Celebrating Robert Hetzel at 70

Scott Sumner once wrote  “I’ll die a happy man if my gravestone reads: Scott Sumner:  Devoted his life to blogging on Hetzelian ideas.” I think that is pretty telling of the importance of Robert Hetzel’s influence on the thinking of Market Monetarists like Scott Sumner, Marcus Nunes and myself.

On July 3 Bob is turning 70 so I find it suiting to celebrate Bob’s enormous contribution to monetary thinking. I will do that in a number of blog posts in the coming weeks ahead of his big day. The plan is to go through Bob’s main contributions. There is a lot so I hope I will be able to finish the job on time.

Discovering Bob  

I personally got to learn about Bob’s work back in the early 1990s – probably 1991 or 1992 – while studying at the University of Copenhagen. Reading Milton Friedman in my teens had already convinced me about the importance of money (before I started studying at the University of Copenhagen). However, the topic was really not getting much attention from my professors at the University so I started to read what I could find on monetarism on my own. That got me to read David Laidler, Anna Schwartz, Karl Brunner, Allan Meltzer and of course Robert Hetzel.

While reading the other monetarists I had obviously been convinced about the relevance of money supply targeting. However, Bob had another idea. He instead suggested that the market should implement monetary policy.

His idea was simple, but also brilliant. Bob in a number of articles in the early 1990s suggested that the government should issue inflation-linked bonds and that the central bank then should ‘peg’ inflation expectations at the central bank’s inflation target. So when inflation expectations for some reason would increase the central bank would simply go out and buy TIPS (as US inflation-linked bonds later became know as). That would reduce the money base and cause inflation (and inflation expectations) to drop.

Milton Friedman in his book Monetary Mischief (1992) endorsed Bob’s idea and said it would probably work better than money supply targeting.

I always felt the this idea was brilliant and I never understood why it did not get a lot more attention among economists and central bankers. Nonetheless it had tremendous influence on my own thinking about monetary policy and I fundamentally think that it is at the core of the ‘second monetarist counterrevolution’ – the development of Market Monetarism in the blogosphere in recent years.

Bob’s development or refinement of Milton Friedman’s monetarism was exactly to introduce rational expectations and to think about how a credible nominal monetary goal will impact the monetary transmission mechanism. This I believe is a tremendous improvement on the Friedmanite monetarist model.

Scott Sumner of course exactly at the same time started to think about how to use markets to implement monetary policy. I personally got familiar with Scott’s work on these issues at the same time as I learned about Bob’s contributions in the early 1990s.

In later posts I will look more specifically on Bob’s ideas about how to use the market to implement monetary policy and how it has impacted actual monetary policy in not only the US, but also other countries.

From the University of Chicago to the Richmond Fed 

Bob got the best monetary education money can buy – or rather could buy – at the University of Chicago in the early 1970s. He got his PhD in 1975 and his dissertation was on the sexy topic Short-Run Reserve Position Adjustment of New York City Banks. Obviously Milton Friedman was chairman of Bob’s dissertation committee.

There is no doubt that Milton Friedman by far has been the biggest influence on Bob’s thinking and he has never kept his admiration for Milton Friedman a secret. Bob has written a numerous articles on Friedman and it is very clear that Bob to this day remains a Friedmanite monetarist.

The same year (1975) Bob finished his PhD he joined the Richmond Fed and he has worked there ever since. As such he is by far one of the most experienced economists within the Fed system. In fact I have a theory that Bob is the current Fed official who has participated in most FOMC meetings ever, but that it just a theory…

Already from the very beginning at the Richmond Fed Bob started to influence the thinking at the bank. Hence, Bob was instrumental in convincing the Richmond Fed under the leadership of the then president Robert Black to challenge Fed Chairman Arthur Burns by arguing that the Fed was responsible for inflation and that it would only be possible to inflation under control by curbing the Fed’s money creation. At that time, only the San Francisco Fed had joined St. Louis in this view.

During the 1980s and 1990s the Richmond Fed became a bastion for monetarist thinking. In fact I believe that the Richmond Fed in those years took over role the St. Louis Fed earlier had had as the monetarist Fed district. Bob obviously played a key role in this.

