Time for the Fed to introduce a forward-looking McCallum rule

Earlier this week Boston Fed chief Eric Rosengreen in an interview on CNBC said that the Federal Reserve could introduce a forth round of quantitative easing – QE4 – since the beginning of the crisis in 2008 if the outlook for the US economy worsens.

I have quite mixed emotions about Rosengreen’s comments. I would of course welcome an increase in money base growth – what the Fed and others like to call quantitative easing – if it is necessary to ensure nominal stability in the US economy.

However, the way Rosengreen and the Fed in general is framing the use of quantitative easing in my view is highly problematic.

First of all when the fed is talking about quantitative easing it is speaking of it as something “unconventional”. However, there is nothing unconventional about using money base control to conduct monetary policy. What is unconventional is actually to use the language of interest rate targeting as the primary monetary policy “instrument”.

Second, the Fed continues to conduct monetary policy in a quasi-discretionary fashion – acting as a fire fighter putting out financial and economic fires it helped start itself.

The solution: Use the money base as an instrument to hit a 4% NGDP level target

I have praised the Fed for having moved closer to a rule based monetary policy in recent years, but the recent escalating distress in the US financial markets and particularly the marked drop in US inflation expectations show that the present monetary policy framework is far from optimal. I realize that the root of the recent distress likely is European and Chinese rather than American, but the fact that US inflation expectations also have dropped shows that the present monetary policy framework in the US is not functioning well-enough.

I, however, think that the Fed could improve the policy framework dramatically with a few adjustments to its present policy.

First of all the Fed needs to completely stop thinking about and communicating about its monetary stance in terms of setting an interest rate target. Instead the Fed should only communicate in terms of money base control.

The most straightforward way to do that is that at each FOMC meeting a monthly growth rate for the money base is announced. The announced monthly growth rate can be increased or decreased at every FOMC-meeting if needed to hit the Fed’s ultimate policy target.

Using “the” interest rate as a policy “instrument” is not necessarily a major problem when the “natural interest rate” for example is 4 or 5%, but if the natural interest rate is for example 1 or 2% and there is major slack in the economy and quasi-deflationary expectations then you again and again will run into a problem that the Fed hits the Zero Lower Bound everything even a small shock hits the economy. That creates an unnecessary degree of uncertainly about the outlook for monetary policy and a natural deflationary bias to monetary policy.

I frankly speaking have a hard time understanding why central bankers are so obsessed about communicating about monetary policy in terms of interest rate targeting rather than money base control, but I can only think it is because their favourite Keynesian models – both ‘old’ and ‘new’ – are “moneyless”.

I have earlier argued that the Fed since the summer of 2009 effectively has target 4% nominal GDP growth (level targeting). One can obviously argue that that has been too tight a monetary policy stance, but we have now seen considerable real adjustments in the US economy so even if the US economy likely could benefit from higher NGDP growth for a couple of year I would pragmatically suggest that the time has come to let bygones-be-bygones and make a 4% NGDP level target an official Fed target.

Alternatively the Fed could once every year announce its NGDP target for the coming five years based on an estimate for potential real GDP growth and the Fed’s 2% inflation target. So if the Fed thinks potential real GDP growth in the US in the coming five years is 2% then it would target 4% NGDP growth. If it thinks potential RGDP growth is 1.5% then it would target 3.5% growth.

However, it is important that the Fed targets a path level rather than the growth rate. Therefore, if the Fed undershoots the targeted level one year it would have to bring the NGDP level back to the targeted level as fast as possible.

Finally it is important to realize that the Fed should not be targeting the present level of NGDP, but rather the future level of NGDP. Therefore, when the FOMC sets the monthly growth rate of the money base it needs to know whether NGDP is ‘on track’ or not. Therefore a forecast for future NGDP is needed.

The way I – pragmatically – would suggest the FOMC handled this is that the FOMC should publish three forecasts based on three different methods for NGDP two years ahead.

The first forecast should be a forecast prepared by the Fed’s own economists.

The second forecast should be a survey of professional forecasts.

And finally the third forecast should be a ‘market forecast’. Scott Sumner has of course suggested creating a NGDP future, which the Fed could target or use as a forecasting tool. This I believe would be the proper ‘market forecast’. However, I also believe that a ‘synthetic’ NGDP future can relatively easily be created with a bit of econometric work and the input from market inflation expectations, the US stock market, a dollar index and commodity prices. In fact it is odd no Fed district has not already undertaken this task.

An idealised policy process

To sum up how could the Fed change the policy process to dramatically improve nominal stability and reduce monetary policy discretion?

It would be a two-step procedure at each FOMC meeting.

First, the FOMC would look at the three different forecasts for the NGDP level two-years ahead. These forecasts would then be compared to the targeted level of NGDP in two year.

The FOMC statement after the policy decision the three forecast should be presented and it should be made clear whether they are above or below the NGDP target level. This would greatly increase policy-making discipline. The FOMC members would be more or less forced to follow the “policy recommendation” implied by the forecasts for the NGDP level.

Second, the FOMC would decide on the monthly money base growth rate and it is clear that it follows logically that if the NGDP forecasts are below (above) the NGDP level target then the money base growth rate would have to be increased (decreased).

It think the advantages of this policy process would be enormous compared to the present quasi-discretionary and eclectic process and it would greatly move the Fed towards a truly rule-based monetary policy.

Furthermore, the process would be easily understood by the markets and by commentators alike and it would in no way be in conflict with the Fed’s official dual mandate as I strongly believe that such a set-up would both ensure price stability – defined as 2% inflation over the cycle – and “maximum employment”.

And finally back to the headline – “Time for the Fed to introduce a forward McCallum rule”. What I essentially have suggested above is that the Fed should introduce a forward-looking version of the McCallum rule. Bennett McCallum obviously originally formulated his rule in backward-looking terms (and in growth terms rather than in level terms), but I am sure that Bennett will forgive me for trying to formulate his rule in forward-looking terms.

PS if the ECB followed the exactly same rule as I have suggested above then the euro crisis would come to an end more or less immediately.

