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You have to be upbeat about the Iranian economy – president Rouhani is a monetarist!

This is the new Iranian president Hassan Rouhani on Twiiter (on November 26):

From an economic perspective, we were in a state of stagflation–negative growth + extremely high inflation–first time in 50 yrs.

…Tracking inflation is very important to me. Change in inflation has been +2.2 – 2.3% MoM, which is now reduced to +1.2%

…Inflation has decreased from 43% to 36%–still very high, but it’s an improvement

…Our plan is to bring inflation below 25% by end of next year, from a level of 43% when we took office.

Ok, fine president Rouhani what do you want to do about it?

And here is his answer:

Screen-Shot-2013-11-29-at-10.19.58-AM

Wauw! Is Rouhani’s favourite economist Milton Friedman?

I wish President Rouhani the best of luck in reducing Iranian inflation and in reviving the Iranian economy – it is badly needed. I am sure he will succeed if he follows his apparent monetarist instincts.

HT Scott Sumner and Left Outside.

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There is nothing “unconventional” about money base control

Central bankers around the world talk about monetary policy as being “unconventional” when they undertake “quantitative easing” to expand the money base. This term frustrates me a great deal as there is nothing unconventional about the fact that the central bank is changing the money base.

In fact controlling the money base is exactly what central banks are doing when they undertake “normal” monetary policy. Central bankers might talk about monetary policy in terms of changing interest rates, but what central banks are doing – when they are undertaking what they consider to be “normal” monetary policy – is to control the money base to target a certain level for short-term interest rates.

In that sense there is nothing unconventional about controlling the money base – it is what central banks have always been doing. Many central bankers have just forgot it as they are used to talk about monetary policy in terms of changes in interest rates.

Therefore it is completely meaningless to talk about quantitative easing as being “unconventional” monetary policy. However, what is “unconventional” is when central bankers think that credit policy is monetary policy.

So when the ECB for example is intervening in the European sovereign bond market to distort the relative prices of for example Spanish and Germans government bond then that is credit policy. Particularly as the ECB consistently has said that any such operations will be “sterilized” – hence, the ECB will ensure that its operations have no impact on the money base. But again that is not “unconventional” monetary policy. It is not monetary policy at all – it is credit policy.

Monetary policy is two things. It is the central banks ability to increase or decrease the money base. It can do this by buying or selling assets in the market place. And second, it is the central bank’s ability to communicate about future changes in the money base (forward guidance).

Unfortunately few central bankers really seem to understand that this is what central banking should be about. Most central bankers still think “normal” monetary policy is about controlling the interest rate to hit some nominal target (mostly inflation). But central bankers can’t really control interest rates and at the same time hit another target – for example inflation. The interest rate is not even a policy instrument – it is an intermediate target. The money base is the instrument.

Therefore, it is of course also completely meaningless when the Federal Reserve earlier tried to influence the shape of the yield in its so-called operation twist and it is equally meaningless that the Fed now seems to be very concerned about what is happening to bond yields. The Fed should not care at all about bond yields.

What the Fed – and other central banks – should do is to define a very clear nominal target (the policy objective) – for example the nominal GDP level, the price level or inflation – and then undertake open-market operations – buying and selling assets – to control the development in the money base so as to hit the policy objective and it of course needs clearly to communicate about what target it has and show full commitment to hitting this.

Central banks should let interest rates and bond yields be determined by the markets. Central banks should not be in the business of distorting relative prices in the money and bond markets. The central bank’s only task is to ensure nominal stability and it should use the control of the money base and forward guidance to do this. Everything else is likely to be counterproductive.

The sooner central bankers realizes this and stop communicating about monetary policy in terms of interest rates as “conventional” monetary policy and money base control as “unconventional” the sooner they will be able to make the necessary decisions to ensure nominal stability.

The ECB’s refusal to conduct monetary policy

The best illustration of central bankers’ lack of understanding of these matters is the ECB’s policy actions. The ECB as a principle refuses to conduct monetary policy. It will not undertake actions to increase the money base even when it is totally clear that it is seriously undershooting its own official 2% inflation target.

