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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The monetary transmission mechanism in a ‘perfect world’

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

Futures based NGDP level targeting – the perfect world

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

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

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

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

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

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

Changes in money demand will do most of the job  

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

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

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

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

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

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

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

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

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

The Great Moderation was close to the ‘perfect world’

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

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

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

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

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

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

Fiscal consolidation in the ‘perfect world’

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

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

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

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

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

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

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

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

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

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

The Kuroda recovery will be about domestic demand and not about exports

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

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

The weaker yen is an indicator of monetary easing – but not the main driver of growth

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

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expect the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate. So it is no wonder that equity analysts feel more optimistic about Japanese companies’ earnings.

Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

The focus on competitiveness is completely misplaced

I have in numerous earlier posts argued that when a country is going through a “devaluation” as a consequence of monetary easing the important thing is not competitiveness, but the impact on domestic demand.

I have for example earlier demonstrated that Swedish growth outpaced Danish growth in 2009-10 not because the Swedish krona depreciated strongly against the Danish krone (which is pegged to the euro), but because the Swedish Riksbank was able to ease monetary policy, while the Danish central bank effectively tightened monetary conditions due to the Danish fixed exchange rate policy. As a consequence domestic demand did much better in Sweden in 2009-10 than in Denmark, while – surprise, surprise – Swedish and Danish exports more or less grew at the same pace in 2009-10 (See graphs below).

Similarly I have earlier shown that when Argentina gave up its currency board regime in 2002 the major boost to growth did not primarly come from exports, but rather from domestic demand. Let me repeat a quote from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

And if we want to go further back in history we can look at what happened in the US after FDR gave up the gold standard in 1933. Here the story was the same – it was domestic demand and not net exports which was the driver of the sharp recovery in growth during 1933.

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

Finally if anybody still worry about “currency war” they might want to rethink how they see the impact of monetary easing. When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

HT Jonathan Cast

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PS Scott Sumner also comments on Japan.

PPS An important non-competitiveness impact of the weaker yen is that it is telling consumers and investors that inflation is likely to increase. Again the important thing is the signal about monetary policy, which is rather more important than the impact on competitiveness.

The Fed’s easing is working…in Mexico

Is the “Bernanke-Evans rule” working? Hell yes! At least in Mexico!

The Mexican economy recovered fast from the shock in 2008-9 and real GDP has been growing around 5% in the last three years and now growth is getting a further boost from the Fed’s monetary easing. Just take a look at the graphs below – especially keep an eye on what have happened since September 13 when the so-called Bernanke-Evans rule effectively was announced.

The Bernanke-Evans rule boosts the Mexican stock market

MXN stock market

Mexican consumers get a boost from Bernanke

conconfMEX

Mexican industrialists are falling in love with Bernanke

PMI mexico

The US-Mex monetary transmission mechanism

A traditional Keynesian interpretation of what is going on would be that Bernanke’s monetary easing is boosting US industrial production, which is leading to an increase in Mexican exports to the US. The story is obviously right, but I would suggest that it is not the most important story. Rather what is important is the monetary transmission mechanism from the US to Mexico.

Here is that story. When the Fed steps up monetary easing it leads to a weakening of the dollar against all other currencies – including the Mexican peso as funds flow out of the US and into the Mexican markets. The Mexican central bank Banxico now has two options. Either the central bank de facto allows the peso to strengthen or it decides to “import” the Fed’s monetary easing by directly intervening in the currency market – buying dollars and selling pesos – or by cutting interest rates. No matter how this is done the result will be an increase in the Mexican money supply (relative to what otherwise would have happened). This in my view is what is driving the rally in the Mexican stock market and the spike in consumer and business confidence. It’s all monetary my friend.

Obviously Banxico don’t have to import the monetary easing from the US, but so far have chosen to do so. This has probably been well-advised, but the Mexican economy is certainly not in need of a US scale monetary easing. What is right for the US is not necessarily right for Mexico when it comes to monetary easing. Therefore, Banxico sooner or later have stop “importing” monetary easing from the US.

Luckily the Banxico can choose to “decouple” from the US monetary easing by allowing the peso to strengthen and thereby curb the increase in the money supply and reduce potential inflationary pressures. This in fact seems to be what has been happening in recent weeks where the peso has rallied against the dollar.

