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PEP, NGDPLT and (how to avoid) Russian monetary policy failure

I am sitting in Riga airport and writing this. I have an early (too early!) flight to Stockholm. I must admit it makes it slightly more fun to sit in an airport when you can do a bit of blogging.

Anyway, I have been giving quite a bit of thought to the Jeff Frankel’s idea about “Peg to the Export Price” (PEP). What Frankel’s is suggesting is that commodity exporters like Russia should peg their currencies to the price of the main commodity they export – in the case of Russia that would of course be the oil price.

This have made me think about the monetary transmission mechanism in an Emerging Market commodity exporter like Russia and how very few people really understand how monetary policy works in an economy like the Russian. I have, however, for more than a decade as part of my day-job spend quite a lot of time analysing the Russian economy so in this post I will try to spell out how I see the last couple of years economic development in Russia from a monetary perspective.

The oil-money nexus and why a higher oil price is a demand shock in Russia

Since the end of communism the Russian central bank has primarily conducted monetary policy by intervening in the currency market and currency intervention remains the Russian central bank’s (CBR) most important policy instrument. (Yes, I know this is a simplification, but bear with me…)

In the present Russian monetary set-up the CBR manages the ruble within a fluctuation band against a basket of euros (45%) and dollars (55%). The composition of the basket has changed over time and the CBR has gradually widened the fluctuation band so one can say that we today has moved closer to a managed or dirty float rather than a purely fixed currency. However, despite of for years having had the official intention of moving to a free float it is very clear that the CBR has a quite distinct “fear of floating”.  The CBR is not alone in this – many central banks around the world suffer from this rather irrational fear. This is also the case for countries in which the central banks officially pursue a floating exchange rate policy. How often have you not heard central bankers complain that the currency is too strong or too weak?

With the ruble being quasi-fixed changes in the money supply is basically determined by currency inflows and outflows and as oil and gas is Russia’s main exports (around 80% of total exports) changes in the oil prices determines these flows and hence the money supply.

Lets say that the global demand for oil increases and as a consequence oil prices increase by 10%. This will more or less lead to an 10% increase in the currency inflow into Russia. With inflows increasing the ruble will tend to strengthen. However, historically the CBR has not been happy to see such inflow translate into a strengthening of the ruble and as a consequence it has intervened in the FX market to curb the strengthening of the ruble. This basically means that that CBR is printing ruble and buying foreign currency. The logic consequence of this is the CBR rather than allowing the ruble to strengthen instead is accumulating ever-larger foreign currency reserves as the oil price is increasing. This basically has been the trend for the last decade or so.

So due to the CBR’s FX policy there is a more or less direct link from rising oil prices to an expansion of the Russian money supply. As we all know MV=PY so with unchanged money-velocity (V) an increase in M will lead to an increase in PY (nominal GDP).

This illustrates a very important point. Normally we tend to associate increases in oil prices with a supply shock. However, in the case of Russia and other oil exporting countries with pegged or quasi-pegged exchange rates an increase in the oil price will be a positive demand shock. Said in another other higher oil prices will push the AD curve to the right. This is also why higher oil prices have not always lead to a higher current account surplus in Russia – higher oil prices will boost private consumption growth and investments growth through an increase in the money supply. This is not exactly good news for the current account.

The point that an increase in oil prices is a demand shock in Russia is illustrated in the graph below. Over the past decade there has been a rather strong positive correlation changes in the price of oil (measured in ruble) and the growth of nominal GDP.

This correlation, however, can only exist as long as the CBR intervenes in the FX market to curb the strengthening of the ruble and if the CBR finally moved to a free floating ruble then the this correlation most likely would break down. Hence, with a freely floating ruble the money supply and hence NGDP would be unaffected by higher or lower oil prices.

PEP would effective have been a ‘productivity norm’ in Russia

So by allowing the ruble to appreciate when oil prices are increase it will effective stabilise the development the money supply and therefore in NGDP. Another way to achieve this disconnect between NGDP and oil prices would be to directly peg the ruble to the oil price. So an increase in the oil price of 10% would directly lead to an appreciation of the ruble of 10% (against the dollar).

As the graph above shows there has been a very close correlation between changes in the oil prices (measured in ruble) and NGDP. Furthermore, over the past decade oil prices has increased around 20% yearly versus the ruble and the yearly average growth of nominal GDP has been the exactly the same. As a consequence had the CBR pegged pegged the ruble a decade ago then the growth of NGDP would likely have averaged 0% per year.

With NGDP growth “pegged” by PEP to 0% we would effectively have had what George Selgin has termed a “productivity norm” in Russia where higher real GDP growth (higher productivity growth) would lead to lower prices. Remember again – if MV=PY and MV is fixed through PEP then any increase in Y will have to lead to lower P. However, as oil prices measured in ruble are fixed it would only be the prices of non-tradable goods (locally produced and consumed goods), which would drop. This undoubtedly would have been a much better policy than the one the CBR has pursued for the last decade – and a boom and bust would have been avoid from 2005 to 2009. (And yes, I assume that nominal rigidities would not have created too large problems).

