Let me say it again – The Kuroda recovery will be about domestic demand and not about exports

This morning we got strong GDP numbers from Japan for Q1. The numbers show that it is primarily domestic demand – private consumption and investment – rather than exports, which drive growth.

This is from Bloomberg:

Japan’s economy grew at the fastest pace since 2011 in the first quarter as companies stepped up investment and consumers splurged before the first sales-tax rise in 17 years last month.

Gross domestic product grew an annualized 5.9 percent from the previous quarter, the Cabinet Office said today in Tokyo, more than a 4.2 percent median forecast in a Bloomberg News survey of 32 economists. Consumer spending rose at the fastest pace since the quarter before the 1997 tax increase, while capital spending jumped the most since 2011.

…Consumer spending rose 2.1 percent from the previous quarter, the highest since a 2.2 percent increase in the first three months of 1997.

So it is domestic demand, while net exports are actually a drag on the economy (also from Bloomberg):

Exports rose 6 percent from the previous quarter and imports climbed 6.3 percent.

The yen’s slide since Abe came to power in December 2012 has inflated the value of imported energy as the nation’s nuclear reactors remain shuttered after the Fukushima disaster in March 2011.

The numbers fits very well with the story I told about the excepted “Kuroda recovery” (it is not Abenomics but monetary policy…) a year ago.

This is what I wrote in my blog post “The Kuroda recovery will be about domestic demand and not about exports” nearly exactly a year ago (May 10 2013):

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

…I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we seeing the yen weaken, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

the focus on the“competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

While I am happy to acknowledge that today’s numbers likely are influenced by a number of special factors – such as increased private consumption ahead of planned sales tax hikes and likely also some distortions of the investment numbers I think it is clear that I overall have been right that what we have seen in the Japanese economy over the past year is indeed a moderate recovery led by domestic demand .

The biggest worry: Inflation targeting and a negative supply shock

That said, I am also worried about the momentum of the recovery and I am particularly concerned about the unfortunate combination of the Bank of Japan’s focus on inflation targeting – rather than nominal GDP targeting – than a negative supply shock.

This is particularly the situation where we are both going to see a sales tax hike – which will increase headline inflation – and we are seeing a significant negative supply shock due to higher energy prices. Furthermore note that the Abe administration’s misguided push to increase wage growth – to a pace faster than productivity growth – effectively also is a negative supply shock to the extent the policy is “working”.

While the BoJ has said it will ignore such effects on headline inflation it is likely to nonetheless at least confuse the picture of the Japanese economy and might make some investors speculate that the BoJ might cut short monetary easing.

This might explain three factors that have been worrying me. First, of all while broad money supply in Japan clearly has accelerated we have not see a pick-up in money-velocity. Second, the Japanese stock market has generally been underperforming this year. Third, we are not really seeing the hoped pick-up in medium-term inflation expectations.

All this indicate that the BoJ are facing some credibility problems – consumers and investors seem to fear that the BoJ might end monetary easing prematurely.

To me there is only one way to fundamentally solve these credibility problems – the BoJ should introduce a NGDP level target of lets say 3-4%. That would significantly reduce the fear among investors and consumers that the BoJ might scale back monetary easing in response to tax hikes and negative supply shocks, while at the same time maintain price stability over the longer run (around 2% inflation over the medium-term assuming that potential real GDP growth is 1-2%).

PS Q1 2014 nominal GDP grew 3.1% y/y against the prior reading of 2.2% y/y.

PPS See also my previous post where I among other things discuss the problems of inflation targeting and supply shocks.

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The monetary transmission mechanism – causality and monetary policy rules

Most economists pay little or no attention to nominal GDP when they think (and talk) about the business cycle, but if they had to explain how nominal GDP is determined they would likely mostly talk about NGDP as a quasi-residual. First real GDP is determined – by both supply and demand side factors – and then inflation is simply added to get to NGDP.

Market Monetarists on the other hand would think of nominal GDP determining real GDP. In fact if you read Scott Sumner’s excellent blog The Money Illusion – the father of all Market Monetarist blogs – you are often left with the impression that the causality always runs from NGDP to RGDP. I don’t think Scott thinks so, but that is nonetheless the impression you might get from reading his blog. Old-school monetarists like Milton Friedman were basically saying the same thing – or rather that the causality was running from the money supply to nominal spending to prices and real GDP.

In my view the truth is that there is no “natural” causality from RGDP to NGDP or the other way around. I will instead here argue that the macroeconomic causality is fully dependent about the central bank’s monetary policy rules and the credibility of and expectations to this rule.

In essenssens this also means that there is no given or fixed causality from money to prices and this also explains the apparent instability between the lags and leads of monetary policy.

From RGDP to NGDP – the US economy in 2008-9?

Some might argue that the question of causality and whilst what model of the economy, which is the right one is a simple empirical question. So lets look at an example – and let me then explain why it might not be all that simple.

The graph below shows real GDP and nominal GDP growth in the US during the sharp economic downturn in 2008-9. The graph is not entirely clearly, but it certainly looks like real GDP growth is leading nominal GDP growth.

RGDP NGDP USA 2003 2012

Looking at the graph is looks as if RGDP growth starts to slow already in 2004 and further takes a downturn in 2006 before totally collapsing in 2008-9. The picture for NGDP growth is not much different, but if anything NGDP growth is lagging RGDP growth slightly.

So looking at just at this graph it is hard to make that (market) monetarist argument that this crisis indeed was caused by a nominal shock. If anything it looks like a real shock caused first RGDP growth to drop and NGDP just followed suit. This is my view is not the correct story even though it looks like it. I will explain that now.

A real shock + inflation targeting => drop in NGDP growth expectations

So what was going on in 2006-9. I think the story really starts with a negative supply shock – a sharp rise in global commodity prices. Hence, from early 2007 to mid-2008 oil prices were more than doubled. That caused headline US inflation to rise strongly – with headline inflation (CPI) rising to 5.5% during the summer of 2008.

The logic of inflation targeting – the Federal Reserve at that time (and still is) was at least an quasi-inflation targeting central bank – is that the central bank should move to tighten monetary condition when inflation increases.

