5%, but this morning the market has been slightly nervous ahead of the monetary policy announcement. However, after the announcement Nikkei initially dropped 1.5% on ‘disappointment’ (as it is said in the financial media) that the Bank of Japan did not introduce new measure to curb ‘bond market volatility’.

This is really rather bizarre. Central banks really shouldn’t run around and announce new initiatives and new monetary policy instruments every other month. Unfortunately we look at the major central banks such as the Federal Reserve, the ECB and Bank of England these banks over the past five years again and again have introduced new policy instruments. A lot of these instruments have not even been aimed at changing monetary conditions (changing the money base and/or expectations of future changes to the money base), but have been credit policies.

Ideally central banks should not even need to hold these monthly monetary policy meetings. If the central bank clearly defines its monetary policy target and define what primary instrument it is using to change monetary conditions then monetary policy to a large extent would be on autopilot. 

Try to target one target and no more than that

First of all the central banks of the world should make it complete clear what they are trying to achieve. What is the central bank targeting?

Second, the central banks should make it clear that it is targeting future value rather than present value of these variables – be it inflation, the price level or nominal GDP. Therefore, central banks should communicate about the expectation for these targets.

For inflation targeting central banks like the Bank of Japan the central bank is lucky has it actually have market expectations for future inflation. Hence, there is no reason for the Bank of Japan to even comment on present inflation. The only thing, which is important, is market expectations. If market expectations for future Japanese inflation is below the BoJ’s 2% inflation target then the BoJ will have to conclude that monetary conditions still are too tight. It can of course easily do something about that – it can just announce that it will continue to escalate the growth of the money base until the market is pricing in 2% future inflation. Remember there are no limits to the central bank’s ability to print money. The term that the central bank should keep the powder dry therefore is also idiotic. The central bank will never run out of gun powder.

Third, central banks should stop confusing themselves and the markets by pursuing more than one target. Essentially the central bank only has one monetary policy instrument – and that is the money base. Hence, the central bank can only hit one nominal target. One would think that this should be obvious, but unfortunately it is not.

Lets take the example of the Polish central bank (NBP). Last week the NBP cut its key policy interest rates by 25bp – effectively trying to boost the growth of the money base. Within days after that decision the same Polish central bank intervened in the currency market to strengthen the zloty. Hence, the NBP was selling foreign currency and buying zloty. Said, in another way the NBP tried to reduce the money base. Are you confused? It seems like the NBP is.

Unfortunately the NBP is not the only central bank in the world, which is confused about its own policies. The recent increased volatility in the Japanese markets is exactly a result of a similar kind of policy maker confusion.  In April the BoJ moved decisively to ease monetary policy. This was seen as a credible and permanent expansion of the money base. Not surprisingly this sparked a rally in the Japanese stock market, weakened the yen and have push up nominal bond yields. Market Monetarists were not surprised. Higher bond yields reflect higher growth and inflation expectations.

However, the BoJ seems to have been surprised by the impact of its own actions – particularly the increase in bond yields have made policy makers nervous. This led both BoJ and government officials to make unclear statements about the connection between bond yields and monetary policy. However, it is clear that if the BoJ in somewhat tries to target the level of bond yields it cannot also target inflation.

A similar problematic tendency of central bankers these days is an aversion against using certain policy instruments. Hence, central bankers have a preference to conduct monetary policy through interest rate changes. However, if the interest rate is close to zero then other instruments have to be used – for example directly expanding the money base.

However, it is very clear that for example a lot of Federal Reserve officials can’t wait to reduce the US money base. Logically that obviously makes no sense as it basically mean that the policy instrument enters on both the left-hand and the right-hand side of the central bank’s reaction function. The fed should obviously not reduce the money base before it is clear that it will hit its – not too well-defined – target.

The textbook advice to central banks therefore must be to target one nominal variable and target the market expectation of the future value of this variable.

Let the markets be the autopilot for monetary policy  

If the central bank formulates its target in the form of expectations then it is really very simple to introduce an autopilot monetary policy.

