It is time for BoE to make the 4% NGDP target official

While I do not want to overestimate the effects of Brexit on the UK economy it is clear that last week’s Brexit vote has significantly increased “regime uncertainty” in the UK.

As I earlier have suggested such a spike in regime uncertainty is essentially a negative supply shock, which could turn into a negative demand shock if interest rates are close the the Zero Lower Bound and the central bank is reluctant to undertake quantitative easing.

In the near-term it seems like the biggest risk is not the increase in regime uncertainty itself, but rather the second order effect in the form of a monetary shock (increased money demand and a drop in the natural interest rate below the ZLB).

Furthermore, from a monetary policy perspective there is nothing the central bank – in the case of the UK the Bank of England – can do about a negative supply other than making sure that the nominal interest rate is equal to the natural interest rate.

Therefore, the monetary response to the ‘Brexit shock’ should basically be to ensure that there is not an additional shock from tightening monetary conditions.

So far the signals from the markets have been encouraging 

One of the reasons that I am not overly worried about near to medium-term effects on the UK economy is the signal we are getting from the financial markets – the UK stock markets (denominated in local currency) has fully recovered from the initial shock, market inflation expectations have actually increased and there are no signs of distress in the UK money markets.

That strongly indicates that the initial demand shock is likely to have been more than offset already by an expectation of monetary easing from the Bank of England. Something that BoE governor Mark Carney yesterday confirmed would be the case.

These expectations obviously are reflected in the fact that the pound has dropped sharply and the market now is price in deeper interest rate cuts than before the ‘Brexit shock’.

Looking at the sharp drop in the pound and the increase in the inflation expectations tells us that there has in fact been a negative supply shock. The opposite would have been the case if the shock primarily had been a negative monetary shock (tightening of monetary conditions) – then the pound should have strengthened and inflation should have dropped.

Well done Carney, but lets make it official – BoE should target 4% NGDP growth

So while there might be uncertainty about how big the negative supply shock will be, the market action over the past week strongly indicates that Bank of England is fairly credible and that the markets broadly speaking expect the BoE to ensuring nominal stability.

Hence, so far the Bank of England has done a good job – or rather because BoE was credible before the Brexit shock hit the nominal effects have been rather limited.

But it is not given that BoE automatically will maintain its credibility going forward and I therefore would suggest that the BoE should strengthen its credibility by introducing a 4% Nominal GDP level target (NGDPLT). It would of course be best if the UK government changed BoE’s mandate, but alternatively the BoE could just announce that such target also would ensure the 2% inflation target over the medium term.

In fact there would really not be anything revolutionary about a 4% NGDP level target given what the BoE already has been doing for sometime.

Just take a look at the graph below.


I have earlier suggested that the Federal Reserve de facto since mid-2009 has followed a 4% NGDP level target (even though Yellen seems to have messed that up somewhat).

It seems like the BoE has followed exactly the same rule.  In fact from early 2010 it looks like the BoE – knowingly or unknowingly – has kept NGDP on a rather narrow 4% growth path. This is of course the kind of policy rule Market Monetarists like Scott Sumner, David Beckworth, Marcus Nunes and myself would have suggested.

In fact back in 2011 Scott authored a report – The Case for NGDP Targeting – for the Adam Smith Institute that recommend that the Bank of England should introduce a NGDP level target. Judging from the actual development in UK NGDP the BoE effectively already at that time had started targeting NGDP.

At that time there was also some debate that the UK government should change BoE’s mandate. That unfortunately never happened, but before he was appointed BoE governor expressed some sympathy for the idea.

This is what Mark Carney said in 2012 while he was still Bank of Canada governor:

“.. adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.

when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.

Shortly after making these remarks Mark Carney became Bank of England governor.

So once again – why not just do it? 1) The BoE has already effectively had a 4% NGDP level target since 2010, 2) Mark Carney already has expressed sympathy for the idea, 3) Interest rates are already close to the Zero Lower Bound in the UK.

Finally, a 4% NGDP target would be the best ‘insurance policy’ against an adverse supply shock causing a new negative demand shock – something particularly important given the heightened regime uncertainty on the back of the Brexit vote.