Obviously one could – and should – argue that clever inflation targeting should only target demand side inflation rather than headline inflation and that monetary policy should ignore supply shocks. To a large extent this is also what the Fed was doing during 2007-8. However, take a look at this from the Minutes from the June 24-25 2008 FOMC meeting:

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards. In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation… 

…Conditions in some financial markets had improved… the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen. Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. 

Hence, not only did some FOMC members (the majority?) believe monetary policy was easy, but they even wanted to move to tighten monetary policy in response to a negative supply shock. Hence, even though the official line from the Fed was that the increase in inflation was due to higher oil prices and should be ignored it was also clear that that there was no consensus on the FOMC about this.

The Fed was of course not the only central bank in the world at that time to blur it’s signals about the monetary policy response to the increase in oil prices.

Notably both the Swedish Riksbank and the ECB hiked their key policy interest rates during the summer of 2008 – clearly reacting to a negative supply shock.

Most puzzling is likely the unbelievable rate hike from the Riksbank in September 2008 amidst a very sharp drop in Swedish economic activity and very serious global financial distress. This is what the Riksbank said at the time:

…the Executive Board of the Riksbank has decided to raise the repo rate to 4.75 per cent. The assessment is that the repo rate will remain at this level for the rest of the year… It is necessary to raise the repo rate now to prevent the increases in energy and food prices from spreading to other areas.

The world is falling apart, but we will just add to the fire by hiking interest rates. It is incredible how anybody could have come to the conclusion that monetary tightening was what the Swedish economy needed at that time. Fans of Lars E. O. Svensson should note that he has Riksbank deputy governor at the time actually voted for that insane rate hike.

Hence, it is very clear that both the Fed, the ECB and the Riksbank and a number of other central banks during the summer of 2008 actually became more hawkish and signaled possible rates (or actually did hike rates) in reaction to a negative supply shock.

So while one can rightly argue that flexible inflation targeting in principle would mean that central banks should ignore supply shocks it is also very clear that this is not what actually what happened during the summer and the late-summer of 2008.

So what we in fact have is that a negative shock is causing a negative demand shock. This makes it look like a drop in real GDP is causing a drop in nominal GDP. This is of course also what is happening, but it only happens because of the monetary policy regime. It is the monetary policy rule – where central banks implicitly or explicitly – tighten monetary policy in response to negative supply shocks that “creates” the RGDP-to-NGDP causality. A similar thing would have happened in a fixed exchange rate regime (Denmark is a very good illustration of that).

NGDP targeting: Decoupling NGDP from RGDP shocks 

I hope to have illustrated that what is causing the real shock to cause a nominal shock is really monetary policy (regime) failure rather than some naturally given economic mechanism.

The case of Israel illustrates this quite well I think. Take a look at the graph below.

NGDP RGDP Israel

What is notable is that while Israeli real GDP growth initially slows very much in line with what happened in the euro zone and the US the decline in nominal GDP growth is much less steep than what was the case in the US or the euro zone.

Hence, the Israeli economy was clearly hit by a negative supply shock (sharply higher oil prices and to a lesser extent also higher costs of capital due to global financial distress). This caused a fairly sharp deceleration real GDP growth, but as I have earlier shown the Bank of Israel under the leadership of then governor Stanley Fischer conducted monetary policy as if it was targeting nominal GDP rather than targeting inflation.

Obviously the BoI couldn’t do anything about the negative effect on RGDP growth due to the negative supply shock, but a secondary deflationary process was avoid as NGDP growth was kept fairly stable and as a result real GDP growth swiftly picked up in 2009 as the supply shock eased off going into 2009.

In regard to my overall point regarding the causality and correlation between RGDP and NGDP growth it is important here to note that NGDP targeting will not reverse the RGDP-NGDP causality, but rather decouple RGDP and NGDP growth from each other.

Hence, under “perfect” NGDP targeting there will be no correlation between RGDP growth and NGDP growth. It will be as if we are in the long-run classical textbook case where the Phillips curve is vertical. Monetary policy will hence be “neutral” by design rather than because wages and prices are fully flexible (they are not). This is also why we under a NGDP targeting regime effectively will be in a Real-Business-Cycle world – all fluctuations in real GDP growth (and inflation) will be caused by supply shocks.

This also leads us to the paradox – while Market Monetarists argue that monetary policy is highly potent under our prefered monetary policy rule (NGDP targeting) it would look like money is neutral also in the short-run.

The Friedmanite case of money (NGDP) causing RGDP

So while we under inflation targeting basically should expect causality to run from RGDP growth to NGDP growth we under NGDP targeting simply should expect that that would be no correlation between the two – supply shocks would causes fluctuations in RGDP growth, but NGDP growth would be kept stable by the NGDP targeting regime. However, is there also a case where causality runs from NGDP to RGDP?

Yes there sure is – this is what I will call the Friedmanite case. Hence, during particularly the 1970s there was a huge debate between monetarists and keynesians about whether “money” was causing “prices” or the other way around. This is basically the same question I have been asking – is NGDP causing RGDP or the other way around.

Milton Friedman and other monetarist at the time were arguing that swings in the money supply was causing swings in nominal spending and then swings in real GDP and inflation. In fact Friedman was very clear – higher money supply growth would first cause real GDP growth to pick and later inflation would pick-up.

Market monetarists maintain Friedman’s basic position that monetary easing will cause an increase in real GDP growth in the short run. (M, V and NGDP => RGDP, P). However, we would even to a larger extent than Friedman stress that this relationship is not stable – not only is there “variable lags”, but expectations and polucy rules might even turn lags into leads. Or as Scott Sumner likes to stress “monetary policy works with long and variable LEADS”.

It is undoubtedly correct that if we are in a situation where there is no clearly established monetary policy rule and the economic agent really are highly uncertain about what central bankers will do next (maybe surprisingly to some this has been the “norm” for central bankers as long as we have had central banks) then a monetary shock (lower money supply growth or a drop in money-velocity) will cause a contraction in nominal spending (NGDP), which will cause a drop in real GDP growth (assuming sticky prices).

This causality was what monetarists in the 1960s, 1970s and 1980s were trying to prove empirically. In my view the monetarist won the empirical debate with the keynesians of the time, but it was certainly not a convincing victory and there was lot of empirical examples of what was called “revered causality” – prices and real GDP causing money (and NGDP).

