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Tighter monetary conditions – not lower oil prices – are pushing down inflation expectations

Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong.

Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future.

2y2y BEI euro zone

But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward.

Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market.

brent 1-year foreard

Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year.

Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices – because the market actual expects higher oil prices – more than 2.5% higher oil prices over the coming year.

So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions.

Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow.

As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now.

Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down.

I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not.

Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening.

We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad.

PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future.

PPS This post was greatly inspired by clever young colleague Jens Pedersen.

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Let me say it again – The Kuroda recovery will be about domestic demand and not about exports

This morning we got strong GDP numbers from Japan for Q1. The numbers show that it is primarily domestic demand – private consumption and investment – rather than exports, which drive growth.

This is from Bloomberg:

Japan’s economy grew at the fastest pace since 2011 in the first quarter as companies stepped up investment and consumers splurged before the first sales-tax rise in 17 years last month.

Gross domestic product grew an annualized 5.9 percent from the previous quarter, the Cabinet Office said today in Tokyo, more than a 4.2 percent median forecast in a Bloomberg News survey of 32 economists. Consumer spending rose at the fastest pace since the quarter before the 1997 tax increase, while capital spending jumped the most since 2011.

…Consumer spending rose 2.1 percent from the previous quarter, the highest since a 2.2 percent increase in the first three months of 1997.

So it is domestic demand, while net exports are actually a drag on the economy (also from Bloomberg):

Exports rose 6 percent from the previous quarter and imports climbed 6.3 percent.

The yen’s slide since Abe came to power in December 2012 has inflated the value of imported energy as the nation’s nuclear reactors remain shuttered after the Fukushima disaster in March 2011.

The numbers fits very well with the story I told about the excepted “Kuroda recovery” (it is not Abenomics but monetary policy…) a year ago.

This is what I wrote in my blog post “The Kuroda recovery will be about domestic demand and not about exports” nearly exactly a year ago (May 10 2013):

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

…I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we seeing the yen weaken, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

the focus on the“competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

While I am happy to acknowledge that today’s numbers likely are influenced by a number of special factors – such as increased private consumption ahead of planned sales tax hikes and likely also some distortions of the investment numbers I think it is clear that I overall have been right that what we have seen in the Japanese economy over the past year is indeed a moderate recovery led by domestic demand .

The biggest worry: Inflation targeting and a negative supply shock

That said, I am also worried about the momentum of the recovery and I am particularly concerned about the unfortunate combination of the Bank of Japan’s focus on inflation targeting – rather than nominal GDP targeting – than a negative supply shock.

This is particularly the situation where we are both going to see a sales tax hike – which will increase headline inflation – and we are seeing a significant negative supply shock due to higher energy prices. Furthermore note that the Abe administration’s misguided push to increase wage growth – to a pace faster than productivity growth – effectively also is a negative supply shock to the extent the policy is “working”.

While the BoJ has said it will ignore such effects on headline inflation it is likely to nonetheless at least confuse the picture of the Japanese economy and might make some investors speculate that the BoJ might cut short monetary easing.

This might explain three factors that have been worrying me. First, of all while broad money supply in Japan clearly has accelerated we have not see a pick-up in money-velocity. Second, the Japanese stock market has generally been underperforming this year. Third, we are not really seeing the hoped pick-up in medium-term inflation expectations.

All this indicate that the BoJ are facing some credibility problems – consumers and investors seem to fear that the BoJ might end monetary easing prematurely.

To me there is only one way to fundamentally solve these credibility problems – the BoJ should introduce a NGDP level target of lets say 3-4%. That would significantly reduce the fear among investors and consumers that the BoJ might scale back monetary easing in response to tax hikes and negative supply shocks, while at the same time maintain price stability over the longer run (around 2% inflation over the medium-term assuming that potential real GDP growth is 1-2%).

PS Q1 2014 nominal GDP grew 3.1% y/y against the prior reading of 2.2% y/y.

PPS See also my previous post where I among other things discuss the problems of inflation targeting and supply shocks.