Russia boom-bust and how tight money cause the 2008-9 crisis in Russia

Anybody who visits Moscow will hear stories of insanely high property prices and especially during the boom years from 2006 to when crisis hit in 2008 property prices exploded in Russia’s big cities such St. Petersburg and Moscow. There is not doubt in my mind that this property market boom was caused my the very steep increase in the Russian money supply which was a direct consequence of the CBR’s fear of floating the ruble. As oil prices where increasing and currency inflows accelerated in 2006-7 the CBR intervened to curb the strengthening of the ruble.

However, the boom came to a sudden halt in 2008, however, unlike what is the common perception the crisis that hit hard in 2008 was not a consequence of the drop in oil prices, but rather as a result of too tight monetary policy. Yes, my friends recessions are always and everywhere a monetary phenomenon and that is also the case in Russia!

Global oil prices started to drop in July 2008 and initially the Russian central bank allowed the ruble to weaken. However, as the sell-off in global oil prices escalated in Q3 2008 the CBR clearly started to worry about the impact it would have on ruble. As a consequence the CBR started intervening very heavily in the FX markets to halt the sell-off in the ruble. Obviously to do this the CBR had to buy ruble and sell foreign currency, which naturally lead to drop in the Russian foreign currency reserves of around 200bn dollars in Q3 2008 and a very sharp contraction in the Russian money supply (M2 dropped around 20%!). This misguided intervention in the currency market and the monetary contraction that followed lead to a collapse in Russian property prices and sparked a major banking crisis in Russia – luckily the largest Russian banks was not too badly affected by this a number medium sized banks collapsed in late 2008 and early 2009. As a consequence money velocity also contracted, which further worsened the economic crisis. In fact the drop in real GDP was the latest among the G20 in 2008-9.

…and how monetary expansion brought Russia out of the crisis

As the Russian FX reserve was dwindling in the Autumn 2008 the Russian central bank (probably) realised that either it would cease intervening in the FX or be faced with a situation where the FX reserve would vanish. Therefore by December 2008 the CBR stepped back from the FX market and allowed for a steeper decline in the value of the ruble. As consequence the contraction in the Russian money supply came to an end. Furthermore, as the Federal Reserve finally started to ease US monetary policy in early 2009 global oil prices started to recover and as CBR now did not allow the rub to strengthen at the same pace of rising oil prices the price of oil measured in ruble increase quite a bit in the first half of 2009.

The monetary expansion has continued until today and as a consequence the Russian economy has continued to recover. In fact contrary to the situation in the US and the euro zone one could easily argue that monetary tightening is warranted it in Russia.

Oil prices should be included in the RUB basket

I hope that my arguments above illustrate how the Russian crisis of 2008-9 can be explained by what the great Bob Hetzel calls the monetary disorder view. I have no doubt that if the Russian central bank had allowed for a freely floating ruble then the boom (and misallocation) in 2006-7 would have been reduced significantly and had the ruble been allowed to drop more sharply in line with oil prices in the Autumn of 2008 then the crisis would have been much smaller and banking crisis would likely have been avoided.

Therefore, the policy recommendation must be that the CBR should move to a free float of ruble and I certainly think it would make sense for Russia also to introduce a NGDP level target. However, the Russian central bank despite the promises that the ruble soon will be floated (at the moment the CBR say it will happen in 2013) clearly seems to maintain a fear of floating. Furthermore, I would caution that the quality of economic data in Russia in general is rather pure, which would make a regular NGDP level targeting regime more challenging. At the same time with a relatively underdeveloped financial sector and a generally low level of liquidity in the Russian financial markets it might be challenging to conduct monetary policy in Russian through open market operations and interest rate changes.

As a consequence it might be an idea for Russia to move towards implementing PEP – or rather a variation of PEP. Today the CBR manages the ruble against a basket of euros and dollars and in my view it would make a lot of sense to expand this basket with oil prices. To begin with oil prices could be introduced into the basket with a 20% weight and then a 40% weight for both euros and dollars. This is far from perfect and the goal certainly should still be to move to a free floating ruble, but under the present circumstances it would be much preferable to the present monetary set-up and would strongly reduce the risk of renewed bubbles in the Russian economy and as well as insuring against a monetary contraction in the event of a new sharp sell-off in oil prices.

…as I am finishing this post my taxi is parking in front of my hotel in Stockholm so now you know what you will be able to write going from Latvia to Sweden on an early Wednesday morning. Later today I will be doing a presentation for Danske Bank’s clients in Stockholm. The topics are Emerging Markets and wine economics! (Yes, wine economics…after all I am a proud member for the American Association of Wine Economists).

27 Comments
by Lars Christensen on April 18, 2012  •  Permalink
Posted in George Selgin, Jeffrey Frankel, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, Peg the Export Price (PEP), Productivity Norm, Robert Hetzel, Russia, Transmission mechanism
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Posted by Lars Christensen on April 18, 2012

https://marketmonetarist.com/2012/04/18/pep-ngdplt-and-how-to-avoid-russian-monetary-policy-failure/

The ideal central banker spends most of his time golfing

Who is the best central banker – one who is very busy with his job or one who is spending most of his/her time on the golf field?

The answer is the golfing central banker is the best of the two because if you are very busy you have probably not been doing your job in a proper fashion. The task of any central banker should be to ensure nominal stability and not to distort relative prices in the economy.

The best way to ensure nominal stability is through implementing a monetary policy regime based on very clear, transparent and automatic rules. Central bankers that do that will not have a lot to do as the markets would do most of the lifting.