 

 

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Tighter monetary conditions – not lower oil prices – are pushing down inflation expectations

Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong.

Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future.

2y2y BEI euro zone

But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward.

Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market.

brent 1-year foreard

Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year.

Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices – because the market actual expects higher oil prices – more than 2.5% higher oil prices over the coming year.

So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions.

Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow.

As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now.

Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down.

I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not.

Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening.

We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad.

PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future.

PPS This post was greatly inspired by clever young colleague Jens Pedersen.

Certainly not perfect, but Fed policy is not worse than during the Great Moderation (an answer to Scott Sumner)

Scott Sumner has replied to my previous post in which I argued that the Federal Reserve de facto has implemented a 4% NGDP level targeting regime (without directly articulating it).

Scott is less positive about actual Fed policy than I am. This is Scott answering my postulate that he would have been happy about a 4% NGDP growth path had it been announced in 2009:

Actually I would have been very upset, as indeed I was as soon as I saw what they were doing.  I favored a policy of level targeting, which meant returning to the previous trend line.

Now of course if they had adopted a permanent policy of 4% NGDP targeting, I would have had the satisfaction of knowing that while the policy was inappropriate at the moment, in the long run it would be optimal.  Alas, they did not do that.  The recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.

I most admit that I am a bit puzzled by Scott’s comments. Surely one could be upset in 2009 – as both Scott and I were – that the Fed did not do anything to bring back the nominal GDP level back to the pre-crisis trend and it would likely also at that time have been a better policy to return to a 5% trend rather than a 4% trend. However, I would also note that that discussion is mostly irrelevant for present day US monetary policy and here I would note two factors, which I find important:

  1. We have had five years of supply side adjustments – five years of “internal devaluation”/”wage moderation” so to speak. It is correct that the Fed didn’t boost aggregate demand sufficiently to push down US unemployment to pre-crisis levels, but instead it has at least kept nominal spending growth very stable (despite numerous shocks – see below), which has allowed for the adjustment to take place on the supply side of the economy and US unemployment is now nearly back at pre-crisis levels (yes employment is much lower, but we don’t know to what extent that is permanent/structural or not).
  2. Furthermore, we have had numerous changes to supply side policies in the US – mostly negative such as Obamacare and an increase in US minimum wages, but also some positive such as the general general reduction in defense spending and steps towards ending the “War on Drugs”.

Given these supply side factors – both the adjustments and the policy changes – it would make very little sense in my view to try to bring the NGDP level back to the pre-2008 trend-level and I don’t think Scott is advocating this even though his comments could leave that impression. Furthermore, given that expectations seem to have fully adjusted to a 4% NGDP level-path there would be little to gain from targeting a higher NGDP growth rate (for example 5%).

The Fed is more credible today than during the Great Moderation

Furthermore, I would dispute Scott’s claim that the Fed’s policy is not credible. Or rather while the monetary policy regime is not well-articulated by the Fed it is nonetheless pretty well-understood by the markets and basically also by the Fed itself (even though that from time to time could be questioned).

Hence, both the markets and the Fed fully understand today that there effectively is no liquidity trap. There might be a Zero Lower Bound on interest rates but if needed the Fed can ease monetary policy through quantitative easing. This is clearly well-understood by the Fed system today and the markets fully well knows that if a new shock to for example money-velocity where to hit the US economy then the Fed would most likely once again step up QE. This is contrary to the situation prior to 2008 where the Fed certainly had not articulated a policy of how to conduct monetary policy at the Zero Lower Bound and this of course was a key reason why the monetary policy stance became so insanely tight in 2008.

This does in no way mean that monetary policy in the US is perfect. It is certainly not – just that it is no less credible than monetary policy was during the Greenspan years and that the Fed today is better prepared to conduct monetary policy at the ZLB than prior to 2008.

NGDP has been more stable since 2009/2010 than during the Great Moderation

If we look at the development in nominal GDP it has actually been considerably more stable – and therefore also more predictable – than during the Great Moderation. The graph below illustrates that.

NGDP gap New Moderation

It is particularly notable in the graph that the NGDP gap – the percentage difference between the actual NGDP level and the NGDP trend – has been considerably smaller in the period from July 2009 and until today than during the Great Moderation (here said to be from 1995 until 2007). In fact the average absolute NGDP gap (the green dotted lines) was nearly three times as large during the Great Moderation than it has been since July 2009. Similarly inflation expectations has been more stable since July 2009 than during the Great Moderation and there unlike in the euro zone there are no signs that inflation expectations have become unanchored.

It is easy to be critical about the Fed’s conduct of monetary policy in recent years, but I find it very hard to argue that monetary policy has been worse than during the Great Moderation. 2008-9 was the catastrophic period, but since 2009/10 the Fed has re-established a considerable level of nominal stability and the Fed should be given some credit for that.

In this regard it is also notable that financial market volatility in the US today is at a historical low point – lower than during most of the Great Moderation period. This I believe to a large extent reflects a considerable level of “nominal predictability”.

No less sensitive to shocks than during the Great Moderation

Scott argues “(t)he recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.” 

It is obviously correct that the Fed has failed to spell out that it is actually targeting a 4% NGDP level path and I agree with Scott that this is a major problem and that means that the US economy is much more sensitive to shocks than otherwise would be the case. However, I would also stress that first of all during the Great Moderation the Fed had an even less clear target officially than is the case today.

Second, we should not forget that we have actually seen considerable shocks to the global and to the US economy since 2009/10. Just think of the massive euro crisis, Greece’s de facto default, the Cyprus crisis, the “fiscal cliff” in the US, a spike in oil prices 2010-12 and lately a sharp rise in global geopolitical tensions. Despite of all these shocks US NGDP has stayed close to the 4% NGDP path started in July 2009.

This to me is a confirmation that the Fed has been able to re-establish a considerable level of nominal stability. It has not been according to Market Monetarist game plan, but it is hard to be critical about the outcome.

In regard to the so-called “fiscal cliff” – the considerable tightening of fiscal policy in 2013 – it is notable that Scott has forcefully and correctly in my view argued that it had no negative impact on total aggregate nominal demand exactly because of monetary policy – or rather the monetary policy regime – offset the fiscal shock.