No matter the outcome of the referendum the BoE should ease monetary conditions 

If we use the 4% NGDP “target” as a benchmark for what the BoE should do in the present situation then it is clear that monetary easing is warranted and that would also have been the case even if the outcome for the referendum had been “Remain”.

Hence, particularly over the past year actual NGDP have fallen somewhat short of the 4% target path indicating that monetary conditions have become too tight.

I see two main reasons for this.

First of all, the BoE has failed to offset the deflationary/contractionary impact from the tightening of monetary conditions in the US on the back of the Federal Reserve becoming increasingly hawkish. This is by the way also what have led the pound to become somewhat overvalued (which also helps add some flavour the why the pound has dropped so much over the past week).

Second, the BoE seems to have postponed taking any significant monetary action ahead of the EU referendum and as a consequence the BoE has fallen behind the curve.

As a consequence it is clear that the BoE needs to cut its key policy to zero and likely also would need to re-start quantitative easing. However, the need for QE would be reduced significantly if a NGDP level target was introduced now.

Furthermore, it should be noted that given the sharp drop in the value of the pound over the past week we are likely to see some pickup in headline inflation over the next couple of month and even though the BoE should not react to this – even under the present flexible inflation target – it could nonetheless create some confusion regarding the outlook for monetary easing. Such confusion and potential mis-communication would be less likely under a NGDP level targeting regime.

Just do it Carney!

There is massive uncertainty about how UK-EU negotiations will turn out and the two major political parties in the UK have seen a total leadership collapse so there is enough to worry about in regard to economic policy in the UK so at least monetary policy should be the force that provides certainty and stability.

A 4% NGDP level target would ensure such stability so I dare you Mark Carney – just do it. The new Chancellor of the Exchequer can always put it into law later. After all it is just making what the Bank of England has been doing since 2010 official!

Three simple changes to the Fed’s policy framework

Frankly speaking I don’t feel like commenting much on the FOMC’s decision today to keep the Fed fund target unchanged – it was as expected, but sadly it is very clear that the Fed has not given up the 1970s style focus on the Phillips curve and on the US labour market rather than focusing on monetary and market indicators. That is just plain depressing.

Anyway, I would rather focus on the policy framework rather than on today’s decision because at the core of why the Fed consistently seems to fail on monetary policy is the weaknesses in the monetary policy framework.

I here will suggest three simple changes in the Fed’s policy framework, which I believe would dramatically improve the quality of US monetary policy.

  1. Introduce a 4% Nominal GDP level target. The focus should be on the expected NGDP level in 18-24 month. A 4% NGDP target would over the medium term also ensure price stability and  “maximum employment”. No other targets are needed.
  2. The Fed should give up doing forecasting on its own. Instead three sources for NGDP expectations should be used: 1) The Fed set-up a prediction market for NGDP in 12 and 24 months. 2) Survey of professional forecasters’ NGDP expectations. 3) The Fed should set-up financial market based models for NGDP expectations.
  3. Give up interest rate targeting (the horrible “dot” forceasts from the FOMC members) and instead use the money base as the monetary policy framework. At each FOMC meeting the FOMC should announce the permanent yearly growth rate of the money base. The money base growth rate should be set to hit the Fed’s 4% NGDP level target. Interest rates should be completely market determined. The Fed should commit itself to only referring to the expected level for NGDP in 18-24 months compared to the targeted level when announcing the money base growth rate. Nothing else should be important for monetary policy.

This would have a number of positive consequences.

First, the policy would be completely rule based contrary to today’s discretion policy.

Second, the policy would be completely transparent and in reality the market would be doing most of the lifting in terms of implementing the NGDP target.

Third, there would never be a Zero-Lower-Bound problem. With money base control monetary policy can always be eased also if interest rates are at the ZLB.

Forth, all the silly talk about bubbles, moral hazard and irrational investors in the stock markets would come to an end. Please stop all the macro prudential nonsense right now. The Fed will never ever be able to spot bubbles and should not try to do it.