This is in fact what happened during the Great Moderation – both in the US and in most of Europe. During the Great Moderation the markets’ had a high level of trust in the credibility of central banks in the US and Europe and in general it was expected that these central banks would deliver nominal stability. In fact markets behaved as if the Fed and the ECB were targeting a NGDP level target. This meant that what central bankers basically had do was to put on the central banker outfit (a dark suit and a not too fancy tie) and then say things that confirmed the markets in the expectation that the central bank would ensure nominal stability. There would be lot of time for golfing in that scenario.

If the central bank is fully credible and monetary policy follow clear rules (for example a NGDP level target) then the central bankers are unlike to be busy – at least not with monetary policy. Monetary demand would simply move up and down and more or less ensure the fulfillment of the nominal target. However, if the central bank is not credible then there will be no time to spend on the golf course.

Lets say that the central bank has a NGDP level target and the NGDP level moves above the target level. In the case of the credible central bank the markets would expect the central bank to act to bring down NGDP to the target level. Hence, market participants would expect monetary policy to be tightened. This would lead to a strengthening of the country’s currency and a drop in stock prices. Similarly as investors and consumers expect tighter monetary policy they would expect the value of money to increase. As a consequence investors and consumers would increase money demand. All this would automatically slow NGDP growth and bring back the NGDP level to the target level. In the scenario with a 100% credible target the central bank would not do anything other than look serious and central bank-like and the market would take care of everything else. Changes in money demand rather than in the money supply that would ensure the fulfillment of the target.

On the other hand if the central bank is not credible then market participants would not expect the that the central bank would bring the NGDP level back on track. In this scenario the central bank would actively have to change the money supply to push back NGDP to the target level. In fact it might have to reduce the money supply a lot to counteract any moves in money demand. Hence, if NGDP increases above the target level and the central bank does not act then market participants would in fact think that the central bank will continue to increase NGDP and as a consequence money demand will drop like a stone. Therefore the central bank would be very busy trying to steer the money supply and would likely not succeed if it does not gain credibility and money-velocity would become increasingly erratic. This is why inflation normally increases much more than the money supply in the “normal” hyperinflation scenario.

The worst possible scenario is that the central bankers start to micromanage things. He/she does not like the currency to be too strong, but property prices are too high and credit growth too strong for his liking. And he is very concerned about foreign currency lending among households. But he is also concerned about the export sector’s weak competitiveness. So he is intervening in the currency market to weaken the currency, but that is spurring money supply growth and he does not like that either so he is telling commercial bank to stop the credit expansion or he will increase reserve requirements. The threats works. The commercial banks curb lending growth, but other players are not willing to listen – so more shady players in the consumer credit market moves in. No time for golfing and the central bankers is just getting more and more angry. “Stupid banks and markets. Can’t they understand that I can’t do everything?”  

This might be a caricature, but look at most central banks in the developed world since 2008 – they have been very busy and they have to a very large extent been busy micromanaging things. And regulators have not made their job easier.

So why is that? They are simply no longer credible central bankers. There is no time for golfing because the focus has been on micromanaging everything rather than on recreating credibility. It is time for that to change so central bankers once again will have time for golfing – and the global economy finally can move out of this crisis.

 

 

 

8 Comments
by Lars Christensen on April 12, 2012  •  Permalink
Posted in Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, The Great Moderation, The Great Recession, Transmission mechanism
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Posted by Lars Christensen on April 12, 2012

https://marketmonetarist.com/2012/04/12/the-ideal-central-banker-spends-most-of-his-time-golfing/

Boettke and Smith on why we are wasting our time

I am beginning to get a serious problem in keeping up with all the interesting papers, which are being published at the moment. The latest paper that I clearly have to read is a rather impressive paper (124 pages!) by Peter Boettke and Daniel Smith.

The topic of Pete’s and Daniel’s paper – which I still have not read – is basically a discussion of the public choice aspects of central banking. This is a topic I find extremely interesting and I look very much forward to reading the paper in the near future (I will be on vacation next week – so maybe…).

Here is the abstract of the paper “Monetary Policy and the Quest for Robust Political Economy”:

The economics profession not only failed to predict the recent financial crisis; it has been struggling in its aftermath to reach a consensus on the cause(s) of the crisis. While competing narratives are being offered and evaluated, the narrow scope of the debate on the strictly technical aspects of monetary policy that have contributed to and prolonged the crisis has precluded the a broader examination of questions of political economy that may prove to be of greater import. Attempting to find the technically optimal policy is futile when the Federal Reserve’s independence is undermined by the political influences of contemporary democracy. Nobel Laureates F.A. Hayek, Milton Friedman, and James Buchanan each sought ways to constrain and protect a monetary authority from political pressures in their research. Each one ended up rejecting the possibility of doing so without a fundamental restructuring of our monetary regime. Hayek turned to denationalization, Buchanan to constitutionalism, and Friedman to binding rules. We incorporate their experiences to make a case for applying the concepts of robust political economy to the Federal Reserve. Robust political economy calls for relaxing idealized assumptions in order to seek out institutional regimes that can overcome both the epistemic and motivational hurdles that characterize contemporary democratic settings.

