When I follow the political debate in North America I am often struck by how little Canadians and Americans know about Europe – and it is particularly frustrating when certain European countries are used as Socialist Bernie Sanders often has done to say that my native Denmark (and the other Scandinavian countries) are “socialist”.

In a new book published by The Fraser Institute, titled “The Free Enterprise Welfare State: A History of Denmark’s Unique Economic Model,” which I have co-authored, we endeavor to explain the unique Danish model and what has made Denmark prosperous.

Denmark: A Model for the World?

Denmark often captures the world’s attention as a model of prosperity and social well-being. Danes are known for their good health, wealth, and happiness. People from both the left and the right sides of the political spectrum frequently point to Denmark as a policy model worth emulating. However, what sets Denmark apart is its exceptional blend of free-market principles and a robust welfare state.

In our book’s introduction, we explore the Danish economic model, its origins, and the valuable lessons that can be drawn from Denmark’s remarkable experience.

The Power of Economic Freedom

For over a century and a half, the people of Denmark have enjoyed unparalleled economic freedom. They can establish and run businesses with minimal government interference. They can engage in trade domestically and internationally on their terms, without state intervention. The Danes can accumulate savings without fear of inflation eroding their hard-earned money. Property rights are protected, and contracts are enforced. This economic freedom has been a driving force behind Denmark’s high standard of living, which is a key lesson we explore in the book.

Taxes and the Welfare State

While Denmark’s economic freedom is noteworthy, it is important to recognize that the Danish welfare state is funded through some of the highest taxes in the world. The country’s two primary sources of state revenue are the value-added tax (VAT) and personal income tax, which largely burden the middle class. Danes, regardless of their income level, contribute to the VAT when they make purchases, and it stands as one of the highest rates globally. Moreover, Denmark’s top personal income tax rate is among the world’s highest and applies to a relatively low income threshold. This means that the burden of financing the welfare state is shared by all citizens.

Learning from Mistakes: The Limits of Big Government

Our book also highlights an important historical lesson. Denmark, like many other countries, faced a challenging period when it experimented with an unsustainably large government. While for most of its history, Denmark had a relatively small government, in the 1970s through the early 1990s, government spending surged, accounting for nearly 60 percent of the GDP by 1995. This expansion led to significant deficits, mounting debt, and spiraling inflation.

However, as the 1990s rolled in, Danish policymakers realized the necessity of change. They embarked on a path of reducing spending, aligning it with government revenue, and committing to sustainable budgeting practices. This shift towards a more balanced budget resulted in declining inflation and interest rates, illustrating that there are indeed limits to the size of government.

Exploring Denmark’s Economic Model

In “The Free Enterprise Welfare State: A History of Denmark’s Unique Economic Model,” my co-authors and I take you on a journey through Denmark’s economic history. We examine what has made Denmark prosper and the delicate balance between economic freedom and a comprehensive welfare state.

I invite my followers to explore the book as a free PDF download. Feel free to share this exciting release with others who share an interest in economic models, welfare states, or Denmark’s unique path to prosperity.

Read more about the book, the authors and download it here.

I have been interviewed for the podcast “Rig på Viden”. Despite the Danish name of the podcast the podcast is in English and is about my research at part of the research project “Nordic Finance & the Good Society” at Copenhagen Business School.

In the podcast I talk about the main drivers of interest rates for the longer-run.

You can listen to the podcast here.

Milton Friedman, the American Nobel Prize laureate in economics, famously stated, “Inflation is always and everywhere a monetary phenomenon.“

In this blog post, I’ll try to show why Milton Friedman was right, and why he is still right, using some simple math.

But first, the entire Friedman quote: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in the quantity of output.”

Inflation, according to Friedman, occurs when the quantity of money increases faster than the rate of production (“output”).

By the way, you can always argue about what the money supply is (e.g., M1 or M2) and which measures of production we use, but Friedman usually refers to relatively broad measures of the money supply (e.g., M2 in the US or M3 in the Eurozone), and production is usually measured as real GDP.

If you asked Friedman what he really meant, he would answer that he begins by understanding the inflation process by using the so-called equation of exchange. So let us take a deeper look.