Again lets take the example of the Bank of Japan. The BoJ is now officially targeting inflation at 2%. It wants to achieve that target in two-years.

The market obviously provides a measure of how likely the BoJ is to meet this target in the form of breakeven inflation expectations from inflation-linked Japanese government bonds. The verdict from the market is clear – while inflation expectations have risen significantly the market is still far from pricing in 2% inflation.

In fact 2-year/2-year inflation expectations – that is the market expectations for inflation two years from now and two years ahead – is closer to 1% than to 2%.

So while the BoJ has credibly eased monetary policy its inflation target is still far from credible.

The easiest way to make that target credible is simply to announce that market expectations for Japanese inflation should be 2%. Or as I have suggested before the BoJ should simply ‘peg’ the inflation expectation to 2%. It should announce that if inflation expectations are below 2% when the BoJ will simply buy inflation linked bonds until inflation expectations hit 2% and similarly of course sell inflation-linked bonds if inflation expectations move above 2%.

In that scenario Japanese monetary policy would be completely on autopilot. The BoJ would not have to confuse itself and markets by introducing instruments every months or by giving cryptic statements about the state of the Japanese economy.

The BoJ could simply monthly report on the markets’ inflation expectations. If that BoJ did that then this months’ monetary policy statement would look something like this:

“The Bank of Japan is targeting 2% inflation. Market expectations for inflation on all relevant time horizons shows that inflation expectations have increased over the past year. Unfortunately inflation expectations are still significantly below 2% and as such the 2% inflation target is no yet fully credible.

However, the Bank of Japan has the full control of the Japanese monetary base and is ready to expand the money base as much as needed to bring inflation expectations fully in line with the inflation target. Hence, the Bank of Japan will continue to step up the buying of inflation-linked government bonds until there is full correspondence between the inflation target and market expectations.”

If I were a market participant that read that statement I would start buying inflation-linked bond immediately – and I would sell the yen and buy some more Japanese equities. And I am sure we very fast would see the market price in 2% inflation. Mission accomplished.

And once inflation expectations have been ‘pegged’ to 2% the BoJ could simply put the following text on it website: “Bank of Japan targets 2% inflation. Inflation expectations are at 2%. Monetary policy is 100% credible. We have gone golfing”.

I am writing this on a flight to Brussels (so I am not on the internet) while BoJ governor Kuroda is having a press conference. I very much hope he will be saying something similar to what I have suggested, but I am not overly optimistic.  

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Update: A quick glance through Kuroda’s comments indicates that he doesn’t really get it. He talks about controlling bond market volatility and makes some but not too impressive comments on breakeven inflation rates. It is sending stock markets down around the world. (By the way if Japanese monetary easing is part of an evil ‘currency war’ why are global stock markets falling when the BoJ fails to deliver?) 

Sweden, Poland and Australia should have a look at McCallum’s MC rule

Sweden, Poland and Australia all managed the shock from the outbreak of Great Recession quite well and all three countries recovered relatively fast from the initial shock. That meant that nominal GDP nearly was brought back to the pre-crisis trend in all three countries and as a result financial distress and debt problems were to a large extent avoided.

As I have earlier discussed on my post on Australian monetary policy there is basically three reasons for the success of monetary policy in the three countries (very broadly speaking!):

1)     Interest rates were initially high so the central banks of Sweden, Poland and Australia could cut rates without hitting the zero lower bound (Sweden, however, came very close).

2)     The demand for the countries’ currencies collapsed in response to the crisis, which effectively led to “automatic” monetary easing. In the case of Sweden the Riksbank even seemed to welcome the collapse of the krona.

3)     The central banks in the three countries chose to interpret their inflation targeting mandates in a “flexible” fashion and disregarded any short-term inflationary impact of weaker currencies.