This is not the place to discuss what Banxico will do, but think the discussion of the US-Mex monetary transmission mechanism pretty well describe what many Emerging Markets central banks are now facing – monetary easing from the US is forcing them to choose between a stronger currency or a monetary expansion. However, unlike what Brazilian Finance Minister Mantega seems to think this is not such a terrible thing. Banxico and the Brazilian central bank and other EM central banks remain fully in charge of monetary policy themselves and if the central banks are clear about their monetary targets then the markets will do most of the lifting through the exchange rate channel.

Imagine for example that the Mexican peso starts to strengthen dramatically. Then that likely will push down Mexican inflation below Banxico’s inflation target pretty fast. With inflation dropping below the inflation target the markets will start to price a counter-reaction and a stepping up of monetary easing from Banxico and that in itself will curb the strengthening of the peso. Hence, the credibility of the central bank’s target is key.

And it is here that the Brazilians are facing a problem. As long as the central bank has one target things are fine. However, the Brazilian authorities often try to do more than one thing with monetary policy. Imagine the Brazilian economy is growing nicely and inflation is around the central bank’s inflation target. Then a positive monetary shock from the US will lead the Brazilian real to strengthen. That is no problem in terms of the inflation target. However, it will likely also lead the Brazilian export sector facing a competitiveness problem. Trying to “fix” this problem by easing monetary policy will on the other hand lead to excessively easy monetary policy. The Brazilian authorities have often tried to solve this “problem” by trying to curb currency inflows with different forms of currency restrictions and taxes. That has hardly been a success and luckily the Mexican authorities are much less interventionist in their attitudes.

The lesson here is that the Federal Reserve is a monetary superpower and the Fed can export monetary easing to other countries, but that do not mean that the Fed is in charge of monetary policy in Brazil or Mexico. The Brazilian and Mexican central banks can also choose not to import the monetary easing by simply letting their currencies strengthen and instead focus on it’s own monetary policy targets instead of trying to solve other “problems” such as competitiveness concerns. Excessive focus on competitiveness will lead central banks to ease monetary policy too much and the result is often rising inflationary pressures and bubbles.

PS don’t think that is this a zero sum – just because the Fed’s easing is working in Mexico does not mean that it is not working in the US.

PPS Nick Rowe once told a similar story about Hong Kong…with another FX regime.

Causality, econometrics and beautiful Saint Pete

I am going to Russia next week. It will be good to be back in wonderful Saint Petersburg. In connection with my trip I have been working on some econometric models for Russia. It is not exactly work that I enjoy and I am deeply skeptical about how much we can learn from econometric studies. That said, econometrics can be useful when doing practical economics – such as trying to forecast Russian growth and inflation.

So I have been working on this model for the Russian economy. The main purpose of the model is to learn about what I would would call the petro-monetary transmission mechanism in the Russian economy. It is my thesis that the primary channel for how oil prices are impacting the Russian economy is through the monetary transmission mechanism rather than through net exports.

Here is my theory in short: The Russian central bank (CBR) dislikes – or at least used to dislike – a freely floating exchange rate. Therefore the CBR will intervene to keep the ruble stable. These days the CBR manages the ruble within a band against a basket of the US dollar and the euro. Today the ruble is much more freely floating than it used to be, but nonetheless the ruble is still tightly managed and the ruble is certainly not a freely floating currency.

So why is that important for my econometric models for Russia? Well, it is important because it means quite a bit to the causality I assume in the model. Lets look at two examples. One where the ruble is completely pegged against another currency or a basket of currencies and another example where the ruble is freely floating and the central bank for example targets inflation or nominal GDP.

Pegged exchange rate: Causality runs from oil to money supply and NGDP 

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

Now lets look at the case where we assume a freely floating ruble.

Floating ruble: Oil prices and monetary policy will be disconnected

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

Do I have to forget about econometrics? Not necessarily

So what do that mean for my little econometric exercise on the Russian economy? Well, basically it means that I have to be extremely careful when I interpret the econometric output. The models I have been playing around with I have estimated from 2000 and until today. I have done what is called Structural VAR analysis (with a lot of help from a clever colleague who knows econometrics much better than me). Some of the results we get are surely interesting, however, we got one major problem and that is that during the 12 years we are looking Russian monetary policy has changed significantly.