ECB officials again and again will tell you that it is not allowed to buy European government bonds because that would be monetization of government debt. But excuse me – the job of central banks is to create money.

Money creation is at the core of what central banks should be doing. And if the ECB doesn’t feel like buying government debt to increase the money base it can always buy something else.

But the ECB seems to think there is something “dirty” about controlling the money base. It is only allowed to conduct monetary policy by hiking or cutting interest rates. But how do you think the ECB is controlling interest rates? By changing the money base! Why this obsession with interest rates?

The ECB should give up controlling interest rates and move to an open and transparent operational procedure by which to control the money base.

I fundamentally think that the ECB should announce that it in the future will stop using interest rates as a way to communicating about monetary policy and instead it should move to a system where it every month will announce the future rate of growth of the money base and that it will change its operational target of money base growth when ever needed to hit a certain nominal target (the policy objective).

The simplest way of controlling the money base for the ECB in my view would be to buy and sell a GDP-weighted basket of 2-year euro zone government bonds. Not with the purpose of influencing the relative prices of European sovereign bonds, but with the purpose of expanding or decreasing the money base.

Over the past five years the ECB (and the BoE and the Fed for that matter) has come up with a complicated set of operational procedures. Most of these procedures have had the purpose of distorting relative prices in the European sovereign bond markets. The ECB should scrap all of these schemes. There is no need for these schemes. They distort markets and have drastically increased moral hazard problems in the European financial system.

The ECB – and other central banks – should of course act as lender-of-last resort. That is a rather simple task. The central bank provides liquidity to the market (including banks) against proper collateral. Other than that the central bank should increase and decrease its money base to hit its nominal target. It is really simple.

So central bankers should stop calling changes to the money base “unconventional” monetary policy. It is perfectly normal monetary policy. But central banks should also give up the complicated and counterproductive credit policies. These credit policy is the unconventional part of “monetary” policy (it is not really monetary policy).

If central bankers acknowledged that controlling the money base is what they are in the business of doing then we could end the fruitless discussion about “exit strategies” from QE. Quantitative easing in that sense is also a meaningless term. Central banks control the quantity of base money. It can increase it and or decrease now and in the future. There is no exit strategy from that. If you have decided to have a central bank then it is because you want it to create money. There is certainly nothing “unconventional” about that – that is what central banks always have done.

—-

As I was writing this post I came to think of the numerous mails I have exchanged with Professor Michael Belongia on this topic and related topics. So I dedicate this post to Mike and I would suggest to my readers that you take a look at some of the papers Mike have written on this topic. See for example here:

Belongia, Michael & Hinich, Melvin, 2009. “The evolving role and definition of the federal funds rate in the conduct of U.S. monetary policy,” MPRA Paper 18970, University Library of Munich, Germany, revised Aug 2009.

Michael T. Belongia, 1992. “Selecting an intermediate target variable for monetary policy when the goal is price stability,” Working Papers 1992-008, Federal Reserve Bank of St. Louis.

Mike has made numerous comments to a draft of this post among other things about how do reorganize it. This post, however, is more or the less the unedited version of the blog post, but I plan to expand this post into a bigger paper based on some of Mike’s insightful suggestions. Hopefully I will get to that soon…Input and suggestions are very welcome.

“Whatever it takes to get deflation” (Stealing two graphs from Marcus Nunes)

Marcus Nunes has two extremely illustratative graphs in his latest blog post. Just take a look here:

 

 I don’t think any other comments are needed…

Good and bad deflation – and horribly low euro zone M3 growth

I had an up-ed in today’s edition of the Danish Business daily Børsen. Here is the English translation:

Recently inflation has fallen sharply in most European countries and in some countries we already have deflation, and it is very likely that deflation will spread to several European countries in the near future.

In Sweden inflation has already fallen below zero , as is the case in several southern European countries.

There is certainly reason to fear deflation. In the 1930s deflation was allowed to spiral out of control and the consequences were disastrous. But in this context it is extremely important to remember that there are good and bad deflation.

