Michael Woodford endorses NGDP level targeting

Here is from Bloomberg:

Central bankers should adopt a clear policy goal, such as the path for nominal gross domestic product, to make remaining easing options more effective under the limits of near-zero interest rates, according to Michael Woodford, a professor of political economy at Columbia University.

Such criteria would increase the impact of efforts to reset public expectations for interest rate policy, such as asset-purchases, Woodford said. Federal Reserve policy makers have kept the benchmark rate near zero since December 2008 and this month reiterated a plan to keep borrowing costs at record lows through at least late 2014.

“A more useful form of forward guidance, I believe, would be one that emphasizes the target criterion that will be used to determine when it is appropriate to raise the federal funds rate target above its current level, rather than estimates of the ‘lift-off’ date,” Woodford said in a paper presented today at the Fed’s annual symposium in Jackson HoleWyoming.

A pledge to restore nominal GDP “to the trend path it had been on up until the fall of 2008” would “make it clear that policy will have to remain looser in the near term” than indicated by the Taylor rule, he said. It would also “provide assurance that the unusually stimulative current policy stance does not imply any intention to tolerate continuing inflation above the Fed’s declared long-run inflation target.”

“But if a central bank’s intention in announcing such purchases is to send such a signal, the signal would seem more likely to have the desired effect if accompanied by explicit forward guidance, rather than regarded as a substitute for it,” Woodford said.

“A more logical policy would rely on a combination of commitment to a clear target criterion to guide future decisions about interest-rate policy with immediate policy actions that should stimulate spending immediately without relying too much on expectational channels,” Woodford said.

The Fed has carried out two rounds of bond purchases known as quantitative easing to reduce borrowing costs. In the first round starting in 2008, the Fed bought $1.25 trillion of mortgage-backed securities, $175 billion of federal agency debt and $300 billion of Treasuries. In the second round, announced in November 2010, the Fed bought $600 billion of Treasuries.

Policies that target specific credit areas, such as buying mortgage-backed securities, or the Bank of England’s Funding for Lending Scheme, may be more effective at boosting spending, though they are “more properly” viewed as fiscal as opposed to monetary stimulus, he said.

Combining central bankers’ nominal GDP target would also “increase the bang for the buck from fiscal stimulus” while limiting inflation concerns, Woodford said. “The most obvious recipe for success is one that requires coordination between the monetary and the fiscal authorities.”

Lets just say I agree with the policy recommendation – even though I certainly do not think US monetary policy is accommodative just because the fed funds rate is low.

Imagine if the ECB would host a conference where somebody would recommend NGDP level targeting…

Here is Woodford’s paper Methods of Policy Accommodation at the Interest-Rate Lower Bound

Update: My fellow Market Monetarists David Beckworth (who is quoted in Woodford’s paper) and Marcus Nunes also comment on Woodford.

The fiscal cliff and why fiscal conservatives should endorse NGDP targeting

One of the hottest political topics in the US today is the so-called fiscal cliff. The fiscal cliff is the expected significant fiscal tightening, which will kick in January 2013 when the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 expires – unless a deal is struck to postpone the tightening. The fiscal cliff is estimated to amount to 4% of GDP – hence a very substantial fiscal tightening.

So how much should we worry about the fiscal cliff? Keynesians claim that we should worry a lot. The Market Monetarist would one the other hand argue that the impact of the fiscal cliff will very much depend on the response of the Federal Reserve to the possible fiscal tightening. If the Fed completely ignores the impact of the fiscal cliff on aggregate demand – if there will be any – then it would be naive to argue that there would be no impact at all on aggregate demand – after all a 4% tightening of fiscal policy in one year is very substantial.

On the other hand if the Federal Reserve had an NGDP target then the impact would likely be minimal as the Fed “automatically” would fill any “hole” in aggregate demand created by the tightening of fiscal policy to keep nominal GDP on track. This of course is the Sumner critique – the fiscal multiplier will be zero under NGDP targeting or inflation targeting for that matter.

Note that I am not making any assumptions about the how the economy works. Even if we assume we are in a Keynesian world, where the “impulse” to aggregate demand from a fiscal tightening would be negative an NGDP targeting regime would ensure that the world would look like a “classical world” (fiscal policy will have no impact on aggregate demand). This by the way would also be the case under inflation targeting – which of course is closer to the actual policy the Fed is conducting.

Said in another we should expect that if fiscal policy indeed would be strongly negative for aggregate demand in the US and push inflation sharply down then the likelihood of more aggressive monetary easing from the Fed would increase and hence sharply reduce any negative effect on aggregate demand (note that nominal GDP is really just another word for aggregate demand – at least according to Market Monetarists like myself). Therefore, we should probably be significantly less worried than some Keynesians seem to be.

Furthermore, it is notable that the US stock market continues rise and inflation expectations have been inching up recently. This is not exactly an indication that the US is facing a sharp drop in aggregate demand in 2013. We can obviously not know why the markets seem so relatively relaxed about the fiscal cliff, but I would think that the reason is that the markets are pricing in a combination of a political compromise that significantly reduces the fiscal tightening in 2013 and also is pricing an increased likelihood of QE3 becoming a reality.

So the conclusion is that Keynesian fears about the scale of the shock to aggregate demand is somewhat overblown as a combination of the Sumner critique and political logrolling will probably reduce the negative shock. We, however, can’t be sure about that so wouldn’t it be great if we didn’t have to worry about this issue? NGDP level targeting could seriously reduce the worries about fiscal shocks.

Fiscal conservatives should endorse NGDP targeting

Both in the US and the euro zone calls for scaling back fiscal consolidation have been growing larger and politicians like the French President Hollande and from Keynesian economists like Paul Krugman and Brad DeLong have even demanded fiscal stimulus. To me it is pretty simple – the state of public finances in most euro zone countries and the US is horrible so I fundamentally don’t think that most countries can afford much fiscal stimulus. That said, I also think that the calls for austerity is somewhat hysterical and I find it rather unlikely that the markets would react very negative if the US budget deficit became 1-2 percentage points of GDP larger next year – just look at US treasury yields it is not so that the markets are telling us that the US economy is on the verge of bankruptcy. The markets are often wrong, but government default rarely happens out of the blue.