In the early part of the estimation period the Russian central bank basically maintained a quasi-pegged exchange for the ruble against the dollar. Later, however, the CBR started to manage the ruble against a basket of dollars and euros and at the same time the CBR would “adjust” the ruble rate to hit changing nominal targets – for example an inflation target. The CBR have had multiple and sometimes inconsistent targets during the past decade. Furthermore, the CBR has moved gradually in the direction of a more freely floating ruble by allowing for a wider “fluctuation band” around the euro-dollar basket.

So basically we would expect that causality in the Russian economy in 2000 would be pretty much as described in the pegged exchange rate case, while it today should be closer to the floating exchange rate case. That of course means that we should not expect the causality in our model to be stable causal structure. Econometricians hate that – to me it is just a fact of life or as Ludwig von Mises used to say “there are no constants in economics” (I am paraphrasing von Mises from my memory). This of course is also know as the Lucas Critique. Some would of course argue that we could take this into account when we do our econometric work, but regime changes do not necessarily happen from day to day. Often regime change is gradual, which makes it impossible to really to take into account in econometric studies.

And this is one of my problems with econometrics – or rather with how econometric studies often are conducted. They do not take into account regime change and therefore do not take into account expectations. As a result well-known correlations tend to breakdown. The best example is of course the disappearance of the Phillips curve relationship in the 1970s and 1980s. Another example is the breakdown of the causal relationship between money supply growth and inflation in 1990s.

So what do I do? Should I give up on my little econometric venture? No, I don’t think so. Econometrics can clearly be useful in determining the magnitude and importance of different shocks in the economy and surely some of our econometric results on the Russian economy seems to be pretty robust. For example over the estimation period it seems like a 10% increase in the oil prices have increased the M2 and nominal GDP by around 2%. That is nice to know and is useful information when you want to do forecasting on the Russian economy. But it would be completely naive to expect this relationship to be constant over time. Rather the Russian central bank is clearly moving in the direction of a more and more freely floating ruble so we should expect the correlation between oil prices one the one hand and M2 and NGDP on the other hand to decrease going forward.

Concluding, econometrics can be useful in doing “practical” economics like macroeconomic forecasting, but one should never forget to do the homework on the institutional structures of the economy and one should never ever forget about the importance of expectations. Economic reasoning is much more important than any statistical results.

Related posts:
Next stop Moscow
International monetary disorder – how policy mistakes turned the crisis into a global crisis
Fear-of-floating, misallocation and the law of comparative advantages
PEP, NGDPLT and (how to avoid) Russian monetary policy failure
Should small open economies peg the currency to export prices?

Please keep “politics” out of the monetary reaction function

During the Great Moderation it was normal to say that the Federal Reserve and the ECB (and many other central banks for that matter) was following a relatively well-defined monetary policy reaction function. It is debatable what these central banks where actually targeting, but there where is no doubt that both the Fed and the ECB overall can be descripted to have conducted monetary policy to minimize some kind of loss function which included both unemployment and inflation.

In a world where the central bank follows a Taylor rule style monetary policy reaction function, targets the NGDP level, do inflation targeting or have pegged the exchange rate the markets will tend to ignore political news. The only important thing will be how the actual economic development is relative to the target and in a situation with a credible nominal target the Chuck Norris effect will ensure that the markets do most of the lifting to achieve the nominal target.  The only things that could change that would be if politicians decided to take away the central bank’s independence and/or change the central bank’s target.

When I 12 years ago joined the financial sector from a job in the public sector I was hugely surprised by how little attention my colleagues in the bank was paying to political developments. I, however, soon learned that both fiscal policy and monetary policy in most developed countries had become highly rule based and therefore there was really no reason to pay too much attention to the nitty-gritty of day-to-day politics. The only thing one should pay attention to was whether or not given monetary targets where on track or not. That was the good old days of the Great Moderation. Monetary policy was rule based and therefore highly predictable and as a result market volatility was very low.

This have all changed in the brave new world of Great Recession (failed) monetary policy and these days it seems like market participants are doing nothing else than trying to forecast what will be the political changes in country X, Y and Z. The reason for that is the sharp increase in the politician of monetary policy.

In the old days – prior to the Great Moderation – market participants were used to have politicians messing up monetary policies. Central banks were rarely independent and did not target clear nominal targets. However, today the situation is different. Gone are the days of rule based monetary policy, but the today it is not the politicians interfering in the conduct of monetary policy, but rather the central bankers interfering in the conduct of other policies.