Even though I have not read the paper yet I have a pretty good idea where Pete and Daniel are going – they are questioning whether we can convince central bankers to do the right thing. Market Monetarists want central banks to target the nominal GDP level. We want central banks to follow rules. However, we are up against the powers of public choice theory. One can easily argue that central bankers will never give up their discretionary powers and politicians will always interfere with the conduct of monetary policy. It is simply in their selfish interest to do so and therefore the project to convince central bankers to do the right thing – NGDP level targeting – is just a waste of time. We should rather focus on fundamental institutional reforms.

This is fundamentally the issue that any reformist in any area will have to struggle with – how can we expect those in power to give up that power? How can we implement reforms? A way to beat the logic of public choice theory is through the powers of ideas. Milton Friedman was in the business of ideas all his life. The powers of governments – and central banks – can be rolled back through the sheer power of strong arguments and good ideas. It is never going to be easing, but when Scott Sumner started to blog about NGDP targeting nobody listened. Now Federal Reserve scholars are serious talking about it and doing research about it and even the FOMC has debate NGDP targeting. There is therefore reason to be optimistic. But I will be the first to admit that I find it unlikely that the Federal Reserve or the ECB will start targeting the NGDP level anytime – neither do I find it likely that these institutions will give up their discretionary powers. That said I never had any illusions that they would and I do agree that we need to talk about the fundamental institutional issues of central banking.

We need to debate whether we should abolish central banks altogether as Free Banking proponents are favouring and I certainly do not rule out that it fundamentally is a more fruitful strategy than to continue to talk about how central banks should ideally conduct monetary policy when we full well know that central banks never can be convinced to do the right thing. Or as Boettke and Smith write in the conclusion to their paper:

“What in our contemporary history of the Federal Reserve should give us any reason to not follow Friedman and tie the hands of the monetary authority so tightly that the bonds cannot be broken to juggle, let alone Hayek and point out that the only robust political economy option when it comes to central banking is to abolish it by taking away the juggler’s balls?”

PS Boettke and Smith does not explicitly mention Market Monetarists or NGDP targeting in paper, but a draft version of the paper was presented at the 2010 Southern Economic Association Annual Meeting Session “Are There Public Choice Problems with Nominal Income Targeting?” Pete has earlier written a blog post on this issue directly challenging the Market Monetarist position: “Political Economy Questions Which Even Market Monetarists Might Want to Think About”. Here is my response to that post.

PPS I have often argued that there is certainly no conflict between favouring NGDP level targeting for central bank and favouring Free Banking as NGDP level targeting in the same way as school vouchers can be seen as a privatization strategy. 

14 Comments
by Lars Christensen on March 30, 2012  •  Permalink
Posted in Daniel Smith, Monetary institutions, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Peter Boettke, Public Choice Theory
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Posted by Lars Christensen on March 30, 2012

https://marketmonetarist.com/2012/03/30/boettke-and-smith-on-why-we-are-wasting-our-time/

The missing equation

Scott Sumner has written dozens of blog posts trying to explain to why the fiscal multiplier is zero if the central bank targets the NGDP level, the price level or inflation. Said in another way Scott – as do I – strongly believe that the impact of fiscal policy strongly dependent the monetary policy reaction to fiscal tightening or fiscal easing (Even today Scott has a discussion of the fiscal multiplier). In fact I don’t even think it is meaningful to talk about fiscal policy as something that can “stimulate” demand. Hence, in a pure barter economy we cannot imagine fiscal policy having any impact on demand as demand always will equal supply in a barter economy. The famous Say’s Law holds in a barter economy and as such there would be full crowding out of fiscal policy. Hence, fiscal policy will only have an impact on demand if monetary policy “plays along”.

Our view is however far from the consensus among economists. Rather most economists think that you can use fiscal policy to “manage” nominal spending/demand. Even economists who in general do not find activist fiscal policy desirable tend to think that fiscal policy can impact nominal demand.

Today after working on some macroeconomic models myself I finally realised that the problem is that the “models” that most economists have in their heads are missing an equation (or at least one equation). Hence, most economists – and here I am talking about practicing macroeconomists like central bank economists or financial sector economists like myself – tend to give very little or no attention at all to the monetary policy regime of the economy they are analysing.

Therefore, the missing equation in most “models” is the policy reaction function of the central bank. And it might even be worse as it seem like most practical macroeconomists tend to assume that the central bank “accommodates” any change in fiscal policy so when fiscal policy is eased the central bank plays along and just automatically increase the money supply so to increase nominal GDP (with sticky prices that will increase RGDP and reduce unemployment). In such a world the “fiscal” multiplier obviously is positive. The problem is, however, that it is not really fiscal policy as such which is increasing NGDP, but the central bank’s “automatic” easing of monetary policy.

This assumption clearly is counterfactual. Anybody who has watched the actions of for example the ECB over the last couple of years would know that central banks certainly does not automatically play along.

The fact that many economists do not realise that they are missing an equation in their (mental) models also means that they completely fail to realise that the causality in their models are hugely dependent on the monetary policy reaction function. This is also why it is so hard for many to comprehend that monetary policy can work with long and variable leads (See my discussion of monetary policy leads and lags here – the discussion is basically a variation of the discussion in this post).

If you don’t believe me then try to have a look at the regular macroeconomic reports of central banks around world. In most of these reports the story of causality is pretty much a simple national account model, where increases in private consumption, investment and government spending etc. are described as “automatically” leading to an increase in real and nominal GDP. The monetary policy reaction is given little or no attention.

