The un-anchoring of inflation expectations – 1970s style monetary policy, but now with deflation

In country after country it is now becoming clear that we are heading for outright deflation. This is particularly the case in Europe – both inside and outside the euro area – where most central banks are failing to keep inflation close to their own announced inflation targets.

What we are basically seeing is an un-anchoring of inflation expectations. What is happening in my view is that central bankers are failing to take responsibility for inflation and in a broader sense for the development in nominal spending. Central bankers simply are refusing to provide an nominal anchor for the economy.

To understand this process and to understand what has gone wrong I think it is useful to compare the situation in two distinctly different periods – the Great Inflation (1970s and earlier 1980s) and the Great Moderation (from the mid-1980s to 2007/8).

The Great Inflation – “Blame somebody else for inflation”

Monetary developments were quite similar across countries in the Western world during the 1970s. What probably best describes monetary policy in this period is that central banks in general did not take responsibility for the development in inflation and in nominal spending – maybe with the exception of the Bundesbank and the Swiss National Bank.

In Milton Friedman’s wonderful TV series Free to Choose from 1980 he discusses how central bankers were blaming everybody else than themselves for inflation (see here)

As Friedman points out labour unions, oil prices (the OPEC) and taxes were said to have caused inflation to have risen. That led central bankers like then Fed chairman Arthur Burns to argue that to reduce inflation it was necessary to introduce price and wage controls.

Friedman of course rightly argued that the only way to curb inflation was to reduce central bank money creation, but in the 1970s most central bankers had lost faith in the fundamental truth of the quantity theory of money.

Said in another way central bankers in the 1970s simply refused to take responsibility for the development in nominal spending and therefore for inflation. As a consequence inflation expectations became un-anchored as the central banks did not provide an nominal anchor. The result was predictable (for any monetarist) – the price level driffed aimlessly, inflation increased, became highly volatile and unpredictable.

Another thing which was characteristic about monetary policy in 1970s was the focus on trade-offs – particularly the Phillips curve relationship that there was a trade-off between inflation and unemployment (even in the long run). Hence, central bankers used high unemployment – caused by supply side factors – as an excuse not to curb money creation and hence inflation. We will see below that central bankers today find similar excuses useful when they refuse to take responsibility for ensuring nominal stability.

The Great Moderation – “Inflation is always and everywhere monetary phenomenon” 

That all started to change as Milton Friedman’s monetarist counterrevolution started to gain influence during the 1970s and in 1979 the newly appointed Federal Reserve chairman Paul Volcker started what would become a global trend towards central banks again taking responsibility for providing nominal stability and in the early 1990s central banks around the world moved to implement clearly defined nominal policy rules – mostly in the form of inflation targets (mostly around 2%) starting with the Reserve Bank of  New Zealand in 1990.

Said in the other way from the mid-1980s or so central banks started to believe in Milton Friedman’s dictum that “Inflation is always and everywhere monetary phenomenon” and more importantly they started to act as if they believed in this dictum. The result was predictable – inflation came down dramatically and became a lot more predictable and nominal spending/NGDP growth became stable.

By taking responsibility for nominal stability central banks around the world had created an nominal anchor, which ensured that the price mechanism in general could ensure an efficient allocation of resources. This was the great success of the Great Moderation period.

The only problem was that few central bankers understood why and how this was working. Robert Hetzel obvious was and still is a notable exception and he is telling us that reason we got nominal stability is exactly because central banks took responsibility for providing a nominal anchor.

That unfortunately ended suddenly in 2008.

The Great Recession – back to the bad habits of the 1970s

If we compare the conduct of monetary policy around the world over the past 5-6 years with the Great Inflation and Great Moderation periods I think it is very clear that we to a large extent has returned to the bad habits of the 1970s. That particularly is the case in Europe, while there are signs that monetary policy in the US, the UK and Japan is gradually moving back to practices similar to the Great Moderation period.

So what are the similarities with the 1970s?

1) Central banks refuse to acknowledge inflation (and NGDP growth) is a monetary phenomenon.

2) Central banks are concerned about trade-offs and have multiple targets (often none-monetary) rather focusing on one nominal target. 