Fifth,the Fed would stop reacting to supply shocks (positive and negative) and finally six the FOMC could essentially be replaced by a computer as long ago suggested by Milton Friedman.

Will this ever happen? No, there is of course no chance that this will ever happen because that would mean that the FOMC members would have to give up the believe in their own super human abilities and the FOMC would have to give up its discretionary powers. So I guess we might as well prepare ourself for a US recession later this year. It seems incredible, but right now it seems like Janet Yellen’s Fed has repeated the Mistakes of ’37.

PS What I here have suggested is essentially a forward-looking McCallum rule.


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Did Bill Gross get some insight from this blog? Maybe but it might (unfortunately) be outdated

The legendary Bill Gross – formerly of PIMCO and these days Janus Capital – does not believe in a hike from the Federal Reserve this year. This is what he has to say about the issue according to a Tweet from Janus Capital:

Fed really tracks Nominal GDP, which since 2012 and last 12 mos avg 3.6%. Unless it moves higher fugetabout a hike. 4th Qtr? 3.0.

I of course to a very large extent agree. In fact I have long been making exactly the argument that the Fed since the second half of 2009 effectively has been targeting 4% NGDP growth.

The first time I argued that was in the blog post The Fed’s un-announced 4% NGDP target was introduced already in July 2009 back in September last year.

I would course love the Fed to in fact target 4% NGDP growth (level targeting), but I am afraid that the Fed has been moving away from this un-announced target in recent months since Janet Yellen took over as Fed chair.

Hence, back in August in my blog post Yellen should re-read Friedman’s “The Role of Monetary Policy” and lay the Phillips curve to rest I argued that Yellen’s had caused the Fed (or rather the FOMC) to shift focus from monetary/nominal factors and towards the labour market and more specifically towards a focus on a rather old-school style Phillips curve.

Yellen’s argument essentially is that inflation is not a monetary phenomena, but rather a result of lower unemployment, which causes wage growth to accelerate, which in turn push up inflation. This is what presently – due the the “low” level of unemployment – seems to be the driving force behind Yellen’s hawkishness.

As a consequence, I am not sure that Bill Gross is right. I would love him to be right, but I am afraid that Bernanke’s de facto 4% NGDP target might not be as rock solid anymore.

Another factor that is pushing the Fed in a more-than-good hawkish direction seems to be the influence of Fed vice-chair Stanley Fischer who has the responsibility for “macroprudential” analysis at the Fed. With a focus on macropru Fischer seems to increasingly thinking the Fed should worry about bubbles and imbalances in the US economy (I by the way see no signs of bubbles – see here what I wrote back in June on the issue.)

Any monetarist would of course be deeply skeptical about the Fed’s ability to spot bubbles and even more skeptical about its ability to do anything about them. However, Fischer does not share that view and it seems to me that he is causing the Fed to become overly worried about these issues.

I am not in the business of making forecasts on this blog, but I can only say that I am less certain about the Fed’s policy rule today than I was a year ago.

A year ago I would without hesitation have said that the Fed of course was targeting 4% NGDP growth and since NGDP expectations (according to prediction markets such as Hypermind) presently are falling somewhat short of this “target” there would be no reason to believe the Fed would hike. However, with Yellen’s Phillips curve focus and Fischer’s macroprudential focus I am beginning to worry that we might be getting “off track” from the 4% NGDP.

I certainly hope I am wrong and I would very much hope that the Fed would clearly articulate that it was targeting 4% NGDP growth for the medium-term and that it will set monetary parametres to hit this target.



If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Jim, it is not complicated – NGDP tells you NOT to hike

This is what St. Louis Fed president James Bullard today told CNBC:

“there’s a powerful case to be made that it’s time to raise interest rates. And the case is not complicated. … Policy settings are [in] an emergency. The economy itself, the goals of the committee, have essentially been met.”

Bullard goes on to talk about the labour market and talk about low oil prices is helpful for the US economy. It all very much sounds like Bullard has made up his decision BEFORE he has looked at any data.