While at the Richmond Fed Bob has written hundreds of articles and papers on monetary theory, thinking and history. And he has written two books on US monetary history:

The Monetary Policy of the Federal Reserve: A History (2008)
The Great Recession: Market Failure or Policy Failure? (2012)

Both books are tremendously good and insightful. I am of course the happy owner of both books and I strongly recommend them both to students. professors and layman alike who are interested in monetary matters and monetary history in particular.

My friend Bob

Bob has been a great inspiration to me since the early 1990s and he is undoubtedly one of the economists who have had the greatest influence on my own thinking about monetary matters. Equally important today is that I am very happy to say that Bob is not only a professional inspiration. I am also proud to call Bob my friend.

So I look forward to celebrating Bob in the coming weeks and pay tribute to his enormous contribution to monetary thinking over the past four decades.

Hetzel and Christensen

Hetzel and Christensen, Copenhagen 2012 (Photo Mary Hetzel)

 

Money and credit confused…again, again and again

The debate over the latest policy actions from the ECB has once again reminded me about one of the oldest failures in monetary debate – the confusion 0f  money and credit. This has been very visible in the discussion about monetary policy over the past six years both in Europe and the US.

The confusion of money and credit again and again has caused central banks to make the wrong decisions implementing credit policies and mistaking it for monetary easing.

I should really write a blog post on this, but it has already been done. Our friend and Market Monetarist blogger Bill Woolsey did it back in 2009. Bill used to be a student of Leland Yeager who back in 1986 wrote the ultimate paper on this issue with Robert Greenfield Money and Credit confused: An Appraisal of Economic Doctrine and Federal Reserve Procedure.

I stole this from Bill’s 2009 post Money and Credit Confused. Bill explains the crucial differences between money and credit very well:

Money is the medium of exchange. The quantity of money is the amount of money that exists at a point in time.

The demand for money is the amount of money that people want to hold at a point in time. To hold money is to not spend it.

The supply of credit is the amount of funds people want to lend during a period of time.

The demand for credit is the amount of funds that people want to borrow during a period of time.

An increase in the demand for money is not the same thing as an increase in the demand for credit.

An increase in the demand for credit means that households and firms want to borrow more. While it is possible that they want to borrow money in order to hold it, the more likely scenario is that they borrow in order to increase spending on some good or service, including, perhaps some other financial asset.

An increase in the demand for money could result in an increase in the demand for credit. People might borrow money in order to hold it. However, the more likely scenario is that people demanding more money will reduce expenditure out of current income, purchasing fewer other assets, goods, or services. Of course, they could also sell other assets.

An increase in the supply of credit isn’t the same thing as an increase in the quantity of money. While it is possible that new money is lent into existence, raising the quantity of money over a period of time while augmenting the supply of credit, it is also possible for the supply of credit to rise without an increase in the quantity of money. Purchases of new corporate bonds by households or firms, for example, adds to the supply of credit without adding to the quantity of money.

Because shifts in the share of the total supply of credit associated with money creation are possible, the quantity of money can rise over a period of time when the supply of credit is shrinking.

There are relationships between the supply and demand for money and the supply and demand for credit, both in disequilibrium and equilibrium. But money and credit are not the same thing.

As Bill notes – the first rule of monetary policy is not to confuse money and credit. Unfortunately central bankers do it all the time.

 —-

Update: A friend of mine thinks the ultimate discussion is not Yeager, but this one: Currie, Lauchlin. “Treatment of Credit in Contemporary Monetary Theory.” Journal of Political Economy 41 (February 1933), 58-79.

The ECB should give Bob Hetzel a call

The ECB is very eager to stress that the monetary transmission mechanism in some way is broken and that the policy measures needed is not quantitative easing, but measures to repair the monetary transmission mechanism.

In regard to ECB’s position I find this quote from a excellent paper – What Is a Central Bank? – by Bob Hetzel very interesting:

For example, in Japan, the argument is common that the bad debts of banks have broken the monetary transmission mechanism. The central bank can acquire assets to increase the reserves of commercial banks, but the weak capital position of banks limits their willingness to engage in additional lending. As in the real bills world, the marketplace controls the ability of the central bank to create independent changes in money that change prices.

According to the quantity theory as opposed to the real bills view, a central bank exercises its control over the public’s nominal expenditure through money (monetary base) creation. That control does not derive from the central bank’s influence over financial intermediation. A commercial bank acquires assets by making its liabilities attractive to individuals who forego consumption to hold them. In contrast, a central bank acquires assets through the ability to impose a tax (seigniorage) that comes from money creation. It imposes the tax directly on holders of cash and indirectly on holders of bank deposits to the extent that banks hold reserves against deposits.