Regarding 1) We have again and again heard central bankers say that they are “out of ammunition” and that they cannot ease monetary policy because interest rates are at zero – hence they are indirectly saying that they cannot control nominal spending growth, the money supply and the price level. Again and again we have heard ECB officials say that the monetary transmission mechanism is “broken”.

Regarding 2) Since 2008 central banks around the world have de facto given up on their inflation targets. In Europe for now nearly two years inflation has undershot the inflation targets of the ECB, the Riksbank, the Polish central bank, the Czech central bank and the Swiss National Bank etc.

And to make matters worse these central banks quite openly acknowledge that they don’t care much about the fact that they are not fulfilling their own stated inflation targets. Why? Because they are concerning themselves with other new (ad hoc!) targets – such as the development in asset prices or household debt.

The Swedish Riksbank is an example of this. Under the leadership of Riksbank governor the Stefan Ingves the Riksbank has de facto given up its inflation targeting regime and is now targeting everything from inflation, credit growth, property prices and household debt. This is completely ad hoc as the Riksbank has not even bothered to tell anybody what weight to put on these different targets.

It is therefore no surprise that the markets no longer see the Riksbank’s official 2% inflation target as credible. Hence, market expectations for Swedish inflation is consistency running below 2%. In 1970s the Riksbank failed because it effectively was preoccupied with hitting an unemployment target. Today the Riksbank is failing – for the same reason: It is trying to hit another other non-monetary target – the level of household debt.

European central bankers in the same way as in the 1970s no longer seem to understand or acknowledge that they have full control of nominal spending growth and therefore inflation and as a consequence they de facto have given up providing a nominal anchor for the economy. The result is that we are seeing a gradual un-anchoring of inflation expectations in Europe and this I believe is the reason that we are likely to see deflation becoming the “normal” state of affairs in Europe unless fundamental policy change is implemented.

Every time we get a new minor or larger negative shock to the European economy – banking crisis in Portugal or fiscal and political mess in France – we will just sink even deeper into deflation and since there is nominal anchor nothing will ensure that we get out of the deflationary trap. This is of course the “Japanese scenario” where the Bank of Japan for nearly two decade refused to take responsibility for providing an nominal anchor.

And as we continue to see a gradual unchoring of inflation expectations it is also clear that the economic system is becomimg increasingly dysfunctional and the price system will work less and less efficiently – exactly as in the 1970s. The only difference is really that while the problem in 1970s was excessively high inflation the problem today is deflation. But the reason is the same – central banks refusal to take responsibility for providing a nominal anchor.

Shock therapy is needed to re-anchor inflation expectations

The Great Inflation came to an end when central banks around the world finally took responsibility for providing a nominal anchor for the economy through a rule based monetary policy based on the fact that the central bank is in full control of nominal spending growth in the economy. To do that ‘shock therapy’ was needed.

For example example the Federal Reserve starting in 1979-82 fundamentally changed its policy and communication about its policy. It took responsibility for providing nominal stability. That re-anchored inflation expectations in the US and started a period of a very high level of nominal stability – stable and predictable growth in nominal spending and inflation.

To get back to a Great Moderation style regime central banks need to be completely clear that they take responsibility for for ensuring nominal stability and that they acknowledge that they have full control of nominal spending growth and as a consequence also the development in inflation. That can be done by introducing a clear nominal targeting – either restating inflation targets or even better introducing a NGDP targeting.

Furthermore, central banks should make it clear that there is no limits on the central bank’s ability to create money and controlling the money base. Finally central banks should permanently make it clear that you can’t have your cake and eat it – central banks can only have one target. It is the Tinbergen rule. There is one instrument – the money base – should the central bank can only hit one target. Doing anything else will end in disaster. 

The Federal Reserve and the Bank of Japan have certainly moved in that direction of providing a nominal anchor in the last couple of years, while most central banks in Europe – including most importantly the ECB – needs a fundamental change of direction in policy to achieve a re-anchoring of inflation expectations and thereby avoiding falling even deeper into the deflationary trap.

