Is Norges Bank targeting nominal GDP?

Is the Norwegian central bank – Norges Bank – targeting nominal GDP? Probably not, but this presentation by Norges Bank governor Øystein Olsen is nonetheless interesting.

Have a look at the graph on slide 17 of the presentation. The graph shows nominal GDP for what is called mainland Norway (“Fastlands-Norge”) which is the non-oil part of the Norwegian economy. The graph obviously is quite Market Monetarist in nature. I would certainly not argue that Norge Bank has started targeting Nominal GDP, but it is nonetheless interesting that governor Øystein have a Market Monetarist style graph in his presentation.

Related posts:

Denmark and Norway were the PIIGS of the Scandinavian Currency Union

Danish and Norwegian monetary policy failure in 1920s – lessons for today

Fear-of-floating, misallocation and the law of comparative advantages

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Fear-of-floating, misallocation and the law of comparative advantages

The first commandment of central banking should be thou shall not distort relative prices. However, central bankers often tend to forget this – knowingly or unknowingly. How often have we not heard stern warnings from central bankers that property prices are too high or too low – or that a currency is overvalued or undervalued. And in the last couple of years central bankers have even tried to manipulate the shape of the bond yield curve – just think of the Fed’s “operation twist”.

Central bankers are distorting relative prices in many ways – by for example by trying to prick bubbles (or what they think are bubbles). Sometimes the distortion of relative prices is done unknowingly. The best example of this is when central banks operate an inflation target. Both George Selgin and David Eagle teach us that inflation targeting means that central banks react to supply shocks and thereby distort relative prices. In an open economy this will lead to a distortion of the relative prices between trade goods and non-traded goods.

As I will show below central bankers’ eagerness to distort relative prices is as harmful as other distortions of relative prices for example as a result of protectionism and will often lead to numerous negative side-effects.

The fear-of-floating – the violation of the Law of comparative advantages

I have recently given a bit of attention to the concept of fear-of-floating. Despite being officially committed to floating exchange rates many central banks from time to time intervene in the FX markets to “manage” the currency. As I have earlier noted a good example is the Norwegian central bank (Norges Bank), which often has intervened either directly or verbally in the currency market or verbally to try to curb the strengthening of the Norwegian krone. In March for example Norges Bank surprisingly cut interest rates to curb the strengthening of the krone – despite the general macroeconomic situation really warranted a tightening of monetary conditions.

So why is Norge Bank so fearful of a truly free floating krone? The best explanation in the case of Norway is that the central bank’s fears that when oil prices rise then the Norwegian krone will strengthen and hence make the non-oil sectors in the economy less competitive. This is what happened in 2003 when a sharp appreciation of the krone cause an “exodus” of non-oil sector companies from Norway. Hence, there is no doubt that it is a sub-target of Norwegian monetary policy to ensure a “diversified” Norwegian economy. This policy is strongly supported by the Norwegian government’s other policies – for example massive government support for the agricultural sector. Norway is not a EU member – and believe it or not government subsidies for the agricultural sector is larger than in the EU!

However, in the same way as government subsidies for the agricultural sector distort economic allocation so do intervention in the currency market. However, while most economists agree that government subsidies for ailing industries is violating the law of comparative advantages and lead to a general economic lose in the form of lower productivity and less innovation few economists seem to be aware that the fear-of-floating (including indirect fear-of-floating via inflation targeting) have the same impact.

Lets look at an example. Let say that oil prices increase by 30% and that tend to strengthen the Norwegian krone. This is the same as to say that the demand curve in the oil sector has shifted to the right. This will increase the demand for labour and capital in the oil sector. In a freely mobile labour market this will push up salaries both in the oil sector and in the none-oil sector. Hence, the none-oil sector will become less competitive – both as a result of higher labour and capital costs, but also because of a stronger krone. As a consequence labour and capital will move from the non-oil sector to the oil sector. Most economists would agree that this is a natural market process that ensures the most productive and profitable use of economic resources. As David Ricardo taught us long ago – countries should produce the goods in which the country has a comparative advantage. The unhampered market mechanism ensures this.