Bob wrote the paper while he was a visiting scholar at the Bank of Japan in 2003.

It is striking how the present position of the ECB is similar to the BoJ’s position at the time Bob spend time there. Maybe the ECB should invite Bob to pay a visit?

—-

See also Bob’s paper Japanese Monetary Policy and Deflation.

Giles Wilkes is back!

Here is some good news for the blog readers, but some bad news for the UK government – my friend Giles Wilkes has left the UK government and is now back in the real life and more importantly he is back blogging. I highly recommend to everybody to follow Giles’ blog Freethinking Economist – A voice of reason against illiberal nonsense.

Anybody who knows Giles knows that he has been a passionate advocate for nominal GDP targeting within the UK government. Giles of course for the paste four years has served as Special Adviser (spad) to UK Secretary of State for Business, Innovation and Skills Vincent Cable.

Prior to serving as spad for Vince Cable Giles was Chief Economist at the self-described liberal think-tank Centre Forum. (For my American readers – remember ‘liberal’ has a somewhat different meaning in the UK than in the US). 

I very much look forward to reading Giles’ take on the UK economy in the future and I am convince that we now have one more UK based Market Monetarist blogger. Giles is not only blogging on monetary issues, but also on contemporary economic and political issues.

I also expect to disagree with Giles on a number of (non-monetary) issues as I general consider him to be to the left of my own views (most people are…), but that will certainly not stop me from reading Giles’ blog. If I have learned anything of the over the past 5-6 years it is that cognitive dissonance is the biggest threat to economic reasoning in the world. To be right you have to on a daily basis confront your own views. So I actually hope that I from time to time will disagree with Giles even though I am very certain that we will agree on major monetary policy issues.


Follow Giles on Twitter here (you can follow me here).

Related: Vince Cable gives me hope

 

“God forbid that our policy should ever work”

This is Mario Draghi at the ECB’s press conference yesterday:

“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring.”

You got to ask yourself why you would ease monetary policy if you don’t want inflation expectations to increase. And ask yourself if the market will believe this will work if the ECB is so eager to say that the policy will not increase inflation expectations.

It all just feel so Japanese – pre-Kuroda…

HT Nicolas Goetzmann

 

The massively negative euro zone ‘money gap’ (another one graph version)

Earlier today I put out post with ‘one graph’ illustrating just how much behind the curve the ECB is in terms of needed monetary easing. At the core of that blog post was a graph of the ‘price gap’. I defined the price gap as the percentage difference between the actual price level (measured with the GDP deflator) and a 2% path.

David Laidler has asked me how the ‘two graph’ version of the post would have looked. The other graph of course being the (broad) money supply rather than price level.

David, take a look at this graph:

money gap euro zone

We know from my earlier post that the ECB prior to 2008 basically was able to keep the actual price level very close to the ‘targeted’ price level (the 2% path). Therefore, we will also have to conclude that the actual money supply (M3) level was more or less right. Hence, if we assume an unchanged trend in money-velocity then it reasonable to also assume that the pre-crisis trend is the trend in the money supply necessary to return the price level to the pre-2008 trend.

I define the ‘money gap’ the percentage difference between the actual M3 level and the pre-2008 trend-level. The graph is extremely scary – the ‘money gap’ is now -30%! Said in another way – the ECB needs to expand M3 by 30% to bring prices back to the pre-crisis trend level or the ECB needs to engineer a massive change in expectations to push up money-velocity.

Don’t tell me that the ECB doesn’t need to do massive QE to avoid deflation…

PS I have chosen to ignore commenting on ECB’s policy decision earlier today, but lets just say that today’s action is unlikely to do much about the deflationary risks in the euro zone. Outright QE is needed.

PPS I have earlier discussed the euro zone ‘money gap’. See for example here.

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Leszek Balcerowicz on Poland’s success and Christensen on Balcerowicz’s success

For the past soon 15 year I have followed the economic development in Poland very closely and have visited the country very often. I have come to love the country and the Poles so I rejoice these days as Poland celebrates the 25 year anniversary of Poland’s first (partly) free election on June 4 1989. The democratic revolution opened the floodgates for free market reforms across the former communist countries in Central and Eastern Europe.