However, from a public choice perspective we should probably think that the deeper a country falls into recession the more likely it is that the wider public will vote for politicians like Hollande and policy makers are more and more likely to start listening to economists like Paul Krugman. That unfortunately will do very little to ending the crisis. Fiscal stimulus is not the answer to our problems – monetary easing is.

So fiscal conservatives are likely going to face more and more resistance – whether we like it or not. On the other hand if the central bank was operating a credible NGDP level target then fiscal conservatives could argue that negative impact of fiscal consolidation would be met by an easing of monetary policy to keep NGDP on track. Therefore there would be no reasons to worry about fiscal tightening hitting growth and increasing unemployment.

Even better imagine that the Federal Reserve tomorrow announced that it would do as much monetary easing needed to bring back NGDP to its pre-crisis trend by for example raising  NGDP by 15% from the present level by the end of 2013. Do you then think anybody would worry about a fiscal tightening of 4% of GDP? I think not.

Therefore, the conclusion is clear to me. Fiscal conservatives should endorse NGDP level targeting as it completely would undermine any Keynesian arguments for postponing fiscal consolidation. Furthermore, a commitment to keep NGDP on track would also likely make fiscal consolidation much less unpopular and therefore the likelihood of success would also increase.

Finally I would highlight two historical examples of successful fiscal consolidation. In the mid-1990s both the US and the UK undertook significant successful fiscal reforms that led to a significant improvement in the public finances. Both was undertaken while monetary conditions was eased significantly. As a result there was very little opposition to fiscal consolidation at the time and there was basically no negative impact on US and UK growth. In fact both economies grew robustly through out the fiscal consolidation phase. This of course is the opposite of the German experience from the early 1990s where the Bundesbank completely “neutralized” any stimulus from fiscal expansion in connection with the Germany reunification (See my earlier post on that topic here.)

PS Above I have not given any attention to the supply side effects of the “scheduled” tax hikes that follows as a result of the US fiscal cliff. NGDP level targeting would not deal with that problem and the issue should certainly not be ignored. Tax hikes can never increase the long-term growth potential of any economy, but the issue is not going to have any visible impact on real GDP growth in 2013 or 2014 for that matter. Supply side effects mostly work with long and variable lags. Furthermore, I am not arguing that one should ignore the fiscal cliff just because the Fed has the power to counteract it. After all the Fed’s performance in recent years has not exactly been impressive so a political compromise would probably be helpful for US growth in 2013 – at least it would reduce some risks of the US falling back into recession.

PPS this is my blog post #400 (including guest posts) since I started blogging last year.

—-

Related posts:
Market Monetarism vs Krugmanism
Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)
The Bundesbank demonstrated the Sumner critique in 1991-92
“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy

Between the money supply and velocity – the euro zone vs the US

When crisis hit in 2008 it was mostly called the subprime crisis and it was normally assumed that the crisis had an US origin. I have always been skeptical about the US centric description of the crisis. As I see it the initial “impulse” to the crisis came from Europe rather than the US. However, the consequence of this impulse stemming from Europe led to a “passive” tightening of US monetary conditions as the Fed failed to meet the increased demand for dollars.

The collapse in both nominal (and real) GDP in the US and the euro zone in 2008-9 was very similar, but the “composition” of the shock was very different. In Europe the shock to NGDP came from a sharp drop in money supply growth, while the contraction in US NGDP was a result of a sharp contraction in money-velocity. The graphs below illustrate this.

The first graph is a graph with the broad money supply relative to the pre-crisis trend (2000-2007) in the euro zone and the US. The second graph is broad money velocity in the US and the euro zone relative to the pre-crisis trend (2000-2007).

The graphs very clearly illustrates that there has been a massive monetary contraction in the euro zone as a result of M3 significantly undershooting the pre-crisis trend. Had the ECB kept M3 growth on the pre-crisis trend then euro zone nominal GDP would long ago returned to the pre-crisis trend. On the other hand the Federal Reserve has actually been able to keep M2 on the pre-crisis path. However, that has not been enough to keep US NGDP on trend as M2-velocity has contracted sharply relative the pre-crisis trend.

Said in another way a M3 growth target of for example 6.5% would basically have been as good as an NGDP level target for the euro zone as velocity has returned to the pre-crisis trend. However, that would not have been the case in the US and that I my view illustrates why an NGDP level target is much preferable to a money supply target.

The European origin of the crisis – or how European banks caused a tightening of US monetary policy

Not surprisingly the focus of the discussion of the causes of the crisis often is on the US given both the subprime debacle and the collapse of Lehman Brothers. However, I believe that the shock actually (mostly) originated in Europe rather than the US. What happened in 2008 was that we saw a sharp rise in dollar demand coming from the European financial sector. This is best illustrated by the sharp drop in EUR/USD from close to 1.60 in July 2008 to 1.25 in early November 2008. The rise in dollar demand is obviously what caused the collapse in US money-velocity and in that regard it is notable that the rise in money demand in Europe primarily was an increase in demand for dollar rather than for euros.

This is why I stress the European origin of the crisis. However, the cause of the crisis nonetheless was a tightening of US monetary conditions as the Fed (initially) failed to appropriately respond to the increase in dollar demand – mostly because of the collapse of the US primary dealer system. Had the Fed had a more efficient system for open market operations in 2008 then I believe the crisis would have been much smaller and would have been over already in 2009. As the Fed got dollar-swap lines up and running and initiated quantitative easing the recovery got underway in 2009. This triggered a brisk recovery in both US and euro zone money-velocity. In that regard it is notable that the rebound in velocity actually was somewhat steeper in the euro zone than in the US.