What Milton Friedman and other monetarists of the time was missing was the elephant in the room – the monetary policy regime. As I hopefully has illustrated in this blog post the causality between NGDP (money) and RGDP (and prices) is completely dependent on the monetary policy regime, which explain that the monetarists only had (at best) a narrow victory over the (old) keynesians.

I think there are two reasons why monetarists in for example the 1970s were missing this point. First of all monetary policy for example in the US was highly discretionary and the Fed’s actions would often be hard to predict. So while monetarists where strong proponents of rules they simply had not thought (enough) about how such rules (also when highly imperfect) could change the monetary transmission mechanism and money-prices causality. Second, monetarists like Milton Friedman, Karl Brunner or David Laidler mostly were using models with adaptive expectations as rational expectations only really started to be fully incorporated in macroeconomic models in the 1980s and 1990s. This led them to completely miss the importance of for example central bank communication and pre-announcements. Something we today know is extremely important.

That said, the monetarists of the times were not completely ignorant to these issues. This is my big hero David Laidler in his book Monetarist Perspectives” (page 150):

“If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

Macroeconomists to this day unfortunately still forget or ignore the wisdom of David Laidler.

HT DL and RH.

Monetary sovereignty is incompatible with inflation targeting

When I started working in the financial sector nearly 15 years ago – after 5 years working for government – one thing that really puzzled me was how my new colleagues (both analysts and traders) where thinking about exchange rates.

As a fairly classically thinking economist I had learned to think of exchange rates in terms of the Purchasing Power Parity. After all why should we expect there to be a difference between the price of a Big Mac in Stockholm and Brussels? Obviously I understood that there could be a divergence from PPP in the short-run, but in the long-run PPP should surely expected to hold.

Following the logic of PPP I would – in the old days – have expected that when an inflation number was published for a country and the number was higher than expected the currency of the country would weaken. However, this is not how it really was – and still is – in most countries. Hence, I was surprised to see that upside surprises on the inflation numbers led to a strengthening of the country’s currency. What I initially failed to understand was that the important thing is not present inflation, but rather the expected future changes to monetary policy.

What of course happens is that if a central bank has a credible inflation target then a higher than expected inflation number will lead market participants to expect the central bank to tighten monetary policy.

Understanding exchange rate dynamic is mostly about understanding monetary policy rules

But what if the central bank is not following an inflation-targeting rule? What if the central bank doesn’t care about inflation at all? Would we then expect the market to price in monetary tightening if inflation numbers come in higher than expected? Of course not.

A way to illustrate this is to think about two identical countries – N and C. Both countries are importers of oil. The only difference is that country N is targeting the level of nominal GDP, while country C targets headline inflation.

Lets now imagine that the price of oil suddenly is halved. This is basically a positive supply to both country N and C. That causes inflation to drop by an equal amount in both countries. Realizing this market participants will know that the central bank of country C will move to ease monetary policy and they will therefore move reduce their holdings of C’s currency.

On the other hand market participants also will realize that country N’s central bank will do absolutely nothing in response to the positive supply shock and the drop in inflation. This will leave the exchange of country N unchanged.

Hence, we will see C’s currency depreciate relatively to N’s currency and it is all about the differences in monetary policy rules.

Exchange rates are never truly floating under inflation targeting

I also believe that this example actually illustrates that we cannot really talk about freely floating exchange rates in countries with inflation targeting regimes. The reason is that external shifts in the demand for a given country’s currency will in itself cause a change to monetary policy.

A sell-off in the currency causes the inflation to increase through higher import prices. This will cause the central bank to tighten monetary policy and the markets will anticipate this. This means that external shocks will not fully be reflected in the exchange rate. Even if the central bank does to itself hike interest rates (or reduce the money base) the market participants will basically automatically “implement” monetary tightening by increasing demand for the country’s currency.

This also means that an inflation targeting nearly by definition will respond to negative supply shocks by tightening monetary policy. Hence, negative external shocks will only lead to a weaker currency, but also to a contraction in nominal spending and likely also to a contraction in real GDP growth (if prices and wages are sticky).

Monetary policy sovereignty and importing monetary policy shocks

This also means that inflation targeting actually is reducing monetary policy sovereignty. The response of some Emerging Markets central banks over the past year illustrates well.

Lets take the example of the Turkish central bank. Over the past the year the Federal Reserve has initiated “tapering” and the People’s Bank of China has allowed Chinese monetary conditions to tighten. That has likely been the main factors behind the sell-off in Emerging Markets currencies – including the Turkish lira – over the past year.

The sell-off in Emerging Markets currencies has pushed up inflation in many Emerging Markets. This has causes inflation targeting central banks like the Turkish central bank (TCMB) to tighten monetary policy. In that sense one can say that the fed and PBoC have caused TCMB to tighten monetary policy. The TCMB hence doesn’t have full monetary sovereignty. Or rather the TCMB has chosen to not have full monetary policy sovereignty.

This also means that the TCMB will tend to import monetary policy shocks from the fed and the PBoC. In fact the TCMB will even import monetary policy mistakes from these global monetary superpowers.

The global business cycle and monetary policy rules

It is well-known that the business cycle is highly correlated across countries. However, in my view that doesn’t have to be so and it is strictly a result of the kind of monetary policy rules central banks follow.

In the old days of the gold standard or the Bretton Woods system the global business cycle was highly synchronized. However, one should have expected that to have broken down as countries across the world moved towards officially having floating exchange rates. However, that has not fully happened. In fact the 2008-9 crisis lead to a very synchronized downturn across the globe.

I believe the reason for this is that central banks do in fact not fully have floating exchange rate. Hence, inflation targeting de facto introduces a fear-of-floating among central banks and that lead central banks to import external shocks.

That would not have been the case if central banks in general targeted the level of NGDP (and ignored supply shocks) instead of targeting inflation.

So if central bankers truly want floating exchanges – and project themselves from the policy mistakes of the fed and the PBoC – they need to stop targeting inflation and should instead target NGDP.

PS It really all boils down to the fact that inflation targeting is a form of managed floating. This post was in fact inspired by Nick Rowe’s recent blog post What is a “managed exchange rate”?