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PS This post has been greatly inspired by re-reading a number of papers by Robert Hetzel on the Quantity Theory of Money and how to understand the importance of central bank credibility. In that sense this post is part of my series of “Tribute posts” to Robert Hetzel in connection with his 70 years birthday.

PPS Above I assume that central banks have responsibility for providing a nominal anchor for the economy. After all if a central bank has a monopoly on money creation then the least it can do is to live up to this responsibility. Otherwise it seems pretty hard to argue why there should be any central bank at all.

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When forward guidance fails: the Fisher equation and the Swedish paradox

On 3 July the Swedish central bank, Riksbanken, cut its key policy rate by 50bp to 0.25%. Most analysts – and the markets – were taken by surprise by this decision. It was particularly surprising as Riksbanken’s governor Stefan Ingves had been voted down by a majority of Riksbanken’s board.

Most people – including myself – would say that when a central bank cuts it key policy rate more than expected, it is monetary easing, and it seemed that was how the market was interpreting Riksbanken’s move – the Swedish krona weakened significantly and Swedish share prices spiked. However, something was not as it should be – Swedish inflation expectations dropped (!) on the back of the rate decision, e.g. Swedish 2-year breakeven inflation dropped from around 0.85% before the rate decision to around 0.65% after the rate decision. This is a paradox – a Swedish paradox: when you cut rates you get lower inflation expectations. So judging from the inflation expectations Riksbanken had actually tightened monetary conditions rather than eased.

BE inflation expectations Sweden

The Fisher equation and focusing on the wrong target

So what went wrong? The answer in my view is that Riksbanken is focusing on the wrong policy target. Hence, the bank communicates in terms of interest rates rather than inflation expectations. And yes, the interest rates are an intermediate target.

Riksbanken controls the Swedish money base and it can use this to control money market rates – in the short term. However, the so-called Tinbergen rule also tells us that a central bank can only hit one target if it has one instrument.

Therefore, if Riksbanken targets interest rates it cannot at the same time effectively target inflation (expectations). Unless it uses an additional “instrument”, such as credibility. If the market believes that Riksbanken will always adjust monetary parameters to ensure that it hits its 2% inflation target, it will be able to move the money market rate (temporarily) away from the ‘natural’ interest rates.

Hence, if Riksbanken’s inflation target is fully credible, inflation expectations will basically be pegged at 2%. However, if the inflation target is not credible, the story is very different, and as inflation expectations are presently well below 2%, it is very clear that the 2% inflation target is presently not credible and has not been credible for years.

A way to illustrate this is to have a look at the so-called Fisher equation:

(1) i = r + pe

i is the nominal interest rate, r is the real interest rate and pe is inflation expectations. When we talk about money market rates we can also see i as the policy rate.

It follows logically from (1) that if the inflation target is fully credible – that is, if pe is ‘fixed’ – a cut in i will ‘automatically’ lower r. On the other hand, if inflation expectations are not well-anchored, a cut in i might as well reduce pe.

I believe this is exactly what happened in Sweden on the back of Riksbanken’s surprise cut.

Not only is Riksbanken communicating in terms of interest rates (rather than inflation expectations) but it is also communicating in terms of the interest rate path. Hence, Riksbanken is not only announcing rate decisions but it is also communicating about future expected changes in the policy rate.

In that regard it is important that Riksbanken actually lowered its expectations for interest rates in two years even more than it lowered its present key policy rate. In other words, Riksbanken flattened the money market rate curve. So for a given real interest rate Riksbanken is actually indirectly telling the market that it expects inflation expectations to decline even further in the coming two years.

Obviously this is not what Riksbanken meant to say (I hope) but when it chooses to focus on interest rates rather than inflation expectations, this is what the market will focus on as well. Riksbanken’s interest rate focus therefore ‘overruled’ the focus on inflation expectations. In fact, in Riksbanken’s statement there was no reference to the market’s inflation expectations.

Lesson: central banks should focus on the ultimate policy target rather than the intermediate one 

I think the lesson we can learn from thisis that central banks should not focus on intermediate targets – such as interest rates and the interest rate path – but should focus on the ultimate policy goal – in the case of Riksbanken expected inflation.