This is of course the so-called Sumner critique. For the Sumner critique to hold it is necessary that the monetary policy regime is well-understood by the markets and that the regime is credible. Hence, when Scott argues that 2013 confirmed the Sumner critique then he is indirectly saying that the monetary policy regime was credible in 2013. Had the monetary policy regime not been credible then the fiscal tightening likely would have led to a sharp slowdown in US growth.

It is time to let bygones be bygones

Nearly exactly a year ago I argued in a post that it is time to let bygones be bygones in US monetary policy:

Obviously even though the US economy seems to be out of the expectational trap there is no guarantee that we could not slip back into troubled waters once again, (but)…

… it is pretty clear to most market participants that the Fed would likely step up quantitative easing if a shock would hit US aggregate demand and it is fairly clear that the Fed has become comfortable with using the money base as a policy instrument…

… I must admit that I increasingly think – and most of my Market Monetarist blogging friends will likely disagree – that the need for a Rooseveltian style monetary positive shock to the US economy is fairly small as expectations now generally have adjusted to long-term NGDP growth rates around 4-5%. So while additional monetary stimulus very likely would “work” and might even be warranted I have much bigger concerns than the lack of additional monetary “stimulus”.

Hence, the focus of the Fed should not be to lift NGDP by X% more or less in a one-off positive shock. Instead the Fed should be completely focused on defining its monetary policy rule. A proper rule would be to target of 4-5% NGDP growth – level targeting from the present level of NGDP. In that sense I now favour to let bygones to be bygones as expectations now seems to have more or less fully adjusted and five years have after all gone since the 2008 shock.

Therefore, it is not really meaningful to talk about bringing the NGDP level back to a rather arbitrary level (for example the pre-crisis trend level). That might have made sense a year ago when we clearly was caught in an expectations deflationary style trap, but that is not the case today. For Market Monetarists it was never about “monetary stimulus”, but rather about ensuring a rule based monetary policy.  Market Monetarists are not “doves” (or “hawks”). These terms are only fitting for people who like discretionary monetary policies.

This remains my view. Learn from the mistakes of the past, but lets get on with life and lets instead focus fully on get the Fed’s target well-defined.

PS I hate being this positive about the Federal Reserve. In fact I am really not that positive. I just argue that the Fed is no worse today than during the Great Moderation.

The Fed’s un-announced 4% NGDP target was introduced already in July 2009

Scott Sumner started his now famous blog TheMoneyIllusion in February 2009 it was among other things “to show that we have fundamentally misdiagnosed the nature of the recession, attributing to the banking crisis what is actually a failure of monetary policy”.

Said in another way the Federal Reserve was to blame for the Great Recession and there was only one way out and that was monetary easing within a regime of nominal GDP level targeting (NGDP targeting).

NGDP targeting is of course today synonymous Scott Sumner. He more or less single-handedly “re-invented” NGDP targeting and created an enormous interest in the topic among academics, bloggers, financial sector economists and even policy makers.

The general perception is that NGDP targeting and Market Monetarism got the real break-through in 2013 when the Federal Reserve introduced the so-called Evans rule in September 2012 (See for example Matt Yglesias’ tribute to Scott from September 2012).

This has also until a few days ago been my take on the story of the success of Scott’s (and other’s) advocacy of NGDP targeting. However, I have now come to realize that the story might be slightly different and that the Fed effectively has been “market monetarist” (in a very broad sense) since July 2009.

The Fed might not have followed the MM game plan, but the outcome has effectively been NGDP targeting

Originally Scott basically argued that the Fed needed to bring the level nominal GDP back to the pre-crisis 5% trend path in NGDP that we had known during the so-called Great Moderation from the mid-1980s and until 2007-8.

We all know that this never happened and as time has gone by the original arguments for returning to the “old” NGDP trend-level seem much less convincing as there has been considerable supply side adjustments in the US economy.

Therefore, as time has gone by it becomes less important what is the “starting point” for doing NGDP targeting. Therefore, if we forgive the Fed for not bringing NGDP back to the pre-crisis trend-level and instead focus on the Fed’s ability to keep NGDP on “a straight line” then what would we say about the Fed’s performance in recent years?

Take a look at graph below – I have used (Nominal) Private Consumption Expenditure (PCE) as a monthly proxy for NGDP.

PCE gap

If we use July 2009 – the month the 2008-9 recession officially ended according to NBER – as our starting point (rather than the pre-crisis trend) then it becomes clear that in past five years PCE (and NGDP) has closely tracked a 4% path. In fact at no month over the past five years have PCE diverged more than 1% from the 4% path. In that sense the degree of nominal stability in the US economy has been remarkable and one could easily argue that we have had higher nominal stability in this period than during the so-called Great Moderation.

In fact I am pretty sure that if somebody had told Scott in July 2009 that from now on the Fed will follow a 4% NGDP target starting at the then level of NGDP then Scott would have applauded it. He might have said that he would have preferred a 5% trend rather than a 4% trend, but overall I think Scott would have been very happy to see a 4% NGDP target as official Fed policy.

The paradox is that Scott has not sounded very happy about the Fed’s performance for most of this period and neither have I and other Market Monetarists. The reason for this is that while the actual outcome has looked like NGDP targeting the Fed’s implementation of monetary policy has certainly not followed the Market Monetarist game plan.

Hence, the Market Monetarist message has all along been that the Fed should clearly announce its target (a NGDP level target), do aggressive quantitative easing to bring NGDP growth “back on track”, stop focusing on interest rates as a policy instrument and target expected NGDP rather than present macroeconomic variables. Actual US monetary policy has gradually moved closer to this ideal on a number of these points – particularly with the so-called Evan rule introduced in September 2012, but we are still very far away from having a Market Monetarist Fed when it comes to policy implementation.

However, in the past five years the implementation of Fed policy has been one of trial-and-error – just think of QE1, QE2 and QE3, two times “Operation Twist” and all kinds of credit policies and a continued obsession with using interest rates rates as the primary policy “instrument”.