The crisis might very well have ended in 2009, but new policy mistakes have prolonged the crisis and once again European problems are causing most headaches and the cause now clearly is that the ECB has allowed European monetary conditions to become excessively tight – just have a look at the money supply graph above. Euro zone M3 has now dropped more than 15% below the pre-crisis trend. This policy mistake has to some extent been counteracted by the Fed’s efforts to increase the US money supply, but the euro crisis have also led to another downleg in US money velocity. The Fed once again has failed to appropriately counteract this.

Both the Fed and the ECB have failed

In the discussion above I have tried to illustrate that we cannot fully understand the Great Recession without understanding the relationship between US and euro zone monetary policy and I believe that a full understanding of the crisis necessitates a discussion of European dollar demand.

Furthermore, the discussion shows that a credible money supply target would significantly have reduced the crisis in the euro zone. However, the shock to US money-velocity shows that an NGDP level target would “perform” much better than a simple money supply rule.

The conclusion is that both the Fed and the ECB have failed. The Fed failed to respond appropriately in 2008 to the increase in the dollar demand. On the other hand the ECB has nearly constantly since 2008/9 failed to increase the money supply and nominal GDP. Not to mention the numerous communication failures and the massively discretionary conduct of monetary policy.

Even though the challenges facing the Fed and ECB since 2008 have been somewhat different in nature I would argue that proper nominal targets (for example a NGDP level target or a price level target) and better operational procedures could have ended this crisis long ago.

—–

Related posts:

Failed monetary policy – (another) one graph version
International monetary disorder – how policy mistakes turned the crisis into a global crisis

NGDP level targeting – the true Free Market alternative (we try again)

Most of the blogging Market Monetarists have their roots in a strong free market tradition and nearly all of us would probably describe ourselves as libertarians or classical liberal economists who believe that economic allocation is best left to market forces. Therefore most of us would also tend to agree with general free market positions regarding for example trade restrictions or minimum wages and generally consider government intervention in the economy as harmful.

I think that NGDP targeting is totally consistent with these general free market positions – in fact I believe that NGDP targeting is the monetary policy regime which best ensures well-functioning and undistorted free markets. I am here leaving aside the other obvious alternative, which is free banking, which my readers would know that I have considerable sympathy for.

However, while NGDP targeting to me is the true free market alternative this is certainly not the common view among free market oriented economists. In fact I find that most of the economists who I would normally agree with on other issues such as labour market policies or trade policy tend to oppose NGDP targeting. In fact most libertarian and conservative economists seem to think of NGDP targeting as some kind of quasi-keynesian position. Below I will argue why this perception of NGDP targeting is wrong and why libertarians and conservatives should embrace NGDP targeting as the true free market alternative.

Why is NGDP targeting the true free market alternative?

I see six key reasons why NGDP level targeting is the true free market alternative:

1) NGDP targeting is ”neutral” – hence unlike under for example inflation targeting NGDPLT do not distort relative prices – monetary policy “ignores” supply shocks.
2) NGDP targeting will not distort the saving-investment decision – both George Selgin and David Eagle argue this very forcefully.
3) NGDP targeting ”emulates” the Free Banking allocative outcome.
4) Level targeting minimizes the amount of discretion and maximises the amount of accountability in the conduct of monetary policy. Central banks cannot get away with “forgetting” about past mistakes. Under NGDP level targeting there is no letting bygones-be-bygones.
5) A futures based NGDP targeting regime will effective remove all discretion in monetary policy.
6) NGDP targeting is likely to make the central bank “smaller” than under the present regime(s). As NGDP targeting is likely to mean that the markets will do a lot of the lifting in terms of implementing monetary policy the money base would likely need to be expanded much less in the event of a negative shock to money velocity than is the case under the present regimes in for example the US or the euro zone. Under NGDP targeting nobody would be calling for QE3 in the US at the moment – because it would not be necessary as the markets would have fixed the problem.

So why are so many libertarians and conservatives sceptical about NGDP targeting?

Common misunderstandings:

1) NGDP targeting is a form of “countercyclical Keynesian policy”. However, Market Monetarists generally see recessions as a monetary phenomenon, hence monetary policy is not supposed to be countercyclical – it is supposed to be “neutral” and avoid “generating” recessions. NGDP level targeting ensures that.
2) Often the GDP in NGDP is perceived to be real GDP. However, NGDP targeting does not target RGDP. NGDP targeting is likely to stabilise RGDP as monetary shocks are minimized, but unlike for example inflation targeting the central bank will NOT react to supply shocks and as such NGDP targeting means significantly less “interference” with the natural order of things than inflation targeting.
3) NGDP targeting is discretionary. On the contrary NGDP targeting is extremely ruled based, however, this perception is probably a result of market monetarists call for easier monetary policy in the present situation in the US and the euro zone.
4) Inflation will be higher under NGDP targeting. This is obviously wrong. Over the long-run the central bank can choose whatever inflation rate it wants. If the central bank wants 2% inflation as long-term target then it will choose an NGDP growth path, which is compatible which this. If the long-term growth rate of real GDP is 2% then the central bank should target 4% NGDP growth path. This will ensure 2% inflation in the long run.

Another issue that might be distorting the discussion of NGDP targeting is the perception of the reasons for the Great Recession. Even many libertarian and conservative economists think that the present crisis is a result of some kind of “market disorder” – either due to the “natural instability” of markets (“animal spirits”) or due to excessively easy monetary policy in the years prior to the crisis. The proponents of these positions tend to think that NGDP targeting (which would mean monetary easing in the present situation) is some kind of a “bail out” of investors who have taken excessive risks.

Obviously this is not the case. In fact NGDP targeting would mean that central bank would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bail out clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.

NGDP level targeting as a privatization strategy

As I argue above there are clear similarities between the allocative outcome under Free Banking – hence a fully privatized money supply – and NGDP targeting. In fact I believe that NGDP level targeting might very well be seen as part of a privatization strategy. (I have argued that before – see here)

Hence, a futures based NGDP targeting regime would basically replace the central bank with a computer in the sense that there would be no discretionary decisions at all in the conduct of monetary policy. In that sense the futures based NGDP targeting regime would be similar to a currency board, but instead of “pegging” monetary policy to a foreign currency monetary policy would be “pegged” to the market expectation of future nominal GDP. This would seriously limit the discretionary powers of central banks and a truly futures based NGDP targeting regime in my view would only be one small step away from Free Banking. This is also why I do not see any conflict between advocating NGDP level targeting and Free Banking. This of course is something, which is fully recognised by Free Banking proponents such as George Selgin, Larry White and Steve Horwitz.