In fact it is hard to see what monetary policy rule Bullard is advocating and he seems to be cherry picking data to make an argument for rate hike. It is frankly speaking not very impressive.

But why doesn’t Bullard just look at nominal GDP? After all back in May he co-authored a Working Paper in which he essentially argued that the Federal Reserve should to target nominal GDP!

So lets have a look at how nominal GDP has been developing:

NGDP level 20102015

NGDP has since mid-2009 essentially been on a straight line growing on average slightly less than 4% a year and in Q2 2015 was slightly below this trend.

Why doesn’t Bullard just acknowledge that? He should be happy – the Fed is doing what he said it should be doing. But of course that would mean that there would not be any arguments for hiking interest rates. After all prediction markets (such as Hypermind) presently are forecasting around 3.5% NGDP growth for all of 2015 and in that sense the Fed is slightly undershooting it’s post-2009 de fact NGDP rule.

Jim, I was very happy to see you advocated NGDP targeting back in May – why have you already changed your mind??

PS Bullard talks about interest rates being at “emergency” setting. I guess Bullard has forgot what Milton Friedman told us about why low interest rates. Jim, interest rates are low because monetary policy has been tight.

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: For US readers note that I will be “touring” the US in the end of October.

Icelandic monetary policy has become too easy – Sedlabanki is (rightly) trying to catch up

Yesterday the Icelandic central bank Sedlabanki hiked its key policy rate by 50bp to 5.50%. The hike was fully expected by the markets and is the second hike this year.

I don’t have much time to write about this, but let me just briefly say that I think there are very good reasons for Sedlabanki to hike rates – in fact it looks as if Sedlabanki is even falling behind the curve and more rate hikes might be warranted.

Overall I think there are three very strong reasons for tightening monetary conditions in Iceland:

1) I have earlier argued that Sedlabanki since Mar Gudmundsson became governor in July 2009 has had a de facto 4.5% nominal GDP target (See here after 50:03). Hence, until recently NGDP was kept on a 4.5% path, but over the past year or so NGDP growth clearly has accelerated and Sedlabanki now forecasts NGDP growth of 10.6% in 2015, which clearly is far too strong and is not consistent with Sedbanki’s 2.5% inflation target.

NGDP gap Iceland

2) It is always extremely useful in the conduct of monetary policy to keep an eye on market expectations and here the signal is very, very clear. Recently inflation expectations have increased rather dramatically and both 2, 5 and 10 year breakeven inflation rates are now around 4.5% inflation – way above Sedlabanki’s 2.5% inflation target.

Breakeven iceland

3) Money supply growth is picking up and (unadjusted) M3 growth is now approaching 15%, which sends a clear signal that inflation and nominal GDP growth could pick up even further. The adjusted M3 numbers, which probably is a more truthfully indicator of inflationary pressures have accelerated to above 5%, which also indicates increased inflationary pressures.


So all in all I think it is very justified to hike interest rates for Sedlabanki and more is certainly needed to bring NGDP growth back towards 4-4-5% and reduce inflation expectations back towards Sedlabanki’s inflation target.

One thing I have noted is that while I here focus on nominal variables and on expectations Sedlabanki is more focused on the labour market situation and the recent wage agreements.

To me the wage agreements is not the cause of inflation, but rather a symptom of high inflation expectations and hence an overly easy monetary policy. That said, I do think that the Icelandic labour market system tend to create an inflationary bias in monetary policy (It is back to the old rules vs discretion debate). But I have to return to that topic in a later post…

PS it is rather incredible that Iceland after a massive banking crisis in 2008-9 now is one of the very few countries in Europe with robust nominal spending growth and a need for monetary tightening. Well done – now make sure not to repeat the mistakes of earlier days.

PPS big news out of Kazakhstan this morning – the central bank has floated the tenge. I strongly believe that this is the right decision on part of the Kazakh authorities. Pegged exchanges is generally not a good idea for commodity exporters (unless they peg to the export price).


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Does Y determine MV or is it MV that determines P?

Scott Sumner a couple of days ago wrote a post on the what he believes is a Great Stagnation story for the US. I don’t agree with Scott about his pessimism about long-term US growth and I don’t think he does a particularly good job arguing his case.