HAWKISH Market Monetarists

Over the past five years Market Monetarists have gotten a reputation for always being dovish in terms of monetary policy. The Market Monetarists have day-in and day-out been pushing for monetary easing in the US, the UK and the euro zone. So our reputation is correct in the sense that we – the Market Monetarists – in general have favoured a more dovish monetary stance both in the US and in Europe than has been implemented by central banks.

However, one might notice that the Market Monetarist bloggers have been surprisingly calm in recent months despite the sharp decline in inflation we have see in particularly Europe. Overall, we have obviously maintained that monetary policy in the euro zone is far too tight and that we are heading for deflation as a result of this. But the primary cause of the sharp decline in headline inflation in the euro zone has been lower commodity prices and to some extent also a result of an “austerity pause” (no indirect tax hikes).

Hence, Market Monetarists do not think a decline in inflation due a positive supply shock in itself should trigger interest rate cuts (or other forms of monetary policy easing). Remember Market Monetarists favour nominal GDP targeting and a supply shock will not impact nominal GDP – only composition of nominal GDP growth between inflation and real GDP growth.

As a result Market Monetarists actually tend to be somewhat less alarmed by the recent inflation decline in the euro zone than for example the ECB and in that sense you can argue that the Market Monetarists actually are more “hawkish” than the ECB presently is when it comes to the need for monetary easing in response to the recent decline in euro zone inflation. When Market Monetarists are calling for monetary easing in the euro zone it is hence for a somewhat different reason than the ECB.

Monetary policy remains overly tight in the euro zone and we are likely heading for deflation – even disregarding the recent supply side driven drop in inflation – and that is why we – the Market Monetarists are advocating monetary easing in the euro zone. Just a look at the dismail growth of nominal GDP in the euro zone – there is no better indication than that of the ECB’s failure to ease monetary policy appropriately. So we shouldn’t be too sad if the ECB moves to ease monetary policy – even if Market Monetarists think it is for the wrong reasons.

In 3-5 years the Market Monetarists will be among the biggest hawks

If we are lucky we continue to see supply side conditions improve both in the US and the euro zone in the coming years. I am personally particular optimistic about the outlook for the US economy, where I do expect a number of factors to give a welcomed lift to US potential growth. The end of the so-called commodity super cycle and fracking might hopefully to reduce oil prices. This is a positive supply shock to the US economy.

Furthermore, as I am optimistic that the US is in the process of ending two wars – the War on Drugs and the War on Terror. I will return to that issue in a later blog post, but I overall think that this is the direction we are moving in and that will be tremendously positive for the US labour supply (and public finances for that matter).

Finally, as the US economy continues to improve the present anti-immigration sentiment in the US will hopefully be reversed – after all Americans are more happy to welcome Mexicans to join the labour force when the economy is doing good rather than bad.

Add to that that US unemployment is still high so there is really no labour market constrains to growth at the moment in the US. So overall, I think we with a bit of luck could be in for a couple of years of fairly high real GDP growth driven by positive supply side factors. In such a scenario we could easily have 4% or even 5% real GDP growth for some years without any substantial pick-up in inflation. This would be very similar to mid-1990s.

Such a scenario would likely in 3-5 years time turn the Market Monetarist bloggers into proponents of Fed tightening – before most other economists would favour it. This would particularly be the case if the Fed overdo it on monetary easing in a scenario where positive supply side factors keep inflation low and hence we see a sharp pick-up in nominal GDP growth. This would of course be what Austrians call relative inflation.

So no, Market Monetarists are not always dovish. We advocate clear monetary policy rules and these rules sometimes leads us to advocate a dovish stance on monetary (as presently), but also to a hawkish stance if needed. For now I have no big fears that US monetary policy is becoming too easy, but if I am right about my “supply side optimism” then a Fed too focused on headline inflation might overdo it on the easy side down the road.

There is of course only one way to avoid such a monetary policy mistake – spell out a clear NGDP level targeting rule today.

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PS The ECB today did NOTHING to avoid deflation in the euro zone. No comments on that other than the ECB missed yet another opportunity to do the right thing.

PPS My best guess is that Scott Sumner will be a ultra hawk on US monetary policy in 2018-9.

Lower (supply) inflation is NOT a reason to ease US monetary policy

Here are two news stories from today:

U.S. import prices fell in April due to a drop in oil costs, a positive sign for household finances that also pointed to benign inflation pressures.