How Stan Fischer predicted the crisis and saved Israel from it

Today I talked to an Israeli friend about the state of the Israeli economy and particularly about the importance of monetary policy. One can really characterise the Israeli economy as being ‘boring’ in the sense that growth, inflation and markets have been quite stable in recent years – despite of the “normal” political (and geopolitical) uncertainty in Israel.

My friend told me a very interesting anecdote, which in my view quite well explains why things have been so ‘boring’ in Israel in recent years. He told me that in 2007 as the first financial jitters had hit the global economy Bank of Israel (BoI) governor Stanley Fischer had explained what was going to happen.

According to my friend Stan Fischer said two things. First, Fischer had warned that what was underway in the global financial markets and the global economy would become very bad. In that sense Fischer rightly ‘predicted’ the crisis. Second, and more importantly in my view Fischer had demonstrated just how well he understand monetary theory and policy. Hence, my friend had asked how it would be possible to offset an external (demand) shock to the Israel if interest rates would drop to zero.

Fischer had explained that there would be no problem at the Zero Lower Bound. The BoI would always be able to ease monetary policy – even if interest rates were stuck at zero. And Fischer then went on to explain how you could do quantitative easing and/or intervene in the currency market.

It should of course be noted that this account is second-hand and my friend might have not gotten everything exactly right from something Fischer said five years ago. However, subsequent events actual tend to show that Fischer was not only well-prepared for the crisis, but also knew exactly what to do when crisis hit. This can hardly be said for European and US central bankers who in general completely failed to do the right thing in 2008.

And note here that I am not praising anybody for acting in a discretionary fashion. What I am praising Fischer for is that he fully well understood that the “liquidity trap” only is a mental constraint in the heads of central bankers (Just listen here to Fischer explaining this on Bloomberg TV back in 2010 when the Fed had announced QE2 – he is also bashing those central bankers who complain about ‘currency war’).

And Fischer did exactly what he had said could be done if necessary when it in fact became necessary in 2009 to ensure nominal stability. Hence, in February 2009 the BoI started to conducted quantitative easing. The graph below illustrates Fischer’s remarkable success.

NGDP Israel

That is a straight line if you ever saw one! And there was no dip in NGDP in 2008 or 2009. Just straight on. Israel never had a Great Recession.

While Stan Fischer in recent years has voiced some scepticism about nominal GDP targeting and instead praised flexible inflation targeting, looking at the data actually shows that the Bank of Israel under his leadership from 2005 to 2013 effectively had a NGDP target. And it is also clear that Fischer quite openly pointed out – particularly in 2009 – that he would not mind temporarily overshooting on the BoI’s official inflation target if the increased inflation was driven by a negative supply shock (depreciation of the Israeli shekel).

I believe that Fischer’s de facto NGDP targeting rule is exactly what has ensured a very high level of nominal stability in the Israeli economy over the past decade. This is a remarkable result given the very sizeable negative shock in 2008-9 and the ever present political and geopolitical shocks to the Israel economy and markets.

Another very important element in my view is that the BoI under Fischer’s leadership has been tremendously forward-looking compared to other central banks in the world. Hence, it is very clear that the BoI has been focused on targeting the forecast rather than targeting present inflation (in the way for example the ECB is doing). Just read nearly any statement from the Bank of Israel. There will nearly always be an reference not only to inflation expectations, but to market inflation expectations. In that sense the BoI is doing exactly what Market Monetarists have been arguing central banks should – use the market to ‘predict’ the outlook for nominal variables whether inflation or nominal GDP.

Furthermore, as market participants realise that the BoI is effectively targeting the (market) forecast the market will do a lot of the implementation of monetary policy. Hence, if market expectations of inflation is too high (low) compared to the BoI’s official inflation target then the market will expect the BoI to tighten (ease) monetary policy. That causes investors to buy (sell) shekel on the expectation of future appreciation (depreciation) as the BoI is expected to move toward monetary tightening (easing). This is of course what I have called the Chuck Norris effect of monetary policy. Under a credible monetary policy regime the markets will more or less “automatically” implement monetary policy to ensure that the monetary policy target is hit – all the central bank has to do is to clearly define its target and to follow the lead from the market.

 Can other central bankers do the same as Fischer?

The economic development in Israel over the past decade is surely remarkable. Few – if any – other countries have achieved anything close to what Stanley Fischer ensured in Israel. The question of course is whether other countries can do the same thing.

Surely I would be the first to acknowledge that luck (and unlock) is important for the success of central bankers. However, I believe that central bankers can indeed copy the success of Fischer by sticking to four general principles:

1) There is no liquidity trap if you just use other instruments to ease monetary policy than the interest rate (in fact central banks should completely stop communicating about the monetary policy in terms of interest rates).

2) Target the forecast. Central banks should not be backward-looking. Instead central banks should follow the example of Fisher’s BoI and focus on the expected future inflation or the level of NGDP rather than looking at present or paste inflation/NGDP level.

3) Let the markets do most of the lifting. By clearly targeting the forecast the market can effectively do most of the actual implementation of monetary policy – and the central bank should encourage this.

4) Be clear on the target. To allow the markets to implement monetary policy the central bank needs to be completely clear about what the central bank actually wants to achieve. And this is probably where I think Fischer did worst during his years at the BoI. It is clear that he de facto was targeting NGDP rather than inflation, but he has never publically acknowledged this.

Luckily Stan Fischer is not retired. Instead he has moved on to become vice-Chairman at the Federal Reserve. If we are lucky he will help Fed boss Janet Yellen do the the right thing on monetary policy and if the US can achieve the same kind of nominal stability as Israel did during Fischer’s term as BoI governor then the outlook for the global economy is quite rosy.

Sam Bowman calls for nominal spending targeting in the euro zone

My friend Sam Bowman, Research Director at the Adam Smith Institute, has written a letter to the Financial Times calling for the introduction of a nominal spending target in the euro zone. This is from Sam’s letter:

…While supply-side reforms are usually helpful and fiscal integration may help some eurozone states, Europe’s main problem is monetary.

Nominal spending has collapsed in the eurozone since 2008 and is still well below its pre-crisis trend level. As a result, Europe’s unemployed face a problem of musical chairs: too many jobseekers chasing too little money.

The eurozone’s best hope is for the European Central Bank to pursue a more expansionary monetary policy to raise nominal spending in the eurozone to its pre-crisis trend level, and commit to a nominal spending target thereafter.