The overall price level in the economy may fall for two reasons. First, productivity increases may cause prices to fall. As will falling input prices – for example lower oil prices. Second, a general contraction in aggregate demand – for example due to tighter monetary policy – can reduce the price level.

Economists normally call productivity increases and falling oil positive supply shock. They are unilaterally positive as an positive supply shock overall increases prosperity. That’s the good deflation.

Conversely a general decline in prices, which is a result of weak aggregate demand – a negative demand shock – is purely negative as it usually leads to higher unemployment and lower capacity utilization in the economy. That’s the bad deflation.

In general the economic development in Europe in the last five years has been characterized by very weak demand development. It has created ​​clear deflationary trends in several European economies. That certainly has not been good. It has been a bad deflation.

However, the recent decline in European inflation we have seen is primarily a result of falling oil prices – that is a good deflation, which in shouldn’t be a worry. The paradox is that these recent (positive) deflationary trends in the European economy seems to have caused the European Central Bank to wake up and reduce interest rates and it is now being speculated that the ECB will undertake further action to ease monetary policy.

According to the monetary policy textbook central banks should not respond to “good deflation”. This obviously could give reason to question the fact that the ECB is now finally moving to ease monetary policy. But the truth is that the ECB in the past five years have failed to sufficiently aggressively ease monetary policy to to avoid bad deflation.

Therefore, one can rightly say that the ECB is doing the right thing by easing monetary policy, but basically for the wrong reasons. But let’s just be happy that the ECB finally makes the right decision – to ease monetary policy – even if it is not for the right reasons.

The big question is now how the ECB will ease monetary policy when interest rates are already close to zero. But this “problem” is easily solved. A central bank can always ease monetary policy – even when the interest rate is zero. The Federal Reserve and Bank of Japan have solved this problem. They have simply increases the monetary base. The ECB has so far been very reluctant to move in this direction, but the fact that we are now moving toward deflation in the euro zone may also cause the ECB to move forward in this field. Let’s hope so – because if the ECB does not move in this direction we’re going to have ongoing problems with deflation – bad deflation – in Europe very soon.

Today we got more data underlining the fact that the ECB should be seriously worried about bad deflation. Hence, euro zone M3 grew by only 1.4% in October. The Telegraph’s Ambrose Evans-Pritchard has an excellent comment on the horrible M3 numbers:

Eurozone money supply growth plummeted in October and loans to firms contracted at a record rate, heightening the risk of a stalled recovery and Japanese-style deflation next year.

The European Central Bank said M3 money growth fell to 1.4pc from a year earlier, lower than expected and far below the bank’s own 4.5pc target deemed necessary to keep the economy on an even keel.

Monetarists watch the M3 data — covering cash and a broad range of bank accounts — as an early warning signal for the economy a year or so in advance. “This a large dark cloud hanging over the eurozone in 2014; it means the public debt ratios in Southern Europe are at greater risk of exploding,” said Tim Congdon from International Monetary Research.

M3_2749266c

Ambrose also quotes me:

“The ECB needs to cut rates to zero and launch quantitative easing (QE) to head off deflation, but they are not there yet,” said Lars Christensen from Danske Bank. “The debt problem in Italy will be much worse if they let nominal GDP fall, leading to yet more austerity.”

So yes, we are seeing some good deflation in the euro zone at the moment and we should be happy about, but unfortunately we are likely to see a lot more bad deflation soon if the ECB does not get its act together soon.

A scary story: The Zero Lower Bound and exchange rate dynamics

I was in Sweden last week and again yesterday (today I am in Norway). My trips to Sweden have once again reminded me about the dangers of conducting monetary policy with interest rates at the Zero Lower Bound (ZLB). The Swedish central bank – Riksbanken – has cut is key policy rate to 1% and is like to cut it further to 0.75% before the end of the year so we are inching closer and closer to zero.

Riksbanken is just one of a number of European central banks close to zero on interest rates – most notably the ECB is at 0.25%. In the Czech Republic the key policy rate stands at 0.05%. And even Poland, Hungary, Norway are moving closer and closer to the ZLB.