I believe we Market Monetarists rightly have been critical about the Fed’s muddling through and lack of commitment to transparent rules. However, I also think that we today have to acknowledge that this process of trail-and-error actually has served an important purpose and that is to have sent a very clear signal to the financial markets (and others for that matter) that the Fed is committed to re-establishing some kind of nominal stability and avoiding a deflationary depression. This of course is contrary to the much less clear commitment of the ECB.

The markets have understood it all along (and much better than the Fed)

Market Monetarists like to say that the markets are better at forecasting and the collective wisdom of the markets is bigger than that of individual market participants or policy makers and something could actually indicate that the markets from an early point understood that the Fed de facto would be keeping NGDP on a straight line.

An example is the US stock market bottomed out a few months before we started to establish the new 4% trend in US NGDP and the US stock markets have essentially been on an upward trend ever since, which is fully justified if you believe the Fed will keep this de facto NGDP target in place. Then we should basically be expecting US stock prices to increase more or less in line with NGDP (disregarding changes to interest rates).

Another and even more powerful example in my view is what the currency markets have been telling us. I  (and other Market Monetarists) have long argued that market expectations play a key role in the in the implementation of monetary policy and in the monetary policy transmission mechanism.

In a situation where the central bank’s NGDP level target is credible rational investors will be able to forecast changes in the monetary policy stance based on the actual level of NGDP relative to the targeted level of NGDP. Hence, if actual NGDP is above the targeted level then it is rational to expect that the central bank will tighten the monetary policy stance to bring NGDP back on track with the target. This obviously has implications for the financial markets.

If the Fed is for example targeting a 4% NGDP path and the actual NGDP level is above this target then investors should rationally expect the dollar to strengthen until NGDP is back at the targeted level.

And guess what this is exactly how the dollar has traded since July 2009. Just take a look at the graph below.

NGDP gap dollar index 2

We are looking at the period where I argue that the Fed effectively has targeted a 4% NGDP path. Again I use PCE as a monthly proxy for NGDP and again the gap is the gap between the actual and the “targeted” NGDP (PCE) level. Look at the extremely close correlation with the dollar – here measured as a broad nominal dollar-index. Note the dollar-index is on an inverse axis.

The graph is very clear. When the NGDP gap has been negative/low (below target) as in the summer of 2010 then the dollar has weakened (as it was the case from from the summer of 2010under spring/summer of 2011. And similarly when the NGDP gap has been positive (NGDP above target) then the dollar has tended to strengthen as we essentially has seen since the second half of 2011 and until today.

I am not arguing that the dollar-level is determining the NGDP gap, but I rather argue that the dollar index has been a pretty good indicator for the future changes in monetary policy stance and therefore in NGDP.

Furthermore, I would argue that the FX markets essentially has figured out that the Fed de facto is targeting a 4% NGDP path and that currency investors have acted accordingly.

It is time for the Fed to fully recognize the 4% NGDP level target

Just because there has a very clear correlation between the dollar and the NGDP gap in the past five years it is not given that that correlation will remain in the future. A key reason for this is – and this is a key weakness in present Fed policy – that the Fed has not fully recognize that it is de facto targeting a 4%. Therefore, there is nothing that stops the Fed from diverging from the NGDP rule in the future.

Recognizing a 4% NGDP level target from the present level of NGDP in my view should be rather uncontroversial as this de facto has been the policy the Fed has been following over the past five years anyway. Furthermore, it could easily be argued as compatible  with the Fed’s (quasi) official 2% inflation target (assuming potential real GDP growth is around 2%).

In my previous post I argued that the ECB should introduce a 4% NGDP target. The Fed already done that. Now it is just up to Fed Chair Janet Yellen to announce it officially. Janet what are you waiting for?

Scott Sumner’s Adam Smith Lecture

Last week Scott Sumner gave a lecture in London on the causes of the Great Recession and Market Monetarism. I had the honour of introducing Scott and you might me hear interrupting Scott near the end of the presentation. Scott made a lot more sense than I did.

Watch Scott’s Adam Smith lecture here.

Enjoy.

HT Sam Bowman

Bob Hetzel’s great idea

As I have promised earlier I will in the coming weeks write a number of blog posts on Robert Hetzel’s contribution to monetary thinking celebrating that he will turn 70 on July 3. Today I will tell the story about what I regard to be Bob’s greatest and most revolutionary idea. An idea which I think marks the birth of Market Monetarism.

I should in that regard naturally say that Bob doesn’t talk about himself as market monetarist, but simply as a monetarist, but his ideas are at the centre of what in recent years has come to be known at Market Monetarism (I coined the phrase myself in 2011).

Here is how Bob describes his great idea in his book “The Monetary Policy of the Federal Reserve”:

“In February 1990, Richmond Fed President Robert Black testified before Congress on Representative Stephen Neal’s Joint Resolution 4009 mandating that the Fed achieved price stability with five years. Bob Black was a monetarist, and he recommend multiyear M2 targets. As an alternative, I had suggested Treasury issuance of matched-maturity securities half of which would be nominal and half indexed to the price level.  The yield difference, which would measure expected inflation, would be a nominal anchor provided that the Fed committed to stabilizing it.

The idea came from observing how exchange-rate depreciation in small open economies constrained central banks because of the way it passed through immediately to domestic inflation. With a market measure of expected inflation, monetary policy seen by markets as inflationary would immediately trigger an alarm even if inflation were slow to respond. I mentioned my proposal to Milton Friedman, who  encouraged me to write a Wall Street Journal op-ed piece, which became Hetzel (1991).”

Bob developed his idea further in a number of papers published in the early 1990s. See for example here and here.

I remember when I first read about Bob’s idea I thought it was brilliant and was fast convinced that it would be much preferable to the traditional monetarist idea of money supply targeting. Milton Friedman obviously for decades advocated money supply targeting, but he also became convinced that Bob’s idea was preferable to his own idea.