I hope to be able to write something on that in the coming days, but this Sunday I will instead focus on another matter Scott (indirectly) brought up in his Great Stagnation post – the question of causality between nominal and real shocks.

This is Scott:

“I’ve been arguing that 1.2% RGDP and 3.0% NGDP growth is the new normal.  The RGDP growth is of course an arbitrary figure, reflecting the whims of statisticians at the BEA.  But the NGDP slowdown is real (pardon the pun.)”

The point Scott really is making here (other than the productivity story) is that it is real GDP that determines nominal GDP (“NGDP slowdown is real”). That doesn’t sound very (market) monetarist does it?

Is this because because Scott – the founding father of market monetarism – suddenly has become a Keynesian that basically just thinks of nominal GDP as a “residual”?

No, Scott has certainly not become a Keynesian, but rather Scott fully well knows that the causality between nominal and real shocks – whether RGDP determines NGDP or it is the other way around – is critically dependent on the monetary policy regime – a fact that most economists tend to forget or even fail to understand.

Let me explain – I have earlier argued that we should think of the monetary policy rule as the “missing equation” in the our model of the world. The equation which “closes” the model.

It is all very easy to understand by looking at the equation of exchange:


The equation of exchange says that the money supply/base (M) times the velocity of money (V) equals the price level (P) times real GDP (Y).

The central bank controls M and sets M to hit a given nominal target. Market Monetarists of course have argued that central banks should set M so to hit an nominal GDP target. This essentially means that the central bank should set M so to hit a given target for P*Y.

We know that in the long run real GDP is determined by supply side factors rather than by monetary factors. So if we have a NGDP target then the central bank basically pegs M*V, which means that if the growth rate in Y drops (the Great Stagnation story) then the growth rate of P (inflation) will increase.

So we see that under an NGDP targeting regime the causality runs from M*V (and Y) to P. Inflation is so to speak the residual in the economy.

But this is not what Scott indicates in the quote above.

This is because he assumes that the Fed is targeting around 2% (in fact 1.8%) inflation. Therefore, IF the Fed in fact targets inflation – rather than NGDP – then in the equation of exchange the Fed “pegs” P (or rather the growth rate of P).

Therefore, under inflation targeting the Fed will have to reduce the growth rate of M (for a given V) by exactly as much has the slowdown in (long-term) growth rate of Y to keep inflation (growth P) on track.

This means that under inflation targeting shocks to Y (supply shocks) determines both M and P*Y, which of course also means that “NGDP slowdown is real” (as Scott argues) if we combine a slowdown in long-term Y growth and an inflation targeting regime.

Scott won – so he is wrong about causality

Scott since 2009 forcefully has argued that the Federal Reserve should target nominal GDP rather than inflation. I on the other hand believe that Scott has been even more succesfull than he believes and that the Federal Reserve already de facto has switched to an NGDP targeting regime (targeting 4% NGDP growth). Furthermore, I believe that the financial markets more or less realise this, which means that money demand (and therefore money-velocity) tend to move to reflect this regime.

This also means that if Scott won the argument over NGDP targeting (in the US) then he is wrong assuming that that real shocks will become nominal (that Y determines M*V).

The problem of course is that we are not entirely sure what the Fed really is targeting – and neither is most officials. As a consequence we should not think that the monetary-real causality in anyway is stable. This by the way is exactly why we can both have long and variable leads and lags in monetary policy.

For further discussion of these topics see these earlier posts of mine:

The monetary transmission mechanism – causality and monetary policy rule

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

How (un)stable is velocity?

The missing equation

The inverse relationship between central banks’ credibility and the credibility of monetarism

St. Louis Fed’s Bullard comes out in support of NGDP targeting

St. Louis Federal Reserve president James Bullard just came out in support of nominal GDP targeting – or rather he has co-authored a rather interesting new Working Paper, which concludes that NGDP targeting under some circumstances would be the best policy to pursue.