Monetary chaos is the source of Europe’s woes: only monetary stability will overcome them.

I fully agree. The ECB can end the European crisis tomorrow by introducing a nominal spending target. Even a very modest proposal of 4% nominal GDP growth targeting would do the trick. Unfortunately nobody in Frankfurt or Brussels seems to be listening.

Stanley Fischer – this guy can keep NGDP on a straight line

This is from Reuters:

Stanley Fischer, who led the Bank of Israel for eight years until he stepped down in June, has been asked to be the Federal Reserve’s next vice chair once Janet Yellen takes over as chief of the U.S. central bank, a source familiar with the issue said on Wednesday.

Fischer, 70, is widely respected as one of the world’s top monetary economists. At the Massachusetts Institute of Technology, he once taught current Fed Chairman Ben Bernanke and Mario Draghi, the European Central Bank president.

Yellen, the current Fed vice chair, is expected to win approval from the U.S. Senate next week to take the reins from Bernanke, whose term ends in January.

Fischer, as an American-Israeli, was widely credited with guiding Israel through the global economic crisis with minimal damage. For the Fed, he would offer the fresh perspective of a Fed outsider yet offer some continuity as well.

Good news! Stanley Fischer certainly is qualified for the job. He knows about monetary theory and policy. And even better he used to have some sympathy for nominal income targeting. Just take a look at this quote from his 1995 American Economic Review article “Central Bank Independence Revisited” (I stole this from Evan Soltas):

“In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run–albeit with long-run targets and consequences in mind. Nominal- income-targeting provides an automatic answer to the question of how to combine real income and inflation targets, namely, they should be traded off one-for-one…Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to implya better automatic response of monetary policy to supply shocks…I judge that inflation-targeting is preferable to nominal-income-targeting, provided the target is adjusted for supply shocks.”

While at the Bank of Israel Fischer certainly conducted monetary policy as if he was targeting the level of nominal GDP. Just take a look at the graph below and note the “missing” crisis in 2008.

NGDP Israel

Undoubtedly Fischer had some luck, while at the BoI, and I must also say that I think he from time to time had a problem with his “forward guidance”, but his track-record speaks for itself – while Bank of Israel  governor, Stanley Fischer provided unprecedented nominal stability, something very rare in Israeli economic history. Lets hope he will help do that at the Fed as well.

Richard Fisher and the “working men and women of America”

This is Richard Fisher, President of Federal Reserve Bank of Dallas:

“We have made rich people richer,” Fisher told CNBC today. “The question is, what have we done for the working men and women of America?”

Fisher was one of the earliest and most outspoken advocates of winding down the bond-buying program…

I had to read the comment a couple of times to make sure that I understood correctly. Fisher actually claims that the fed should scale back monetary easing because it is not doing anything for the “working men and women of America”.

Fisher’s comments are truly bizarre. Most wealthy Americans are still very wealthy (I have no problem with that) – crisis or not – but it is pretty clear that the overly tight monetary policies in the US over the past fives years has been the main cause of the significant increase in US unemployment and in that sense been a massive assault on the “working men and women of America”.

If Richard Fisher seriously wants to do you something for the “working men and women” then he should come out and support to bring back the level of nominal GDP to the pre-crisis trend level. That undoubtedly would be the best “employment policy” anybody could come up with in the present situation. However, I suspect that Fisher is just coming up with random arguments for opposing monetary easing rather than truly caring about the “working men and women of America”. I am not impressed…

employment NGDP

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PS I am certainly not claiming to be speaking on behalf of the “working men and women of America” – I just find ludicrous when somebody actually in a position to do something for these people through his actions (opposing monetary easing) is doing exactly the opposite.

PPS I don’t think it should be the job of central banks to hit a certain “employment level” or any other real variable and I find the fed’s “dual mandate” seriously flawed, but it is certainly not the job of central banks to “destroy jobs” either. A proper NGDP level targeting regime will provide the best nominal framework for letting the labour market work in a proper and undistorted way and as such would indirectly ensure the highest level of employment given the structures of the economy.

PPPS I wrote this on a flight to Stockholm. I had been thinking about writing something about Swedish monetary policy or Africa (the topic I will be speaking about in Stockholm today), but you can all blame Richard Fisher for distracting me.

The monetary transmission mechanism in a ‘perfect world’

I fundamentally think that what really sets Market Monetarism aside from other macroeconomic schools it how we see the monetary transmission mechanism. I this blog post I will try to describe how I think the monetary transmission mechanism would look like in a ‘perfect world’ and how in such a perfect world the central bank basically would do nothing at all and changes in monetary conditions would be nearly 100% determined by market forces.

Futures based NGDP level targeting – the perfect world

No monetary regime is perfect, but I think the regime that get closest to perfection (leaving out Free Banking) is a regime where the central bank targets the nominal GDP level and implement this target with the use of an NGDP-linked bond.

How would this work? Well imagine that the government – lets say the US government – issues bonds linked to the NGDP level. So if the market expectation for the future NGDP level increases the price of the bond increased (and yields drop) and similarly if the NGDP expectation drops the bond price will decline.

Now imagine that the central bank announces that it will always buy or sell these bonds to ensure that the expected NGDP level is equal to the targeted NGDP level.

Then lets now imagine that the price of the bond rise is reflecting expectations for a higher NGDP level. If the expected NGDP level increases above the targeted NGDP level then the central bank will “automatically” go out and sell NGDP-linked bonds until the price is pushed down so the expected NGDP level is equal to the targeted level. This means that the central bank will automatically reduce the money base by a similar amount as the amount of bond selling. The drop in the money base obviously in itself will contribute to pushing back the NGDP level to the targeted level.

It don’t take a genius to see that the mechanism here is very similar to a fixed exchange rate policy, but the outcome of the policy is just much better than what you would get under a fixed exchange rate policy.

And similarly to under a fixed exchange rate regime the money base is endogenous in the sense that it is changed automatically to hit the NGDP target. There is no discretion at all.

Changes in money demand will do most of the job  

It is not only the supply of money, which will be endogenous in a perfect world – so will the demand for money be. In fact it is very likely that most of the adjustments in this world will happen through changes in money demand rather than through changes in the money base.

The reason for this is that if the NGDP targeting policy is credible then investors and consumers will adjust the demand for money to ‘pre-empt’ future changes in monetary policy.