The main architect of the Polish reforms, which have led to a remarkable economic success over the past 25 years was Leszek Balcerowicz. Balcerowicz is one of my absolut biggest heroes. A great economist and a true reformer. Poles have a lot to thank Leszek Balcerowicz for. If anybody symbolizes the successful transition from communist dictatorship to free market democracy in Poland it is Leszek Balcerowicz.

Balcerowicz has a very good piece on Polish success story on FT.com.

I really feel like quoting the whole thing. But here is just a piece of it:

How does one explain these and other differences in economic performance after socialism, including the relative success of Poland? First, the quicker and more radical the improvement in the economic system – if sustained – the faster the long-term economic growth.

An early “Big Bang”, pioneered by Poland in 1990, and implemented even more radically by Estonia, has proved much better than delayed, slow or inconsistent reforms. For example, Poland introduced the convertibility of the currency as part of a large package of liberalisation and stabilisation measures less than four months from the start of its new government, while in Ukraine it took almost four years.

What kind of capitalism emerges is vital. In Poland (and most other CEE countries) the success of private groups does not depend, as a rule, on their political and bureaucratic connections, while in Russia or Ukraine this has been crucial.

Politicised or crony capitalism is not only unfair but inefficient, as it stifles economic competition and generates huge rent-seeking activity. Equal treatment is not only a matter of ethics but of efficiency.

Second, fiscal stance matters for growth. One reason for Hungary’s poor record has been the size of its government, coupled with persistent deficits, occasional fiscal crises and huge public debt. Poland’s fiscal situation has been far from ideal, but not as bad as Hungary’s.

Third, longer-term economic growth slows down when countries suffer deep recessions – a result of external shocks, boom-bust policies (Baltics, Bulgaria, Ukraine) or of the misallocation of credit by the dominant state banks (Slovenia).

Uniquely among post-socialist economies, Poland had no recession after 1989. A boom-bust pattern was avoided by relatively prudent monetary and supervisory policies while politicised misallocation of credit was avoided due to a surge in bank privatisation during 1998-2000.

Great stuff!

By the way this is what I wrote about Balcerowicz when he stepped down as central bank governor in 2007:

“Balcerowicz musi odejsc” (“Balcerowicz must go”). This was the all-too-familiar demand made by the populist Polish politician Andrzej Lepper when the outgoing Polish central bank governor Leszek Balcerowicz was Polish Finance Minister in the early 90s. Mr Lepper’s wish is to some extent now finally being fulfilled, as Mr. Balcerowicz steps down today after six successful years as central bank governor.

Mr. Balcerowicz has always been a controversial figure in Polish policymaking, but no one can dispute his enormous influence in the past 20 years – first as an economic advisor within the independent labour union Solidarność and participant in the roundtable negotiations that in 1989 led to the end of communist rule in Poland. As the first Finance Minister in post-communist Poland, from September 1989 to August 1991, Mr. Balcerowicz used what he has called a window of opportunity to implement the plan named after him – the Balcerowicz Plan – to transform Poland from an inefficient planned economy to a market economy. The Balcerowicz Plan was the first example of shock therapy being applied in the former communist countries in Central and Eastern Europe, and in our view there is no doubt that the reforms Mr. Balcerowicz engineered are one of the key reasons for Poland’s economic success over the last 18 years. Mr. Balcerowicz later continued the reform effort as Finance Minister once more from October 1997 to June 2000.

From December 2000 until today Mr. Balcerowicz has been governor of the Polish central bank (NBP). As NBP governor he has shown himself as a strong anti-inflationist central banker who has fearlessly defended the independence of the NBP from numerous unfortunate political attacks. The best measure of a central banker’s success is undoubtedly is the development in inflation, and here there is no doubt about Mr. Balcerowicz’s achievements. From December 2000 to November 2006, inflation in Poland dropped from 8.5% to 1.4% y/y – clearly something that Mr. Balcerowicz and his colleagues at the NBP can be proud of. Obviously there have also been policy mistakes over the last six years at the NBP. Some would, for example, argue that the NBP took far too long to ease monetary policy and this helped to push the Polish economy into a massive slowdown in 2001-2003. On the other hand, the NBP’s conservative approach to monetary policy during Mr. Balcerowicz’s rule has opened the door to a much more sustainable recovery in the Polish economy than would otherwise have been the case. It, of course, should also be noted that Mr. Balcerowicz’s term as NBP governor was to a minor degree tainted by fairly bad communication policies – that to some extent reflected internal disagreement at times within the NBP’s monetary policy council.