However, if the central bank suffers from fear-of-floating then the central bank will intervene to curb the strengthening of the krone. This has two consequences. First, the increase in profitability in the oil sector will be smaller than it would have been had the krone been allowed to strengthen. This would also mean that the increase in demand for capital and labour in the oil sector would be smaller than it would have been if the krone had been allowed to float completely freely (or had been pegged to the oil price). Second, this would mean that the “scaling down” of the non-oil sector will be smaller than otherwise would have been the case – and as a result this sector will demand too much labour and capital relative to what is economically optimal. This is exactly what the central bank would like to see. However, I think the example pretty clearly shows that such as policy is violating the law of comparative advantages. Relative prices are distorted and as a result the total economic output and welfare will be smaller than would have been the case under a freely floating currency.

It is often argued that if the oil price is very volatile and the krone (or another oil-exporting country’s currency) therefore would be more volatile and as a consequence the non-oil sector will see large swings in economic activity and it would be in the interest of the central bank to reduce this volatility and thereby stabilise the development in the non-oil sector. However, this completely misses the point with free markets. Prices should be allowed to adjust to ensure an efficient allocation of capital and labour. If you intervene in the market process allocation of resources will be less efficient.

Furthermore, the central bank cannot permanently distort relative prices. If the currency is kept artificially weak by easier monetary policy it will just inflated the entire economy – and as a result capital and labour cost will increase – as will inflation – and sooner or later the competitive advantage created by an artificially weak currency will be gradually eaten by higher prices and wages. In an economy where wages and prices are downward rigid – as surely is the case in the Norwegian economy – this will created major adjustment problems if oil prices drops sharply especially if the central bank also try to curb the weakening of the currency (as the Russian central bank did in 2008). Hence, by trying to dampen the swings in the FX rates the central bank will actually move the adjustment process from the FX markets (which is highly flexible) to the much less flexible labour and good markets. So even though the central bank might want to curb the volatility in economic activity in the non-oil sector it will actually rather increase the general level of volatility in the economy. In an economy with fully flexible prices and wages the manipulation of the FX rate would not be a problem. However, if for example wages are downward rigid because interventionist labour market policy as it is the case in Norway then a policy of curbing the volatility in the FX rate quite obviously (to me at least) leads to lower productivity and higher volatility in both nominal and rate variables.

I have used the Norwegian economy as an example. I should stress that I might as well have used for example Brazil or Russia – as the central banks in these countries to a much larger degree than Norges Bank suffers from a fear-of-floating. I could in fact also have used the ECB as the ECB indirectly suffers from a fear-of-floating as the ECB is targeting inflation.

I am not aware of any research on the consequences for productivity of fear-of-floating, but I am sure it could be an interesting area of research – I wonder if Norge Banks is aware how big the productive lose in the Norwegian economy has been due to it’s policy of curbing oil price driven swings in the krone. I am pretty sure that the Russian central bank and the Brazilian central bank have not given this much thought at all. Neither has most other Emerging Market central banks that frequently intervenes in the FX markets. 

PS do I need to say how to avoid these problems? Yes you guessed right – NGDP level targeting or by pegging the currency to the oil price. If you want to stay with in a inflation targeting framework then central bank central bank should at least target domestic demand inflation or what I earlier inspired by David Eagle has termed Quasi-Real inflation (QRPI).

PS Today I am spending my day in London – I wrote this on the flight. I bet a certain German central banker will be high on the agenda in my meetings with clients…

Exchange rates are not truly floating when we target inflation

There is a couple of topics that have been on my mind lately and they have made me want to write this post. In the post I will claim that inflation targeting is a soft-version of what economists have called the fear-of-floating. But before getting to that let me run through the topics on my mind.