Hence, let imagine a situation where NGDP growth for some reason start to slow down. This initially pushes market expectations for future NGDP below the targeted level. However, this will only be short-lived as forward-looking investors will realise that the central bank will start buying NGDP-linked bonds and hence increase the money base. As investors realise this they will expect the value of money to go down and as forward-looking investors they will re-allocate their portfolios – buying assets that go up in value when NGDP increases and selling assets that go down in value when this happens.

Assets that go up in value when NGDP expectations increase includes shares, real estate and of course NGDP-linked bond and also the national currency, while regular bonds will drop in value when NGDP expectations increase.

This is key to the monetary transmission mechanism in the ‘perfect world’ – it is all about consumers and investors anticipating the central bank’s future actions and the impact this is having on portfolio reallocation.

Similarly there is also an impact on macroeconomic variables due to this portfolio reallocation. Hence, if NGDP drops below the targeted level then rational consumers and investors will realise that the central bank will ease monetary policy to bring NGDP back on track. That would mean that the value of cash should be expected to decline relative to other assets. As a consequence consumers and investors will reduce their cash holdings – and instead increase consumption and investment. Similarly as monetary easing is expected this will tend to weaken the national currency, which will boost exports. Hence, the “NGDP anchor” will have a stabilizing impact on the macro economy.

Therefore, if the central bank’s NGDP targeting regime is credible it will effectively be the market mechanism that automatically through a portfolio reallocation mechanism will ensure that NGDP continuously tend to return the targeted NGDP level.

We can see in the ‘perfect world’ the money base would likely not change much and probably be closed the ideal of a ‘frozen money base’ and the continuously adjustment in monetary conditions would happens by changes in the money demand and hence in money-velocity.

It should also be noted that the way I describe the transmission mechanism above interest rates play no particularly important role and the only thing we can say is that interest rates and bond yields will tend to move up and down with NGDP expectations. However, the interest rate is not the policy instrument and interest rate is just one of many prices that adjust to changes in NGDP expectations.

The Great Moderation was close to the ‘perfect world’

The discussion above might seem somewhat like science fiction, but in fact I believe the way I describe the transmission mechanism above is very similarly to how the transmission mechanism actually was working during the Great Moderation from the mid-1980s to 2007/8 particularly in the US.

Effectively the Fed during this period targeted 5-5½% NGDP growth and that “target” was highly credible – even though it was never precisely defined. Furthermore, the NGDP “target” was not implemented by utilizing NGDP-linked bonds and officially the fed’s used the fed funds target rate to implement monetary policy. However, the reality was that it was the market that determined what level of interest rates that was necessary to hit the “target”.

Hence, only very rarely did the fed surprised the market expectation for changes in the fed fund target rate during that period. Furthermore, it was basically a portfolio reallocation mechanism that ensured NGDP stability – not changes in the fed funds target rate. So when NGDP was above ‘target’ investors would expect monetary tightening – that would cause market interest rates rise, stock prices to drop and the dollar to strengthen as future monetary tightening was priced in. In this process the demand for money would also increase and hence the velocity of money would decline.

So the real achievement of monetary policy in the US during the Great Moderation was effectively to create a credible NGDP targeting regime where monetary policy basically was market determined. The problem of course was, however, that this was never acknowledged and equally problematic was the reliance on the fed funds target as the key monetary policy instrument. This of course turned out to be catastrophic defects in the system in 2008.

In 2008 it was very clear that NGDP expectations were declining – stock prices was declining, bond yields dropped, the dollar strengthened and money velocity declined. Had there been a futures based NGDP targeting regime in place this would likely have lead to the price of NGDP linked-bonds to drop already in 2006 as US property prices peaked. As the fed would have pledged to keep NGDP expectations on track this would have led to an automatic increase in the money base as the fed would have been buying NGDP-linked bonds. That would have sent a clear signal to consumers and investors that the fed would not let the NGDP level drop below target for long. As a consequence we would not have seen the massive increase in money demand we saw and even if it that had happened the supply of money would have been completely elastic and the supply of dollars would have risen one-to-one with the increase in money demand. There would hence have been no monetary contraction at all.

Instead the system ‘broke down’ as the fed funds target rate effectively hit the Zero Lower Bound (ZLB) and the fed effectively became unable to ease monetary policy with its preferred monetary policy instrument – the fed funds target rate. Obviously in the ‘perfect world’ there is no ZLB problem. Monetary policy can always – and will always – be eased if NGDP expectations drop below the targeted NGDP level.

Fiscal consolidation in the ‘perfect world’

In the ‘perfect world’ the fiscal multiplier will always be zero. To understand this try to imagine the following situation. The US government announces that government spending will be cut by 10% of GDP next year. It is pretty obvious that the initial impact of this would for aggregate demand to drop. Hence, the expectation for next year’s NGDP level would drop.

However, if NGDP expectations drop below the targeted level the fed would automatically expand the money base to ‘offset’ the shock to NGDP expectations. The fed would likely have to do very little ‘offsetting’ as the market would probably do most of the work. Hence, as the fiscal tightening is announced this would be an implicit signal to the market that the fed would ease monetary policy. The expectation of monetary easing obviously would lead to a weakening of the dollar and push up stock prices and property prices. As a consequence most of the ‘offsetting’ of the fiscal tightening would be market determined.

We should therefore, expect money demand to drop and velocity increase in response to an announcement of fiscal tightening. As an aside it should be noticed at this is the opposite of what would be the case in a paleo-keynesian world. Here a tightening of monetary policy would lead to a drop in money-velocity. I plan to return to this issue in a future post.

The important point here is that in the ‘perfect world’ there is no room or reason for using fiscal policy for cyclical purposes. As a consequence the there are no argument as consolidating fiscal policy is long-term considerations necessitate this.

Market Monetarism is not about ‘stimulus’ and QE, but above rules

I think my conclusion above clearly demonstrates what is the ‘core’ of Market Monetarist thinking. So while Market Monetarism often wrongly is equated with ‘monetary stimulus’ and advocacy of ‘quantitative easing’ the fact is that this really has nothing to do with Market Monetarism. Instead what we are arguing is that monetary policy should be ‘market determined’ by the use of targeting the price of NGDP-linked bonds. In such a world there would be no ‘stimulus’ in the sense that there would be no need for discretionary changes in monetary policy. Monetary conditions would change completely automatically to always ensure NGDP stability. As a consequence monetary conditions would likely mostly change through changes in money demand rather than through changes in the money base. Therefore we can hardly talk about ‘QE’ in such a regime.