This description is of course not totally fair as many central banks are using so-called DSGE models that take explicitly take into account (some kind of) the monetary policy reaction. However, one thing is a model for simulations – another thing is the verbal description of the economy.

See for example here:

“The slowing domestic demand growth observed since 2010 Q4 turned into a noticeable annual decline in 2011 Q3. This decline was due to all its components, but most of all to change in inventories…Household and government consumption, whose annual decline intensified, affected domestic demand to a lesser extent. A renewed decline in fixed investment also contributed to the contraction in domestic demand.”

This is from the Czech central bank’s latest quarterly inflation report (page 35). We are told that demand slowed because of weak private consumption and tighter fiscal policy have lowered demand growth. However, what role did monetary policy play in this? Isn’t nominal demand sorely determined by monetary policy? So we cannot see the slowing of Czech demand without taking into account monetary policy.

In fact it is interesting that when central bankers describe the ups and downs in the economy nearly never hold themselves accountable. If inflation overshoots the inflation target we rarely (in fact never) hear central banks say “the failure to fulfil our inflation target was due to our overly loose monetary policy”. I wouldn’t really expect that and frankly I also hate admitting being mistaken. But this is nonetheless telling of the general tendency for macroeconomists – including those working for central banks – to fail to realise the importance of the monetary policy reaction function.

I should of course stress that I am certainly no saint. I am as lazy as any other economist and I most admit to many times both in written and spoken form to have argued along the lines of the “national account model”, but I hope that I at least know when I am intellectually lazy.

PS The mentioning of the Czech central bank’s inflation report above is not meant as a specific critique of my friends at the CNB. The economists at the CNB are certainly capable economists and it should be noted that the DSGE model used by the CNB’s research department explicitly tries to take into account the monetary policy reaction function of the board of the CNB.

3 Comments
by Lars Christensen on March 27, 2012  •  Permalink
Posted in MM Research agenda, Monetary policy, Monetary policy rules, Scott Sumner
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Posted by Lars Christensen on March 27, 2012

https://marketmonetarist.com/2012/03/27/the-missing-equation/

How (un)stable is velocity?

Traditional monetarists used to consider money-velocity as rather stable and predictable. In the simple textbook version of monetarism V in MV=PY is often assumed to be constant. This of course is a caricature. Traditional monetarists like Milton Friedman, Karl Brunner or Allan Meltzer never claimed that velocity was constant, but rather that the money demand function is relatively stable and predictable.

Market Monetarists on the other hand would argue that velocity is less stable than traditional monetarists argued.  However, the difference between the two views is much smaller than it might look on the surface. The key to understanding this is the importance of expectations and money policy rules.

In my view we can not think of money demand – and hence V – without understanding monetary policy rules and expectations (Robert Lucas of course told us that long ago…). Therefore, the discussion of the stability of velocity is in some way similar to the discussion about whether monetary policy whether monetary policy works with long and variable leads or lags.

Therefore, V can said to be a function of the expectations of future growth in M and these expectations are determined by what monetary policy regime is in place. During the Great Moderation there was a clear inverse relationship between M and V. So when M increased above trend V would tend to drop and vice versa. The graph below shows this very clearly. I use the St. Louis Fed’s so-called MZM measure of the money supply.

This is not really surprising if you take into account that the Federal Reserve during this period de facto was targeting a growth path for nominal GDP (PY). Hence, a “overshoot” on money supply growth year one year would be counteracted the following year(s). That also mean that we should expect money demand to move in the direct opposite direction and this indeed what we saw during the Great Moderation. If the NGDP target is 100% credible the correlation between growth in M and growth in V to be exactly -1. (For more on the inverse relationship between M and V see here.)

The graph below shows the 3-year rolling correlation growth in M (MZM) and V in the US since 1960.

The graph very clearly illustrates changes in the credibility of US monetary policy and the monetary policy regimes of different periods. During the 1960 the correlation between M or V was highly unstable. This is during the Bretton Woods period, where the US effectively had a (quasi) fixed exchange rate. Hence, basically the growth of M and V was determined by the exchange rate policy.

However, in 1971 Nixon gave up the direct convertibility of gold to dollars and effectively killed the Bretton Woods system. The dollar was so to speak floated. This is very visible in the graph above. Around 1971 the (absolute) correlation between M and V becomes slightly more stable and significant higher. Hence, while the correlation between M and V was highly volatile during the 1960s and swung between +0 and -0.8 the correlation during the 1970s was more stable around -0.6, but still quite unstable compared to what followed during the Great Moderation.

The next regime change in US monetary policy happened in 1979 when Paul Volcker became Fed chairman. This is also highly visible in the graph. From 1979 we see a rather sharp increase in the (absolute) correlation between money supply growth and velocity growth.  Hence, from 1979 to 1983 the 3-year rolling correlation between MZM growth and velocity growth increased from around -0.6 to around -0.9. From 1983 and all through the rest of the Volcker-Greenspan period the correlation stayed around -0.8 to -0.9 indicating a very credible NGDP growth targeting regime. This is rather remarkable given the fact that the Fed never announced such a policy – nonetheless it seems pretty clear that money demand effectively behaved as if such a regime was in place.

It is also notable that there is a “pullback” in the correlation between M and V during the three recessions of the Great Moderation – 1990-91, 2001-2 and finally in 2008-9. This is rather clear indication of the monetary nature of these recessions.