Hence, in Friedman’s book Money Mischief (1992) he went on to publicly endorse Bob’s ideas. This is Friedman:

“Recently, Robert Hetzel has made an ingenious proposal that may be more feasible politically than my own earlier proposal for structural change, yet that promises to be highly effective in restraining inflationary bias that infects government…

…a market measure of expected inflation would make it possible to monitor the Federal Reserve’s behavior currently and to hold it accountable. That is difficult at present because of the “long lag” Hetzel refers to between Fed’s actions and the market reaction. Also, the market measure would provide the Fed itself with information to guide its course that it now lacks.”

In a letter to then Bank of Israel governor Michael Bruno in 1991 Friedman wrote (quoted from Hetzel 2008):

“Hetzel has suggested a nominal anchor different from those you or I may have considered in the past…His proposal is…that the Federal Reserve be instructed by Congress to keep that (nominal-indexed yield) difference below some number…It is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply. Clearly it is far better than a price level anchor which…is always backward looking.”

The two versions of Bob’s idea

It was not only Friedman who liked Hetzel’s ideas. President Clinton’s assistant treasury secretary Larry Summers also liked the idea – or at least the idea about issuing bonds linked to inflation. This led the US Treasury to start issuing so-called Treasury Inflation Protected Securities (TIPS) in 1997. Since then a number of countries in the world have followed suit and issued their own inflation-linked bonds (popularly known as linkers).

However, while Bob succeed in helping the process of issuing inflation-linked bonds in the US he was less successfully in convincing the Fed to actually use market expectations for inflation as a policy goal.

In what we could call the strict version of Bob’s proposal the central bank would directly target the market’s inflation expectations so they always were for example 2%. This would be a currency board-style policy where monetary policy was fully automatic. Hence, if market expectations for, for example inflation two years ahead were below the 2% target then the central bank would automatically expand the money base – by for example buying TIPS, foreign currency, equities or gold for that matter. The central bank would continue to expand the money base until inflation expectations had moved back to 2%. The central bank would similarly reduce the money base if inflation expectations were higher than the targeted 2%.

In this set-up monetary policy would fully live up to Friedman’s ideal of replacing the Fed with a “computer”. There would be absolutely no discretion in monetary policy. Everything would be fully rule based and automatic.

In the soft version of Bob’s idea the central bank will not directly target market inflation expectations, but rather use the market expectations as an indicator for monetary policy. In this version the central bank would likely also use other indicators for monetary policy – for example money supply growth or surveys of professional forecasters.

One can argue that this is what the Federal Reserve was actually doing from around 2000-3 to 2008. Another example of a central bank that de facto comes close to conducting monetary policy in way similar to what has been suggested by Hetzel is the Bank of Israel (and here there might have been a more or less direct influence through Bruno, but also through Stanley Fisher and other University of Chicago related Bank of Israel officials). Hence, for more than a decade the BoI has communicated very clearly in terms of de facto targeting market expectations for inflation and the result has been a remarkable degree of nominal stability (See here).

Even in the soft version it is likely that the fact that the central bank openly is acknowledging market expectations as a key indicator for monetary policy will likely do a lot to provide nominal stability. This is in fact what happened in the US – and partly in other places during the 2000s – until everything when badly wrong in 2008 and inflation expectations were allowed to collapse (more on that below).

Targeting market expectations and the monetary transmission mechanism

It is useful when trying to understand the implications of Bob’s idea to target the market expectations for inflation to understand how the monetary transmission mechanism would work in such a set-up.

As highlighted above thinking about fixed exchange rate regimes gave Bob the idea to target market inflation expectations, and fundamentally the transmission mechanism under both regimes are very similar. In both regimes both money demand and the money supply (both for the money base and broad money) become endogenous.

Both money demand and the money supply will automatically adjust to always “hit” the nominal anchor – whether the exchange rate or inflation expectations.

One thing that is interesting in my view is that both in a fixed exchange rate regime and in Bob’s proposal the actual implementation of the policy will likely happen through adjustments in money demand - or said in another way the market will implement the policy. Or that will at least be the case if the regime is credible.

Lets first look at a credible fixed exchange regime and lets say that for some reason the exchange rate is pushed away from the central bank’s exchange rate target so the actual exchange rate is stronger than the targeted rate. If the target is credible market participants will know that the central bank will act – intervene in the currency market to sell the currency – so to ensure that in the “next period” the exchange rate will be back at the targeted rate.

As market participants realize this they will reduce their currency holdings and that in itself will push back the exchange rate to the targeted level. Hence, under 100% credibility of the fixed exchange rate regime the central bank will actually not need to do any intervention to ensure that the peg is kept in place – there will be no need to change the currency reserve/money base. The market will effectively ensure that the pegged is maintained.

The mechanism is very much the same in a regime where the central bank targets the market’s inflation expectations. Lets again assume that the regime is fully credible. Lets say that the central bank targets 2% inflation (expectations) and lets assume that for some reason a shock has pushes inflation expectations above the 2%.

This should cause the central bank to automatically reduce the money base until inflation expectations have been pushed back to 2%. However, as market participants realize this they will also realize that the value of money (the inverse of the price level) will increase – as the central bank is expected to reduce the money base. This will cause market participants to increase money demand. For a given money base this will in itself push down inflation until the 2% inflation expectations target is meet.

Hence, under full credibility the central bank would not have to do a lot to implement its target – either a fixed exchange rate target or a Hetzel style target – the markets would basically take care of everything and the implementation of the target would happen through shifts in money demand rather than in the money base. That said, it should of course be noted that it is exactly because the central bank has full control of the money base and can always increase or decrease it as much as it wants that the money demand  taking care of the actual “lifting” so the central bank don’t actually have to do much in terms of changing the money base.

This basically means that the money base will remain quite stable while the broad money supply/demand will fluctuate – maybe a lot – as will money-velocity. Hence, under a credible Hetzel style regime there will be a lot of nominal stability, but it will look quite non-monetarist if one think of monetarism of an idea to keep money supply growth stable. Obviously there is nothing non-monetarist about ensuring a stable nominal anchor. The anchor is just different from what Friedman – originally – suggested.

Had the Fed listened to Bob then there would have been no Great Recession

Effectively during the Great Moderation – or at least since the introduction of TIPS in 1997 – the world increasingly started to look as if the Federal Reserve actually had introduced Bob’s proposal and targeted break-even inflation expectations (around 2.5%). The graph below illustrates this.