The paper with the ambitious title Optimal Monetary Policy at the Zero Lower Bound Bullard has co-authored with Costas Azariadis, Aarti Singh and Jacek Suda.

As the abstract reveals it is a rather technical paper:

We study optimal monetary policy at the zero lower bound. The macroeconomy we study has considerable income inequality which gives rise to a large private sector credit market. Households participating in this market use non-state contingent nominal contracts (NSCNC). A second, small group of households only uses cash and cannot participate in the credit market. The monetary authority supplies currency to cash-using households in a way that changes the price level to provide for optimal risk-sharing in the private credit market and thus to overcome the NSCNC friction. For succinctly large and persistent negative shocks the zero lower bound on nominal interest rates may threaten to bind. The monetary authority may credibly promise to increase the price level in this situation to maintain a smoothly functioning (complete) credit market. The optimal monetary policy in this model can be broadly viewed as a version of nominal GDP targeting.

I think the interesting thing about the paper is the focus on non-state contingent nominal contracts (NSCNC) as the key rigidity in economy rather wage and price rigidities. Simply stated, essentially NSCNC means that debt is nominal rather than real – and when a major negative shock to nominal incomes (NGDP) occurs then that causes debt/NGDP to rise and that is really at the cure of the financial distress that follows from a major negative NGDP shock (this by the way is why Greece now has a problem).

We can solve this problems in two ways – either by introducing (quasi) real contracts rather than nominal contract or by having the central bank targeting NGDP.

As such the paper is part of a growing, but small literature that focuses on NSCNC and the importance of this for the optimal monetary policy rule.

I was, however, a bit disappoint to see that the authors of the paper did not have a reference to any of the paper on this topic by the extremely overlooked David Eagle. I have written numerous blog posts on David’s work since 2011 and David has even written a number of guest posts for my blog. I list these posts below and I suggest everybody interested in this topic read not only the posts but also David’s papers.

The authors on the other hand do have a reference to the work of Evan Koenig who has done academic work very much in same spirit as David Eagle. I have also written about Evan’s work on this blog over the last couple of years and also list these blog posts below.

Will this change anything?

For those of us deeply interested in monetary policy matters the new paper obviously is interesting. First of all, it is helping deepening the theoretical understanding of monetary policy and second the paper could help further push the Federal Reserve (and other central banks!) toward in fact officially implementing some version of NGDP targeting – or at least I hope so.

That said there is a huge difference between in principle supporting NGDP targeting in a theoretical paper and then actually advocating NGDP targeting the real world and so far as I can see Jim Bullard has not yet done that. But obviously this is a huge step in the direction of Jim Bullard actually becoming an NGDP advocate and that obviously should be welcomed.

I have numerous times argued that the Fed actually from mid-2009 de facto started a policy to NGDP level targeting around a 4% path and this policy effectively has continued to this day (see here and here). However, this has never been articulated by any Fed official, which makes the “policy” much less effective and less credible.

Therefore, it would be great if we not only would get a theoretical endorsement of NGDP targeting from the likes of Jim Bullard, but rather a concrete proposal on how to actually implement NGDP targeting. I hope that will be the next paper Jim Bullard authors.

PS My friend Marcus Nunes also comments on the paper here.

PPS One of the authors of the paper discussed above is Jacek Suda from the Polish central bank (NBP). I would love to see a discussion of introducing NGDP targeting in my beloved Poland!


Blog posts on and by David Eagle:

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!” (by David Eagle)

Guest post: GDP-Linked Bonds (by David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest blog: Why Price-Level Targeting Pareto Dominates Inflation Targeting (By David Eagle)

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

Guest blog: Growth or level targeting? (by David Eagle)

Guest post: Why I Support NGDP Targeting (by David Eagle)

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

David Eagle’s framework and the micro-foundation of Market Monetarism

David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”

Selgin and Eagle should be best friends

Quasi-Real indexing – indexing for Market Monetarists

David Davidson and the productivity norm

Two Equations on the Pareto-Efficient Sharing of Real GDP Risk (a paper David and I co-authored in 2012)

Blog posts on Evan Koeing:

The Integral Reviews: Paper 1 – Koenig (2011)

“Monetary Policy, Financial Stability, and the Distribution of Risk”


UPDATE: Scott Sumner also comments on the Bullard el al paper.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Mario, stay on track and avoid the mistakes of 1937 and 2011

The global stock markets have been facing some headwinds recently, and there may be numerous reasons for this. One obvious one is the recent rebound in oil prices, which I believe is essentially driven by markets’ expectation that the Saudi-led global oil price war is now ending.