PS this is no the first time I try to convince libertarians and conservatives that NGDP level targeting is the true free market alternative. See my first attempt here.

—–

Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Update (July 23 2012): Scott Sumner once again tries to convince “conservatives” that monetary easing is the “right” position. I agree, but I predict that Scott will fail once again because he argue in terms of “stimulus” rather than in terms of rules.

Selgin’s challenge to the Market Monetarists

Anybody who have been following my blog knows how much admiration I have for George Selgin so when George speaks I listen and if he says I am wrong I would not easily dismiss it without very careful consideration.

Now George has written a challenge on Freebanking.org for us Market Monetarists. In his post “A Question for the Market Monetarists” George raises a number of issues that deserves answers. Here is my attempt to answer George’s question(s). But before you start reading I will warn you – as it is normally the case I think George is right at least to some extent.

Here is George:

“Although my work on the “Productivity Norm” has led to my being occasionally referred to as an early proponent of Market Monetarism, mine has not been among the voices calling out for more aggressive monetary expansion on the part of the Fed or ECB as a means for boosting employment.”

While it is correct that Market Monetarists – and I am one of them – have been calling for monetary easing both in the US and the euro zone this to me is not because I want to “boost employment”. I know that other Market Monetarists – particularly Scott Sumner – is more outspoken on the need for the Federal Reserve to fulfill it’s “dual mandate” and thereby boost employment (Udpate: Evan Soltas has a similar view – see comment section). I on my part have always said that I find the Fed’s dual mandate completely misguided. Employment is not a nominal variable so it makes no sense for a central bank to target employment or any other real variable. I am in favour of monetary easing in the euro zone and the US because I want the Fed and the ECB to undo the mistakes made in the past. I am not in favour of monetary policy letting bygones-be-bygones. I do, however, realise that the kind of monetary easing I am advocating likely would reduce unemployment significantly in both the euro zone and the US. That would certainly be positive, but it is not my motive for favouring monetary easing in the present situation. See here for a discussion of Fed’s mandate and NGDP targeting.

Said in another way what I want the is that the Fed and the ECB should to live up to what I have called Selgin’s monetary credo:

“The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability“

Back to George:

“There are several reasons for my reticence. The first, more philosophical reason is that I think the Fed is quite large enough–too large, in fact, by about $2.8 trillion, about half of which has been added to its balance sheet since the 2008 crisis. The bigger the Fed gets, the dimmer the prospects for either getting rid of it or limiting its potential for doing mischief. A keel makes a lousy rudder.”

This is the Free Banking advocate George Selgin speaking. The Free Banking advocate Lars Christensen does not disagree with George’s fundamental free banking position. However, George also knows that in the event of a sharp rise in money demand in a free banking regime the money supply will expanded automatically to meet that increase in money demand (I learned that from George). In 2007-9 we saw a sharp rise in dollar demand and the problem was not that the Fed did too much to meet that demand, but rather that it failed to meet the increase in money demand. Something George so well has described in for example his recent paper on the failed US primary dealer system. See here.

However, I certainly agree with George’s position that had monetary policy been conducted in another more rational way – for example within a well-defined NGDP targeting regime and a proper lender-of-last-resort regime – then the Fed would likely have had to expand it’s money base much less than has been the case. Here I think that we Market Monetarists should listen to George’s concerns. Sometimes some of us are to eager to call for what could sound like a discretionary expansion of the money base. This is not really the Market Monetarist position. The Market Monetarist position – at least as I think of it – is that the Fed and the ECB should “emulate” a free banking outcome and ensure that any increase in money demand is met by an increase in the money base. This should obviously be based on a rule based set-up rather than on discretionary monetary policy changes. Both the Fed and the ECB have been insanely discretionary in the past four years.

Back to George:

“The second reason is that I worry about policy analyses (such as this recent one) that treat the “gap” between the present NGDP growth path and the pre-crisis one as evidence of inadequate NGDP growth. I am, after all, enough of a Hayekian to think that the crisis of 2008 was itself at least partly due to excessively rapid NGDP growth between 2001 and then, which resulted from the Fed’s decision to hold the federal funds rate below what appears (in retrospect at least) to have been it’s “natural” level.” 

This is a tricky point on which the main Market Monetarist bloggers do not necessarily agree. Scott Sumner and Marcus Nunes have both strongly argued against the “Hayekian position” and claim that US monetary policy was not too easy prior to 2008. David Beckworth prior to the crisis clearly was arguing that US monetary policy was too easy. My own position is somewhere in between. I certainly think that monetary policy was too easy in certain countries prior to the crisis. I for example have argued that continuously in my day-job back in 2006-7 where I warned that monetary conditions in for example Iceland, the Baltic States and in South Eastern European were overly loose. I am, however, less convinced that US monetary policy was too easy – for the US economy, but maybe for other economies in the world (this is basically what Beckworth is talking about when he prior to crisis introduced the concept the Fed as a “monetary superpower”).

However, it would be completely wrong to argue that the entire drop in NGDP in the US and the euro zone is a result of a bubble bursting. In fact if there was any “overshot” on pre-crisis NGDP or any “bubbles” (whatever that is) then they certainly long ago have been deflated. I am certain that George agrees on that. Therefore the possibility that there might or might have been a “bubble” is no argument for maintain the present tight monetary conditions in the euro zone and the US.