Most of these central banks seem to be quite unprepared for what might happen at the Zero Lower Bound. In this post I will particularly focus on the exchange rate dynamics at the ZLB.

A Taylor rule world

Lets say we can describe monetary policy with a simple Taylor rule:

r = rN+a*(p-pT)+b(ygap)

In a “normal” world where everything is fine and the key policy rate (r) is well-above zero the central bank will hike or cut r in response to increasing or declining inflation (p) relative to the inflation target (pT) or in response to the output gap (ygap) increasing or decreasing. If the output gap is closed and inflation is at the inflation target then the central bank will set it’s key policy rate at the “natural” interest rate rN.

What happens at the ZLB?

However, lets assume that we are no longer in a normal world. Lets instead assume that p is well below the inflation target and the output gap is negative. As we know this is the case in most European countries today.

So if we plug these numbers into our Taylor rule above we might get r=1%. As long as r>0 we are not in trouble yet. The central bank can still conduct monetary policy with its chosen instrument – the key policy interest rate. This is how most inflation targeting central banks in the world are doing their business today.

But what happens if we get a negative shock to the economy. Lets for example assume that an overheated property markets starts to cool gradually and real GDP starts to slow. In this case the central bank according to it’s Taylor rule should cut its key policy rate further. Sooner or later the central bank hits the ZLB.

An then suddenly the currency starts strengthening dramatically

In fact imagine that the interest rate level needed to close the output gap and keep inflation at the inflation target is -2%.

We can say that monetary policy is neutral when the central bank sets interest rates according to the Taylor rule, but if interest rates are higher than the what the Taylor rule stipulates then monetary policy is tight. So if the Taylor rule tells us that the key policy rate should be -2% and the actual policy rate is zero then monetary policy is of course tight. This is what many central bankers fail to understand. Monetary policy is not necessarily easy just because the interest rate is low in a historical or absolute perspective.

And this is where it gets really, really dangerous because we now risk getting into a very unstable economic and financial situation – particularly if the central bank insists that monetary policy is already easy, while it is in fact tight.

What happens to the exchange rate in a situation where monetary policy is tightened? It of course appreciates. So when the “stipulated” (by the Taylor rule) interest rate drops to for example -2% and the actual interest rate is at 0% then obviously the currency starts to appreciates – leading to a further tightening of monetary conditions. With monetary conditions tightening inflation drops further and growth plummets. So now we might need an interest rate of -4 or -7%.

With that kind of monetary tightening you will fast get financial distress. Stock markets start to drop dramatically as inflation expectations plummets and the economy contracts. It is only a matter of time before the talk of banking troubles start to emerge.

The situation becomes particularly dangerous if the central bank maintains that monetary policy is easy and also claim that the appreciation of the currency is a signal that everything is just fine, but it is of course not fine. In fact the economy is heading for a massive collapse if the central bank does not change course.

This scenario is of course very similar to what played out in the US in 2008-9. A slowdown in the US property market caused a slowdown in the US economy. The Fed failed to respond by not cutting interest rates aggressive and fast enough and as a consequence we soon hit the ZLB. And what happened to the dollar? It strengthened dramatically! That of course was a very clear indication that monetary conditions were becoming very tight. Initially the Fed clearly failed to understand this – with disastrous consequences.

But don’t worry – there is a way out

The US is of course special as the dollar is a global reserve currency. However, I am pretty sure that if a similar thing plays out in other countries in the world we will see a similar exchange rate dynamics. So if the Taylor rule tells you that the key policy rate should be for example -4% and it is stuck at zero then the the currency will start strengthening dramatically and inflation and growth expectations will plummet potentially setting off financial crisis.

However, there is no reason to repeat the Fed’s failure of 2008. In fact it is extremely easy to avoid such a scenario. The central bank just needs to acknowledge that it can always ease monetary policy at the ZLB. First of all it can conduct normal open market operations buying assets and printing its own currency. That is what we these days call Quantitative Easing.