We say goodbye and thanks to Mr. Balcerowicz, but we don’t believe the charismatic liberal economist will be silenced and we expect – and hope – that Mr. Balcerowicz will continue to engage in the debate on economic policy in Poland in the coming years. Poland surely needs his input.

Luckily Leszek Balcerowicz has not been silenced and he has continued to call for further economic reforms in Poland so the success of the past 25 years can be continued.

This is Balcorwicz’s suggestions for reform in Poland – also from his FT-piece:

However, past success can be a poor predictor of performances, and Poland is not immune to this rule. Indeed, without additional reforms, Poland’s economic growth will slow considerably.

There are three reasons for this. First, the ageing population would reduce employment and increase the share of older, non-employed people. Second, Poland’s private investment ratio is the lowest in the region, along with that of Hungary. Third, the growth of overall efficiency (as measured by total factor productivity – TFP) which has been a main driver of Poland’s economic success, has slowed considerably in recent years.

These negative tendencies could be neutralised by further reforms. For example, Poland could considerably increase employment of younger and older people.

The gradual increase in the retirement age to 67 was a step in the right direction. But more has to be done – for example stopping and reversing the rise in the mandatory minimum wage.

Private investment could be raised by the elimination of various regulatory or bureaucratic barriers to investment and by increasing the savings ratio. Unfortunately, the de facto confiscation of the mandatory retirement savings enacted in 2013 was a step in the wrong direction.

I fully agree with Balcerowicz’s analysis and policy recommendations. Further deep structural reforms are certainly needed in Poland if the success of the past 25 years should be continued. But I am also hopeful that the great Polish people understands this.Congratulation to my beloved Poland with 25 years’ freedom and economic success.
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Balcerowicz book

 

 

The ECB is way behind the curve (the one graph version)

The ECB is today widely expected to introduce a number of measures to ease monetary conditions in the euro zone and it seems like the ECB is finally beginning to recognize the serious deflationary risks facing the euro zone.

But how far behind the curve is the ECB? There are a lot of measures of that, but if we look at the ECB’s own stated goal of 2% inflation then we will see that the ECB has basically failed consistently since 2008.

Below I look at the the level of the GDP deflator (which I believe is a better indicator of inflation than the ECB’s prefered measure – the HCIP inflation).

Price gap ECB

I think the graph very well illustrates just how big the ECB’s policy failure has been since 2008. From 1999 to 2008 the ECB basically kept the actual price level on a straight 2% path in line with its stated policy goal. However, since 2008 GDP deflator-inflation has consistently been well-below the 2%. As a result what I here call the price gap – the percentage difference between the actual price level and the 2% path – has kept on widening so the gap today is around 4%.

This is a massive policy mistake – and this is why the euro zone remains in crisis – and given the fact that we are basically not seeing any broad money supply growth at the moment the price gap is very likely to continue to widen. In fact outright deflation seems very likely if the ECB once again fails to take decisive action.

What should be done? It is really easy, but the ECB is likely to make it complicated 

At the ECB in Frankfurt they are happy to repeat Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon. So it should be really simple – if you have less than 2% inflation and want to ensure 2% inflation then you need to create more money. Unfortunately the ECB seems to think that it is in someway ‘dirty’ to create money and therefore we are unlikely to see any measures today to actually create money.

Most analysts expect a cut in ECB’s deposit rate to negative territory and maybe a new LTRO and even some kind of lending scheme to European SMEs. But all of that is basically credit policies and not monetary policy. Credit policy has the purpose of distorting market prices – and that shouldn’t really be the business of central banks – while monetary policy is about hitting nominal variables such as the price level or nominal spending by controlling the money base (money creation).

The ECB needs to stop worrying about credit markets and instead focus on ensuring nominal stability. So to me it is very simple. Today Mario Draghi simply should announce that the ECB has failed since 2008, but that that will now change.

He should pre-commit to bringing back the price level to the ‘old’ trend within the next two years and do that he should keep expanding the euro zone money base (by buying a basket of GDP weight euro zone government bonds) until he achieves that goal and he should make is completely clear that there will be no limits to the expansion of the money base. The sole purpose of his actions will be to ensure that the price level is brought back on track as fast as possible.