This particularly is the case in the euro zone where the ECB now openly is “sharing” the central bank’s view on all kind of policy matters – such as fiscal policy, bank regulation, “structural reforms” and even matters of closer European political integration. Furthermore, the ECB has quite openly said that it will make monetary policy decisions conditional on the “right” policies being implemented. It is for example clear that the ECB have indicated that it will not ease monetary policy (enough) unless the Greek government and the Spanish government will “deliver” on certain fiscal targets. So if Spanish fiscal policy is not “tight enough” for the liking of the ECB the ECB will not force down NGDP in the euro zone and as a result increase the funding problems of countries such as Spain. The ECB is open about this. The ECB call it to use “market forces” to convince governments to implement fiscal tightening. It of course has nothing to do with market forces. It is rather about manipulating market expectations to achieve a certain political outcome.

Said in another way the ECB has basically announced that it does not only have an inflation target, but also that certain political outcomes is part of its reaction function. This obviously mean that forward looking financial markets increasingly will act on political news as political news will have an impact of future monetary policy decisions from the ECB.

Any Market Monetarist will tell you that the expectational channel is extremely important for the monetary transmission mechanism and this is particularly important when a central bank start to include political outcomes in it’s reaction function.

Imaging a central bank say that it will triple the money supply if candidate A wins the presidential elections (due to his very sound fiscal policy ideas), but will cut in halve the money supply if candidate B wins (because he is a irresponsible bastard). This will automatically ensure that the opinion polls will determine monetary policy. If the opinion polls shows that candidate A will win then that will effectively be monetary easing as the market will start to price in future monetary policy easing. Hence, by announce that political outcomes is part of its reaction function will politics will make monetary policy endogenous. The ECB of course is operating a less extreme version of this set-up. Hence, it is for example very clear that the ECB’s monetary policy decisions in the coming months will dependent on the outcome of the Greek elections and on the Spanish government’s fiscal policy decisions.

The problem of course is that politics is highly unpredictable and as a result monetary policy becomes highly unpredictable and financial market volatility therefore is likely to increase dramatically. This of course is what has happened over the past year in Europe.

Furthermore, the political outcome also crucially dependents on the economic outcome. It is for example pretty clear that you would not have neo-nazis and Stalinists in the Greek parliament if the economy were doing well. Hence, there is a feedback from monetary policy to politics and back to monetary policy. This makes for a highly volatile financial environment.  In fact it is hard to see how you can achieve any form of financial or economic stability if central banks instead of targeting only nominal variables start to target political outcomes.

So I long for the days when politics was not market moves in the financial markets and I hope central banks around the world would soon learn that it is not part of their mandate to police the political process and punish governments (and voters!) for making the wrong decisions. Central banks should only target nominal targets and nothing else. If they diverge from that then things goes badly wrong and market volatility increases sharply.

Finally I should stress that I am not arguing in anyway that the ECB is wrong to be concerned about fiscal policy being unsustainable in a number of countries. I am deeply concerned about that state of fiscal policy in a number of countries and I think it is pretty clear to my regular readers that I do not favour easier fiscal policy to solve the euro zone crisis. I, however, is extremely sceptical about certain political results being included in the ECB’s reaction function. That is a recipe for increased market volatility.

PS this discussion is of course very similar to what happened during the Great Depression when politics kept slipping into the newspapers’ financial sector (See here and here)

The Jedi mind trick – Matt O’Brien’s insightful version of the Chuck Norris effect

Our friend Matt O’Brien has a great new comment on the Atlantic.com. Matt is one of the most clever commentators on monetary matters in the US media.

In Matt’s new comment he set out to explain the importance of expectations in the monetary transmission mechanism.

Here is Matt:

“These aren’t the droids you’re looking for.” That’s what Obi-Wan Kenobi famously tells a trio of less-than-with-it baddies in Star Wars when — spoiler alert! — they actually were the droids they were looking for. But thanks to the Force, Kenobi convinces them otherwise. That’s a Jedi mind trick — and it’s a pretty decent model for how central banks can manipulate expectations. Thanks to the printing press, the Fed can create a self-fulfilling reality. Even with interest rates at zero.