The discussion above illustrates that the relationship between M and V to a very large degree is regime dependent. So while it might have been perfectly reasonable to assume that there was little correlation between M and V during the 1950s and 1960s that changed especially after Volcker defeated inflation and introduced a rule based monetary policy.

MV=PY is still the best tool for monetary analysis

So while V is far from as stable as traditional monetarists assumed the correlation between M and V is highly stable if monetary policy is credible and there is a clearly defined nominal target. Therefore MV=PY still provides the best tool for understanding monetary policy – and macroeconomics for that matter – as long as we never forget about the importance of monetary policy rules and expectations.

However, the discussion above also shows that we should be less worried about maintaining a stable rate of growth in M than traditional monetarists would argue. In fact the market mechanism will ensure a stable development in MV is the central bank has a credible target for PY. If we have a credible NGDP targeting regime then the correlation between M and V will be pretty close to -1.

—-

PS This discussion of course is highly relevant for what happened to US monetary policy in 2008, but the purpose of this post is to discuss the general mechanism rather than what happened in 2008. I would however notice that the correlation between growth in M and V dropped in 2008, but still remains fairly high. One should of course note here that this is the correlation between the growth of M and V rather than the level of M and V.

PPS In my discussion and graph above I have used MZM data rather than for example M2 data. The results are similar with M2, but slightly less clear. That to me indicates that MZM is a much better monetary indicator than M2. I am sure William Barnett would agree and maybe I would try to do the same exercise with his Divisia Money series.

13 Comments
by Lars Christensen on March 18, 2012  •  Permalink
Posted in Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, The Great Moderation, Velocity, William Barnett

Posted by Lars Christensen on March 18, 2012

https://marketmonetarist.com/2012/03/18/how-unstable-is-velocity/

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

————-

PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

10 Comments
by Lars Christensen on March 15, 2012  •  Permalink
Posted in David Glasner, ECB, Efficient-Market Hypothesis, euro crisis, Federal Reserve, Financial markets, Guido Mantega, Inflation Targeting, Japan, Josh Hendrickson, Monetary policy, Monetary policy rules, The euro, The Great Moderation, The Great Recession, Transmission mechanism, Uncategorized, Velocity
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Posted by Lars Christensen on March 15, 2012

https://marketmonetarist.com/2012/03/15/chuck-norris-just-pushed-sp500-above-1400/

Josh Barro sounds like a Market Monetarist – will he also advocate NGDP targeting?

Josh Barro has an interesting comment on the economic policies of US presidential candidate. However, more interesting really is his comments on past and present US monetary policy:

Just as with fiscal policy, an improving economy will change our monetary policy needs. Contrary to popular opinion, the Federal Reserve has not been irresponsibly “printing money” in recent years. The weak economy has led people to hoard cash instead of spending it — which has more than overcompensated for the Fed’s supposedly aggressive policies.

Today, given the recovering economy, the Fed is now just about loose enough. This hopefully means that the economic recovery will accelerate, no longer held back by bad monetary policy.

But the Fed must resist the urge to tighten prematurely, which could set us back into another slump. A moderate period of moderate inflation is nothing to be afraid of; in fact, it will help underwater homeowners to get out of hock and improve the housing markets.

Josh is of course right. US monetary policy has not been loose, but rather too tight. The recession is a result of a sharp increase in dollar demand. Josh is also right that monetary policy now seem to have become more accommodative. This is visible from the improvement in US macroeconomic data, but obviously also something we can observe directly from the financial markets – rising stock prices, higher bond yields and higher commodity prices. So yes, there certainly seem to be both a recovery and some stabilisation in expectations. Said, in another way it seems like the Fed is regaining some credibility.

That said, the discussion about monetary policy should really not be about whether it is a bit too tight or a bit too loose at the moment. Rather we need to continue to discuss what the Fed should target. There need to be a continued discussion about the Fed’s operational framework and about it’s target. Market Monetarists obviously would prefer that the Fed introduced a NGDP level target. I wonder if Josh Barro would support that?

HT Blake Johnson

4 Comments
by Lars Christensen on March 15, 2012  •  Permalink
Posted in Federal Reserve, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting
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Posted by Lars Christensen on March 15, 2012

https://marketmonetarist.com/2012/03/15/josh-barro-sounds-like-a-market-monetarist-will-he-also-advocate-ngdp-targeting/

Expectations and the transmission mechanism – why didn’t anybody think of that before?

As I was writing my recent post on the discussion of the importance of expectations in the lead-lag structure in the monetary transmission mechanism I came think that is really somewhat odd how little role the discussion of expectations have had in the history of the theory of transmission mechanism .

Yes, we can find discussions of expectations in the works of for example Ludwig von Mises, John Maynard Keynes and Frank Knight. However, these discussions are not directly linked to the monetary transmission mechanism and it was not really before the development of rational expectations models in the 1970s that expectations started to entering into monetary theory. Today of course New Keynesians, New Classical economists and of course most notably Market Monetarists acknowledge the central role of expectations. While most monetary policy makers still seem rather ignorant about the connection between the monetary transmission mechanism and expectations. And even fewer acknowledge that monetary policy basically becomes endogenous in a world of a perfectly credible nominal target.