1) Last week I did a presentation for a group of Norwegian investors and even thought the topic was the Central and Eastern European economies the topic of Norwegian monetary politics came up. I am no big expert on the Norwegian economy or Norwegian monetary policy so I ran for the door or rather I started to talk about an other large oil producing economy, which I know much better – The Russian economy. I essentially re-told what I recently wrote about in a blog post on the Russian central bank causing the 2008/9-crisis in the Russian economy, by not allowing the ruble to drop in line with oil prices in the autumn of 2008. I told the Norwegian investors that the Russian central bank was suffering from a fear-of-floating. That rang a bell with the Norwegian investors – and they claimed – and rightly so I think – that the Norwegian central bank (Norges Bank) also suffers from a fear-of-floating. They had an excellent point: The Norwegian economy is booming, domestic demand continues to growth very strongly despite weak global growth, asset prices – particularly property prices – are rising strongly and unemployment is very low and finally do I need to mention that Norwegian NGDP long ago have returned to the pre-crisis trend? So all in all if anything the Norwegian economy probably needs tighter monetary policy rather than easier monetary policy. However, this is not what Norges Bank is discussing. If anything the Norges Bank has recently been moving towards monetary easing. In fact in March Norges Bank surprised investors by cutting interest rates and directly cited the strength of the Norwegian krone as a reason for the rate cut.

2) My recent interest in Jeff Frankel’s idea that commodity exporters should peg their currency to the price of the main export (PEP) has made me think about the connect between floating exchange rates and what monetary target the central bank operates. Frankel in one of his papers shows that historically there has been a rather high positive correlation between higher import prices and monetary tightening (currency appreciation) in countries with floating exchange rates and inflation targeting. The mechanism is clear – strict inflation targeting central banks an increase in import prices will cause headline inflation to increase as the aggregate supply curve shots to the left and as the central bank does not differentiate between supply shocks and nominal shocks it will react to a negative supply shock by tightening monetary policy causing the currency to strengthen. Any Market Monetarist would of course tell you that central banks should not react to supply shocks and should allow higher import prices to feed through to higher inflation – this is basically George Selgin’s productivity norm. Very few central banks allow this to happen – just remember the ECB’s two ill-fated rate hikes in 2011, which primarily was a response to higher import prices. Sad, but true.

3) Scott Sumner tells us that monetary policy works with long and variable leads. Expectations are tremendously important for the monetary transmission mechanism. One of the main channels by which monetary policy works in a small-open economy  - with long and variable leads - is the exchange rate channel. Taking the point 2 into consideration any investor would expect the ECB to tighten monetary policy  in responds to a negative supply shock in the form of a increase in import prices. Therefore, we would get an automatic strengthening of the euro if for example oil prices rose. The more credible an inflation target’er the central bank is the stronger the strengthening of the currency. On the other hand if the central bank is not targeting inflation, but instead export prices as Frankel is suggesting or the NGDP level then the currency would not “automatically” tend to strengthen in responds to higher oil prices. Hence, the correlation between the currency and import prices strictly depends on what monetary policy rule is in place.

These three point leads me to the conclusion that inflation targeting really just is a stealth version of the fear-of-floating. So why is that? Well, normally we would talk about the fear-of-floating when the central bank acts and cut rates in responds to the currency strengthening (at a point in time when the state of the economy does not warrant a rate cut). However, in a world of forward-looking investors the currency tends move as-if we had the old-fashioned form of fear-of-floating – it might be that higher oil prices leads to a strengthening of the Norwegian krone, but expectations of interest rate cuts will curb the strengthen of NOK. Similarly the euro is likely to be stronger than it otherwise would have been when oil prices rise as the ECB again and again has demonstrated the it reacts to negative supply shocks with monetary easing.

Exchange rates are not truly floating when we target inflation 

And this lead me to my conclusion. We cannot fundamentally say that currencies are truly floating as long as central banks continue to react to higher import prices due to inflation targeting mandates. We might formally have laid behind us the days of managed exchange rates (at least in North America and Europe), but de facto we have reintroduced it with inflation targeting. As a consequence monetary policy becomes excessively easy (tight) when import prices are dropping (increasing) and this is the recipe for boom-bust. Therefore, floating exchange rates and inflation targeting is not that happy a couple it often is made out to be and we can fundamentally only talk about truly floating exchange rates when monetary policy cease to react to supply shocks.

Therefore, the best way to ensure true exchange rates flexibility is through NGDP level targeting and if we want to manage exchange rates then at least do it by targeting the export price rather than the import price.

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