BE inflation

The graph shows that from 2004 to 2008 we see that the 5-year “break-even” inflation rate fluctuated between 2 and 3%. We could also note that we during that period also saw a remarkable stable growth in nominal GDP growth. In that sense we can say that monetary policy was credible as it ensured nominal stability – defined as stable inflation expectations.

However, in 2008 “something” happened and break-even inflation expectations collapsed. Said, in another way – the Fed’s credibility broke down. The markets no longer believed that the Fed would be able to keep inflation at 2.5% going forward. Afterwards, however, one should also acknowledge that some credibility has returned as break-even inflation particularly since 2011 has been very stable around 2%. This by the way is contrary to the ECB – as euro zone break-even inflation on most time horizons is well-below the ECB’s official 2% inflation target.

While most observers have been arguing that the “something”, which happened was the financial crisis and more specifically the collapse of Lehman Brothers Market Monetarists – and Bob Hetzel – have argued that what really happened was a significant monetary contraction and this is very clearly illustrated by the collapse in inflation expectations in 2008.

Now imagine what would have happened if the Fed had implemented what I above called the strict version of Bob’s proposal prior to the collapse of Lehman Brother. And now lets say that Lehman Brothers collapses (out of the blue). Such a shock likely would cause a significant decline in the money-multiplier and a sharp decline in the broad money supply and likely also a sharp rise in money demand as investors run away from risky assets.

This shock on its own is strongly deflationary – and if the shock is big enough this potentially could give a shock to the Fed’s credibility and therefore we initially could see inflation expectations drop sharply as we actually saw in 2008.

However, had Bob’s regime been in place then the Fed would automatically have moved into action (not in a discretionary fashion, but following the rule). There would not have been any discussion within the FOMC whether to ease monetary policy or not. In fact there would not be a need for a FOMC at all – monetary policy would be 100% automatic.

Hence, as the shock hits and inflation expectations drop the Fed would automatically – given the rule to target for example 2.5% break-even inflation expectations – increase the money base as much as necessary to keep inflation expectations at 2.5%.

This would effectively have meant that the monetary consequences of Lehman Brothers’ collapse would have been very limited and the macroeconomic contraction therefore would have been much, much smaller and we would very likely not have had a Great Recession. In a later blog post I will return to Bob’s explanation for the Great Recession, but as this discussion illustrates it should be very clear that Bob – as I do – strongly believe that the core problem was monetary disorder rather than market failure.

Hetzel and NGDP targeting

There is no doubt in my mind that the conduct of monetary policy would be much better if it was implemented within a market-based set-up as suggested by Robert Hetzel than when monetary policy is left to discretionary decisions.

That said as other Market Monetarists and I have argued that central banks in general should target the nominal GDP level rather than expected inflation as originally suggested by Bob. This means that we – the Market Monetarists – believe that governments should issue NGDP-linked bonds and that central banks should use NGDP expectations calculated from the pricing of these bonds.

Of course that means that the target is slightly different than what Bob originally suggested, but the method is exactly the same and the overall outcome will likely be very similar whether one or the other target is chosen if implemented in the strict version, where the central bank effectively would be replaced by a “computer” (the market).

In the coming days and weeks I will continue my celebration of Robert Hetzel. In my next Hetzel-post I will look at “Bob’s model” and I will try to explain how Bob makes us understand the modern world within a quantity theoretical framework.

PS I should say that Bob is not the only economist to have suggested using markets and market expectations to implement monetary policy and to ensure nominal stability. I would particularly highlight the proposals of Irving Fisher (the Compensated Dollar Plan), Earl Thompson (nominal wage targeting “The Perfect Monetary System”) and of course Scott Sumner (NGDP targeting).

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Suggested further reading:

I have in numerous early posts written about Bob’s suggestion for targeting market inflation expectations. See for example here:

A few words that would help Kuroda hit his target
How to avoid a repeat of 1937 – lessons for both the fed and the BoJ
The cheapest and most effective firewall in the world

Scott Sumner will be in London next week

This is from the Adam Smith Institute:

Adam Smith Lecture with Scott Sumner

Speaker: Scott Sumner

Date: Tuesday 17 June 2014

Time: 07:00pm – 07:00pm

RSVP: events@adamsmith.org

Location: 10-11 Carlton House Terrace

Map: find us!

Scott Sumner is an American economist who shot to fame between 2009 and 2013 as a result of his blog, themoneyillusion.com, and was in 2012 named the world’s 15th top thinker by Foreign Policy—the same rank as then-Federal Reserve Governor Ben Bernanke.

Prof. Sumner is the father of market monetarism, a macroeconomic school of thought centred on markets and money. Though it takes its foundations from academic work, including that of Robert Lucas, Eugene Fama and of course Milton Friedman, it arose largely on the blogosphere. The Atlantic named Sumner “the blogger who saved the US economy” after his ideas were seen as part of the intellectual support that convinced the Fed to implement QE3. And his view that central banks should target total spending—nominal GDP—rather than consumer price inflation has provoked comment from, among others, Mark Carney.

Prof Sumner teaches at Bentley University, a small, well-regarded private college in Massachusetts. His academic papers—which tackle subjects ranging from whether the US should privatise its mint to the causes of business cycles and recessions—have been featured in prestigious journals including the Journal of Money, Credit & Banking and the Journal of Political Economy.

Please let me (ben@adamsmith.org) know if you’re a journalist and you’d like to arrange an interview with Prof. Sumner.

 

Committed to a failing strategy: low for longer = deflation for longer?

Recently there has been a debate about whether low interest rates counterintuitively actually leads deflationNarayana Kocherlakota, President of the Minneapolis Fed, made such an argument a couple of years ago (but seems to have changed his mind now) and it seems like BIS’ Claudio Borio has been making an similar argument recently. Maybe surprisingly to some (market) monetarists will make a similar argument. We will just turn the argument upside down a bit. Let me explain. 