If that is indeed the case then we are seeing a (minor) negative supply shock, particularly to the European and U.S. economies. Such supply shocks often get central banks into trouble. Just think of the ECB’s massive policy blunder(s) in 2011, when it reacted to a negative shock (higher oil prices on the back of the Arab spring) by hiking interest rates twice, or the Federal Reserve’s (or rather the Roosevelt Administration’s) premature monetary tightening in 1937 – also on the back of high global commodity prices.

It may be that the ECB will not repeat the mistakes of 2011, but you can’t blame investors for thinking that there is a risk that this could happen – particularly because the ECB continues to communicate primarily in terms of headline inflation.

Therefore, even if the ECB isn’t contemplating a tightening of monetary conditions in response to a negative supply, the markets will effectively tighten monetary conditions if there is uncertainty about the ECB’s policy rule. I believe that is part of the reason for the market action we have seen lately.

The ECB needs to spell out the policy rule clearly

What the ECB therefore needs to do right now is to remind market participants that it is not reacting to a negative supply shock, and that it will ignore any rise in inflation caused by higher oil prices. There are numerous ways of doing this.

1) Spell out an NGDP target

In my view the best thing would essentially be for the ECB to make it clear that it is focusing on the development of expected nominal GDP growth. This does not necessarily have to be in conflict with the overall target of hitting 2% over the medium term. All the ECB needs to do is to say that it is targeting, for example, 4% NGDP growth on average over the coming 5 years, reflecting a 2% inflation target and 2% growth in potential real GDP in the euro zone. That would ensure that markets also ignore short-term fluctuations in headline inflation.

2) Target 2y/2y and 5y/5y inflation

Alternatively, the ECB should only communicate about inflation developments in terms of what is happening to market inflation expectations – for example 2y/2y and 5y/5y inflation expectations. Again, this would seriously reduce the risk of sending the signal that the bank is about to react to negative supply shocks.

3) Re-introduce the focus on M3

There are numerous reasons not to rely on money supply data as the only indicator of monetary conditions. However, I strongly believe that it is useful to still keep an eye on monetary aggregates such as M1 and M3. Both M1 and M3 show that monetary conditions have indeed gotten easier since the ECB introduced its QE programme. That said, the money supply data is also telling us that monetary conditions overall can hardly be described as excessively easy. Yes, money supply growth is still picking up, but M3 growth is still below the 6.5% y/y that it reached in 2000-2008, and significantly below the 10% “target” I earlier suggested would be needed to bring us back to 2% inflation over the medium term.

If the ECB re-introduces more focus on the money supply numbers – and monetary analysis in general – then it would also send a pretty clear signal that the bank is not about to change course on QE just because oil prices are rising.

4) Change the price index to the GDP deflator or core inflation

Another pretty straightforward way of trying to convince the markets that the ECB will not react to negative supply shocks is by changing the focus in terms of the inflation target. Today, the ECB is officially targeting HICP (headline) inflation. This measure is highly sensitive to swings in oil and food prices as well as changes in indirect taxes. These factors obviously are completely outside the direct control of the ECB, and it therefore makes very little sense that the ECB is focusing on this measure.

Recently, ECB chief Mario Draghi hinted that the ECB could start focusing on a core measure of inflation that excludes energy, food and taxes, and I certainly think that would be a step in the right direction if the bank does not want to introduce NGDP targeting. This would effectively mean that the ECB had a target similar to the Fed’s core PCE inflation measure. It would not be perfect, but certainly a lot better than the present headline inflation measure.