That said, as time goes by it makes less and less sense to talk about returning to a pre-crisis trend level for NGDP both in the US and the euro zone. But let’s address the issue in slightly different fashion. Let’s say we are where presented with two different scenarios. In scenario 1 the Fed and the ECB would bring back NGDP to the pre-crisis trend level, but then thereafter forget about NGDP level targeting and just continue their present misguided policies. In scenario 2 both the Fed and the ECB announce that they in the future will implement NGDP level targeting with the use of NGDP futures (as suggested by Scott), but would initiate the new policy from the present NGDP level. I would have no doubt that I would prefer the second scenario. I can of course not speak from my Market Monetarist co-conspiritors, but to me the it is extremely important that we return to a rule based monetary policy. The actual level of NGDP in regard is less important.

And then finally George’s question:

“And so, my question to the MM theorists: If a substantial share of today’s high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?”

This is an empirical question and I am not in a position to give an concrete answer to that. However, would argue that most of the increase in unemployment and the lack of a recovery in the labour market both in the US and the euro zone certainly is due to a lack of spending and therefore monetary easing would likely significantly reduce unemployment in both the US and the euro zone.

Finally I don’t really think that George challenge to the Market Monetarists is question about wage-expectations. Rather I think George wants us to succeed in our endeavor to get the ECB and the Fed to target NGDP. While George does not spell it out directly I think he share the concern that I from time to time has voiced that we should be careful that we do not sound like vulgar Keynesians screaming for “monetary stimulus”. To many the call for QE3 from the sounds exactly like that and for exact that reason I have cautious in calling for another badly executed QE from the Fed. Yes, we certainly need to call for monetary easing, but no one should be in doubt that we want it within a proper ruled based regime.

I have in a number of posts since I started blogging in October last year warned that we should put more emphasis on our arguments for a rule based regime than on monetary expansion as our call for monetary easing creates confusion about what we really think. Or has I stated it back in November last year my my post NGDP targeting is not a Keynesian business cycle policy“:

“I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically”…if the central bank would implement a strict NGDP level target.

So when Market Monetarists (have)… called for “monetary stimulus” it NOT does mean that (we) want to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply…

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo.” 

I hope that that is an answer to George’s more fundamental challenge to us Market Monetarists. We are not keynesians and we are strongly against discretionary monetary policy and I want to thank George for telling us to be more clear about that.

Finally I should stress that I do not speak on behalf of Scott, Marcus, Nick, 2 times David, Josh and Bill (and all the other Market Monetarists out there) and I am pretty sure that the rest of the gang will join in with answers to George. After all most of us are Selginians.

—-

Update: George now has an update where is answers his own question. I think it is a good answer. Here is George:

“My further reflections make me more inclined to see merit in Market Monetarists’ arguments for more accommodative monetary policy.”

Update 2: Scott also has a comment on George’s posts. I think this is highly productive. We are moving forward in our understanding of not only the theoretical foundation for Market Monetarism, but also in the understanding of the economic situation.

Udpate 3: Also comments from David Glasner, Marcus Nunes and Bill Woolsey.
—-

Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Imagine that a S&P500 future was the Fed’s key policy tool

Here is Yale economics professor Stephen Roach:

“The ECB is pretty much out of ammunition.”

This sentence probably best illustrates what is wrong with monetary policy thinking in today’s world. Obviously the ECB is not out of ammunition, but Roach’s perception is very common.

What Roach fails to realise is that when central banks announce what we in general terms could call the “key policy rate” it is really just announcing a intermediate target for a given market interest rate. What the central bank actually is doing it setting the money base to fix a given market interest rate at a given level. In that sense the interest rates is merely a tool for communication. Nothing else.

The problem is that in most standard macroeconomic models the central bank does not determine the money base – in fact there is no money in most of today’s mainstream macroeconomic models – but rather the “interest rate”. In a world where interest rates are well above zero that is not a major problem, but when the key policy rate gets close to zero you get a communication problem. However, this is really only a perceived problem rather than an actual problem. The central bank can always expand the money base – also if the key policy rate is zero or close to zero.

The mental problem really is that interest rates have replaced money in today’s mainstream (mostly New Keynesian) macroeconomic models. Lets therefore imagine that we constructed a simple macroeconomic model where there is no interest rate, but where the central bank’s communication tool is stock prices or rather stock futures.

Many economists would willingly accept that stock prices can influence both private consumption (through a wealth effect) and investments (through a funding cost effect) and as such that would not be different from the “normal” assumption about how interest rates influence domestic demand. Therefore, by influencing the stock prices the central bank would be able to influence domestic demand. Note of course that I on purpose am “keynesian” in my rhetoric just to make my point in regard to mainstreaming thinking of monetary policy. (Obviously stock prices as well and private consumption and investments are determined by expectations of future nominal income.)

Then now imagine that the central bank every month announces a certain level for the a stock market future instead of announcing a key policy interest rate. So for example in the case of the Federal Reserve the FOMC would every month announce a “target” for a given S&P500 future.

Would anybody question that the Fed could do this? And would anybody question whether the Fed could hit that target? No, of course not. The ECB obviously could do the exact same thing. There would be absolutely no technical problem in using stock prices (or rather stock futures) as a policy instrument.

Do you think Stephen Roach would argue that the ECB “pretty much” was out of ammunition had just increased it’s target for the Euronext 24 month future with 5%? No of course not and that in my view clearly illustrates that the zero bound on interest rates only is a mental problem, but an actual problem.

Finally note that I am not advocating that central banks should target stock prices (I advocate they should target an NGDP future), but I see little difference in such a policy instrument and interest rate targeting. Furthermore, there would not be a zero bound problem if the Fed was targeting S&P500 futures rather than interest rates and Stephen Roach might even realise that the ECB in no way is out of ammunition.

——

PS over the long run NGDP and stock prices are actually quite strongly correlated and hence if the Fed announced that S&P500 should increase by lets say 5% a year over the coming 5 years and that it would ensure that by buying (or selling) S&P futures then it would probably do a much better job at hitting a given level of NGDP or inflation for that matter than the Fed’s present weird policy of promising to keep interest rates low for longer or the silly operation twist.

PPS I am pretty sure that Stephen Roach full well knows that the ECB is not out of ammunition, but when you talk to journalists you might make some intellectual short-cuts that distorts what you really think. At least I hope that is what happened.