So why have Market Monetarists then seemly supported quantitative easing in for example the US. Well, the point is first and foremost that the fed’s monetary policy regime over the past five years have not been entirely credible – we are getting closer, but we are very far away from the ‘perfect world’. Hence, the fed needs to undertake quantitative easing to demonstrate first of all that it can indeed ease monetary policy even with interest rates basically at zero. Secondly since monetary policy is not credible (countercyclical) changes in money demand will not happen automatically so the fed will instead have to change the money base.

Obviously these measures would not be necessary if the US Treasury issue NGDP-linked bonds and the fed at the same time announced an NGDP level target and utilized the NGDP-linked bonds to hit this target. If such a system were credibly announced then it would be very hard to argue for ‘monetary stimulus’ and quantitative easing in the discretionary sense.

It might be that the discussion above is pure fantasy and it is pretty clear that we are very, very far away from such a monetary policy regime anywhere, but I nonetheless think that the discussion illustrates how important it is for monetary policy to be rule based rather than to be conducted in a discretionary fashion. Both the Bank of Japan and the Federal Reserve have within the last six months moved (a little) closer to the ‘perfect world’ in the sense that their policies have become a lot more rule based than used to be the case and there is no doubt that the policies are ‘working’. Especially in the case of Japan it seems clear that ‘automatic’ adjustments in money demand is going to play a very key role in achieve BoJ’s 2% inflation target. Hence, it is likely that it will not be the expansion of the money base that will do it for BoJ, but rather the likely sharp increase in money-velocity that will ensure that BoJ’s hits its target.

Finally, I would argue that my discussion above also demonstrates why a proper NGDP level targeting regime is a true free market alternative as the system relies heavy on market forces for the implementation of monetary policy and is strictly rule base.

A five-step plan for Mark Carney

I am on the way to London – in fact I am writing this on the flight from Copenhagen – so I thought it would be fitting to write a piece on the challenges for the new Bank of England governor Mark Carney.

I fundamentally think that the UK economy is facing the same kind of problems as most other European economies – weak aggregate demand. However, I also believe that the UK economy is struggling with some serious supply side problems. Monetary policy can do something about the demand problem, but not much about the supply side problem.

Five things Carney should focus on

Bank of England’s legal mandate remains a flexible inflation targeting regime – however, in latest “update” of the mandate gives the Bank of England considerable leeway to be “flexible” – meaning it can allow for an overshoot on inflation in the short-run if needed to support growth. I am not happy with BoE’s updated mandate as I fear it opens the door for too much discretion in the conduct of monetary policy, but on the other hand it do also make it possible to put good policies in place. I therefore strongly believe that Mark Carney from day one at the BoE needs to be completely clear about the BoE’s policy objectives and on how to achieve this objective. I therefore suggest that Carney fast implement the following policy changes:

1)   Implement a temporary Nominal GDP level target: The BoE should announce that it over the coming two years will bring back the level of NGDP to the pre-crisis level defined as a 4% trend path from the 2008 peak. This would be fairly aggressive as it would require 8-10% NGDP growth over the coming two years. That, however, is also pretty telling about how deep the crisis is in the UK economy. Furthermore, the BoE should make it clear that it will do whatever it takes to reach this target and that it will step up these efforts if it looks like it is falling behind on reaching this target. It should similarly be made clear that the BoE is targeting the forecasted level of NGDP and not the present level. Finally, it should be made clear that once the temporary NGDP target is hit then the BoE will revert to flexible inflation targeting, but with a watchful eye on the level of NGDP as an indicator for inflationary/deflationary pressures. I would love to see a permanent NGDP targeting regime put in place, but I doubt that that is within the BoE’s present legal mandate.

NGDP UK Carney

 

2)   Institutionalise the Sumner Critique: According to the Sumner Critique the fiscal multiplier is zero is the central bank targets the NGDP level, the price level or inflation. I believe it would greatly enhance monetary policy predictability and transparency if the BoE so to speak institutionalized the Sumner Critique by announcing that the BoE in it conduct of monetary policy will offset significant demand shocks that threaten it’s NGDP target. Hence, the BoE would announce that if the UK government where to step up fiscal consolidation then the BoE will act to fully offset the impact of these measures on aggregate demand. Similarly the BoE should announce that any change in financial regulation that impacts aggregate demand will be offset by monetary policy. And finally any shocks to aggregate demand from the global economy will be fully offset. The “offset rule” should of course be symmetrical. Negative demand shocks will be lead to a stepping up of monetary easing, while positive demand shocks will be offset by tighter monetary policy. However, as long as NGDP is below the targeted level positive shocks to demand – for example if financial regulation is eased or fiscal policy is eased – then these shocks will not be offset as they “help” achieve the monetary policy target. This offset rule would to a large extent move the burden of adjusting monetary conditions to the financial markets as the markets “automatically” will pre-empt any policy changes. Hence, it for example British exports are hit by a negative shock then investors would expect the BoE to offset this and as a consequence the pound would weaken in advance, which in itself would provide stimulus to aggregate demand reducing the need for actually changes to monetary policy.

3)   Introduce a new policy instrument – the money base – and get rid of interest rates targeting: There is considerable confusion about what monetary policy instrument the BoE is using. Hence, the BoE has over the past five years both changed interest rates, done quantitative easing and implement different forms of credit policies. The BoE needs to focus on one instrument and one instrument only. To be able to ease monetary policy at the Zero Lower Bound the BoE needs to stop communicating about monetary policy in terms of interest rates and instead use the money base as it’s primary monetary policy instrument. The annual targeted money base growth rate should be announced every month at the BoE Monetary Policy Committee meetings. For transparency the BoE could announce that it will be controlling the growth of the money base by it buying or selling 2-year Treasury bonds from risk and GDP weighted basket of G7 countries. The money base will hence be the operational target of the BoE, while the level of NGDP will be the ultimate target. The targeted growth rate of the money base should always be set to hit the targeted level of NGDP.