Most people would of course say that low interest rates equals easy monetary policy and that that leads to higher inflation – and not deflation. However, this traditional keynesian (not New Keynesian) view is wrong because it confuses “the” interest rate for the central bank’s policy instrument, while the interest rate actually in the current setting for most inflation targeting central banks is an intermediate target.

The crucial difference between instruments, intermediate instruments and policy goals

To understand the problem at hand I think it is useful to remind my readers of the difference between monetary policy instruments, intermediate targets and policy goals.

The central bank really only has one instrument and that is the control of the amount of base money in the economy (now and in the future). The central bank has full control of this.

On the other hand interest rates or bond yields are not under the direct control of the central bank. Rather they are intermediate targets. So when a central bank says it is it is cutting or hiking interest rates it is not really doing that. It is intervening in the money market (or for that matter in the bond market) to change market pricing. But it is doing so by controlling the money base. This is why interest rates is an intermediate target. The idea is that by changing the money base the central bank can push interest rates up or down and there by influencing the aggregate demand to increase or decrease inflation is that is what the central bank ultimately wants to “hit”.

Similarly Milton Friedman’s suggestion for central banks to target money supply growth is an intermediate target. The central bank does not directly control M2 or M3, but only the money base.

So while interest rates (or bond yields) and the money supply are not money policy instruments they are intermediate targets. Something central banks “targets” to hit an the ultimate target of monetary policy. What we could call this the policy goal. This could be for example inflation or nominal GDP.

When you say interest rates will be low – you tell the markets you plan to fail

Why is this discussion important? Well, it is important because because when central banks are confused about these concepts they also fail to send the right signals about the monetary policy stance.

Milton Friedman of course famously told us that when interest rates are low it is normally because monetary policy has been tight. This of course is nothing else than what Irving Fisher long ago taught us – that there is a crucial difference between real and nominal interest rates. When inflation expectations increase nominal interest rates will increase – leaving real interest rates unchanged.

The graph below pretty well illustrates this relationship.

PCE core yield Fed funds

The correlation is pretty obvious – there is a positive (rather than a negative) correlation between on the one hand interest rates/bond yields and on the other hand inflation (PCE core). This of course says absolutely nothing about causality, but it seems to pretty clearly show that Friedman and Fisher were right – interest rates/yields are high (low) when inflation is high (low).

This is of course does not mean that we can increase inflation by hiking interest rates. This is exactly because the central bank does not directly control interest rates and yields. Arguably the central bank can of course (in some circumstances) in the short decrease rates and yields through a liquidity effect. For example by buying bonds the central banks can in the short-term push up the price of bonds and hence push down yields. However, if the policy is continued in a committed fashion it should lead to higher inflation expectations – this will push up rates and yields.  This is exactly what the graph above shows. Central bankers might suffer from money illusion, but you can’t fool everybody all of the time and investors, consumers and labourers will demand compensation for any increase in inflation.

This also illustrates that it might very well be counterproductive for central bankers to communicate about monetary in terms of interest rates or yields. Because when central bankers in recent years have said that they want to keep rates ‘low for longer’ or will do quantitative easing to push down bond yields they are effectively saying that they will ensure lower inflation or even deflation. Yes, that is correct central bankers have effectively been saying that they want to fail.

Said, in another if the central bank communicates as if the interest rate is it’s policy goal then when it says that it will ensure low interest rates then market expectation will adjust to reflect that. Therefore, market participants should expect low inflation or deflation. This will lead to an increase in money demand (lower velocity) and this will obviously on its own be deflationary. This is why “low for longer” if formulated as a policy goal could actually lead to deflation.

Obviously this is not really what central bankers want. But they are sending confusing signals then they talk about keeping rates and yields low and at the same time want to “stimulate” aggregate demand. As consequence “low for longer”-communication is actually undermining the commitment to spurring aggregate demand and “fighting” deflation.

Forget about rates and yields – communicates in terms of the ultimate target/goal 

Therefore, central bankers should stop communicating about monetary policy in terms of interest rates or bond yields. Instead central bankers should only communicate in terms of what they ultimately want to achieve – whether that is an inflation target or a NGDP target. In fact the word “target” might be a misnomer. Maybe it is actually better to talk about the goal of monetary policy.

Lets take an example. The Federal Reserve wants to hit a given NGDP level goal. It therefore should announces the following:

“To ensure our goal of achieve 5% nominal GDP growth (level targeting) we will in the future adjust the money base in such a fashion to alway aiming at hitting our policy goal. There will be no limits to increases or decreases in the money base. We will also do whatever is necessary to hit this goal.”

And lets say Fed boss Janet Yellen is asked by a journalist about the interest rates and bond yields. Yellen should reply the following:

“Interest rate and bond yields are market prices in the same way as the exchange rate or property prices. The Fed is not targeting either and it is not our policy instrument. Our policy goal is the level of nominal GDP and we use changes in the money base – this is our policy instrument – to ensure this policy goal. We expect interest rates and yield to adjust in such a fashion to reflect our monetary policy. My only advice to investors is to expect us to alway hit our policy goal.”

Said in another way interest rates and yields are endogenous. They reflect market expectations for inflation and growth. So when the Fed and other central banks in giving “forward guidance” in terms of interest rates they are seriously missing the point about forward guidance. The only forward guidance needed is what policy goal the central bank has and an “all-in” commitment to hit that policy goal by adjusting the money base.

Finally, notice that I am NOT arguing that the Fed or any other central bank should hike interest rates to fight deflation – that would be complete nonsense. I am arguing to totally stop communicating about rates and yields as it totally mess up central bank communication.

PS Scott Sumner and Tim Duy have similar discussions in recent blog posts.

PPS Mike Belongia has been helpful in shaping my view on these matters.

It is time to get government out of US housing finance

Scott Sumner has a great post on the very scary state of US housing finance. This is something that many Europeans might not realise, but when it comes to housing finance the US is likely one of the most socialist countries among the developed economies of the world.

This is from the Wall Street Journal article Scott quotes in his post:

Fannie and Freddie, which remain under U.S. conservatorship, and federal agencies continue to backstop the vast majority of new mortgages being issued.