PPPS If the Fed wanted to target the NGDP level then it is pretty easy to construct indicator for future NGDP from S&P500 futures, TIPS inflation expectations, CRB futures and the nominal effective dollar rate and then the Fed could just use that as a communication tool. Then it would never ever again have to talk about QE or running out of ammunition.

—–

Update: When I started writing my post I was thinking that Nick Rowe might have  written something similar. And yes, indeed he actually wrote a number of posts on the topic. So take a look at Nick’s posts:

“The Bank of Canada should peg the TSE 300” – revisited
Why the Bank of Canada should ‘rise’ interest rates
The Fed should buy pro-cyclical assets, not bonds

The Fed can hit any NGDP target

I hate getting into debates where different bloggers go back and forth forever and never reach any conclusion. I am not blogging to get into debates, however, I must admit that Steven Williamson’s recent posts on NGDP level targeting have provoked me quite a bit.

In his first post Williamson makes a number of claims, which I find highly flawed. However, Scott Sumner has already at length addressed most of these issues in a reply to Williamson so I don’t want to get into that (and as you guessed I am fully in agreement with Scott). However, Williamson’s reply to Scott is not less flawed than his initial post. Again I don’t want to go through the whole thing. However, one statement that Williamson makes I think is a very common mistake and I therefore think a comment is in order. Here is Williamson:

“The key problem under the current circumstances is that you can’t just announce an arbitrary NGDP target and hit it with wishful thinking. The Fed needs some tools, and in spite of what Ben Bernanke says, it doesn’t have them.”

This is a very odd comment coming from somebody who calls himself a (New) Monetarist. It is at the core of monetarism in the sense of Friedman, Brunner, Meltzer, Cagan, Schwartz, Warburton and Yeager etc. that nominal GDP is determined by the central bank and no monetarist has ever acknowledged that there is a liquidity trap. Williamson claims that he does not agree with everything Friedman said, but I wonder what Friedman said he agrees with. If you don’t believe that NGDP is determined by the central bank then it makes absolutely no sense to call yourself a monetarist.

Furthermore, if you don’t think that the Fed can hit an NGDP target how could you think it could hit an inflation target? Both changes in NGDP and in prices are monetary phenomena.

Anyway, let’s get back to the question whether the central bank can hit an NGDP target and what instruments could be used to hit that target.

The simplest way to do it is actually to use the exchange rate channel. Let’s assume that the Federal Reserve wants to increase the US NGDP level by 15% and that it wants to do it by the end of 2013.

Scott has suggested using NGDP futures to hit the NGDP target, but let’s assume that is too complicated to understand for the critics and the Fed. Instead the Fed will survey professional forecasters about their expectations for the level of NGDP by the end of 2013. The Fed will then announce that as long as the “consensus” forecast for NGDP is below the target the Fed will step up monetary easing. The Fed will do the survey once a month.

Let’s start out with the first announcement under this new regime. Initially the forecasters are skeptical and forecast NGDP to be 12% below target. As a consequence the Fed announces a Swiss style exchange target. It simply announces that it will intervene in the FX market buying unlimited amounts of foreign currency until the US dollar has weakened 20% in nominal effective terms (and yes, the Fed has the instruments to do that – it has the printing press to print dollars). I am pretty sure that Williamson would agree that that directly would increase US NGDP (if not I would love to see his model…).

The following month the forecasters will likely have moved their forecasts for NGDP closer to the target level. But we might still have too low a level of forecasted NGDP. Therefore, the Fed will the following month announce a further “devaluation” by lets say 5%. The process will continue until the forecasted level for NGDP equals the target level. If the consensus forecast starts to overshoot the target the Fed will simply announce that it will reverse the process and revalue the dollar.

Therefore there is certainly no reason to argue 1) that the Fed can not hit any NGDP target 2) that the Fed does not have an instrument. The exchange rate channel can easily do the job. Furthermore, if the Fed announces this policy then it is very likely that the market will be doing most of the lifting. The dollar would automatically appreciate and depreciate until the market expectations are equal to the NGDP target.

If you have heard all this before then it is because this a variation of Irving Fisher’s compensated dollar plan and Lars E. O. Svensson’s foolproof way out of a liquidity trap. And yes, I have previously suggested this for small open economies, but the Fed could easily use the same method to hit a given NGDP target.

Update: I should note that the example above is exactly that – an example. I use the example to illustrate that a central bank can always increase NGDP and that the exchange rate channel is an effective tool to achieve this goal. However, the numbers mentioned in my post are purely “fictional” and again it example rather than a policy recommendation. That said, I am pretty that if the Fed did exactly as what I suggest above the US would very fast bee out of this crisis. The same goes for the ECB.

Update II: Marcus Nunes and Bill Woolsey also comment on Williamson. Nick Rowe comments on David Adolfatto’s anti-NGDP targeting post(s).

Jeff Frankel restates his support for NGDP targeting

It is no secret that I have been fascinated by some of Havard professor Jeff Frankel’s ideas especially his idea for Emerging Markets commodity exporters to peg the currency to the price of their main export (PEP). I have written numerous posts on this (see below) However, Frankel is also a long-time supporter of NGDP target and now he has restated is his views on NGDP targeting.

Here is Jeff:

“In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT), much as the currency crises of the 1990s dramatized the vulnerability of exchange rate targeting and the velocity shocks of the 1980s killed money supply targeting.   But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations?

The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting.  It has gained popularity rather suddenly, over the last year.  But the idea is not new.  It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to shifts in money demand.  Under certain conditions, it dominates not only a money target (due to velocity shocks) but also an exchange rate target  (if exchange rate shocks are large) and a price level target (if supply shocks are large).   First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean(1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein & Jim Stock (1994), Bob Hall & Greg Mankiw (1994), Ben McCallum (1987, 1999), and others.

Nominal GDP targeting was not adopted by any country in the 1980s.  Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy.  (They ended up with a “two pillar approach,” of which one pillar was supposedly the money supply.)” 

