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.
The Market Monetarist 
Ryan Sanchez
/ March 16, 2012Hmmm… This might be a triumph of the expectations channel, but whether those expectations were positive or negative for the near future were dependent upon economic data and not necessarily Bernanke and the other central banks.
Take Bernanke’s statement to keep interest rates low through 2014: “In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. ”
I see it like this, Bernanke was gambling that the new economic data would be positive instead of negative, therefore his commitment to low interest rates were a signal that he would allow nominal expectations to rise over the medium term. But had the recent economic data come back negative and instead of positive, Bernanke’s low interest rate commitment could have been interpreted as a negative signal that the economy is in the doldrums and will expand at frustratingly slow pace.
So yes, expectations are powerful, but so is your chosen target.
Lars Christensen
/ March 16, 2012Ryan, you might be right, but I actually think this has very little to do with the Fed. The markets have changed the expectation about the ECB’s reaction function. As a consequence the risk of a euro collapsed has eased dramatically and that has ease the demand for dollar – and thereby eased US monetary conditions. Bernanke of course has “allowed” this to happen – and I am pretty soon he don’t mind that this is the way he got his QE3 instead of having to do it himself.
I am no fan of the interest rate path stuff. To me it make much more sense to announce what you want to achieve rather than what you will do with some random policy instrument. But it might of course have sent a signal to the market that the Fed would accept higher inflation and NGDP growth before tightening monetary conditions than was expected earlier.
Ryan Sanchez
/ March 16, 2012Yes good point Lars. All hail Draghi for now, could have been a dollar demand disaster had Trichet been left in charge. Perhaps we really have turned a nice corner in this recovery, this week’s rally in US equities has also been met with an increase in the value of the USD as opposed to the risk on / risk off negative correlation we have seen over the last 12 months.
Cheers
Diego Espinosa
/ March 16, 2012Lars,
For three years the S&P rallied 100%+ from its lows. Commodity prices also spiked, and corporate credit spreads plunged to record lows. In hindsight, was the Fed “easy” or “tight” during this 3/09-3/12 period?
Diego Espinosa
/ March 16, 2012Lars,
BTW, the Dow doubled between 1933 and 1937 (it actually took a year longer than the current doubling).
MM’s praise FDR’s 1933 devaluation as a great example of the power of monetary policy over expectations. Using asset prices as a guide, its hard to see why the same would not be said about Ben Bernanke in 2009.
Lars Christensen
/ March 16, 2012Diego,
To me it is not a question about being too tight or too tight, but rather was the Fed credible? And particularly was the ECB credible? To me it is very clear that the ECB caused most of the distress in the global markets during the second half of 2011. The Fed mostly failed in 2008 – thereafter the Fed has to some extent “tried” to ease monetary conditions, but the Ben Bernanke & Co. has completely failed in terms of communicating the purpose of the attempted easing of monetary policy.
Said, in another way if the Fed already back in 2008 or 2009 had defined a much more clear nominal target then I doubt that QE2 would ever had been necessary and I think the recovery in the US economy would have been much stronger. Talking about the ECB in that regard is just plain depressing…
Lars Christensen
/ March 16, 2012Concerning FDR, I do not like to praise him – he did a lot of harm to the US economy. Taking the US off gold was the correct decision however. I think what market monetarists like myself are arguing is that the decisions of April-June 1933 illustrate however powerful monetary policy can be.
Should we then praise Bernanke as well? Yes, he certainly understand monetary factors. However, he should be criticized for failing to push through a proper nominal anchor or target. How hard can it be? Why is he continue to talk about how much QE to do or for how long he will keep interest rates low when he could just announce a proper target and let the market take care of most of the lifting…
Again the the major failure in 2011 was that the ECB moved to tighten monetary policy prematurely. Bernanke can not be blame for that…and in that he sense I am probably more forgiving than my American co-bloggers.
Diego Espinosa
/ March 16, 2012Lars,
I’m probably arguing with the wrong MM! Seriously, most MM’s seem to play up the contrast between the regime change of 1933 and the Fed’s actions in 2009. My point is that, judging from the “impartial arbitror” of asset prices, the two periods are not different at all. My observation is that the “market” in “Market Monetarism” might require a different interpretation of events. It was sparked by your “Chuck Norris” comment. If Chuck made markets rise in 1933 and late 2011, then he certainly did in 2009. Why highlight the last 5% of this equity price move instead of the first 95%?
Lars Christensen
/ March 16, 2012Diego,
I like the fact that you highlight the “market” in MM. I think it is very important. The reason why I think it is worth highlighting the market action since December is that in October-November we saw a near total collapse of ECB credibility. The markets basically were behaviouring as the ECB was unwilling to provide any nominal stability. That changed with LTRO. Now the markets are no longer expecting the ECB to try a “financial-economic-suicide”. We are gradually moving back towards markets having some faith in nominal stability.
In 2009 the Fed provide some nominal stability after initially failing and QE2 clearly also helped. Frankly speaking had thought the crisis was ending in the second half of 2010, but then the ECB seriously failed and triggered major crisis.
In terms of the Great Depression – April-June 1933 provides an excellent example of how potent monetary policy can be, but 1937 also shows that that is not enough. Clear nominal targets are also needed. Had the Fed/FDR put in place clear nominal targets the US economy would never have been back in recession in 1937/38. Similarly Fed has failed to articulate a clear nominal target this time around and that in my view is the biggest threat to the present recovery. At the moment the the recovery in money-velocity (I believe that is happening at the moment even though it is not yet in the data…) is driven by 50% trust and 50% hope that the ECB will not once again tighten prematurely. There is probably a bit more trust in the Fed, but you never know…