Yes, that is true – the two largest mortgage lenders in the US is effectively government owned. So to the extent that you think that there was a bubble in US property market prior to 2008 – I am not sure that there was – then you should probably forget the talk about overly easy monetary policy and instead focus on the massive US government involvement in housing finance.

Post-2008 the regulatory move has been to tighten lending standards for mortgage lenders, but now we have this (also from the WSJ article):

The Obama administration and federal regulators are reversing course on some of the biggest post crisis efforts to tighten mortgage-lending standards amid concern they could snuff out the fledgling housing rebound and dent the economic recovery.

On Tuesday, Mel Watt, the newly installed overseer of Fannie Mae and Freddie Mac said the mortgage giants should direct their focus toward making more credit available to homeowners, a U-turn from previous directives to pull back from the mortgage market.

In coming weeks, six agencies, including Mr. Watt’s, are expected to finalize new rules for mortgages that are packaged into securities by private investors. Those rules largely abandon earlier proposals requiring larger down payments on mortgages in certain types of mortgage-backed securities.

My god…it seems like the Obama administration wants a new government subsidized subprime market. Good luck with that!

The regulatory wave that have rolled over the US banking and finance industry in the past five years has not made moral hazard problems smaller, but rather the opposite and the continued massive government involvement in housing finance is seriously adding to these problems.

It is very clear that the US housing finance system over the past couple of decades has become insanely politicized. An example is Mr. Watt – the newly appointed overseer of Fannie and Freddie. Mr. Watt do not have a background in finance or in economics. Rather he is a career politician. Is a career politician really what you want if you want to avoid moral hazard? I think not.

Blame Bill Clinton  

In his great book The Great Recession – Market Failure or Policy Failure? Robert Hetzel spells out how  the present housing finance debacle in the US started back in the 1990s during the Clinton administration – with strong bi-partisan support I should say. (See particular 10 in Bob’s book).

Hence, the Clinton administration set ambitious goals to raise homeownership in the US in a document called “The National Homeownership Strategy: Partners in the American Dream”.

The document starts with a message from president Clinton:

“…This past year, I directed HUD Secretary Henry G. Cisneros to work with leaders in the housing industry, with nonprofit organizations, and with leaders at every level of government to develop a plan to boost homeownership in America to an all-time high by the end of this century. The National Homeownership Strategy: Partners in the American Dream outlines a substantive, detailed plan to reach this goal. This report identifies specific actions that the federal government, its partners in state and local government, the private, nonprofit community, and private industry will take to lower barriers that prevent American families from becoming homeowners. Working together, we can add as many as eight million new families to America’s homeownership rolls by the year 2000.”

Did Clinton “succeed”? You bet he did. Just take a look at this graph of the US home ownership rate (I stole it from Bob’s book):

Homeownership rate US

It is hard to avoid the conclusion that there is a clear connection between the US government’s stated goal of boosting homeownership and the actual sharp increasing in homeownership from around 1995.

Therefore, I also find it likely that the sharp increase in housing demand from the mid-1990s was a result of US government policies to subsidize housing finance rather than a result of overly easy monetary policy. There certainly also were other reasons such as demography, but direct and indirect subsidizes likely were the main culprit.

Forgetting monetary policy and increasing moral hazard

In the light of this I completely share Scott’s reaction to the latest policy actions from the Obama administration. It is particularly horrifying that the Obama administration consistently has undermined the efforts to ease US monetary policy during this crisis – among other things by appointing über hawkish Fed officials – while at the same time now is trying to “boost growth” by further increasing moral hazard problems in the US financial system. And just imagine what would have happened if Larry Summers had been appointed new Fed chairman…

That I believe once again shows how policy makers again and again prefer credit policies and quasi-fiscal policies to monetary policy. The result is that we are not really seeing any lift in nominal demand growth, but moral hazard problems continue to increase. That is the case in the US as well as in Europe. Or as Scott so clearly explains it:

So let’s see, we have to taper QE because otherwise the economy will “overheat.” After all, unemployment has fallen to 6.3% and many of the remaining unemployed are supposedly unemployable.  And yet we need to go back to the subprime mortgage economy to juice the economy.  Is that the view of the Fed? Forget about “getting in all the cracks,” can we stop opening up new cracks as wide as the Grand Canyon?”

Get government out of housing finance and implement a rule based monetary policy

The US government involvement in housing finance has been an utter failure. It has strongly increased Too Big To Fail problems and moral hazard in the US financial system and the latest initiatives are likely to further increase the risk of a new housing crisis.

There in my view is only one solution and that is to get the US government completely out of housing finance and to significantly scale back the US government’s (and the Federal Reserve’s) involvement in the credit markets. There are no economic valid arguments for why the US tax payers should subsidize housing finance.

Obviously one can argue that such badly needed reforms in the near-term could tighten financial and credit conditions, which effectively could cause a tightening of monetary conditions (through a drop in the money-multiplier). However, this is no argument against such reforms. Rather it is yet another argument why the Fed should implement a strictly rule based monetary policy – preferably a NGDP target.

If indeed housing finance reforms where to tighten credit conditions and cause the money-multiplier to drop then this can always be counteracted by an increase in the US money base. This of course would happen quasi-automatically under a strict NGDP target.

In that sense there is also a good argument for the Fed and the US government to coordinate such reforms. The US government should reduce its role in the credit markets to a minimum, while the Fed should commit itself to maintaining nominal stability and if needed postponing tapering or even expand quantitative easing as housing finance reform is implemented.

PS I hope this post clearly illustrate that Market Monetarists like Scott and myself are horrified by government involvement in such things as housing finance and that we are deeply concerned about moral hazard problems. We have in the past five years advocated monetary easing to ensure nominal stability, but we have NEVER advocated credit policies of any kind. As a higher level of nominal stability is returning particularly in the US we are likely to increasingly focus on moral hazard problem and yes in 1-2 years time we might start to sound quite hawkish in terms of the Fed’s monetary policy stance, but our views will not have changed. We continue to advocate that governments should get out of the credit markets and housing finance and that central banks should follow clear and transparent monetary policy rules to ensure nominal stability.

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.

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