For small open economies there is an even simpler way out. The central bank can simply intervene directly in the currency market to weak its currency and remember the market can never beat the central bank in this game. The central bank has the full control of the printing press.

So imagine we now hit the ZLB and we would need to ease monetary policy further. The central bank could simply announce that it will weaken its currency by X% per months until the output gap is close and inflation hits the inflation target. It is extremely simple. This is what Lars E.O. Svensson – the former deputy central bank governor in Sweden – has termed the foolproof way out of deflation.

And even better any central bank, which is getting dangerously close to the ZLB should pre-announce that it will in fact undertake such Svenssonian monetary operations to avoid the dangerous of conducting monetary policy at the ZLB. That would mean that as the economy is moving closer to the ZLB the currency would automatically start to weaken – ahead of the central bank doing anything – and in that sense the risk of hitting the ZLB would be much reduced.

Some central bankers understand this. For example Czech central bank governor Miroslav Singer who recently has put a floor under EUR/CZK, but unfortunately many other central bankers in Europe are dangerously ignorant about these issues.

PS I told the story above using a relatively New Keynesian framework of a Taylor rule, but this is as much a Market Monetarist story about understanding expectations and that the interest rate level is a very bad indicator of the monetary policy stance.

“Synthesizing State and Spontaneous Order Theories of Money”

I have been traveling quite a bit recently and have had a bit of a hard time finding time for blogging. I really wanted to blog about why I think that there is a very serious risk that the Swedish Riksbank might hit the Zero Lower Bound soon and is totally unprepared for this.

I also want to blog more about the recent major changes in Czech monetary policy and finally I want to blog about development economics and particularly about my view of Nina Munk’s fantastic new book – “The Idealist” – about Jeffrey Sachs and why all kinds of central planing is insane (some thing Sachs apparently has failed to understand).

But I have no time or energy for all that now. Instead I think you should read this paper – “Synthesizing State and Spontaneous Order Theories of Money” – by the two young and clever economists Will Luther and Alex Salter. Here is the abstract:

What role does government play in determining the medium of exchange? Economists weighing in on the issue typically espouse one of two views. State theorists credit government with the emergence and continued acceptance of commonly accepted media of exchange. In contrast, spontaneous order theorists find little need for government, maintaining that money emerges and continues to circulate as a result of a decentralized market process. History suggests a more subtle theory is required. We provide a generalized theory of the emergence and perpetuation of money, informed by both approaches and consistent with recent theoretical and empirical advances in the literature.

Enjoy!

Hopefully I will get back to blogging in the coming days…

PS Will and Alex you are both very clever economists, but you need to work on your marketing credentials – “Synthesizing State and Spontaneous Order Theories of Money” is not a sexy title for a paper. I am happy I know your qualities so I will read your paper anyway and I am sure my readers will do so as well.

The Crowd: “Lars, you are fat!”

On Friday I was doing a presentation on the global economy (yes, yes mainly on global monetary policy) for 40-50 colleagues who are working as investment advisors in the Danske Bank group.

As I was about to start my presentation somebody said “The audience have been kind of quiet today”. I thought that was a challenge so I immediately so I jumped on top of a table. That woke up the crowd.

I asked the audience to guess my weight. They all wrote their guesses on a piece of paper. All the guesses were collected and an average guess – the “consensus forecast” – was calculated, while I continued my presentation.

I started my presentation and I naturally started telling why all of my forecasts would be useless – or at least that they should not expect that I would be able to beat the market. I of course wanted to demonstrate exactly that with my little stunt. It was a matter of demonstrating the wisdom of the crowds – or a simple party-version of the Efficient Market Hypothesis.

I am certainly not weighing myself on a daily basis so I was “guestimating” my own weight then I told the audience that my weight is 81 kilograms (fully dressed). I usually think of my own weight as being just below 80 kg, but I was trying to correct it for the fact I was fully dressed – and I added a bit extra because my wife has been teasing me that I gained weight recently.

