HAWKISH Market Monetarists

Over the past five years Market Monetarists have gotten a reputation for always being dovish in terms of monetary policy. The Market Monetarists have day-in and day-out been pushing for monetary easing in the US, the UK and the euro zone. So our reputation is correct in the sense that we – the Market Monetarists – in general have favoured a more dovish monetary stance both in the US and in Europe than has been implemented by central banks.

However, one might notice that the Market Monetarist bloggers have been surprisingly calm in recent months despite the sharp decline in inflation we have see in particularly Europe. Overall, we have obviously maintained that monetary policy in the euro zone is far too tight and that we are heading for deflation as a result of this. But the primary cause of the sharp decline in headline inflation in the euro zone has been lower commodity prices and to some extent also a result of an “austerity pause” (no indirect tax hikes).

Hence, Market Monetarists do not think a decline in inflation due a positive supply shock in itself should trigger interest rate cuts (or other forms of monetary policy easing). Remember Market Monetarists favour nominal GDP targeting and a supply shock will not impact nominal GDP – only composition of nominal GDP growth between inflation and real GDP growth.

As a result Market Monetarists actually tend to be somewhat less alarmed by the recent inflation decline in the euro zone than for example the ECB and in that sense you can argue that the Market Monetarists actually are more “hawkish” than the ECB presently is when it comes to the need for monetary easing in response to the recent decline in euro zone inflation. When Market Monetarists are calling for monetary easing in the euro zone it is hence for a somewhat different reason than the ECB.

Monetary policy remains overly tight in the euro zone and we are likely heading for deflation – even disregarding the recent supply side driven drop in inflation – and that is why we – the Market Monetarists are advocating monetary easing in the euro zone. Just a look at the dismail growth of nominal GDP in the euro zone – there is no better indication than that of the ECB’s failure to ease monetary policy appropriately. So we shouldn’t be too sad if the ECB moves to ease monetary policy – even if Market Monetarists think it is for the wrong reasons.

In 3-5 years the Market Monetarists will be among the biggest hawks

If we are lucky we continue to see supply side conditions improve both in the US and the euro zone in the coming years. I am personally particular optimistic about the outlook for the US economy, where I do expect a number of factors to give a welcomed lift to US potential growth. The end of the so-called commodity super cycle and fracking might hopefully to reduce oil prices. This is a positive supply shock to the US economy.

Furthermore, as I am optimistic that the US is in the process of ending two wars – the War on Drugs and the War on Terror. I will return to that issue in a later blog post, but I overall think that this is the direction we are moving in and that will be tremendously positive for the US labour supply (and public finances for that matter).

Finally, as the US economy continues to improve the present anti-immigration sentiment in the US will hopefully be reversed – after all Americans are more happy to welcome Mexicans to join the labour force when the economy is doing good rather than bad.

Add to that that US unemployment is still high so there is really no labour market constrains to growth at the moment in the US. So overall, I think we with a bit of luck could be in for a couple of years of fairly high real GDP growth driven by positive supply side factors. In such a scenario we could easily have 4% or even 5% real GDP growth for some years without any substantial pick-up in inflation. This would be very similar to mid-1990s.

Such a scenario would likely in 3-5 years time turn the Market Monetarist bloggers into proponents of Fed tightening – before most other economists would favour it. This would particularly be the case if the Fed overdo it on monetary easing in a scenario where positive supply side factors keep inflation low and hence we see a sharp pick-up in nominal GDP growth. This would of course be what Austrians call relative inflation.

So no, Market Monetarists are not always dovish. We advocate clear monetary policy rules and these rules sometimes leads us to advocate a dovish stance on monetary (as presently), but also to a hawkish stance if needed. For now I have no big fears that US monetary policy is becoming too easy, but if I am right about my “supply side optimism” then a Fed too focused on headline inflation might overdo it on the easy side down the road.

There is of course only one way to avoid such a monetary policy mistake – spell out a clear NGDP level targeting rule today.

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PS The ECB today did NOTHING to avoid deflation in the euro zone. No comments on that other than the ECB missed yet another opportunity to do the right thing.

PPS My best guess is that Scott Sumner will be a ultra hawk on US monetary policy in 2018-9.

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Lower (supply) inflation is NOT a reason to ease US monetary policy

Here are two news stories from today:

U.S. import prices fell in April due to a drop in oil costs, a positive sign for household finances that also pointed to benign inflation pressures.