A good example of this disconnect between the view of expectations and the view of the monetary transmission mechanism is of course the works of Milton Friedman. Friedman more less prior to the Muth’s famous paper on rational expectation came to the conclusion that you can’t fool everybody all of the time and as consequence monetary policy can not permanently be use to exploit a trade-off between unemployment and inflation. This is of course was one of things that got him his Nobel Prize. However, Friedman to his death continued to talk about monetary policy as working with long and variable lags. However, why would there be long and variable lags if monetary policy was perfectly credible and the economic agents have rational expectations? One answer is – as I earlier suggested – that monetary policy in no way was credible when Friedman did his research on monetary theory and policy. One can say Friedman helped develop rational expectation theory, but never grasped that this would be quite important for how we understand the monetary transmission mechanism.

Friedman, however, was not along. Basically nobody (please correct me if I am wrong!!) prior to the development of New Keynesian theory talked seriously about the importance of expectations in the monetary transmission mechanism. The issue, however, was not ignored. Hence, at the centre of the debate about the gold standard in the 1930s was of course the discussion of the need to tight the hands of policy makers. And Kydland and Prescott did not invent Rules vs Discretion. Henry Simons of course in his famous paper Rules versus Authorities in Monetary Policy from 1936 discussed the issue at length. So in some way economists have always known the importance of expectations in monetary theory. However, they have said, very little about the importance of expectation in the monetary transmission mechanism.

Therefore in many ways the key contribution of Market Monetarism to the development of monetary theory might be that we fully acknowledge the importance of expectations in the transmission mechanism. Yes, New Keynesian like Mike Woodford and Gauti Eggertsson also understand the importance of expectations in the transmission mechanism, but their view of the transmission mechanism seems uniformly focused in the expectations of the future path of real interest rates rather than on a much broader set of asset prices.

However, I might be missing something here so I am very interested in hearing what my readers have to say about this issue. Can we find any pre-rational expectations economists that had expectations at the core of there understand of the monetary transmission mechanism? Cassel? Hawtrey? Wicksell? I am not sure…

PS Don’t say Hayek he missed up badly with expectations in Prices and Production…

PPS I will be in London in the coming days on business so I am not sure I will have much time for blogging, but I will make sure to speak a lot about monetary policy…

15 Comments
by Lars Christensen on March 12, 2012  •  Permalink
Posted in Efficient-Market Hypothesis, General economic theory, Hayek, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, Reading recommendations, Transmission mechanism
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Posted by Lars Christensen on March 12, 2012

https://marketmonetarist.com/2012/03/12/expectations-and-the-transmission-mechanism-why-didnt-anybody-think-of-that-before/

Long and variable leads and lags

Scott Sumner yesterday posted a excellent overview of some key Market Monetarist positions. I initially thought I would also write a comment on what I think is the main positions of Market Monetarism but then realised that I already done that in my Working Paper on Market Monetarism from last year – “Market  Monetarism – The  Second  Monetarist  Counter-­revolution”. 

My fundamental view is that I personally do not mind being called an monetarist rather than a Market Monetarist even though I certainly think that Market Monetarism have some qualities that we do not find in traditional monetarism, but I fundamentally think Market Monetarism is a modern restatement of Monetarism rather than something fundamentally new.

I think the most important development in Market Monetarism is exactly that we as Market Monetarists stress the importance of expectations and how expectations of monetary policy can be read directly from market pricing. At the core of traditional monetarism is the assumption of adaptive expectations. However, today all economists acknowledge that economic agents (at least to some extent) are forward-looking and personally I have no problem in expressing that in the form of rational expectations – a view that Scott agrees with as do New Keynesians. However, unlike New Keynesian we stress that we can read these expectations directly from financial market pricing – stock prices, bond yields, commodity prices and exchange rates. Hence, by looking at changes in market pricing we can see whether monetary policy is becoming tighter or looser. This also has to do with our more nuanced view of the monetary transmission mechanism than is found among mainstream economists – including New Keynesians. As Scott express it:

Like monetarists, we assume many different transmission channels, not just interest rates.  Money affects all sorts of asset prices.  One slight difference from traditional monetarism is that we put more weight on the expected future level of NGDP, and hence the expected future hot potato effect.  Higher expected future NGDP tends to increase current AD, and current NGDP.

This is basically also the reason why Scott has stressed that monetary policy works with long and variable leads rather than with long and variable lags as traditionally expressed by Milton Friedman. In my view there is however really no conflict between the two positions and both are possible dependent on the institutional set-up in a given country at a given time.

Imagine the typical monetary policy set-up during the 1960s or 1970s when Friedman was doing research on monetary matters. During this period monetary policy clearly was missing a nominal anchor. Hence, there was no nominal target for monetary policy. Monetary policy was highly discretionary. In this environment it was very hard for market participants to forecast what policies to expect from for example the Federal Reserve. In fact in the 1960s and 1970s the Fed would not even bother to announce to market participant that it had changed monetary policy – it would simply just change the policy – for example interest rates. Furthermore, as the Fed was basically not communicating directly with the markets market participant would have to guess why a certain policy change had been implemented. As a result in such an institutional set-up market participants basically by default would have backward-looking expectations and would only gradually learn about what the Fed was trying to achieve. In such a set-up monetary policy nearly by definition would work with long and variable lags.