Imagine that Riksbanken had issued the following statement last week:

‘Inflation expectations are presently well below Riksbanken’s 2% inflation target. This is unsatisfactory and as a consequence the repo rate is now being cut by 0.5 percentage points to 0.25% and Riksbanken is fully committed to introducing further monetary easing if needed to ensure that market expectations will fully reflect its 2% inflation target. If needed the repo rate will be cut further and Riksbanken will actively intervene in the currency markets to ease monetary conditions through the FX channel until inflation expectations are at 2%’.

I think it is pretty clear that such a statement would have caused an immediate jump in (market) inflation expectations to 2%. This would obviously also have caused a significant drop in real interest rates – both as a result of the lower nominal rates AND, more importantly, through higher inflation expectations.

What a difference a few words make…

PS Riksbanken is not alone in terms of these problems. The ECB faces a similar problems, while the Fed and the Bank of Japan are focusing on the ultimate policy goal rather than on intermediate targets. However, during Operation Twist in 2011-12 the Fed was facing Riksbanken-style problems.

PPS In Swedish CPI there is an explicit (mortgage) interest rate component, weighing around 5% of total CPI (and hence, of course, incl when calculating breakeven inflation), implying that shorter breakeven inflation should indeed come down by some 0.3 p.p. if a full pass-through into mortgage rates from the cut. That, however, does not really change the point. The Riksbank is targeting CPI so it is really irrelevant why inflation is too low.

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Related blog posts:

Committed to a failing strategy: low for longer = deflation for longer?
Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call
A scary story: The Zero Lower Bound and exchange rate dynamics

 

Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call

In a very surprising move the Swedish Riksbank this morning cut its key policy rate by 50bp to 0.25%. It was about time! The Riksbank has for a very long time undershot its 2% inflation target and inflation expectations have consistently been below 2% for a long time as well.

The interesting question now is what is next? The Riksbank is now very close to the Zero Lower Bound and with inflation still way below the inflation target one could argue that even more easing is needed.

I have earlier addressed how to conduct monetary policy at the ZLB for small-open economies like Sweden. Traditional quantitative easing obviously is an option, but it is also possible to get some inspiration from the works of such great economists as Lars E. O. Svensson or Bennett McCallum.

Already back in 2012 I wrote a post about what advice Bennett would give to the Riksbank in a situation like it now find itself in. This is from my blog post Sweden, Poland and Australia should have a look at McCallum’s MC rule

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? …

…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…

…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”

…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 … 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.

…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…can.. avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

That is it – now back to writing on the Polish central bank’s failure to do the right thing at it’s rate decision yesterday.

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See also A scary story: The Zero Lower Bound and exchange rate dynamics

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.

A scary story: The Zero Lower Bound and exchange rate dynamics

I was in Sweden last week and again yesterday (today I am in Norway). My trips to Sweden have once again reminded me about the dangers of conducting monetary policy with interest rates at the Zero Lower Bound (ZLB). The Swedish central bank – Riksbanken – has cut is key policy rate to 1% and is like to cut it further to 0.75% before the end of the year so we are inching closer and closer to zero.

Riksbanken is just one of a number of European central banks close to zero on interest rates – most notably the ECB is at 0.25%. In the Czech Republic the key policy rate stands at 0.05%. And even Poland, Hungary, Norway are moving closer and closer to the ZLB.

Most of these central banks seem to be quite unprepared for what might happen at the Zero Lower Bound. In this post I will particularly focus on the exchange rate dynamics at the ZLB.

A Taylor rule world

Lets say we can describe monetary policy with a simple Taylor rule:

r = rN+a*(p-pT)+b(ygap)

In a “normal” world where everything is fine and the key policy rate (r) is well-above zero the central bank will hike or cut r in response to increasing or declining inflation (p) relative to the inflation target (pT) or in response to the output gap (ygap) increasing or decreasing. If the output gap is closed and inflation is at the inflation target then the central bank will set it’s key policy rate at the “natural” interest rate rN.

What happens at the ZLB?

However, lets assume that we are no longer in a normal world. Lets instead assume that p is well below the inflation target and the output gap is negative. As we know this is the case in most European countries today.