Import prices slipped 0.5 percent last month, the biggest decline since December, the Labor Department said on Tuesday. March’s data was revised to show a 0.2 percent decline instead of the previously reported 0.5 percent drop.”

And the second one:

“U.S. producer prices recorded their largest drop in three years in April while a reading of manufacturing in New York indicated contraction.

Producer prices slid as gasoline and food costs tumbled, pointing to weak inflation pressures that should give the Federal Reserve latitude to keep monetary policy very accommodative.”

Now some might of course think that this would make Market Monetarists scream for the Federal Reserve to step up monetary easing. However, that would be extremely wrong. There are certainly good reasons for the fed to ease monetary policy, but a drop in inflation caused by a positive supply shock – lower import prices – is certainly not one of them.

At the core of Market Monetarist thinking is that central banks should not react to supply shock – positive or negative. Hence, we are arguing that central banks should target the level of nominal GDP – not inflation.

Therefore, imagine that the fed indeed was targeting the the NGDP level and NGDP was “on track” and a positive supply shock hit. Then the fed would maintain monetary conditions completely unchanged – keeping NGDP on track – and allowed the positive supply shock to feed through to lower inflation (and higher real GDP). This is benign inflation and as such very welcomed as it do not reflect a deflationary and recessionary demand shock. Furthermore, some Market Monetarists like David Beckworth and myself also believe that monetary easing in response to positive supply shocks risks leading to economic misallocation and what Austrian economists call relative inflation.

Lower (supply) inflation is no reason for more QE
…but the fed needs to focus on defining its target

One can certainly argue that NGDP growth is too weak to catch up with the pre-crisis NGDP trend, but on the other hand it is also pretty clear that US NGDP growth is fairly robust. So instead of stepping up quantitative easing in response to lower import prices the fed instead should focus on becoming much more clear on what it wants to achieve. Hence, there is still considerable uncertainty about what the fed really wants to achieve.

Therefore, the fed should become more clear on its target. Preferably of course the fed should adopt an NGDP level target and decide whether the present growth rate of the money base is strong enough to achieve that or not. Regarding that I don’t think that the present policy with a not clearly defined target and the present growth rate of the money base is enough to return NGDP to the pre-crisis trend, but it is nonetheless likely to keep NGDP growing 4-5% and that is likely enough to maintain the present speed of recovery in real GDP and the US labour market. I think that is far too unambitious, but it is certainly better than what we are seeing in Europe.

The paradox – the positive supply shock is “pushing” central banks to do the right thing for the wrong reasons

The paradox, however, is that the recent drop in global commodity prices have pushed down headline inflation around the world and central banks have over the last couple of weeks been responding by cutting interest rates. Hence, Central banks in the eurozone, India, Australia, South Korea, Poland and Israel have all cut rates in recent weeks. While there certainly is very good reasons for monetary easing in nearly all of these countries it a paradox that these central banks now seem to have been “shocked” into easing monetary policy in response to a positive supply shock rather than in response to weak demand growth.

It would clearly be wrong to criticize these central banks for doing the right thing – easing monetary policy – but I also believe that it is important to stress that had monetary policy in these countries been “right” then these central banks would likely have been making a policy mistakes by easing monetary policy at the moment.

In that regard it is of course also important that central banks’ (apparent mental) inability to differentiate between supply and demand shocks often has lead central banks to tight monetary policy in response to negative supply. The ECB’s catastrophic rate hikes in 2011 is a very good example of this. Paradoxically we might be happy at the moment that the ECB’s tendency to react to supply shocks might push the ECB into stepping up monetary easing.

Finally I should stress that the recent decline in inflation globally is certainly not only caused by a positive supply. In fact I have long argued that we are likely heading for deflation in the euro zone due to excessively tight monetary policy. So my discussion above should mostly be seen as an attempt to stress the need for understanding the difference between demand and supply for the conduct of monetary policy. Unfortunately many central bankers seem unable to understand these important difference.

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Update: Market Monetarists think alike – I just realized that Marcus Nunes did a post yesterday that made the exact same argument as me.

Can NGDP level targeting cure the flu?