However, recently the story for the three economies have become somewhat less rosy and there has been a visible slowdown in growth in Poland, Sweden and Australia. As a consequence all three central banks are back to cutting interest rates after increasing rates in 2009/10-11 – and paradoxically enough the slowdown in all three countries seems to have been exacerbated by the reluctance of the three central banks to re-start cutting interest rates.

This time around, however, the “rate cutting cycle” has been initiated from a lower “peak” than was the case in 2008 and as a consequence we are once heading for “new lows” on the key policy rates in all three countries. In fact in Australia we are now back to the lowest level of 2009 (3%) and in Sweden the key policy rate is down to 1.25%. So even though rates are higher than the lowest of 2009 (0.25%) in Sweden another major negative shock – for example another escalation of the euro crisis – would effectively push the Swedish key policy rate down to the “zero lower bound” – particularly if the demand for Swedish krona would increase in response to such a shock.

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? he discusses a new policy rule that could be highly relevant for the central banks in Sweden, Poland and Australia – and for matter a number of other central banks that risk hitting the zero lower bound in the event of a new negative demand shock (and of course for those who have ALREADY hit the zero lower bound as for example the Czech central bank).

What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target. Therefore we could also formulate the rule for example in terms of commodity prices (that would basically be Irving Fisher’s Compensated dollar standard) or for that matter stock prices (See my earlier post on how to use stock prices as a monetary policy instrument here). That is not really important. The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

Implementing a MC rule would be easy, but very effective

So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank or the Polish central bank (NBP) should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

You might object that in for example in Poland the key policy rate is still way above zero so why worry now? Yes, that is true, but the experience over the last four years shows that when you hit the zero lower bound and there is no pre-prepared operational framework in place then it is much harder to come up with away around the problem. Furthermore, by announcing such a rule the risk that it will have to “kick in” is in fact greatly reduced – as the exchange rate automatically would start to weaken as interest rates get closer to zero.

Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank, the Polish central bank and the Australian Reserve Bank could all avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

PS it should be noted that this post is not meant as a discussion about what the central bank ultimately should target, but rather about what instruments to use to hit the given target. McCallum in his 2005 paper expresses his MC as a Taylor style rule, but one could obviously also think of a MC rule that is used to implement for example a price level target or even better an NGDP level rule and McCallum obviously is one of the founding father of NGDP targeting (I have earlier called McCallum the grandfather of Market Monetarism).

Dangerous bubble fears

Here is Swedish central bank governor Stefan Ingves in an op-ed piece in the Swedish newspaper Svenska Dagbladet last week:

“I also have to take responsibility for the long term consequences of today’s monetary policy…And there are risks associated with an all too low interest rate over a long period, which cannot be ignored.”

Said in another way if we keep interest rates too low we will get bubbles. So despite very clear signs that the Swedish economy is slowing Ingves would not like to ease monetary policy. Ingves in that sense is similar to many central bankers around the world. Many central bankers have concluded that the present crisis is a result of a bubble that bursted and the worst you could do is to ease monetary policy – even if the economic data is telling you that that is exactly what you should.

The sentiment that Ingves is expressing is similar to the view of the ECB and the fed in 2008/9: We just had a bubble and if we ease too aggressively we will get another one. Interestingly enough those central banks that did well in 2008/9 and eased monetary policy more aggressively and therefore avoided major crisis today seem to be most fearful about “bubbles”. Take the Polish central bank (NBP). The NBP in 2009 allowed the zloty to weaken significantly and cut interest rates sharply. That in my view saved the Polish economy from recession in 2009 – Poland was the only country in Europe with positive real GDP growth in 2009. However, today the story is different. NBP hiked interest rates earlier in the year and is now taking very long time in easing monetary policy despite very clear signs the Polish economy is slowing quite fast. In that sense you can say the NBP has failed this year because it did so well in 2009.

The People’s Bank of China in many ways is the same story – the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.

So the story is the same in Sweden, Poland and China. The countries that escaped the crisis did so by easing monetary conditions. As their exports collapsed domestic demand had to fill the gap and easier monetary policy made that possible. So it not surprising that these countries have seen property prices continuing to increase during the last four years and also have seen fairly strong growth in private consumption and investments. However, this now seem to be a major headache for central bankers in these countries.