As always I was completely confident that the “survey” result would come in close to the “right” number. So I was bit surprised when the  “consensus forecast” for my weight came in at 84.6 kg

It was close enough for me to claim that the “market” – or the crowd – was good at “forecasting”, but I must say that I thought the “verdict” was wrong – nearly 85 kg. That is fat. I am not fat…or am I?

So once I came back home I immediately jumped on the scale – for once I hoped to show that the Efficient Market Hypothesis was wrong. But the verdict was even more cruel. 84 kg!

So the “consensus forecast” was only half a kilo wrong and way better than my own guestimate. So not only am I fat, but I was also beaten by the “market” in guessing my own weight.

I need a cake

PS My height is 183 cm – so my Body Mass Index is 25.08 – that is officially overweight (just a little – above 25 is overweight).

PPS I have done this kind of experiments before. See here.

Deflation – not hyperinflation – brought Hitler to power

This Matt O’Brien in The Atlantic:

“Everybody knows you can draw a straight line from its hyperinflation to Hitler, but, in this case, what everybody knows is wrong. The Nazis didn’t take power when prices were doubling every 4 days in 1923– they tried, and failed — but rather when prices were falling in 1933.”

Matt is of course right – unfortunately few European policy makers seem to have studied any economic and political history. Furthermore, few advocates of free market Capitalism today realise that the biggest threat to the capitalist system is not overly easy monetary policy. The biggest threat to free market Capitalism is overly tight monetary policy as it brings reactionary and populist forces – whether red or brown – to power.

Update: This is from the German magazine Spiegel:

From 1922-1923, hyperinflation plagued Germany and helped fuel the eventual rise of Adolf Hitler.”

…I guess somebody in the German media needs a lesson in German history.

HT Petar Sisko.

PS Scott Sumner has a new blog post on how wrong many free market proponents are about monetary issues.

PPS take a look at this news story from the deflationary euro zone.

Venezuela’s monetary craziness

Yesterday I wrote a post about how we are inching closer and closer to outright deflation in Europe. However, for other countries the risk of deflation is not the issue. In Argentina and Venezuela outright hyperinflation is becoming more and more likely.

The situation seems particularly insane in Venezuela. This is from Bloomberg (a week ago):

Venezuela’s annual inflation rate rose more than expected to 54.3 percent last month, the fastest pace in as many as 16 years, as shoppers scrambled for scarce goods ahead of Christmas festivities.

October inflation compares with an annualized 49.4 percent the month earlier and the 52 percent median estimate of three analysts surveyed by Bloomberg. Prices rose 5.1 percent in the month, the central bank said today.

Currency controls have crimped imports in a country that gets about 70 percent of its goods from abroad, pushing up the cost of products that make it into the country. Price increases in the capital, Caracas, are running at the fastest pace since 1997, two years before former President Hugo Chavez came to power.

Anybody with the faintest idea about economics knows that you can only get this kind of inflation if the printing is running too fast. So there is only one way to combat inflation – slow the printing press. It is very simple.

But of course this is not the kind of answer Venezuela’s socialist president Nicolas Maduro would like to hear. Instead he has ordered the army to enforce massive cuts in retail prices. Just see this story:

After taking control of several appliance stores last week, Maduro vowed late Sunday to step up inspections of businesses selling shoes, clothes, automobiles and other goods to make sure they aren’t gouging consumers. He also said he’ll impose limits on profits as the government tries to curb inflation running at 54 per cent.

In eastern Caracas, a five-block line of bargain hunters, some waiting since Saturday, snaked from a JVG electronics store hoping for the chance to buy televisions, washing machines and refrigerators at deep discounts.

“We’ve been waiting for this for a long time,” said Sixto Mesa, a government supporter.

Maduro is gambling that by expanding price controls he can regain support he has lost since winning election in April, as inflation soared to a two-decade high and the U.S. dollar shot up on the black market to nine times its official value.

“We can’t just close the businesses; the owners have to go to jail,” Maduro said in an impassioned speech Sunday night in which he cited Jewish, Muslim and Christian texts to harangue businessmen he accuses of usury. “We can’t allow our hard currency to be used to rob people through the sale of these goods.”