Central banks have a strong influence on market expectations. Actually, they have as strong an influence as they want to have. Sometimes they use quantitative easing to communicate what they want. Sometimes they use their words. And that’s where monetary policy basically becomes a Jedi mind trick.

The true nature of central banking isn’t about interest rates. It’s about making and keeping promises. And that brings me to a confession. I lied earlier. Central banks don’t really buy or sell short-term bonds when they lower or raise short-term interest rates. They don’t need to. The market takes care of it. If the Fed announces a target and markets believe the Fed is serious about hitting that target, the Fed doesn’t need to do much else. Markets don’t want to bet against someone who can conjure up an infinite amount of money — so they go along with the Fed.

Don’t underestimate the power of expectations. It might sound a like a hokey religion, but it’s not. Consider Switzerland. Thanks to the euro’s endless flirtation with financial oblivion, investors have piled into the Swiss franc as a safe haven. That sounds good, but a massively overvalued currency is not good. It pushes inflation down to dangerously low levels, and makes exports uncompetitive. So the Swiss National Bank (SNB) has responded by devaluing its currency — setting a ceiling on its value at 1.2 Swiss francs to 1 euro. In other words, the SNB has promised to print money until its money is worth what it wants it to be worth. It’s quantitative easing with a target. And, as Evan Soltas pointed out, the beauty of this target is that the SNB hasn’t even had to print money lately, because markets believe it now. Markets have moved the exchange rate to where the SNB wants it.”

This is essentially the Star Wars version of the Chuck Norris effect as formulated by Nick Rowe and myself. The Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.

It is pretty simple. It is all about credibility. A central bank has all the powers in the world to increase inflation and nominal GDP (remember MV=PY!) and if the central bank clearly demonstrates that it will use this power to ensure for example a stable growth path for the NGDP level then it might not have to do any (additional) money printing to achieve this. The market will simply do all the lifting.

Imagine that a central bank has a NGDP level target and a shock to velocity or the money supply hits (for example due to banking crisis) then the expectation for future NGDP (initially) drops below the target level. If the central bank’s NGDP target is credible then market participants, however, will know that the central bank will react by increasing the money base until it achieves it’s target. There will be no limits to the potential money printing the central bank will do.

If the market participants expect more money printing then the country’s currency will obviously weaken and stock prices will increase. Bond yields will increase as inflation expectations increase. As inflation and growth expectations increase corporations and household will decrease their cash holdings – they will invest and consume more. The this essentially the Market Monetarist description of the monetary transmission mechanism under a fully credible monetary nominal target (See for example my earlier posts here and here).

This also explains why Scott Sumner always says that monetary policy works with long and variable leads. As I have argued before this of course only is right if the monetary policy is credible. If the monetary target is 100% credible then monetary policy basically becomes endogenous. The market reacts to information that the economy is off target. However, if the target is not credible then the central bank has to do most of the lifting itself. In that situation monetary policy will work with long and variable lags (as suggested by Milton Friedman). See my discussion of lag and leads in monetary policy here.

During the Great Moderation monetary policy in the euro zone and the US was generally credible and monetary policy therefore was basically endogenous. In that world any shock to the money supply will basically be automatically counteracted by the markets. The money supply growth and velocity tended to move in opposite directions to ensure the NGDP level target (See more on that here). In a world where the central bank is able to apply the Jedi mind trick the central bankers can use most of their time golfing. Only central bankers with no credibility have to work hard micromanaging things.

“I FIND YOUR LACK OF A TARGET DISTURBING”

So the reason European central bankers are so busy these days is that the ECB is no longer a credible. If you want to test me – just have a look at market inflation expectations. Inflation expectations in the euro zone have basically been declining for more than a year and is now well below the ECB’s official inflation target of 2%. If the ECB had an credible inflation target of 2% do you then think that 10-year German bond yields would be approaching 1%? Obviously the ECB could solve it’s credibility problem extremely easy and with the help of a bit Jedi mind tricks and Chuck Norris inflation expectations could be pegged at close to 2% and the euro crisis would soon be over – and it could do more than that with a NGDP level target.