Once the price level is brought back to the old trend it should be kept on this 2% trend path.

How hard can it be?

PS Yes, I fundamentally would like the ECB to target the nominal GDP level, but targeting the GDP deflator price level would be pretty close to my preferred policy.

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A clean break with Hollande (A lesson for Piketty)

Over the past week we have had reports of the deteriorating state of public finances in France and particular the drop in tax revenues. It seems like Hollande’s steep tax increases are not bringing in any extra revenue. President Hollande has been hit right in the face by the Laffer curve.

This is from BBC.com (it is not exactly news – the story is six days old):

The French government faces a 14bn-euro black hole in its public finances after overestimating tax income for the last financial year.

French President Francois Hollande has raised income tax, VAT and corporation tax since he was elected two years ago.

The Court of Auditors said receipts from all three taxes amounted to an extra 16bn euros in 2013.

That was a little more than half the government’s forecast of 30bn euros of extra tax income.

The Court of Auditors, which oversees the government’s accounts, said the Elysee Palace’s forecasts of tax revenue in 2013 were so wildly inaccurate that they cast doubt on its forecasts for this year.

It added the forecasts were overly optimistic and based on inaccurate projections.

The figures come a week after French Prime Minister Manuel Valls, who was appointed in March following the poor showing of Mr Hollande’s Socialists in municipal elections, appeared to criticise the president’s tax policy by saying that “too much tax kills tax”.

The failed policies of Mr. Hollande have reminded me of an excellent quote from Bernard Connolly’s great book “The Rotten Heart of Europe”:

“Mitterand had spoken of ‘making a clean break with capitalism’. Capital immediately decided to make a clean break with him: funds flowed out of France at a dizzy rate in the days following his triumph”

Yesterday, I finished reading Thomas Piketty’s Capital in the twenty-first century. In the book he is advocating a global tax on capital – indicating a capital gains tax in excess of 80% would be preferable. This is the kind of policies that Mitterrand tried and failed with and that Hollande is now trying again.

What strikes me is that neither Mitterrand nor Hollande had any idea about how economic incentives work. And frankly speaking when I read Piketty’s book then my main take away was exactly the same – Piketty doesn’t seem to understand incentives. It is social planing or engineering rather than economics.

The state of the France economy would be so much better if French policy makers studied the real great French economists – Jean-Baptiste Say and Frédéric Bastiat – rather than Thomas Piketty.

Committed to a failing strategy: low for longer = deflation for longer?

Recently there has been a debate about whether low interest rates counterintuitively actually leads deflationNarayana Kocherlakota, President of the Minneapolis Fed, made such an argument a couple of years ago (but seems to have changed his mind now) and it seems like BIS’ Claudio Borio has been making an similar argument recently. Maybe surprisingly to some (market) monetarists will make a similar argument. We will just turn the argument upside down a bit. Let me explain. 

Most people would of course say that low interest rates equals easy monetary policy and that that leads to higher inflation – and not deflation. However, this traditional keynesian (not New Keynesian) view is wrong because it confuses “the” interest rate for the central bank’s policy instrument, while the interest rate actually in the current setting for most inflation targeting central banks is an intermediate target.

The crucial difference between instruments, intermediate instruments and policy goals

To understand the problem at hand I think it is useful to remind my readers of the difference between monetary policy instruments, intermediate targets and policy goals.

The central bank really only has one instrument and that is the control of the amount of base money in the economy (now and in the future). The central bank has full control of this.

On the other hand interest rates or bond yields are not under the direct control of the central bank. Rather they are intermediate targets. So when a central bank says it is it is cutting or hiking interest rates it is not really doing that. It is intervening in the money market (or for that matter in the bond market) to change market pricing. But it is doing so by controlling the money base. This is why interest rates is an intermediate target. The idea is that by changing the money base the central bank can push interest rates up or down and there by influencing the aggregate demand to increase or decrease inflation is that is what the central bank ultimately wants to “hit”.

Similarly Milton Friedman’s suggestion for central banks to target money supply growth is an intermediate target. The central bank does not directly control M2 or M3, but only the money base.

So while interest rates (or bond yields) and the money supply are not money policy instruments they are intermediate targets. Something central banks “targets” to hit an the ultimate target of monetary policy. What we could call this the policy goal. This could be for example inflation or nominal GDP.