At the same time Maduro is attacking merchants he calls the “parasitic bourgeoisie,” he has vowed zero tolerance for looting. On Monday, police fired shots in the air to prevent crowds from raiding a toy store in the Caracas suburb of Los Teques, with many businesses in the town shuttering early for fear of violence.

Maduro also took his offensive to the Internet, blocking access to seven websites that track the value of the country’s bolivar currency on the black market. The president over the weekend accused the websites of spreading panic and conspiring against his government.

What can you say? Insane…

“The Army just helped me ‘buy’ this nice flat-screen TV…”

Venezuela Frenzied Shopping

Tick tock…here comes the Zero Lower Bound again

This week have brought even more confirmation that we are still basically in a deflationary world – particularly in Europe. Hence, inflation numbers for October in a number of European countries published this week confirm that that inflation is declining markedly and that we now very close to outright deflation in a number of countries. Just take the case of the Czech Republic where the so-called monetary policy relevant inflation dropped to 0.1% y/y in October or even worse Sweden where we now have outright deflation – Swedish consumer prices dropped by 0.1% in October compared to a year ago.

And the picture is the same everywhere – even a country like Hungary where inflation notoriously has been above the central bank’s 3% inflation target inflation is now inching dangerously close to zero.

Some might say that there is no reason to worry because the recent drop in inflation is largely driven by supply side factors. I would agree that we shouldn’t really worry about deflation or disinflation if it is driven by a positive supply shocks and central banks would not react to such shocks if they where targeting nominal GDP rather than headline consumer price inflation. In fact I think that we are presently seeing a rather large positive supply shock to the global economy and in that sense the recent drop in inflation is mostly positive. However, the fact is that the underlying trend in European prices is hugely deflationary even if we strip out supply side factors.

Just the fact that euro zone money supply growth have averaged 0-3% in the past five years tells us that there is a fundamental deflationary problem in the euro zone – and in other European countries. The fact is that inflation has been kept up by negative supply shocks in the past five years and in many countries higher indirect taxes have certainly also helped kept consumer price inflation higher than otherwise would have been the case.

So yes supply side factors help drag inflation down across Europe at the moment – however, some of this is due to the effect of earlier negative supply side shocks are “dropping out” of the numbers and because European governments are taking a break from the austerity measures and as a result is no longer increasing indirect taxes to the same extent as in earlier years in the crisis. Hence, what we are no seeing is to a large extent the real inflation picture in Europe and the fact is that Europe to a very large extent is caught in a quasi-deflatonary trap not unlike what we had in Japan for 15 years.

Here comes the Zero Lower Bound

Over the past five years it is not only the ECB that stubbornly has argued that monetary policy was easy, while it in fact was über tight. Other European central banks have failed in a similar manner. I could mention the Polish, the Czech central banks and the Swedish Riksbank. They have all to kept monetary policy too tight – and the result is that in all three countries inflation is now well-below the central bank’s inflation targets. Sweden already is in deflation and deflation might very soon also be the name of the game in the Czech Republic and Poland. It is monetary policy failure my friends!

In the case of Poland and Sweden the central banks have had plenty of room to cut interest rates, but both the Polish central bank and the Swedish Riksbank have been preoccupied with other issues. The Riksbank has been busy talking about macro prudential indicators and the risk of a property market bubble, while the economy has slowed and we now have deflation. In fact the Riksbank has consistently missed its 2% inflation target on the downside for years.

In Poland the central bank for mysteries reasons hiked interest rates in early 2012 and have ever since refused to acknowledged that the Polish economy has been slowing fairly dramatically and that inflation is likely to remain well-below its official 2.5% inflation target. In fact yesterday the Polish central bank published new forecasts for real GDP growth and inflation and the central bank forecasts inflation to stay well-below 2.5% in the next three years and real GDP is forecasted to growth much below potential growth.

If a central bank fails to hit its inflation target blame the central bank and if a central bank forecasts three years of failure to hit the target something is badly wrong. Polish monetary policy remains overly tight according to it own forecasts!