Import prices slipped 0.5 percent last month, the biggest decline since December, the Labor Department said on Tuesday. March’s data was revised to show a 0.2 percent decline instead of the previously reported 0.5 percent drop.”

And the second one:

“U.S. producer prices recorded their largest drop in three years in April while a reading of manufacturing in New York indicated contraction.

Producer prices slid as gasoline and food costs tumbled, pointing to weak inflation pressures that should give the Federal Reserve latitude to keep monetary policy very accommodative.”

Now some might of course think that this would make Market Monetarists scream for the Federal Reserve to step up monetary easing. However, that would be extremely wrong. There are certainly good reasons for the fed to ease monetary policy, but a drop in inflation caused by a positive supply shock – lower import prices – is certainly not one of them.

At the core of Market Monetarist thinking is that central banks should not react to supply shock – positive or negative. Hence, we are arguing that central banks should target the level of nominal GDP – not inflation.

Therefore, imagine that the fed indeed was targeting the the NGDP level and NGDP was “on track” and a positive supply shock hit. Then the fed would maintain monetary conditions completely unchanged – keeping NGDP on track – and allowed the positive supply shock to feed through to lower inflation (and higher real GDP). This is benign inflation and as such very welcomed as it do not reflect a deflationary and recessionary demand shock. Furthermore, some Market Monetarists like David Beckworth and myself also believe that monetary easing in response to positive supply shocks risks leading to economic misallocation and what Austrian economists call relative inflation.

Lower (supply) inflation is no reason for more QE
…but the fed needs to focus on defining its target

One can certainly argue that NGDP growth is too weak to catch up with the pre-crisis NGDP trend, but on the other hand it is also pretty clear that US NGDP growth is fairly robust. So instead of stepping up quantitative easing in response to lower import prices the fed instead should focus on becoming much more clear on what it wants to achieve. Hence, there is still considerable uncertainty about what the fed really wants to achieve.

Therefore, the fed should become more clear on its target. Preferably of course the fed should adopt an NGDP level target and decide whether the present growth rate of the money base is strong enough to achieve that or not. Regarding that I don’t think that the present policy with a not clearly defined target and the present growth rate of the money base is enough to return NGDP to the pre-crisis trend, but it is nonetheless likely to keep NGDP growing 4-5% and that is likely enough to maintain the present speed of recovery in real GDP and the US labour market. I think that is far too unambitious, but it is certainly better than what we are seeing in Europe.

The paradox – the positive supply shock is “pushing” central banks to do the right thing for the wrong reasons

The paradox, however, is that the recent drop in global commodity prices have pushed down headline inflation around the world and central banks have over the last couple of weeks been responding by cutting interest rates. Hence, Central banks in the eurozone, India, Australia, South Korea, Poland and Israel have all cut rates in recent weeks. While there certainly is very good reasons for monetary easing in nearly all of these countries it a paradox that these central banks now seem to have been “shocked” into easing monetary policy in response to a positive supply shock rather than in response to weak demand growth.

It would clearly be wrong to criticize these central banks for doing the right thing – easing monetary policy – but I also believe that it is important to stress that had monetary policy in these countries been “right” then these central banks would likely have been making a policy mistakes by easing monetary policy at the moment.

In that regard it is of course also important that central banks’ (apparent mental) inability to differentiate between supply and demand shocks often has lead central banks to tight monetary policy in response to negative supply. The ECB’s catastrophic rate hikes in 2011 is a very good example of this. Paradoxically we might be happy at the moment that the ECB’s tendency to react to supply shocks might push the ECB into stepping up monetary easing.

Finally I should stress that the recent decline in inflation globally is certainly not only caused by a positive supply. In fact I have long argued that we are likely heading for deflation in the euro zone due to excessively tight monetary policy. So my discussion above should mostly be seen as an attempt to stress the need for understanding the difference between demand and supply for the conduct of monetary policy. Unfortunately many central bankers seem unable to understand these important difference.

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Update: Market Monetarists think alike – I just realized that Marcus Nunes did a post yesterday that made the exact same argument as me.

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