So if we plug these numbers into our Taylor rule above we might get r=1%. As long as r>0 we are not in trouble yet. The central bank can still conduct monetary policy with its chosen instrument – the key policy interest rate. This is how most inflation targeting central banks in the world are doing their business today.

But what happens if we get a negative shock to the economy. Lets for example assume that an overheated property markets starts to cool gradually and real GDP starts to slow. In this case the central bank according to it’s Taylor rule should cut its key policy rate further. Sooner or later the central bank hits the ZLB.

An then suddenly the currency starts strengthening dramatically

In fact imagine that the interest rate level needed to close the output gap and keep inflation at the inflation target is -2%.

We can say that monetary policy is neutral when the central bank sets interest rates according to the Taylor rule, but if interest rates are higher than the what the Taylor rule stipulates then monetary policy is tight. So if the Taylor rule tells us that the key policy rate should be -2% and the actual policy rate is zero then monetary policy is of course tight. This is what many central bankers fail to understand. Monetary policy is not necessarily easy just because the interest rate is low in a historical or absolute perspective.

And this is where it gets really, really dangerous because we now risk getting into a very unstable economic and financial situation – particularly if the central bank insists that monetary policy is already easy, while it is in fact tight.

What happens to the exchange rate in a situation where monetary policy is tightened? It of course appreciates. So when the “stipulated” (by the Taylor rule) interest rate drops to for example -2% and the actual interest rate is at 0% then obviously the currency starts to appreciates – leading to a further tightening of monetary conditions. With monetary conditions tightening inflation drops further and growth plummets. So now we might need an interest rate of -4 or -7%.

With that kind of monetary tightening you will fast get financial distress. Stock markets start to drop dramatically as inflation expectations plummets and the economy contracts. It is only a matter of time before the talk of banking troubles start to emerge.

The situation becomes particularly dangerous if the central bank maintains that monetary policy is easy and also claim that the appreciation of the currency is a signal that everything is just fine, but it is of course not fine. In fact the economy is heading for a massive collapse if the central bank does not change course.

This scenario is of course very similar to what played out in the US in 2008-9. A slowdown in the US property market caused a slowdown in the US economy. The Fed failed to respond by not cutting interest rates aggressive and fast enough and as a consequence we soon hit the ZLB. And what happened to the dollar? It strengthened dramatically! That of course was a very clear indication that monetary conditions were becoming very tight. Initially the Fed clearly failed to understand this – with disastrous consequences.

But don’t worry – there is a way out

The US is of course special as the dollar is a global reserve currency. However, I am pretty sure that if a similar thing plays out in other countries in the world we will see a similar exchange rate dynamics. So if the Taylor rule tells you that the key policy rate should be for example -4% and it is stuck at zero then the the currency will start strengthening dramatically and inflation and growth expectations will plummet potentially setting off financial crisis.

However, there is no reason to repeat the Fed’s failure of 2008. In fact it is extremely easy to avoid such a scenario. The central bank just needs to acknowledge that it can always ease monetary policy at the ZLB. First of all it can conduct normal open market operations buying assets and printing its own currency. That is what we these days call Quantitative Easing.

For small open economies there is an even simpler way out. The central bank can simply intervene directly in the currency market to weak its currency and remember the market can never beat the central bank in this game. The central bank has the full control of the printing press.

So imagine we now hit the ZLB and we would need to ease monetary policy further. The central bank could simply announce that it will weaken its currency by X% per months until the output gap is close and inflation hits the inflation target. It is extremely simple. This is what Lars E.O. Svensson – the former deputy central bank governor in Sweden – has termed the foolproof way out of deflation.

And even better any central bank, which is getting dangerously close to the ZLB should pre-announce that it will in fact undertake such Svenssonian monetary operations to avoid the dangerous of conducting monetary policy at the ZLB. That would mean that as the economy is moving closer to the ZLB the currency would automatically start to weaken – ahead of the central bank doing anything – and in that sense the risk of hitting the ZLB would be much reduced.

Some central bankers understand this. For example Czech central bank governor Miroslav Singer who recently has put a floor under EUR/CZK, but unfortunately many other central bankers in Europe are dangerously ignorant about these issues.