Until recently it looked like Ben Bernanke and the Fed had nailed it (See here – once I believed that Bernanke did nail it). Despite an escalating euro crisis the US stock market was holding up quite well, the dollar did not strengthen against the euro and inflation expectations was not declining – clear indications that the Fed was not “importing” monetary tightening from Europe. The markets clearly was of the view that if the euro zone crisis escalated the Fed would just step up quantitative ease (QE3). However, the Fed’s credibility once again seems to be under pressures. US stock markets have taken a beating, US inflation expectations have dropped sharply and the dollar has strengthened. It seems like Ben Bernanke is no Chuck Norris and he does not seem to master the Jedi mind trick anymore. So why is that?

Matt has the answer:

“I’ve seen a lot of strange stuff, but nothing quite as strange as the Fed’s reluctance to declare a target recently. Rather than announce a target, the Fed announces how much quantitative easing it will do. This is planning for failure. Quantitative easing without a target is more quantitative and less easing. Without an open-ended commitment that shocks expectations, the Fed has to buy more bonds to get less of a result. It’s the opposite of what the SNB has done.

Many economists have labored to bring us this knowledge — including a professor named Ben Bernanke — and yet the Fed mostly ignores it. I say mostly, because the Fed has said that it expects to keep short-term interest rates near zero through late 2014. But this sounds more radical than it is in reality. It’s not a credible promise because it’s not even a promise. It’s what the Fed expects will happen. So what would be a good way to shift expectations? Let’s start with what isn’t a good way.”

I agree – the Fed needs to formulate a clear nominal target andit needs to formulate a clear reaction function. How hard can it be? Sometimes I feel that central bankers like to work long hours and want to micromanage things.

UPDATE: Marcus Nunes and Bill Woolsey also comments on Matt’s piece..

International monetary disorder – how policy mistakes turned the crisis into a global crisis

Most Market Monetarist bloggers have a fairly US centric perspective (and from time to time a euro zone focus). I have however from I started blogging promised to cover non-US monetary issues. It is also in the light of this that I have been giving attention to the conduct of monetary policy in open economies – both developed and emerging markets. In the discussion about the present crisis there has been extremely little focus on the international transmission of monetary shocks. As a consequences policy makers also seem to misread the crisis and why and how it spread globally. I hope to help broaden the discussion and give a Market Monetarist perspective on why the crisis spread globally and why some countries “miraculously” avoided the crisis or at least was much less hit than other countries.

The euro zone-US connection

– why the dollar’ status as reserve currency is important

In 2008 when crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused to drop by both a contraction in velocity and in the money supply. Reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss franc – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss franc will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over.

Why was the contraction so extreme in for example the PIIGS countries and Russia?

While the Fed failed to increase the money supply enough to counteract the increase in dollar demand it nonetheless acted through a number of measures. Most notably two (and a half) rounds of quantitative easing and the opening of dollar swap lines with other central banks in the world. Other central banks faced bigger challenges in terms of the possibility – or rather the willingness – to respond to the increase in dollar demand. This was especially the case for countries with fixed exchanges regimes – for example Denmark, Bulgaria and the Baltic States – and countries in currencies unions – most notably the so-called PIIGS countries.

I have earlier showed that when oil prices dropped in 2008 the Russian ruble started depreciated (the demand for ruble dropped). However, the Russian central bank would not accept the drop in the ruble and was therefore heavily intervening in the currency market to curb the ruble depreciation. The result was a 20% contraction in the Russian money supply in a few months during the autumn of 2008. As a consequence Russia saw the biggest real GDP contraction in 2009 among the G20 countries and rather unnecessary banking crisis! Hence, it was not a drop in velocity that caused the Russian crisis but the Russian central bank lack of willingness to allow the ruble to depreciate. The CBR suffers from a distinct degree of fear-of-floating and that is what triggered it’s unfortunate policy response.

The ultimate fear-of-floating is of course a pegged exchange rate regime. A good example is Latvia. When the crisis hit the Latvian economy was already in the process of a rather sharp slowdown as the bursting of the Latvian housing bubble was unfolding. However, in 2008 the demand for Latvian lat collapsed, but due to the country’s quasi-currency board the lat was not allowed to depreciate. As a result the Latvian money supply contracted sharply and send the economy into a near-Great Depression style collapse and real GDP dropped nearly 30%. Again it was primarily the contraction in the money supply rather and a velocity collapse that caused the crisis.