When you say interest rates will be low – you tell the markets you plan to fail

Why is this discussion important? Well, it is important because because when central banks are confused about these concepts they also fail to send the right signals about the monetary policy stance.

Milton Friedman of course famously told us that when interest rates are low it is normally because monetary policy has been tight. This of course is nothing else than what Irving Fisher long ago taught us – that there is a crucial difference between real and nominal interest rates. When inflation expectations increase nominal interest rates will increase – leaving real interest rates unchanged.

The graph below pretty well illustrates this relationship.

PCE core yield Fed funds

The correlation is pretty obvious – there is a positive (rather than a negative) correlation between on the one hand interest rates/bond yields and on the other hand inflation (PCE core). This of course says absolutely nothing about causality, but it seems to pretty clearly show that Friedman and Fisher were right – interest rates/yields are high (low) when inflation is high (low).

This is of course does not mean that we can increase inflation by hiking interest rates. This is exactly because the central bank does not directly control interest rates and yields. Arguably the central bank can of course (in some circumstances) in the short decrease rates and yields through a liquidity effect. For example by buying bonds the central banks can in the short-term push up the price of bonds and hence push down yields. However, if the policy is continued in a committed fashion it should lead to higher inflation expectations – this will push up rates and yields.  This is exactly what the graph above shows. Central bankers might suffer from money illusion, but you can’t fool everybody all of the time and investors, consumers and labourers will demand compensation for any increase in inflation.

This also illustrates that it might very well be counterproductive for central bankers to communicate about monetary in terms of interest rates or yields. Because when central bankers in recent years have said that they want to keep rates ‘low for longer’ or will do quantitative easing to push down bond yields they are effectively saying that they will ensure lower inflation or even deflation. Yes, that is correct central bankers have effectively been saying that they want to fail.

Said, in another if the central bank communicates as if the interest rate is it’s policy goal then when it says that it will ensure low interest rates then market expectation will adjust to reflect that. Therefore, market participants should expect low inflation or deflation. This will lead to an increase in money demand (lower velocity) and this will obviously on its own be deflationary. This is why “low for longer” if formulated as a policy goal could actually lead to deflation.

Obviously this is not really what central bankers want. But they are sending confusing signals then they talk about keeping rates and yields low and at the same time want to “stimulate” aggregate demand. As consequence “low for longer”-communication is actually undermining the commitment to spurring aggregate demand and “fighting” deflation.

Forget about rates and yields – communicates in terms of the ultimate target/goal 

Therefore, central bankers should stop communicating about monetary policy in terms of interest rates or bond yields. Instead central bankers should only communicate in terms of what they ultimately want to achieve – whether that is an inflation target or a NGDP target. In fact the word “target” might be a misnomer. Maybe it is actually better to talk about the goal of monetary policy.

Lets take an example. The Federal Reserve wants to hit a given NGDP level goal. It therefore should announces the following:

“To ensure our goal of achieve 5% nominal GDP growth (level targeting) we will in the future adjust the money base in such a fashion to alway aiming at hitting our policy goal. There will be no limits to increases or decreases in the money base. We will also do whatever is necessary to hit this goal.”

And lets say Fed boss Janet Yellen is asked by a journalist about the interest rates and bond yields. Yellen should reply the following:

“Interest rate and bond yields are market prices in the same way as the exchange rate or property prices. The Fed is not targeting either and it is not our policy instrument. Our policy goal is the level of nominal GDP and we use changes in the money base – this is our policy instrument – to ensure this policy goal. We expect interest rates and yield to adjust in such a fashion to reflect our monetary policy. My only advice to investors is to expect us to alway hit our policy goal.”

Said in another way interest rates and yields are endogenous. They reflect market expectations for inflation and growth. So when the Fed and other central banks in giving “forward guidance” in terms of interest rates they are seriously missing the point about forward guidance. The only forward guidance needed is what policy goal the central bank has and an “all-in” commitment to hit that policy goal by adjusting the money base.

Finally, notice that I am NOT arguing that the Fed or any other central bank should hike interest rates to fight deflation – that would be complete nonsense. I am arguing to totally stop communicating about rates and yields as it totally mess up central bank communication.

PS Scott Sumner and Tim Duy have similar discussions in recent blog posts.

PPS Mike Belongia has been helpful in shaping my view on these matters.

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