So far so good…and here is something, which will make all of us blogging Market Monetarists happy:

“But now nominal GDP targeting is back, thanks to enthusiastic blogging by ScottSumner (at Money Illusion), LarsChristensen (at Market Monetarist), David Beckworth (at Macromarket Musings),Marcus Nunes (at Historinhas) and others.  Indeed, the Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere.”

This is a great endorsement of the Market Monetarist “movement” and it is certainly good news that Jeff so clearly recognize the work of the blogging Market Monetarists. Anyway back to the important points Jeff are making.

“Fans of nominal GDP targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks.    Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy.  An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.

In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target).   But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity?  Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world:  Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.”

Exactly! The great advantage of NGDP level targeting compared to other monetary policy rules is that it handles both velocity shocks and supply shocks. No other rules (other than maybe Jeff’s own PEP) does that. Furthermore, I would add something, which is tremendously important to me and that is that unlike any other monetary policy rule NGDP level targeting does not distort relative prices. NGDP level targeting as such ensures the optimal and unhampered working of a free market economy.

Back to Jeff:

“Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential.  It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent.   (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap.)  But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s.  Of course one could declare that the shift from a 2 % target to 4 % would be temporary.  But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number.   An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year – which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target – and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor.”

I completely agree. I have always found the idea of temporary changing the inflation target to be very odd. The problem is not whether to target 2,3 or 4% inflation. The problem is the inflation targeting itself. Inflation targeting tends to create bubbles when the economy is hit by positive supply shocks. It does not fully response to negative velocity shocks and it leads to excessive tightening of monetary policy when the economy is hit by negative supply shocks (just have look at the ECB’s conduct of monetary policy!)
Market Monetarists advocate a clear rule based monetary policy exactly because we think that expectations is tremendously important in the monetary transmission mechanism. A temporary change in the inflation target would completely undermining the effectiveness of the monetary transmission mechanism and we would still be left with a bad monetary policy rule.
Let me give the final word to Jeff:
Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.
_______
Some of my earlier posts on Jeff’s ideas:

Next stop Moscow
International monetary disorder – how policy mistakes turned the crisis into a global crisis
Fear-of-floating, misallocation and the law of comparative advantages
Exchange rates are not truly floating when we target inflation
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
PEP, NGDPLT and (how to avoid) Russian monetary policy failure
Should small open economies peg the currency to export prices?

Scott Sumner also comments on Jeff’s blogpost.

Please keep “politics” out of the monetary reaction function

During the Great Moderation it was normal to say that the Federal Reserve and the ECB (and many other central banks for that matter) was following a relatively well-defined monetary policy reaction function. It is debatable what these central banks where actually targeting, but there where is no doubt that both the Fed and the ECB overall can be descripted to have conducted monetary policy to minimize some kind of loss function which included both unemployment and inflation.

In a world where the central bank follows a Taylor rule style monetary policy reaction function, targets the NGDP level, do inflation targeting or have pegged the exchange rate the markets will tend to ignore political news. The only important thing will be how the actual economic development is relative to the target and in a situation with a credible nominal target the Chuck Norris effect will ensure that the markets do most of the lifting to achieve the nominal target.  The only things that could change that would be if politicians decided to take away the central bank’s independence and/or change the central bank’s target.

When I 12 years ago joined the financial sector from a job in the public sector I was hugely surprised by how little attention my colleagues in the bank was paying to political developments. I, however, soon learned that both fiscal policy and monetary policy in most developed countries had become highly rule based and therefore there was really no reason to pay too much attention to the nitty-gritty of day-to-day politics. The only thing one should pay attention to was whether or not given monetary targets where on track or not. That was the good old days of the Great Moderation. Monetary policy was rule based and therefore highly predictable and as a result market volatility was very low.

This have all changed in the brave new world of Great Recession (failed) monetary policy and these days it seems like market participants are doing nothing else than trying to forecast what will be the political changes in country X, Y and Z. The reason for that is the sharp increase in the politician of monetary policy.

In the old days – prior to the Great Moderation – market participants were used to have politicians messing up monetary policies. Central banks were rarely independent and did not target clear nominal targets. However, today the situation is different. Gone are the days of rule based monetary policy, but the today it is not the politicians interfering in the conduct of monetary policy, but rather the central bankers interfering in the conduct of other policies.

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

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

Any Market Monetarist will tell you that the expectational channel is extremely important for the monetary transmission mechanism and this is particularly important when a central bank start to include political outcomes in it’s reaction function.

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

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

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

So I long for the days when politics was not market moves in the financial markets and I hope central banks around the world would soon learn that it is not part of their mandate to police the political process and punish governments (and voters!) for making the wrong decisions. Central banks should only target nominal targets and nothing else. If they diverge from that then things goes badly wrong and market volatility increases sharply.

Finally I should stress that I am not arguing in anyway that the ECB is wrong to be concerned about fiscal policy being unsustainable in a number of countries. I am deeply concerned about that state of fiscal policy in a number of countries and I think it is pretty clear to my regular readers that I do not favour easier fiscal policy to solve the euro zone crisis. I, however, is extremely sceptical about certain political results being included in the ECB’s reaction function. That is a recipe for increased market volatility.

PS this discussion is of course very similar to what happened during the Great Depression when politics kept slipping into the newspapers’ financial sector (See here and here)

The Jedi mind trick – Matt O’Brien’s insightful version of the Chuck Norris effect

Our friend Matt O’Brien has a great new comment on the Atlantic.com. Matt is one of the most clever commentators on monetary matters in the US media.

In Matt’s new comment he set out to explain the importance of expectations in the monetary transmission mechanism.

Here is Matt:

“These aren’t the droids you’re looking for.” That’s what Obi-Wan Kenobi famously tells a trio of less-than-with-it baddies in Star Wars when — spoiler alert! — they actually were the droids they were looking for. But thanks to the Force, Kenobi convinces them otherwise. That’s a Jedi mind trick — and it’s a pretty decent model for how central banks can manipulate expectations. Thanks to the printing press, the Fed can create a self-fulfilling reality. Even with interest rates at zero.