An alternative to a core inflation measure, which I believe is even better, would be to focus on the GDP deflator. The good thing about the GDP deflator (other than being the P in MV=PY) is that it measures the price of what is produced in the euro zone, and hence excludes imported inflation and indirect taxes.

Conclusion: It is still all about credibility – so more needs to be done

One can always discuss what is in fact going on in the markets at the moment – and I will deliberately avoid trying to explain why German government bond yields have spiked recently (it tells us very little about monetary conditions) – but I would focus instead on the markets’ serious nervousness about whether the ECB will prematurely end its QE programme.

There would be no reason for such nervousness if the ECB clearly spelled out that it does not intend to let a negative supply shock change its plans for quantitative easing, and that it is intent on ensuring nominal stability. I have given some suggestions on how the ECB could do that, and I fundamentally think that Mario Draghi understands that the ECB needs to move in this direction. Now he just needs to make it completely clear to the markets (and the Bundesbank?)


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The hawks should start advocating NGDP targeting to avoid embarrassment

Over the past six years the “hawks” among UK and US central bankers have been proven wrong. They have continued to argue that a spike in inflation was just around the corner because monetary policy was “high accommodative”. Obviously Market Monetarists have continued to argue that monetary policy has not been easy, but rather to tight in the US and the UK – at least until 2012-13.

The continued very low inflation continues to be an embarrassment for the hawks and looking into 2015-16 there are no indication that inflation is about to pick-up either in the US or in the UK.

That said, there might actually be good reasons for turning more hawkish right now – nominal GDP growth continues to pick up in both the UK and the US (I will ignore the euro zone in this blog post…)

The sharp drop in oil prices in recent months is likely to further push down headline inflation in the coming months. Central bankers should obviously completely ignore any drop in inflation caused by a positive supply shock, but with most hawks completely obsessed with inflation targeting a hawkish stance will become harder and harder to justify from an inflation targeting perspective exactly at the time when it actually might become more justified than at any time before in the past six years.

I would personally not be surprised if we get close to deflation in both the UK and the US in 2015 and maybe also in 2016 if we don’t get a rebound in oil prices, but I would also think that there is a pretty good chance that we could get 4-5% or maybe even higher nominal GDP growth in both the UK and US in 2015-16. And that would be a strong argument for a tighter monetary stance.

Hence, if strict inflation targeters would follow their own logic then they would be advocating monetary easing in 2015-16 in both Britain and the US, while those of us who are more focused on NGDP growth will likely see an increasing need for monetary tightening in 2015-16.

As a consequence if you are an old hawk who “feels” that there is a need for monetary tightening then you better stop looking at present inflation and instead start to focusing on expected NGDP growth.

But of course the idea that you are hawkish or dovish is in itself an idiotic idea. You should never be hawkish or dovish as that in itself means that you are likely advocating some sort of discretionary monetary policy. What should concern you should be the rules of the game – the monetary policy regime.

The story of a remarkably stable US NGDP trend

Today revised US GDP numbers for Q3 were released. While most commentators focused on the better than expected real GDP numbers I am on the other hand mostly impressed by just how stable the development in nominal GDP is. Just take a look at the graph below.

US NGDP 4 pct trend

I have earlier argued that the development in NGDP looks as if the Federal Reserve has had a 4% NGDP level target since Q3 2009. In fact at no time since 2009 has the actual level of NGDP diverged more than 1% from the 4% trend started in Q3 2009 and right now we are basically exactly on the 4% trend line. This is remarkable especially because the Fed never has made any official commitment to this target.

With market expectations fully aligned to with this trend and US unemployment probably quite close to the structural level of unemployment I see no reason why the Fed should not announce this – a 4% NGDP level target – as its official target.

PS I might join the hawks soon – if the trend in NGDP growth over the last couple of quarters continues in the coming quarter then we will move above the 4% NGDP trend and in that sense there is an argument for tighter monetary conditions.

PPS I am not arguing that monetary policy was appropriate back in 2009 or 2010. In fact I believe that monetary policy was far too tight, but after six years of real adjustments it is time to let bygones-be-bygones and I don’t think there would be anything to gain from a stepping up of monetary easing at the present time.

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