How to avoid a repeat of 1937 – lessons for both the fed and the BoJ

The Japanese stock market dropped more than 7% on Thursday and even though we are up 3% this morning there is no doubt that “something” had scared investors.

There are likely numerous reasons for the spike in risk aversion on Thursday, but one reason is probably that investors are getting concerned about the Federal Reserve and the Bank of Japan getting closer to scaling back monetary easing. That has reminded me on what happened in 1937 – when market participants panicked as they started to fear that the Federal Reserve would move prematurely towards monetary tightening – after the US economy had been in recovery since FDR took the US off the gold standard in 1933.

Going into 1937 both US government officials and the Fed officials started to voice concerns about inflationary pressures, which clearly sent a signal to market participants that monetary policy was about to be tightened. That caused the US stock market to slump and sent the US economy back into recession – the famous Recession in the Depression.

At the core of this policy mistake was the fact that the fed had never clearly defined and articulated a clear monetary policy target after going off the gold standard in 1933. The situation in many ways is similar today.

Market participants in general know that the fed is likely to scale back monetary easing when the US economy “improves”, but there is considerable uncertainties about what that means and the fed still has not clearly articulated its target(s). Furthermore, the fed continues to be very unclear about its monetary policy instruments. Hence, the fed still considers the fed fund target rate as its primary monetary policy instrument while at the same time doing quantitative easing.

These uncertainties in my view certainly make for a much less smooth ‘transition’ in monetary policy conditions in the US. Therefore, instead of focusing on when to scale back “QE” the fed should focus 100% on explaining its target so nobody is in doubt about what the fed really is targeting. Furthermore, the fed needs to stop thinking and communicating about monetary policy in terms of interest rates. The money base and not the interest rate is the key monetary policy instrument in the US and it is about time that the fed acknowledges this.

How about trying the “perfect world”

The best way of getting rid of these monetary policy uncertainties is for the fed to first of all give an explicit nominal target. Preferably the fed should simply state that it will conduct monetary policy in a way to increase nominal GDP by 15% in the coming two years and thereafter target 5% annual NGDP growth (level targeting).

Second, the fed then should become completely clear about its monetary policy. The best thing would be a futures based NGDP targeting. See here for a description about how that would work. Alternatively the fed should clearly spell out a ‘reaction function’ and clearly describe its monetary policy instrument – what assets will the fed buy to expand or contract the money base? It is really simple, but so far the fed has totally failed to do so.

Japanese monetary policy has become a lot clearer after Haruhiko Kuroda has become Bank of Japan chief, but even the BoJ needs to work on its communication policy. Why is the BoJ not just announcing that since it now officially has a 2% inflation target it will ‘peg’ the market expectations for example for 2-year or 5 year (or both) inflation at 2% – and hence simply announce a commitment to sell or buy inflation-linked bonds so the implicit breakeven inflation is 2% on all time horizons at any period in time. This is of course a set-up Bob Hetzel long ago suggested for the fed. Maybe it is time the BoJ invited Bob back to for a visit in Japan?

If the fed and the BoJ in this fashion could greatly increased monetary policy transparency the markets would not be left guessing about what they central banks are targeting or about whether there will be a sudden redrawl of monetary policy accommodation.  Thereby it could be ensured that the scaling back of monetary easing will happen in a disorderly fashion. There is not reason why we need repeating the mistakes of 1937.


Both David Glasner and Marcus Nunes have related posts.

See also here if you want to read what I wrote about the Japanese “jitters” yesterday in my day-job.

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