Central banks have a strong influence on market expectations. Actually, they have as strong an influence as they want to have. Sometimes they use quantitative easing to communicate what they want. Sometimes they use their words. And that’s where monetary policy basically becomes a Jedi mind trick.

The true nature of central banking isn’t about interest rates. It’s about making and keeping promises. And that brings me to a confession. I lied earlier. Central banks don’t really buy or sell short-term bonds when they lower or raise short-term interest rates. They don’t need to. The market takes care of it. If the Fed announces a target and markets believe the Fed is serious about hitting that target, the Fed doesn’t need to do much else. Markets don’t want to bet against someone who can conjure up an infinite amount of money — so they go along with the Fed.

Don’t underestimate the power of expectations. It might sound a like a hokey religion, but it’s not. Consider Switzerland. Thanks to the euro’s endless flirtation with financial oblivion, investors have piled into the Swiss franc as a safe haven. That sounds good, but a massively overvalued currency is not good. It pushes inflation down to dangerously low levels, and makes exports uncompetitive. So the Swiss National Bank (SNB) has responded by devaluing its currency — setting a ceiling on its value at 1.2 Swiss francs to 1 euro. In other words, the SNB has promised to print money until its money is worth what it wants it to be worth. It’s quantitative easing with a target. And, as Evan Soltas pointed out, the beauty of this target is that the SNB hasn’t even had to print money lately, because markets believe it now. Markets have moved the exchange rate to where the SNB wants it.”

This is essentially the Star Wars version of the Chuck Norris effect as formulated by Nick Rowe and myself. The Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.

It is pretty simple. It is all about credibility. A central bank has all the powers in the world to increase inflation and nominal GDP (remember MV=PY!) and if the central bank clearly demonstrates that it will use this power to ensure for example a stable growth path for the NGDP level then it might not have to do any (additional) money printing to achieve this. The market will simply do all the lifting.

Imagine that a central bank has a NGDP level target and a shock to velocity or the money supply hits (for example due to banking crisis) then the expectation for future NGDP (initially) drops below the target level. If the central bank’s NGDP target is credible then market participants, however, will know that the central bank will react by increasing the money base until it achieves it’s target. There will be no limits to the potential money printing the central bank will do.

If the market participants expect more money printing then the country’s currency will obviously weaken and stock prices will increase. Bond yields will increase as inflation expectations increase. As inflation and growth expectations increase corporations and household will decrease their cash holdings – they will invest and consume more. The this essentially the Market Monetarist description of the monetary transmission mechanism under a fully credible monetary nominal target (See for example my earlier posts here and here).

This also explains why Scott Sumner always says that monetary policy works with long and variable leads. As I have argued before this of course only is right if the monetary policy is credible. If the monetary target is 100% credible then monetary policy basically becomes endogenous. The market reacts to information that the economy is off target. However, if the target is not credible then the central bank has to do most of the lifting itself. In that situation monetary policy will work with long and variable lags (as suggested by Milton Friedman). See my discussion of lag and leads in monetary policy here.

During the Great Moderation monetary policy in the euro zone and the US was generally credible and monetary policy therefore was basically endogenous. In that world any shock to the money supply will basically be automatically counteracted by the markets. The money supply growth and velocity tended to move in opposite directions to ensure the NGDP level target (See more on that here). In a world where the central bank is able to apply the Jedi mind trick the central bankers can use most of their time golfing. Only central bankers with no credibility have to work hard micromanaging things.

“I FIND YOUR LACK OF A TARGET DISTURBING”

So the reason European central bankers are so busy these days is that the ECB is no longer a credible. If you want to test me – just have a look at market inflation expectations. Inflation expectations in the euro zone have basically been declining for more than a year and is now well below the ECB’s official inflation target of 2%. If the ECB had an credible inflation target of 2% do you then think that 10-year German bond yields would be approaching 1%? Obviously the ECB could solve it’s credibility problem extremely easy and with the help of a bit Jedi mind tricks and Chuck Norris inflation expectations could be pegged at close to 2% and the euro crisis would soon be over – and it could do more than that with a NGDP level target.

Until recently it looked like Ben Bernanke and the Fed had nailed it (See here – once I believed that Bernanke did nail it). Despite an escalating euro crisis the US stock market was holding up quite well, the dollar did not strengthen against the euro and inflation expectations was not declining – clear indications that the Fed was not “importing” monetary tightening from Europe. The markets clearly was of the view that if the euro zone crisis escalated the Fed would just step up quantitative ease (QE3). However, the Fed’s credibility once again seems to be under pressures. US stock markets have taken a beating, US inflation expectations have dropped sharply and the dollar has strengthened. It seems like Ben Bernanke is no Chuck Norris and he does not seem to master the Jedi mind trick anymore. So why is that?

Matt has the answer:

“I’ve seen a lot of strange stuff, but nothing quite as strange as the Fed’s reluctance to declare a target recently. Rather than announce a target, the Fed announces how much quantitative easing it will do. This is planning for failure. Quantitative easing without a target is more quantitative and less easing. Without an open-ended commitment that shocks expectations, the Fed has to buy more bonds to get less of a result. It’s the opposite of what the SNB has done.

Many economists have labored to bring us this knowledge — including a professor named Ben Bernanke — and yet the Fed mostly ignores it. I say mostly, because the Fed has said that it expects to keep short-term interest rates near zero through late 2014. But this sounds more radical than it is in reality. It’s not a credible promise because it’s not even a promise. It’s what the Fed expects will happen. So what would be a good way to shift expectations? Let’s start with what isn’t a good way.”

I agree – the Fed needs to formulate a clear nominal target andit needs to formulate a clear reaction function. How hard can it be? Sometimes I feel that central bankers like to work long hours and want to micromanage things.

UPDATE: Marcus Nunes and Bill Woolsey also comments on Matt’s piece..

<span>%d</span> bloggers like this: