All posts in category Federal Reserve

The graph Bernanke should look at before ‘exiting’ anything

Here is the Federal Reserve’s mandate:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

I don’t think it is the greatest mandate in the world, but it is the Fed’s mandate nonetheless.

I tried to estimate a simple reaction function for the fed based on “employment” (rate, Civilian Employment-Population ratio) and “prices” (PCE core inflation).  The estimation period is 1990 to 2007. 2008-13 is forecast.

Mankiw rule

Take a look at the forecast. The model is “forecasting” that the Fed funds target rate should be -7%!

I will leave it to my readers to judge whether the fed should ‘exit’ its quantitative easing programmes or not.

3 Comments
by Lars Christensen on March 11, 2013  •  Permalink
Posted in Ben Bernanke, Federal Reserve
Tagged , , ,

Posted by Lars Christensen on March 11, 2013

https://marketmonetarist.com/2013/03/11/the-graph-bernanke-should-look-at-before-exiting-anything/

It’s Frankfurt that should be your worry – not Rome

This week investors have been spooked by the election outcome in Italy, but frankly speaking is there anything new in that shady characters are doing well in an Italian election? Is there anything new in a hung parliament in Italy? Nope, judging from post-WWII Italian political history this is completely normal. Ok, Italian public finances is a mess, but again that not really news either.

So if all this is ‘business-as-usual’ why are investors suddenly so worried? My explanation would be that investors are not really worrying about what is going on in Rome, but rather about what is going on in Frankfurt.

Last year I argued that the ECB had introduced ‘political outcomes’ in its reaction function:

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

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

And this is really what concerns investors. The logic is that a ‘bad’ political outcome in Italy will lead the ECB to become more hawkish and effectively tighten monetary conditions by signaling that the ECB is not happy about the ‘outcome’ in Italy and therefore will not ease monetary policy going forward even if economic conditions would dictate that. This is exactly what happened in 2011-12 in the euro zone, where the political ‘outcomes’ in Greece, Italy and Spain clearly caused the ECB to become more hawkish.

The problems with introducing political outcomes into the monetary reaction function are obvious – or as I wrote last year:

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

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

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

Therefore investors are likely to watch comments from the ECB on the Italian elections as closely as the daily political show in Rome. However, there might be reasons to be less worried now than in 2011-12. The reason is not Europe, but rather what has been happening with US and Japanese monetary policy since August-September last year.

Hence, with the Fed effective operating the Bernanke-Evans rule and the Bank of Japan having introduced a 2% inflation target these two central banks effective have promised to offset any negative spill-over to aggregate demand from the euro zone to the US and the Japanese economy (this is basically the international financial version of the Sumner Critique – there is no global spill-over if the central banks have proper nominal targets).

Hence, if Italian political jitters spark financial jitters that threaten to push up US unemployment then the Fed will “automatically” step up monetary easing to offset the shock and investors should full well understand that. Hence, the Bernanke-Evans rule and the BoJ’s new inflation target are effective backstops that reduces the risk of spill-over from Italy to the global markets and the global economy.

However, investors obviously still worry about the possible reaction from the ECB. If the ECB – and European policy makers in general – uses political events in Italy to tighten monetary conditions then we are likely to see more unrest in the European markets. Hence, the ECB can end market worries over Italy today by simply stating that the ECB naturally will act to offset any spill-over from Italy to the wider European markets that threatens nominal stability in the euro zone.

Related posts:
News of Berlusconi once again slipped into the financial section
Spanish and Italian political news slipped into the financial section
Greek and French political news slipped into the financial section
Political news kept slipping into the financial section – European style
“…political news kept slipping into the financial section”

7 Comments
by Lars Christensen on February 28, 2013  •  Permalink
Posted in Bank of Japan, Bernanke-Evans rule, ECB, euro crisis, Federal Reserve, Italy, Sumner Critique
Tagged , , , , , ,

Posted by Lars Christensen on February 28, 2013

https://marketmonetarist.com/2013/02/28/its-frankfurt-that-should-be-your-worry-not-rome/

Don’t tell me the ‘currency war’ is bad for European exports – the one graph version

It is said that Europe is the biggest “victim” in what is said to be an international ‘currency war’ (it is really no war at all, but global monetary easing) as the euro has strengthened significantly on the back of the Federal Reserve and Bank of Japan having stepped up monetary easing.

However, the euro zone is no victim – to claim so is to reason from a price change as Scott Sumner would say. The price here of course is the euro exchange rate. The ‘currency war worriers’ claim that the strengthening is a disaster for European exports. What they of course forget is to ask is why the euro has strengthened.

The euro is stronger not because of monetary tightening in the euro zone, but because of monetary easing everywhere else. Easier monetary policies in the US and Japan obviously boost domestic demand in those countries and with it also imports. Higher American and Japanese import growth is certainly good news for European exports and that likely is much more important than the lose of “competitiveness” resulting from the stronger euro.

But have a look at European exporters think. The graph below is the Purchasing Managers Index (PMI) for euro zone new export orders. The graph is clear – optimism is spiking! The boost from improved Japanese and American growth prospects is clearly what is on the mind of European exporters rather than the strong euro.

PMIexport euro zone

11 Comments
by Lars Christensen on February 19, 2013  •  Permalink
Posted in Bank of Japan, Currency war, ECB, euro crisis, Federal Reserve
Tagged , , , ,

Posted by Lars Christensen on February 19, 2013

https://marketmonetarist.com/2013/02/19/dont-tell-me-the-currency-war-is-bad-for-european-exports-the-one-graph-version/

Jeff Cox is puzzled – maybe because he never asked anybody about monetary policy

This is CNBC’s Jeff Cox:

Investors who fled in fear over potentially massive tax increases associated with the “fiscal cliff” have barely broken a sweat over corresponding spending cuts that are only two weeks away.

The so-called sequestration of $110 billion a year in discretionary spending will happen March 1 if Congress does not come to an agreement.

With little indication that Washington is anywhere near a compromise similar to the one that avoided the full brunt of the fiscal cliff, markets could be expected to be in full panic mode.

But the post-cliff rally has shown no signs of letting up and the topic has gained little traction around Wall Street.

It is clear that Jeff never read any Market Monetarist blogs. If he had he would have known that monetary policy always overrules fiscal policy – there is monetary policy dominance and therefore financial markets should not be worried about a sizable fiscal tightening.

With the Bernanke-Evans rule the Fed has committed itself to continuing and escalating – if necessary – monetary easing until there is a substantial improvement of US labour market conditions – essentially this is a commitment to increasing aggregate demand. Hence, the Fed is also committed to counteract any negative impact on aggregate demand from a potential tightening of fiscal policy.

I have explained earlier that there is no reason to fear the fiscal cliff as long as there is a ‘monetary backstop’ in the form of the Bernanke-Evans rule:

Even if the fiscal cliff would be a negative shock to private consumption and public spending it is certainly not given that that would lead to a drop in overall aggregate demand. As I have discussed in earlier posts if the central bank targets NGDP or inflation for that matter then the central bank tries to counteract any negative demand shock (for example a fiscal tightening) by a similarly sized monetary expansion.

Even if we assume that we are in a textbook style IS/LM world with sticky prices and where the money demand is interest rate sensitive the budget multiplier will be zero if the central bank follows a rule to stabilize aggregate demand/NGDP.

As I have shown in an earlier post the LM curve becomes vertical if the monetary policy rule targets a certain level of unemployment or aggregate demand. This is exactly what the Bernanke-Evans rule implies. Effectively that means that if the fiscal cliff were to push up unemployment then the Fed would simply step up quantitative easing to force back down unemployment again.

Obviously the Fed’s actual conduct of monetary policy is much less “automatic” and rule-following than I here imply, but it is pretty certain that a 3, 4 or 5% of GDP tightening of fiscal policy in the US would trigger a very strong counter-reaction from the Federal Reserve and I strongly believe that the Fed would be able to counteract any negative shock to aggregate demand by easing monetary policy. This of course is the so-called Sumner Critique.

So Jeff the reason the markets are so relaxed about the so-called sequestration might very well be that the Fed has regained some credibility that it actually is controlling aggregate demand/NGDP. I know it is hard to understand that it is not important what is going on in the US Congress, but the markets really don’t care as long as the Fed is doing its job.

2 Comments
by Lars Christensen on February 16, 2013  •  Permalink
Posted in Bernanke-Evans rule, Federal Reserve, Fiscal cliff, Sumner Critique
Tagged , , , , ,

Posted by Lars Christensen on February 16, 2013

https://marketmonetarist.com/2013/02/16/jeff-cox-is-puzzled-maybe-because-he-never-asked-anybody-about-monetary-policy/

The root of most fallacies in economics: Forgetting to ask WHY prices change

Even though I am a Dane and work for a Danish bank I tend to not follow the Danish media too much – after all my field of work is international economics. But I can’t completely avoid reading Danish newspapers. My greatest frustration when I read the financial section of Danish newspapers undoubtedly is the tendency to reason from different price changes – for example changes in the price of oil or changes in bond yields – without discussing the courses of the price change.

The best example undoubtedly is changes in (mortgage) bond yields. Denmark has been a “safe haven” in the financial markets so when the euro crisis escalated in 2011 Danish bond yields dropped dramatically and short-term government bond yields even turned negative. That typically triggered the following type of headline in Danish newspapers: “Danish homeowners benefit from the euro crisis” or “The euro crisis is good news for the Danish economy”.

However, I doubt that any Danish homeowner felt especially happy about the euro crisis. Yes, bond yields did drop and that cut the interest rate payments for homeowners with floating rate mortgages. However, bond yields dropped for a reason – a sharp deterioration of the growth outlook in the euro zone due to the ECB’s two unwarranted interest rate hikes in 2011. As Denmark has a pegged exchange rate to the euro Denmark “imported” the ECB’s monetary tightening and with it also the prospects for lower growth. For the homeowner that means a higher probability of becoming unemployed and a prospect of seeing his or her property value go down as the Danish economy contracted. In that environment lower bond yields are of little consolation.

Hence, the Danish financial journalists failed to ask the crucial question why bond yields dropped. Or said in another way they failed to listen to the advice of Scott Sumner who always tells us not to reason from a price change.

This is what Scott has to say on the issue:

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

I totally agree. When we see a price change – for example oil prices or bond yields – we should ask ourselves why prices are changing if we want to know what macroeconomic impact the price change will have. It is really about figuring out whether the price change is caused by demand or supply shocks.

The euro strength is not necessarily bad news – more on the currency war that is not a war

A very good example of this general fallacy of forgetting to ask why prices are changing is the ongoing discussion of the “currency war”. From the perspective of some European policy makers – for example the French president Hollande – the Bank of Japan’s recent significant stepping up of monetary easing is bad news for the euro zone as it has led to a strengthening of the euro against most other major currencies in the world. The reasoning is that a stronger euro is hurting European “competitiveness” and hence will hurt European exports and therefore lower European growth.

This of course is a complete fallacy. Even ignoring the fact that the ECB can counteract any negative impact on European aggregate demand (the Sumner critique also applies for exports) we can see that this is a fallacy. What the “currency war worriers” fail to do is to ask why the euro is strengthening.

The euro is of course strengthening not because the ECB has tightened monetary policy but because the Bank of Japan and the Federal Reserve have stepped up monetary easing.

With the Fed and the BoJ significantly stepping up monetary easing the growth prospects for the largest and the third largest economies in the world have greatly improved. That surely is good news for European exporters. Yes, European exporters might have seen a slight erosion of their competitiveness, but I am pretty sure that they happily will accept that if they are told that Japanese and US aggregate demand – and hence imports – will accelerate strongly.

Instead of just looking at the euro rate European policy makers should consult more than one price (the euro rate) and look at other financial market prices – for example European stock prices. European stock prices have in fact increased significantly since August-September when the markets started to price in more aggressive monetary easing from the Fed and the BoJ. Or look at bond yields in the so-called PIIGS countries – they have dropped significantly. Both stock prices and bond yields in Europe hence are indicating that the outlook for the European economy is improving rather than deteriorating.

The oil price fallacy – growth is not bad news, but war in the Middle East is

A very common fallacy is to cry wolf when oil prices are rising – particularly in the US. The worst version of this fallacy is claiming that Federal Reserve monetary easing will be undermined by rising oil prices.

This of course is complete rubbish. If the Fed is easing monetary policy it will increase aggregate demand/NGDP and likely also NGDP in a lot of other countries in the world that directly or indirectly is shadowing Fed policy. Hence, with global NGDP rising the demand for commodities is rising – the global AD curve is shifting to the right. That is good news for growth – not bad news.

Said another way when the AD curve is shifting to the right – we are moving along the AS curve rather than moving the AS curve. That should never be a concern from a growth perspective. However, if oil prices are rising not because of the Fed or the actions of other central banks – for example because of fears of war in the Middle East then we have to be concerned from a growth perspective. This kind of thing of course is what happened in 2011 where the two major supply shocks – the Japanese tsunami and the revolutions in Northern Africa – pushed up oil prices.

At the time the ECB of course committed a fallacy by reasoning from one price change – the rise in European HICP inflation. The ECB unfortunately concluded that monetary policy was too easy as HICP inflation increased. Had the ECB instead asked why inflation was increasing then we would likely have avoided the rate hikes – and hence the escalation of the euro crisis. The AD curve (which the ECB effectively controls) had not shifted to the right in the euro area. Instead it was the AS curve that had shifted to the left. The ECB’s failure to ask why prices were rising nearly caused the collapse of the euro.

The money supply fallacy – the fallacy committed by traditional monetarists 

Traditional monetarists saw the money supply as the best and most reliable indicator of the development in prices (P) and nominal spending (PY). Market Monetarists do not disagree that there is a crucial link between money and prices/nominal spending. However, traditional monetarists tend(ed) to always see the quantity of money as being determined by the supply of money and often disregarded changes in the demand for money. That made perfectly good sense for example in the 1970s where the easy monetary policies were the main driver of the money supply in most industrialized countries, but that was not the case during the Great Moderation, where the money supply became “endogenous” due to a rule-based monetary policies or during the Great Recession where money demand spiked in particularly the US.

Hence, where traditional monetarists often fail – Allan Meltzer is probably the best example today – is that they forget to ask why the quantity of money is changing. Yes, the US money base exploded in 2008 – something that worried Meltzer a great deal – but so did the demand for base money. In fact the supply of base money failed to increase enough to counteract the explosion in demand for US money base, which effectively was a massive tightening of US monetary conditions.

So while Market Monetarists like myself certainly think money is extremely important we are skeptical about using the money supply as a singular indicator of the stance of monetary policy. Therefore, if we analyse money supply data we should constantly ask ourselves why the money supply is changing – is it really the supply of money increasing or is it the demand for money that is increasing? The best way to do that is to look at market data. If market expectations for inflation are going up, stock markets are rallying, the yield curve is steepening and global commodity prices are increasing then it is pretty reasonable to assume global monetary conditions are getting easier – whether or not the money supply is increasing or decreasing.

Finally I should say that my friends Bob Hetzel and David Laidler would object to this characterization of traditional monetarism. They would say that of course one should look at the balance between money demand and money supply to assess whether monetary conditions are easy or tight. And I would agree – traditional monetarists knew that very well, however, I would also argue that even Milton Friedman from time to time forgot it and became overly focused on money supply growth.

And finally I happily will admit committing that fallacy very often and I still remain committed to studying money supply data – after all being a Market Monetarist means that you still are 95% old-school traditional monetarist at least in my book.

PS maybe the root of all bad econometrics is the also forgetting to ask WHY prices change.

13 Comments
by Lars Christensen on February 14, 2013  •  Permalink
Posted in Bank of Japan, Currency war, David Laidler, Denmark, euro crisis, Federal Reserve, Mexico, Milton Friedman, Robert Hetzel, Scott Sumner, Sumner Critique, The Great Recession
Tagged , , , , , , , , , , , ,

Posted by Lars Christensen on February 14, 2013

https://marketmonetarist.com/2013/02/14/the-root-of-most-fallacies-in-economics-forgetting-to-ask-why-prices-change/

The exchange rate fallacy: Currency war or a race to save the global economy?

This is from CNB.com:

Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace…

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

This pretty much is what I would call the ‘exchange rate fallacy’ – hence the belief that monetary easing in someway is a zero sum game where monetary easing works through an “unfair” competitiveness channel and one country’s gain is another country’s lose.

Lets take the arguments one-by-one.

“…countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.”

The perception here is that monetary policy primarily works through a “competitiveness channel” where a monetary easing leads to a weakening of the currency and this improve the competitiveness of the nation by weakening the real value of the currency. The problem with this argument is first of all that this only works if there is no increase in prices and wages. It is of course reasonable to assume that that is the case in the short-run as prices and wages tend to be sticky. However, empirically such gains are minor.

I think a good illustration of this is relative performance of Danish and Swedish exports in 2008-9. When crisis hit in 2008 the Swedish krona weakened sharply as the Riksbank moved to cut interest rates aggressive and loudly welcomed the weakening of the krona. On the other hand Denmark continued to operate it’s pegged exchange rate regime vis-a-vis the euro. In other words Sweden initially got a massive boost to it’s competitiveness position versus Denmark.

However, take a look at the export performance of the two countries in the graph below.

swedkexports
Starting in Q3 2008 both Danish and Swedish exports plummeted. Yes, Swedish dropped slightly less than Danish exports but one can hardly talk about a large difference when it is taken into account how much the Swedish krona weakened compared to the Danish krone.

And it is also obvious that such competitiveness advantage is likely to be fairly short-lived as inflation and wage growth sooner or later will pick up and erode any short-term gains from a weakening of the currency.

The important difference between Denmark and Sweden in 2008-9 was hence not the performance of exports.

The important difference on the other hand the performance of domestic demand. Just have a look at private consumption in Sweden and Denmark in the same period.

SWDKcons

It is very clear that Swedish private consumption took a much smaller hit than Danish private consumption in 2008-9 and consistently has grown stronger in the following years.

The same picture emerges if we look at investment growth – here the difference it just much bigger.

swdkinvest

The difference between the performance of the Danish economy and the Swedish economy during the Great Recession hence have very little to do with export performance and everything to do with domestic demand.

Yes, initially Sweden gained a competitive advantage over Denmark, but the major difference was that Riksbanken was not constrained in it ability to ease monetary policy by a pegged exchange rate in the same way as the Danish central bank (Nationalbanken) was.

(For more on Denmark and Sweden see my earlier post The luck of the ‘Scandies’)

Hence, we should not see the exchange rate as a measure of competitiveness, but rather as an indicator of monetary policy “tightness”.When the central bank moves to ease monetary policy the country’s currency will tend to ease, but the major impact on aggregate demand will not be stronger export performance, but rather stronger growth in domestic demand. There are of course numerous examples of this in monetary history. I have earlier discussed the case of the Argentine devaluation in 2001 that boosted domestic demand rather exports. The same happened in the US when FDR gave up the gold standard in 1931. Therefore, when journalists and commentators focus on the relationship between monetary easing, exchange rates and “competitiveness” they are totally missing the point.

The ‘foolproof’ way out of deflation

That does not mean that the exchange rate is not important, but we should not think of the exchange rate in any other way than other monetary policy instruments like interest rates. Both can lead to a change in the money base (the core monetary policy instrument) and give guidance about future changes in the money base.

With interest rates effectively stuck at zero in many developed economies central banks needs to use other instruments to escape deflation. So far the major central banks of the world has focused on “quantitative easing” – increasing in the money base by buying (domestic) financial assets such as government bonds. However, another way to increase the money base is obviously to buy foreign assets – such as foreign currency or foreign bonds. Hence, there is fundamentally no difference between the Bank of Japan buying Japanese government bonds and buying foreign bonds (or currency). It is both channels for increasing the money base to get out of deflation.

In fact on could argue that the exchange rate channel is a lot more “effective” channel of monetary expansion than “regular” QE as exchange rate intervention is a more transparent and direct way for the central bank to signal it’s intentions to ease monetary policy, but fundamentally it is just another way of monetary easing.

It therefore is somewhat odd that many commentators and particularly financial journalists don’t seem to realise that FX intervention is just another form of monetary easing and that it is no less “hostile” than other forms of monetary easing. If the Federal Reserve buys US government treasuries it will lead to a weakening of dollar in the same way it would do if the Fed had been buying Spanish government bonds. There is no difference between the two. Both will lead to an expansion of the money base and to a weaker dollar.

“Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market”

This quote is typical of the stories about “currency war”. Monetary easing is seen as a zero sum game and only the first to move will gain, but it will be on the expense of other countries. This argument completely misses the point. Monetary easing is not a zero sum game – in fact in an quasi-deflationary world with below trend-growth a currency war is in fact a race to save the world.

Just take a look at Europe. Since September both the Federal Reserve and the Bank of Japan have moved towards a dramatically more easy monetary stance, while the ECB has continue to drag its feet. In that sense one can say that that the US and Japan have started a “currency war” against Europe and the result has been that both the yen and the dollar have been weakened against the euro. However, the question is whether Europe is better off today than prior to the “currency war”. Anybody in the financial markets would tell you that Europe is doing better today than half  a year ago and European can thank the Bank of Japan and the Fed for that.

So how did monetary easing in the US and Japan help the euro zone? Well, it is really pretty simple. Monetary easing (and the expectation of further monetary easing) in Japan and the US as push global investors to look for higher returns outside of the US and Japan. They have found the higher returns in for example the Spanish and Irish bond markets. As a result funding costs for the Spanish and Irish governments have dropped significantly and as a result greatly eased the tensions in the European financial markets. This likely is pushing up money velocity in the euro zone, which effectively is monetary easing (remember MV=PY) – this of course is paradoxically what is now making the ECB think that it should (prematurely!) “redraw accommodation”.

The ECB and European policy makers should therefore welcome the monetary easing from the Fed and the BoJ. It is not an hostile act. In fact it is very helpful in easing the European crisis.

If the more easy monetary stance in Japan and US was an hostile act then one should have expected to see the European markets take a beating. That have, however, not happened. In fact both the European fixed income and equity markets have rallied strongly on particularly the new Japanese government’s announcement that it want the Bank of Japan to step up monetary easing.

So it might be that some financial journalists and policy makers are scare about the prospects for currency war, but investors on the other hand are jubilant.

If you don’t need monetary easing – don’t import it

Concluding, I strongly believe that a global “currency war” is very good news given the quasi-deflationary state of the European economy and so far Prime Minister Abe and Fed governor Bernanke have done a lot more to get the euro zone out of the crisis than any European central banker has done and if European policy makers don’t like the strengthening of the euro the ECB can just introduce quantitative easing. That would curb the strengthening of the euro, but more importantly it would finally pull the euro zone out of the crisis.

Hence, at the moment Europe is importing monetary easing from the US and Japan despite the euro has been strengthening. That is good news for the European economy as monetary easing is badly needed. However, other countries might not need monetary easing.

As I discussed in my recent post on Mexico a country can decide to import or not to import monetary easing by allowing the currency to strengthen or not. If the Mexican central bank don’t want to import monetary easing from the US then it can simply allow the peso strengthen in response to the Fed’s monetary easing.

Currency war is not a threat to the global economy, but rather it is what could finally pull the global economy out of this crisis – now we just need the ECB to join the war.

11 Comments
by Lars Christensen on January 20, 2013  •  Permalink
Posted in Bank of Japan, Currency war, Denmark, ECB, Exchange rate policy, Exchange rates, Federal Reserve, Japan, Mexico, Sweden
Tagged , , , , , , , ,

Posted by Lars Christensen on January 20, 2013

https://marketmonetarist.com/2013/01/20/the-exchange-rate-fallacy-currency-war-or-a-race-to-save-the-global-economy/

The Fed’s easing is working…in Mexico

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

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

The Bernanke-Evans rule boosts the Mexican stock market

MXN stock market

Mexican consumers get a boost from Bernanke

conconfMEX

Mexican industrialists are falling in love with Bernanke

PMI mexico

The US-Mex monetary transmission mechanism

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

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

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

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

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

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

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

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

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

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

7 Comments
by Lars Christensen on January 18, 2013  •  Permalink
Posted in Bernanke-Evans rule, Evans rule, Federal Reserve, Mexico, Transmission mechanism
Tagged , , ,

Posted by Lars Christensen on January 18, 2013

https://marketmonetarist.com/2013/01/18/the-feds-easing-is-working-in-mexico/

Will anybody read this post if I put “data revisions” in the headline?

Opponents of NGDP level targeting often argue that nominal GDP is problematic as national account data often is revised and hence one would risk targeting the wrong data and that that could lead to serious policy mistakes. I in general find this argumentation flawed and find that it often based on a misunderstanding about what NGDP level targeting is about.

First of all let me acknowledge that macroeconomic data in general tend to undergo numerous revisions and often the data quality is very bad. That goes for all macroeconomic data in all countries. Some have for example argued that the seasonal adjustment of macroeconomic data has gone badly wrong in many countries after 2008. Furthermore, it is certainly not a nontrivial excise to correct data for different calendar effects – for example whether Easter takes place in February or March. Therefore, macroeconomic data are potentially flawed – not only NGDP data. That said, in many countries national account numbers – including GDP data – are often revised quite dramatically.

However, what critics fail to realise is that Market Monetarists and other proponents NGDP level targeting is arguing to target the present or history level of NGDP, but rather the future NGDP level. Therefore, the real uncertainty is not data revisions but about the forecasting abilities of central banks. The same is of course the case for inflation targeting – even though it often looks like the ECB is targeting historical or present inflation the textbook version of inflation forecasting clearly states that the central bank should forecast future inflation. In that sense future NGDP is not harder to forecast than future inflation.

I believe, however, there is pretty strong evidence that central banks in general are pretty bad forecasters and the forecasts are often biased in one or the other direction. There is therefore good reason to believe that the market is better at predicting nominal variables such as NGDP and inflation than central banks. Therefore, Market Monetarists – and Bill Woolsey and Scott Sumner particular – have argued that central banks (or governments) should set up futures markets for NGDP in the same way the so-called TIPS market in the US provides a market forecast for inflation. As such a market is a real-time “forecaster” and there will be no revisions and as the market would be forecasting future NGDP level the market would also provide an implicit forecast for data revisions – unlike regular macroeconomic forecasts. By using NGDP futures to guide monetary policy the central banks would not have to rely on potentially bias in-house forecasts and there would be no major problem with potential data revisions.

Furthermore, arguing that NGDP data can be revised might point to a potential (!) problem with NGDP, but at the same time if one argues that national account data in general is unreliable then it is also a problem for an inflation targeting central bank. The reason is that most inflation targeting central banks historical have use a so-called Taylor rule (or something similar) to guide monetary policy – to see whether interest rates should be increased or lowered.

We can write a simple Taylor rule in the following way:

R=a(p-pT)+b(y-y*)

Where R is the key policy interest rate, a and b are coefficients, p is actual inflation pT is the inflation target, y is real GDP and y* is potential GDP.

Hence, it is clear that a Taylor rule based inflation target also relies on national account data – not NGDP, but RGDP. And even more important the Taylor rule dependent on an estimate of potential real GDP.

Anybody who have ever seriously worked with trying to estimate potential GDP will readily acknowledge how hard it is to estimate and there are numerous methods to estimate potential GDP and the different methods – for example production function or HP filters – that would lead to quite different results. So here we both have the problem with data revisions AND the problem with estimating potential GDP from data that might be revised.

This is particularly important right now as many economists have argued that potential GDP has dropped in the both the US and the euro zone on the back of the crisis. If that is in fact the case then for a given inflation target monetary policy will have to be tighter than if there has not been a drop in potential GDP. Whether or not that has been a case is impossible to know – we might know it in 5 or 10 years, but now it is impossible to say whether euro zone trend growth is 1.2% or 2.2%. Who knows? That is a massive challenge to inflation targeting central bankers.

Contrary to this changes in potential GDP or for that matter short-term supply shocks (for example higher oil prices) will have no impact on the conduct on monetary policy as the NGDP targeting central bank will not concern itself with the split between real GDP growth and inflation.

An example of the problems of how we measure inflation is the ECB two catastrophic interest rate hikes in 2011. The ECB twice hiked interest rates and in my view caused a massive escalation of the euro crisis. What the ECB reacted to was a fairly steep increase in headline consumer prices. However, in hindsight (and for some of us also in real-time) it is (was) pretty clear that there was not a real increase in inflationary pressures in the euro zone. The increase in headline consumer price inflation was caused by supply shocks and higher indirect taxes, which is evident from comparing the GDP deflator (which showed no signs of escalating inflationary pressures) with consumer prices inflation. Again, there would have been no mixing up of demand and supply shocks if the ECB had targeted the NGDP level instead. From that it was very clear that monetary conditions were very tight in 2011 and got even tighter as the ECB moved to hike interest rates. Had the ECB focused on the NGDP level then it would obviously have realised that what was needed was monetary easing and not monetary tightening and had the ECB acted on that then the euro crisis likely would already have been over.

It should also be noted that even though NGDP numbers tend to be revised that does not mean that the quality of the numbers as such are worse than inflation data. In fact inflation data are often of a very dubious character. An example is the changes in the measurement of consumers prices in the US after the so-called Boskin report came out in 1996. The report concluded that US inflation data overestimated inflation by more than 1% – and therefore equally underestimated real GDP growth. Try to plug that into the Taylor rule above. That means that p is lower and y* is higher – both would lead to the conclusion that interest rates should be lowered. Some have claimed that the revisions made to the measurement of consumer prices in the US caused the Federal Reserve to pursue an overly easy monetary stance in the end of the 1990s, which caused the dot-com bubble. I have some sympathy for this view and at least I know that had the Fed been following a strict NGDP level targeting regime at the end of the 1990s then it would have tighten monetary faster and more aggressively than it did in particularly 1999-2000 as the Fed would have disregarded the split between prices and real GDP and instead focused on the escalation of NGDP growth.

Concluding, yes national account numbers – including NGDP numbers – are often revised and that creates some challenges for NGDP targeting. However, the important point is that present and historical data is not important, but rather the expectation of the future NGDP, which an NGDP futures market (or a bookmaker for that matter) could provide a good forecast of (including possible data revisions). Contrary to this inflation targeting central banks also face challenges of data revisions and particularly a challenge to separate demand shocks from supply shocks and estimating potential GDP.
Therefore, any critique of NGDP targeting based on the “data revision”-argument is equally valid – or even more so – in the case of inflation targeting. Hence, worries about data quality is not an argument against NGDP targeting, but rather an argument for scrapping inflation targeting – the ECB with its unfortunate actions proved that in both 2008 and 2011.

5 Comments
by Lars Christensen on January 9, 2013  •  Permalink
Posted in Bill Woolsey, ECB, Federal Reserve, Scott Sumner
Tagged , , , , ,

Posted by Lars Christensen on January 9, 2013

https://marketmonetarist.com/2013/01/09/will-anybody-read-this-post-if-i-put-data-revisions-in-the-headline/

Imagine the FOMC had listened to Al Broaddus in 2003

In my recent post on how the central banks of Australia, Poland and Sweden should have a look at Bennett McCallum’s MC rule I briefly mentioned how Richmond fed president Al Broaddus already back in 2003 warned that the Federal Reserve should have a plan for how to conduct monetary policy at the the “Zero Lower Bound”. It was of course Bob Hetzel’s brilliant book on the Great Recession that inspired me. In his book Bob quotes Broaddus’ comments at the June 24-25 2003 FOMC meeting.

Here is Broaddus (my bold):

With respect to our strategy and tactics going forward—trying to apply some of the lessons from history and even looking beyond them—I recognize that we may be able to address further disinflation by inducing significant additional reductions in long-term interest rates whether we explicitly target them or not. That’s what most people seem to be thinking about as the next step. But I’d like to add a new dimension to this discussion because bond rates, like short rates, are also subject to a zero bound at some point, which ultimately would put a limit on this policy channel if disinflation persisted or deflation began to threaten us. So I’d like to talk about what I’ll refer to as the “what next” issue for a couple of minutes. That issue is, How should we think about further monetary stimulus if we get to the point where both long- and short-term interest rate policies essentially have been immobilized?

Now, I agree with a lot of other people—although I’m not sure how many people around the table here—that the odds we will face this situation are small and may be exceedingly small. Because of that, it’s tempting to conclude that we have plenty of time and really don’t need to think about this or discuss it yet. In other words, we’ll cross that bridge when we get to it. But I would argue that it’s not only useful but actually urgent that we think about these kinds of options now. I’m building on the point you were making, Cathy, because confronting deflation just like confronting inflation involves a credibility problem. That’s the essence of it for me. Moreover, unlike inflation, the credibility problem in dealing with deflation is compounded by the zero bound on nominal interest rates. That raises at least the possibility that interest rate policy alone can’t deter deflation even if we’re willing to drive both short- and long-term interest rates to zero.

In the current situation—I’m not going to talk about current policy but use that as a framework in this situation—if the funds rate were to get closer to zero, the possibility of deflation has the potential to create deflation expectations and actual deflation simply because people may doubt that we can and will use monetary policy to combat deflation effectively at the zero bound. My concern is that waiting to say or think about how we would deliver further monetary stimulus if rates were to fall to zero could in some circumstances lead the public to conclude that we can’t do it.If people think we can’t deliver, that would risk creating a credibility deficit that could make it much more difficult to deal with this situation if in fact it arises and we try to use different types of policies to deal with it. So that’s why I think it’s essential that we begin to talk about this and consider it now. I’m not talking about developing a detailed strategy but at least putting something on the table.

…

Let me quickly recapitulate the key points I’ve tried to make here. The first is that, until we work through this “what next” scenario and communicate a credible strategy, addressing it to the public at some point, I think our contingency plans for confronting deflation will be incomplete. In my view, that would be a serious omission. We do a lot of contingency planning at the Fed, and I believe we should do some comprehensive contingency planning on this kind of scenario even if its probability is low. And I would say the sooner the better. We don’t have a stash of credibility as deflation fighters yet. If we delay thinking about and developing a strategy for dealing with further disinflation and it continues—and especially if it accelerates—we could wind up with a sizable credibility deficit.That could make it very difficult for us to employ successfully any strategy that we might be forced to come up with in this kind of situation. So I would just put that view on the table, too.

Today we can only imagine how the world would have looked if the FOMC had listened to Broaddus’ suggestions and put in place “contingency planning” to avoid crisis if the fed funds rate hit the zero lower bound. The FOMC unfortunately failed to do so – and so did the ECB, the Bank of England, the Bank of Japan and basically every single central bank in the world – maybe with the exception of the Monetary Authority in Singapore.

However, it is not to late for other central banks in the world to put in place contingency plans to “automatically prevent” disaster at the zero lower bound. Are you listening in Stockholm, Warsaw and Sydney? In Prague? (I have given up on Frankfurt…)

3 Comments
by Lars Christensen on December 11, 2012  •  Permalink
Posted in Al Broaddus, ECB, Federal Reserve, Marvin Goodfriend, MAS, McCallum, Robert Hetzel
Tagged , , , , ,

Posted by Lars Christensen on December 11, 2012

https://marketmonetarist.com/2012/12/11/imagine-the-fomc-had-listened-to-al-broaddus-in-2003/

Narayana – this might be love

Narayana Kocherlakota is fast becoming my favourite US central banker (leaving out a number of fed economists like Bob Hetzel who obviously is my main man at the fed…). Here is Kocherlakota:

“Let me turn then to the current stance of monetary policy. Five years ago, in October 2007, the Federal Reserve had under $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—of just under 5 percent. Five years later, the Federal Reserve owns nearly $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. It plans to buy still more over the remainder of 2012. It has also been targeting a fed funds rate of under a quarter percent for nearly four years—and anticipates continuing to do so through mid-2015. In the language of central banking, the Fed’s policy stance is considerably more accommodative than it was five years ago.

Some observers argue that the Fed has done too much, has been too accommodative. I strongly disagree. These critics are certainly right that the Fed’s actions—tripling its balance sheet and keeping the fed funds rate near zero for years—are historically unprecedented. But it is also clear that the economy has been hit by the worst shock in 80 years. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend, and so push down on both employment and prices. In order to fulfill its dual mandate of promoting price stability and promoting maximum employment, the FOMC must offset these adverse shocks by making monetary policy more accommodative.

In light of the unusually large macroeconomic shock, I believe that it is misleading to assess the FOMC’s actions by comparing its current choices to policy steps taken over the past 30 years. Instead, we have to assess monetary policy by comparing the economy’s performance relative to the FOMC’s goals of price stability and maximum employment. In particular, if the FOMC’s policy is too accommodative, that should manifest itself in inflation above the Fed’s target of 2 percent. This has not been true over the past year: Personal consumption expenditure inflation—including food and energy—is running closer to 1.5 percent than the Fed’s target of 2 percent.1

But this comparison using inflation over the past year is at best incomplete. Current monetary policy is typically thought to affect inflation with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy using our best possible forecast of inflation, not current inflation. Along those lines, most FOMC participants expect that inflation will remain at or below 2 percent over the next one to two years. Given how high unemployment is expected to remain over the next few years, these inflation forecasts suggest that monetary policy is, if anything, too tight, not too easy.”

I used to think Kocherlakota had no clue about monetary policy. I was obviously completely wrong –  Kocherlakota is very clearly one of the most clever fed voices around.

PS Scott Sumner also comments on Kocherlakota.

3 Comments
by Lars Christensen on October 31, 2012  •  Permalink
Posted in Federal Reserve, Narayana Kocherlakota
Tagged ,

Posted by Lars Christensen on October 31, 2012

https://marketmonetarist.com/2012/10/31/narayana-this-might-be-love/

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