Contrary to this is the kind of set-up we had during the Great Moderation. Even though the Federal Reserve had not clearly formulated its policy target (it still hasn’t) market participants had a pretty good idea that the Fed probably was targeting the nominal GDP level or followed a kind of Taylor rule and market participants rarely got surprised by policy changes. Hence, market participants could reasonably deduct from economic and financial developments how policy would be change in the future. During this period monetary policy basically became endogenous. If NGDP was above trend then market participant would expect that monetary policy would be tightened. That would increase money demand and push down money-velocity and push up short-term interest rates. Often the Fed would even hint in what direction monetary policy was headed which would move stock prices, commodity prices, the exchange rates and bond yields in advance for any actual policy change. A good example of this dynamics is what we saw during early 2001. As a market participant I remember that the US stock market would rally on days when weak US macroeconomic data were released as market participants priced in future monetary easing. Hence, during this period monetary policy clear worked with long and variable leads.

In fact if we lived in a world of perfectly credible NGDP level targeting monetary policy would be fully automatic and probably monetary easing and tightening would happen through changes in money demand rather than through changes in the money base. In such a world the lead in monetary policy would be extremely short. This is the Market Monetarist dream world. In fact we could say that not only is “long and variable leads” a description of how the world is, but a normative position of how it should be.

Concluding there is no conflict between whether monetary policy works with long and variable leads or lags, but rather this is strictly dependent on the monetary policy regime and how monetary policy is implemented. A key problem in both the ECB’s and the Fed’s present policies today is that both central banks are far from clear about what nominal targets they have and how to achieve it – in some ways we are back to the pre-Great Moderation days of policy uncertainty. As a consequence market participants will only gradually learn about what the central bank’s real policy objectives are and therefore there is clearly an element of long and variable lags in monetary policy. However, if the Fed tomorrow announced that it would aim to increase NGDP by 15% by the end of 2013 and it would try to achieve that by buying unlimited amounts of foreign currency I am pretty sure we would swiftly move to a world of instantaneously working monetary policy – hence we would move from a quasi-Friedmanian world to a Sumnerian world.

Without rules we live in Friedmanian world – with clear nominal targets we live live in Sumnerian world.

PS Today is a Sumnerian day – hints from both the Fed and the ECB about possible monetary tightening is leading to monetary policy tightening today. Just take a look at US stock markets…(Ok, Greek worries is also playing apart, but that is passive monetary tightening as dollar demand increases)

15 Comments
by Lars Christensen on March 6, 2012  •  Permalink
Posted in ECB, Economic and monetary history, Efficient-Market Hypothesis, Federal Reserve, Financial markets, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Scott Sumner, The Great Moderation, The Great Recession, Transmission mechanism
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Posted by Lars Christensen on March 6, 2012

https://marketmonetarist.com/2012/03/06/long-and-variable-leads-and-lags/

NGDP level targeting and the Fed’s mandate

Renee Haltom has an interesting article in the recent edition of Richmond’s Fed’s magazine Region Focus on “Would a LITTLE inflation produce a BIGGER recover?”.

Renee among other things discusses NGDP targeting – it is unclear from the article whether it is a reference to growth or level targeting and somewhat surprisingly Market Monetarists such as Scott Sumner is not mentioned in the discussion. Rather Renee Haltom has interviewed Bennett McCallum. Professor McCallum is of course the grandfather of Market Monetarism so Renee is forgiven for not mentioning Scott.

What I found most interesting in Renee’s discussion was actually the relationship between NGDP targeting and the Fed’s legal mandate:

“NGDP is everything that is produced times the current prices people pay for it. It is similar to “real” GDP, the measure of economic growth reported in the news, except NGDP isn’t adjusted for inflation. One appeal is that growth in NGDP is the sum of exactly two things: inflation and the growth rate of real GDP (the amount of actual goods and services produced). Thus, it captures both sides of the Fed’s mandate in a single variable.”

So what Renee is basically suggesting is a that NGDP targeting would be fully comparable with the Federal Reserve’s mandate – to ensure price stability as well as to maximize employment. Unlike Scott Sumner I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target. However, lets play along and say that the Fed’s mandate is meaningful.

In his 2001 paper “U.S. Monetary Policy During the 1990s” Greg Mankiw suggested that Fed’s policy reaction function (for interest rates) could be seen as a function of the rate of unemployment minus core inflation. Lets call this measure Mankiw’s constant. The clever reader will of course notice that we now capture Fed’s mandate in one variable.

The graph below shows Mankiw’s constant and the ‘NGDP gap’ defined as percentage deviation from the trend in nominal GDP from 1990 to 2007 (the Great Moderation period).

The graph is pretty clear – there is a very strong correlation between the Fed’s mandate and NGDP level targeting. If the Fed keeps NGDP on trend then it will also ensure that Mankiw constant in fact would be a constant and fulfill it’s mandate. The graph of course also shows very clearly that the Federal Reserve at the moment is very far from fulfilling its mandate.

Given the very strong correlation between Mankiw’s constant and the NGDP gap it should be pretty easy for the Fed to argue that NGDP level (!) targeting is fully comparable with the Fed’s target. So Ben why are you still waiting?

14 Comments
by Lars Christensen on February 26, 2012  •  Permalink
Posted in Ben Bernanke, Federal Reserve, McCallum, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
Tagged , , , , , , ,

Posted by Lars Christensen on February 26, 2012

https://marketmonetarist.com/2012/02/26/ngdp-level-targeting-and-the-feds-mandate/

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