The story was – and still is – the same for the so-called PIIGS countries in the euro zone. Take for example the Greek central bank. It is not able to on it’s own to increase the money supply as it is part of the euro area. As the crisis hit (and later escalated strongly) banking distress escalated and this lead to a marked drop in the money multiplier and drop in bank deposits. This is what caused a very sharp drop in the Greek board money supply. This of course is at the core of the Greek crisis and this has massively worsened Greece’s debt woes.

Therefore, in my view there is a very close connection between the international spreading of the crisis and the currency regime in different countries. In general countries with floating exchange rates have managed the crisis much better than countries with countries with pegged or quasi-pegged exchange rates. Obviously other factors have also played a role, but at the key of the spreading of the crisis was the monetary policy and exchange rate regime in different countries.

Why did Sweden, Poland and Turkey manage the crisis so well?

While some countries like the Baltic States or the PIIGS have been extremely hard hit by the crisis others have come out of the crisis much better. For countries like Poland, Turkey and Sweden nominal GDP has returned more or less to the pre-crisis trend and banking distress has been much more limited than in other countries.

What do Poland, Turkey and Sweden have in common? Two things.

First of all, their currencies are not traditional reserve currencies. So when the crisis hit money demand actually dropped rather increased in these countries. For an unchanged supply of zloty, lira or krona a drop in demand for (local) money would actually be a passive or automatic easing of monetary condition. A drop in money demand would also lead these currencies to depreciate. That is exactly what we saw in late 2008 and early 2009. Contrary to what we saw in for example the Baltic States, Russia or in the PIIGS the money supply did not contract in Poland, Sweden and Turkey. It expanded!

And second all three countries operate floating exchange rate regimes and as a consequence the central banks in these countries could act relatively decisively in 2008-9 and they made it clear that they indeed would ease monetary policy to counter the crisis. Avoiding crisis was clearly much more important than maintaining some arbitrary level of their currencies. In the case of Sweden and Turkey growth rebound strongly after the initial shock and in the case of Poland we did not even have negative growth in 2009. All three central banks have since moved to tighten monetary policy – as growth has remained robust. The Swedish Riksbank is, however, now on the way back to monetary easing (and rightly so…)

I could also have mentioned the Canada, Australia and New Zealand as cases where the extent of the crisis was significantly reduced due to floating exchange rates regimes and a (more or less) proper policy response from the local central banks.

Fear-of-floating via inflation targeting

Some countries fall in the category between the PIIGS et al and Sweden-like countries. That is countries that suffer from an indirect form of fear-of-floating as a result of inflation targeting. The most obvious case is the ECB. Unlike for example the Swedish Riksbank or the Turkish central bank (TCMB) the ECB is a strict inflation targeter. The ECB does target headline inflation. So if inflation increases due to a negative supply shock the ECB will move to tighten monetary policy. It did so in 2008 and again in 2011. On both occasions with near-catastrophic results. As I have earlier demonstrated this kind of inflation targeting will ensure that the currency will tend to strengthen (or weaken less) when import prices increases. This will lead to an “automatic” fear-of-floating effect. It is obviously less damaging than a strict currency peg or Russian style intervention, but still can be harmful enough – as it clear has been in the case of the euro zone.

Conclusion: The (international) monetary disorder view explains the global crisis

I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also lead to a monetary contraction in especially Europe. Not because of an increase demand for euro, lats or rubles, but because central banks tighten monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as member of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

The international transmission was not caused by “market disorder”, but by monetary policy failure. In a world of freely floating exchange rates (or PEP – currencies pegged to export prices) and/or NGDP level targeting the crisis would never have become a global crisis and I certainly would have no reason to write about it four-five years after the whole thing started.

Obviously, the “local” problems would never have become any large problem had the Fed and the ECB got it right. However, the both the Fed and the ECB failed – and so did monetary policy in a number of other countries.

DISCLAIMER: I have discussed different countries in this post. I would however, stress that the different countries are used as examples. Other countries – both the good, the bad and the ugly – could also have been used. Just because I for example highlight Poland, Turkey and Sweden as good examples does not mean that these countries did everything right. Far from it. The Polish central bank had horrible communication in early 2009 and was overly preoccupied the weakening of the zloty. The Turkish central bank’s communication was horrific last year and the Sweden bank has recently been far too reluctant to move towards monetary easing. And I might even have something positive to say about the ECB, but let me come back on that one when I figure out what that is (it could take a while…) Furthermore, remember I often quote Milton Friedman for saying you never should underestimate the importance of luck of nations. The same goes for central banks.