Not even Scott Sumner would answer “yes” to this question, but while NGDP level targeting will not cure the flu at least it will not kill you. Inflation targeting on the other hand will kill you if you get the flu. Confused? Then let me explain…

Over the past week the entire Christensen family has been down with a nasty flu. It has not been great, but it for some reason reminded me about economics. After consulting Google Trends (and seeing Fabebook updates from US Facebook friends) I realized that there is a pretty big flu epidemic on the entire Northern Hemisphere. Just take a look at Google flu trends. In the US the U.S. Centers for Disease Control and Prevention on Friday said that flu had reached epidemic proportions.

I am certainly no flu expert, but judging what I have just been through and from talking to friends and colleagues this is a pretty nasty flu causing people to feel sick for as much as 5-10 days. Obviously we have flu season every year, but this one seems to be especially nasty so you don’t have to be an economic (or medical) genius to realize that that could negatively impact economic activity across the entire Northern Hemisphere.

In fact the flu epidemic is a negative supply side to the affected countries and given the fact that most major countries on the Northern Hemisphere have been affected one could make the argument without being an alarmist that this is a sizable negative shock. Or at least for the sake of the argument lets say it is. This is how the “flu shock” looks like to the Northern Hemisphere economy:

Flu ASADThe “flu shock” pushes the AS curve to the left. This lead to a drop in production (real GDP) to Y’ from Y and at the same time pushes up prices from P to P’.

This is the cost of flu shock – lower production and higher prices.

This pretty well illustrates the primary difference between inflation targeting (or price level targeting) and NGDP level targeting.

In the case of NGDP level targeting the central bank will keep the NGDP level constant (or at a constant growth path) – hence try to keep P*Y constant.

As I have drawn the graph the size of P*Y more or less is the same size as P’*Y’ in this scenario so the central bank will just keep AD unchanged.

Said in another way since the central bank cannot cure the flu (supply shocks) it will not try. But at least that will (hopefully) not kill you.

Inflation targeting will kill the patient 

As the graph above shows a flu shock will push up the price level (and hence inflation). An inflation targeting central bank in response will tighten monetary policy (we completely unrealistically assume it is a ECB type inflation targeting central bank that take all supply shocks to be permanent). The graph below shows that:

Flu ASAD IT

This is the doctor treating the flu (a negative supply) with pneumonia (a negative demand shock).

So if the flu will not kill the patient there is a good chance the pneumonia will.

So if  Northern Hemisphere economic data starts to deteriorate in the coming weeks and inflation indicators start to inch up at the same time – then please ignore the “German doctor” if he prescribes pneumonia to cure your flu. Not ignoring him might kill you.

Sandy is BAD NEWS. The two graph version.

Let me just quote Steve Horwitz’s latest Facebook update:

“It’s a good thing I shaved my head this morning or else I’d be tearing out my peach fuzz with my fingernails thanks to the plethora of broken windows fallacies being bandied about in the media today. If you think Sandy is “good for the economy,” you are hereby remanded to my Econ 100 class (and ordered to read endless Bastiat) and I expect to see you cheering the next disaster that kills people because it boosts the demand for funeral homes and cemeteries.

Disasters, whether natural or social, DESTROY WEALTH AND MAKE US WORSE OFF. Period. End of sentence. There is NO “silver lining.” The economy would be BETTER OFF HAD SANDY NEVER HAPPENED. Got it?”
I got more hair than Steve, but he is spot on. It is unbearable to hear the stories about Sandy being good news for the US economy. Sandy is horrible news – for the the victims and for the US economy. Any other view is bordering idiotic.
Here is the two graph version of Sandy. Sandy is a negative supply shock and not a positive demand shock (that is what the journalists – and some keynesians – apparently fail to understand…). Sandy destroys production resources and disrupts production. That shifts the AS curve to the left (from AS to AS’) and reduces productions (from Y to Y’) and increases prices (from P to P’). That’s not good news. That is BAD NEWS.
But it could be worse! Imagine you have a inflation/price level targeting central bank that targets prices at P. Then it would tighten monetary policy and shift the AD curve to the left (to AD”) – maintaining prices at P and reducing production to Y”. This is what would have happened if Sandy had hit Europe. Yes, the ECB would have tightened monetary policy in reaction to Sandy – just remember what the ECB did in 2011 after the Japanese tsunami.
Update: I decided to add a picture to this post – this guy knew about the “Sandy fallacy”.
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