4)   Reform the Lender of Last Resort (LoLR): Since the outbreak of the crisis in 2008 the BoE has introduced numerous more or less transparent lending facilities. The BoE should get rid of all these measures and instead introduce only one scheme that has the purpose of providing pound liquidity to the market against proper collateral. Access to pound liquidity should be open for everyone – bank or not, UK based or not. The important thing is that proper collateral is provided. In traditional Bagehotian fashion a penalty fee should obviously be paid on this lending. Needless to say the BoE should immediately stop the funding for lending program as it is likely to create moral hazard problems and it unlikely to be of any significantly value in terms of achieving BoE’s primary policy objectives. If the UK government – for some odd reason – wants to subsidies lending then it should not be a matter for the BoE to get involved in.  My suggestion for LoLR is similar to what George Selgin has suggested for the US.

5)   Reform macroeconomic forecasting: To avoid politicized and biased forecasts the BoE needs to serious reform it macroeconomic forecasting process by outsourcing forecasting. My suggestion would be that macroeconomic forecasts focusing on BoE’s policy objectives should come from three sources. First, there should be set up a prediction market for key policy variables. There is a major UK betting industry and there is every reason to believe that a prediction market easily could be set up. Second, the BoE should survey professional forecasters on a monthly basis. Third, the BoE could maintain an in-house macroeconomic forecast, but it would then be important to give full independence to such forecasting unit and organizationally keep it fully independent from the daily operations of the BoE and the Monetary Policy Committee. Finally, it would be very helpful if the British government started to issue NGDP-linked government bonds in the same way it today issues inflation-linked bonds.  These different forecasts should be given equal weight in the policy making process and it should be made clear that the BoE will adjust policy (money base growth) if the forecasts diverge from the stated policy objective. This is basically a forward-looking McCallum rule.

This is my five-step program for Mark Carney. I very much doubt that we will see much of my suggestions being implemented, but I strongly believe that it would greatly benefit the UK economy and dramatically improve monetary and financial stability if these measures where implemented. However, my flight is soon landing – so over and out from here…

PS it takes considerably longer to fly from Canada to the UK and from Denmark to the UK so Carney have more than two hours to put in place his program so maybe he can come up with something better than me.

Fed NGDP targeting would greatly increase global financial stability

Just when we thought that the worst was over and that the world was on the way safely out of the crisis a new shock hit. Not surprisingly it is once again a shock from the euro zone. This time the badly executed bailout (and bail-in) of Cyprus. This post, however, is not about Cyprus, but rather on importance of the US monetary policy setting on global financial stability, but the case of Cyprus provides a reminder of the present global financial fragility and what role monetary policy plays in this.

Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster 

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity.

Hence, lets for example imagine that a sovereign default in an euro zone country shocks investors, who run for cover and starts buying ‘safe assets’. Among other things that would be the US dollar. This would obviously be similarly to what happened in the Autumn of 2008 then US monetary policy became ‘adaptive’ when interest rates effectively hit zero. As a consequence the US dollar rallied strongly. The ill-timed interest rates hikes from the ECB in 2011 had exactly the same impact – a run for safe assets caused the dollar to rally.

In that sense under an ‘adaptive’ monetary policy the Fed is effective allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

As the Fed is a ‘global monetary superpower’ a tightening of US monetary conditions by default leads to a tightening of global monetary conditions due to the dollar’s role as an international reserve currency and due to the fact that many central banks around the world are either pegging their currencies to the dollar or at least are ‘shadowing’ US monetary policy.

In that sense a negative financial shock from Europe will be ‘escalated’ as the fed conducts monetary policy in an adaptive way and fails to offset negative velocity shocks.

This also means that under an ‘adaptive’ policy regime the risk of contagion from one country’s crisis to another is greatly increased. This obviously is what we saw in 2008-9.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity as Fed policy automatically would counteract the shock to US money-velocity. As a consequence there would be no reason to expect any major negative impact on for example the overall performance of US stock markets. Furthermore, as a ‘global monetary policy’ the automatic increase in the US money base would curb the strengthening of the dollar and hence curb the tightening of global monetary conditions, which great would reduce the global financial fallout from the euro zone sovereign default.

Finally and most importantly the financial markets would under a system of a credible Fed NGDP target figure all this out on their own. That would mean that investors would not necessarily run for safe assets in the event of an euro zone country defaulting – or some other major financial shock happening – as investors would know that the supply of the dollar effectively would be ‘elastic’. Any increase in dollar demand would be meet by a one-to-one increase in the dollar supply (an increase in the US money base). Hence, the likelihood of a ‘global financial panic’ (for lack of a better term) is massively reduced as investors will not be lead to fear that we will ‘run out of dollar’ – as was the case in 2008.

The Bernanke-Evans rule improves global financial stability, but is far from enough

We all know that the Fed is not operating an NGDP targeting regime today. However, since September last year the Fed clearly has moved closer to a rule based monetary policy in the form of the Bernanke-Evans rule. The BE rule effective mean that the Fed has committed itself to offset any shock that would increase US unemployment by stepping up quantitative easing. That at least partially is a commitment to offset negative shocks to money-velocity. However, the problem is that the fed policy is still unclear and there is certainly still a large element of ‘adaptive’ policy (discretionary policy) in the way the fed is conducting monetary policy.  Hence, the markets cannot be sure that the Fed will actually fully offset negative velocity-shocks due to for example an euro zone sovereign default. But at least this is much better than what we had before – when Fed policy was high discretionary.

Furthermore, I think there is reason to be happy that the Bank of Japan now also have moved decisively towards a more rule based monetary policy in the form of a 2% inflation targeting (an NGDP targeting obviously would have been better). For the past 15 year the BoJ has been the ‘model’ for adaptive monetary policy, but that hopefully is now changing and as the yen also is an international reserve currency the yen tends to strengthen when investors are looking for safe assets. With a more strict inflation target the BoJ should, however, be expected to a large extent to offset the strengthening of the yen as a stronger yen is push down Japanese inflation.

Therefore, the recent changes of monetary policy rules in the US and Japan likely is very good news for global financial stability. However, the new regimes are still untested and is still not fully trusted by the markets. That means that investors can still not be fully convinced that a sovereign default in a minor euro zone country will not cause global financial distress.

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