I think these bubble fears are quite dangerous. It was this kind of fears that led the fed and the ECB to allow monetary conditions to become excessive tight in 2008/9. Riksbanken, NBP and the PBoC now risk making the same kind of mistake.

At the core of this problem is that central bankers are trying to concern themselves with relative prices. Monetary policy is very effective when it comes to determine the price level or nominal GDP, but it is also a very blunt instrument. Monetary policy cannot – and certainly should not – influence relative prices. Therefore, the idea that the central bank should target for example property prices in my view is quite a unhealthy suggestion.

Obviously I do not deny that overly easy monetary policy under certain circumstances can lead to the formation of bubbles, but it should not be the job of central bankers to prick bubbles.

The best way to avoid that monetary policy do not create bubbles is that the central bank has a proper monetary target such as NGDP level targeting. Contrary to inflation targeting where positive supply shocks can lead to what Austrians call relative inflation there is not such a risk with NGDP level targeting.

Let’s assume that the economy is hit by a positive supply shock – for example lower import prices. That would push down headline inflation. An inflation targeting central bank – like Riksbanken and NBP – in that situation would ease monetary policy and as a result you would get relative inflation – domestic prices would increase relative to import prices and that is where you get bubbles in the property markets. Under NGDP level targeting the central bank would not ease monetary policy in response to a positive supply shock and inflation would drop ease, but the NGDP level would on the other hand remain on track.

However, the response to a demand shock – for example a drop in money velocity – would be symmetric under NGDP level targeting and inflation target. Both under IT and NGDP targeting the central bank would ease monetary policy. However, this is not what central banks that are concerned about “bubbles” are doing. They are trying to target more than one target. The first page in the macroeconomic textbook, however, tells you that you cannot have more policy targets than policy instruments. Hence, if you target a certain asset price – like property prices – it would mean that you effectively has abandoned your original target – in the case of Riksbanken and NBP that is the inflation target. So when governor Ingves express concern about asset bubbles he effective has said that he for now is not operating an inflation targeting regime. I am sure his colleague deputy governor Lars E. O. Svensson is making that argument to him right now.

I don’t deny that bubbles exist and I am not claiming that there is no bubbles in the Swedish, Polish or Chinese economies (I don’t know the answer to that question). However, I am arguing that monetary policy is a very bad instrument to “fight” bubbles. Monetary policy should not add to the risk of bubbles, but “bubble fighting” should not be the task of the central bank. The central bank should ensure nominal stability and let the market determine relative prices in the economy. Obviously other policies – such as tax policy or fiscal policy should not create moral hazard problems through implicit or explicit guarantees to “bubble makers”.

Japan has been in a 15 year deflationary environment with falling asset prices and a primary reason for that is the Bank of Japan’s insane fear of creating bubbles. I doubt that the Riksbank, NBP or the PBoC will make the same kind of mistakes, but bubbles have clearly led all three central banks to become overly cautious and as a result the Swedish, the Polish and the Chinese economy are now cooling too much.

I should stress that I do not suggest some kind of “fine tuning” policy, but rather I suggest that central banks should focus on one single policy target – and I prefer NGDP level targeting – and leave other issues to other policy makers. If central banks are concerned about bubbles they should convince politicians to implement policies that reduce moral hazard rather than trying to micromanage relative prices and then of course focus on a proper and forward looking monetary policy target like NGDP level targeting.

PS Note that I did not mention the interest rate fallacy, but I am sure Milton Friedman would have told governor Ingves about it.
PPS You can thank Scandinavian Airlines for this blog post – my flight from London to Copenhagen got cancelled so I needed to kill some time before my much later flight.

Related posts:

Boom, bust and bubbles
The luck of the ‘Scandies’
Four reasons why central bankers ignore Scott Sumner’s good advice

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