PS I told the story above using a relatively New Keynesian framework of a Taylor rule, but this is as much a Market Monetarist story about understanding expectations and that the interest rate level is a very bad indicator of the monetary policy stance.

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.

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

Irving Fisher and the New Normal

A lot of the debate about how to escape the Great Recession is focused on the question of deleveraging and it is often said that we have entered a period of more or less permanent low growth – a “New Normal”. I fundamentally think the idea of the new normal theoretically and empirically flawed.

Irving Fisher – undoubtedly one of the greatest economists of the 20th century – formulated his debt-deflation theory, which is highly relevant for the debate about the “New Normal” and more importantly about how to escape the “New Normal”.

According to Fisher the economy and market goes through nine phases after the bubble bursts:

  1. Debt liquidation and distress selling.
  2. Contraction of the money supply as bank loans are paid off.
  3. A fall in the level of asset prices.
  4. A still greater fall in the net worth of businesses, precipitating bankruptcies.
  5. A fall in profits.
  6. A reduction in output, in trade and in employment.
  7. Pessimism and loss of confidence.
  8. Hoarding of money.
  9. A fall in nominal interest rates and a rise in deflation adjusted interest rates.

This is how a lot of people today think of the crisis. We had a bubble and it busted and now we have to go through these more or less “natural” phases and therefore we will just have to take the pain.

I would certainly not disagree that there is a serious risk that we indeed will live through a long period of low growth and a quasi-deflationary environment. Here is Fisher:

“Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

This is pretty much Fisher description of the New Normal. However, unlike the New Normal crowd Fisher did not think that we have to live through “a vicious spiral, for many years”:

“On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”

So what is Fisher saying? Basically advocating a variation of the Market Monetarists solution to bring NGDP back to the pre-crisis trend level.

The skeptics, however, are saying that it is not possible to do that with monetary policy, but Fisher has an answer ready to the liquidity trap crowd:

That the price level is controllable is not only claimed by monetary theorists but has recently been evidenced by two great events: (1) Sweden has now for nearly two years maintained a stable price level, practically always within 2 per cent of the chosen par and usually within 1 per cent. (2) The fact that immediate reversal of deflation is easily achieved by the use, or even the prospect of use, of appropriate instrumentalities has just been demonstrated by President Roosevelt.

Fisher continues – about Roosevelt’s decision to give up the gold standard in 1933:

“Those who imagine that Roosevelt’s avowed reflation is not the cause of our recovery but that we had “reached the bottom anyway” are very much mistaken. At any rate, they have given no evidence, so far as I have seen, that we had reached the bottom. And if they are right, my analysis must be woefully wrong. According to all the evidence, under that analysis, debt and deflation, which had wrought havoc up to March 4, 1933, were then stronger than ever and, if let alone, would have wreaked greater wreckage than ever, after March 4. Had no “artificial respiration” been applied, we would soon have seen general bankruptcies of the mortgage guarantee companies, savings banks, life insurance companies, railways, municipalities, and states. By that time the Federal Government would probably have become unable to pay its bills without resort to the printing press, which would itself have been a very belated and unfortunate case of artificial respiration. If even then our rulers should still have insisted on “leaving recovery to nature” and should still have refused to inflate in any way, should vainly have tried to balance the budget and discharge more government employees, to raise taxes, to float, or try to float, more loans, they would soon have ceased to be our rulers. For we would have insolvency of our national government itself, and probably some form of political revolution without waiting for the next legal election. The mid-west farmers had already begun to defy the law…If all this is true, it would be as silly and immoral to “let nature take her course” as for a physician to neglect a case of pneumonia. It would also be a libel on economic science, which has its therapeutics as truly as medical science.”

So what is Fisher saying? Yes we are going through a debt-deflation cycle started by a monetary shock and it can go on for years, but the downward spiral can be stopped with monetary policy – for example by bringing NGDP back to the pre-crisis trend level – and there is no liquidity trap as long as policy makers use Rooseveltian Resolve or learn a lesson from the Swedish central bank Riksbanken.

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