PS You are probably wondering, “Why did Lars not mention Asia?” Well, that is easy – the Asian economies in general did not have a major funding problem in US dollar (remember the Asian countries’ general large FX reserve) so dollar demand did not increase out of Asia and as a consequence Asia did not have the same problems as Europe. Long story, but just show that Asia was not key in the global transmission of the crisis and the same goes for Latin America.

PPS For more on the distinction between the ‘monetary disorder view’ and the ‘market disorder view’ in Hetzel (2012).

The ideal central banker spends most of his time golfing

Who is the best central banker – one who is very busy with his job or one who is spending most of his/her time on the golf field?

The answer is the golfing central banker is the best of the two because if you are very busy you have probably not been doing your job in a proper fashion. The task of any central banker should be to ensure nominal stability and not to distort relative prices in the economy.

The best way to ensure nominal stability is through implementing a monetary policy regime based on very clear, transparent and automatic rules. Central bankers that do that will not have a lot to do as the markets would do most of the lifting.

This is in fact what happened during the Great Moderation – both in the US and in most of Europe. During the Great Moderation the markets’ had a high level of trust in the credibility of central banks in the US and Europe and in general it was expected that these central banks would deliver nominal stability. In fact markets behaved as if the Fed and the ECB were targeting a NGDP level target. This meant that what central bankers basically had do was to put on the central banker outfit (a dark suit and a not too fancy tie) and then say things that confirmed the markets in the expectation that the central bank would ensure nominal stability. There would be lot of time for golfing in that scenario.

If the central bank is fully credible and monetary policy follow clear rules (for example a NGDP level target) then the central bankers are unlike to be busy – at least not with monetary policy. Monetary demand would simply move up and down and more or less ensure the fulfillment of the nominal target. However, if the central bank is not credible then there will be no time to spend on the golf course.

Lets say that the central bank has a NGDP level target and the NGDP level moves above the target level. In the case of the credible central bank the markets would expect the central bank to act to bring down NGDP to the target level. Hence, market participants would expect monetary policy to be tightened. This would lead to a strengthening of the country’s currency and a drop in stock prices. Similarly as investors and consumers expect tighter monetary policy they would expect the value of money to increase. As a consequence investors and consumers would increase money demand. All this would automatically slow NGDP growth and bring back the NGDP level to the target level. In the scenario with a 100% credible target the central bank would not do anything other than look serious and central bank-like and the market would take care of everything else. Changes in money demand rather than in the money supply that would ensure the fulfillment of the target.

On the other hand if the central bank is not credible then market participants would not expect the that the central bank would bring the NGDP level back on track. In this scenario the central bank would actively have to change the money supply to push back NGDP to the target level. In fact it might have to reduce the money supply a lot to counteract any moves in money demand. Hence, if NGDP increases above the target level and the central bank does not act then market participants would in fact think that the central bank will continue to increase NGDP and as a consequence money demand will drop like a stone. Therefore the central bank would be very busy trying to steer the money supply and would likely not succeed if it does not gain credibility and money-velocity would become increasingly erratic. This is why inflation normally increases much more than the money supply in the “normal” hyperinflation scenario.

The worst possible scenario is that the central bankers start to micromanage things. He/she does not like the currency to be too strong, but property prices are too high and credit growth too strong for his liking. And he is very concerned about foreign currency lending among households. But he is also concerned about the export sector’s weak competitiveness. So he is intervening in the currency market to weaken the currency, but that is spurring money supply growth and he does not like that either so he is telling commercial bank to stop the credit expansion or he will increase reserve requirements. The threats works. The commercial banks curb lending growth, but other players are not willing to listen – so more shady players in the consumer credit market moves in. No time for golfing and the central bankers is just getting more and more angry. “Stupid banks and markets. Can’t they understand that I can’t do everything?”  

This might be a caricature, but look at most central banks in the developed world since 2008 – they have been very busy and they have to a very large extent been busy micromanaging things. And regulators have not made their job easier.

So why is that? They are simply no longer credible central bankers. There is no time for golfing because the focus has been on micromanaging everything rather than on recreating credibility. It is time for that to change so central bankers once again will have time for golfing – and the global economy finally can move out of this crisis.

 

 

 

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

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PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

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