The stubbornly tight monetary stance of the Polish, the Czech and the Swedish central banks over the past couple of years have pushed these countries into a basically deflationary situation. That mean that these central banks now have to ease more than would have been the case had they not preoccupied themselves with property prices, the need for structural reforms and fiscal policy in recent years. However, as interest rates have been cut in all three countries – but too late and too little – we are now inching closer and closer to the Zero Lower Bound on interest rates.

In fact the Czech central bank has been there for some time and the Polish and the Swedish central bank might be there much earlier than policy makers presently realise. If we just get one “normal size” negative shock to the European economy and then the Polish and Swedish will have eventually to cut rates to zero. In fact with Sweden already in deflation one could argue that the Riksbank already should have cut rates to zero.

The Swedish and the Polish central banks are not unique in this sense. Most central banks in the developed world are very close to the ZLB or will get there if we get another negative shock to the global economy. However, most of them seem to be completely unprepared for this. Yes, the Federal Reserve now have a fairly well-defined framework for conducting monetary policy at the Zero Lower Bound, but it is still very imperfect. Bank of Japan is probably closer to having a operational framework at the ZLB. For the rest of the central banks you would have to say that they seem clueless about monetary policy at the Zero Lower Bound. In fact many central bankers seem to think that you cannot ease monetary policy more when you hit the ZLB. We of course know that is not the case, but few central bankers seem to be able to answer how to conduct monetary policy in a zero interest rate environment.

It is mysteries how central banks in apparently civilised and developed countries after five years of crisis have still not figured out how to combat deflation with interest rates at the Zero Lower Bound. It is a mental liquidity trap and it is telling of the serious institutional dysfunctionalities that dominate global central banking that central bankers are so badly prepared for dealing with the present situation.

But it is nonetheless a fact and it is hard not to think that we could be heading for decades of deflation in Europe if something revolutionary does not happen to the way monetary policy is conducted in Europe – not only by the ECB, but also by other central banks in Europe. In that sense the track record of the Swedish Riksbank or the Polish and Czech central banks is not much better than that of the ECB.

We can avoid deflation – it is easy!

Luckily there is a way out of deflation even when interest rates are stuck at zero. Anybody reading the Market Monetarists blogs know this and luckily some central bankers know it as well. BoJ chief Kuroda obviously knows what it takes to take Japan out of deflation and he is working on it. As do Czech central bank chief Miroslav Singer who last week – finally  – moved to use the exchange rate as policy instrument and devalued the Czech kurona by introducing a floor on EUR/CZK of 27. By doing this he copied the actions of the Swiss central bank. So there is hope.

Some central bankers do understand that there might be an Zero Lower Bound, but there is no liquidity trap. You can always avoid deflation. It is insanely easy, but mentally it seems to be a big challenge for central bankers in most countries in the world.

I am pretty optimistic that the Fed’s actions over the past year is taking the US economy out of the crisis. I am optimistic that the Bank of Japan will win the fight against deflation. I am totally convinced that the Swiss central bank is doing the right thing and I am hopeful that Miroslav Singer in the Czech Republic is winning the battle to take the Czech economy out of the deflationary trap. And I am even optimistic that the recent global positive supply shock will help lift global growth.

However, the ECB is still caught in its own calvinist logic and seems unable to realise what needs to be done to avoid a repeat of the past failures of the Bank of Japan. The Swedish central bank remains preoccupied with macro prudential stuff and imaginary fears of a property market bubble, while the Swedish economy now caught is in a deflationary state. The Polish central bank continues to forecast that it will fail to meet its own inflation target, while we are inching closer and closer to deflation. I could mention a number of other central banks in the world which seem trapped in the same kind of failed policies.

Ben Bernanke once argued that the Bank of Japan should show Rooseveltian resolve to bring Japan out of the deflationary trap. Unfortunately very few central bankers in the world today are willing to show any resolve at all despite the fact that we at least Europe is sinking deeper and deeper into a deflationary trap.

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Update: Former Riksbank deputy governor Lars E. O. Svensson comments on the Swedish deflation. See here.

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