The exchange equation
Friedman began with the exchange equation, which was initially formulated mathematically in 1911 by fellow American economist, Irving Fisher, in his book The Purchasing Power of Money:

(1) M•V=P•T

Where M is the money supply, V denotes the velocity of the money supply in the economy during a certain time period, P denotes the price level, and T denotes the number of transactions in the economy.

We must keep in mind that “transactions” at Fisher can be converted into economic production, therefore we can also formulate the equation of exchange as follows:

(2) M•V=P•Y

Where Y represents real GDP (“output”). It also implies that the right side of the equation depicts nominal GDP, which is the price level (P) multiplied by real GDP (the number of commodities produced in the economy).

You can alternatively state that the left side (M•V) of the equation is the price of the entire economy.

At the same time, you can state that (2) is a definition, because it must apply absolutely that in an economy with money, everything we buy and sell is bought and sold with money.

(2), on the other hand, does not state definitively how money, pricing, and output are related. (2) says nothing about what decides what. Hence (2) is not telling us anything about causality.

But consider Friedman’s claim that inflation is always a monetary phenomenon.

We might begin by expressing (2) as growth rates rather than levels:

(3) m + v = p + y

Here, m is the rate of growth in the money supply (e.g. over a quarter or a year), v is the growth rate of velocity, y is the percentage growth in real GDP, and p is the percentage rise in the price level – i.e. what we commonly term inflation.

We obtain the following if we move (3) around a little:

(4) p = m + v – y

And here’s what Friedman says: if m (“the quantity of money”) grows faster than y (“output”), it follows that inflation (p) rises.

However, in the formulation above, Friedman does not mention velocity (v). However, this does not imply that Friedman is unaware of the existence of v or that it has no bearing on inflation. Of course, he knows that – afterall the basis for what he is saying is the equation of exchange.

As a result, one could argue that Friedman could have been more specific in stating that inflation (p) happens when the sum of the money supply (m) and the velocity (v) increases faster than production (y).

An alternate phrasing could have been that money’s purchasing power is determined by the supply of and demand for money.

If the supply of money (M) rises relative to the demand for money (V and Y), the value of money falls – in other words, you can buy less of the production for the same amount of money – and so the prices of goods rise (P).

Monetarists such as Milton Friedman (and myself) doesn’t argue that there is an one-to-one link between the rise of the money supply and inflation.

However, we can see from the preceding that this is not the case because it would require us to ignore what happens to Y (y) and V (v), and understanding the inflation process requires far more than just looking at the development of the money supply, but on the contrary, we see that understanding the money supply must be central to understanding why we get inflation (or deflation).

What about supply shocks?
When economists and others discuss inflation, they frequently state that rising oil costs, for example, have caused inflation to rise. But what role does it play in the quantity equation?

Does Friedman (and other monetarists) genuinely believe that rising gas prices (as in 2022) have no effect on inflation? No they don’t, but again it is more complicated that most commentators make it out to be.

The explanation is that if the price of a production input (for example energy prices) rises, it will naturally have a negative effect on production, causing Y to fall.

And, recalling equation (4) above:

p = m + v – y

Then, logically, for a given m and v, if y goes negative, then p must increase. In other words, a negative supply shock that cuts output will cause the economy’s price level to rise, but only if the central bank lets it.

The central bank will always be able to cut m correspondingly, and therefore the price level (and consequently inflation) is always determined by the central bank – even if there are negative supply shocks.

However, reducing m if a negative supply shock causes y to fall is not necessarily a good monetary policy response, and Friedman would certainly not argue for it.

However, this does not change the fact that the central bank has complete control over the price level through managing the amount of money in the economy.

It should be emphasized that while gas prices in Europe climbed in 2022, real GDP in fact also increased. This suggests that it was not simply a negative supply shock, since real GDP then would have declined. That however as we know did not happen. However, more on that in a later piece.

Finally, when we talk about inflation, we don’t mean individual months or quarters in which prices rise (or fall), but rather a continuous increase in the general price level, and in order for a supply shock to be able to trigger continuous price increases, we need a continuous negative supply shock, which historically hasn’t been happening for longer periods.

Rather, in modern market economies, productivity grows over time – that is, Y increases over time, and so the price level should fall over time. The reason that hasn’t happened in the Western world since WWII is that M (and V) have increased faster than Y.

Inflation is not caused by changes in RELATIVE prices
Above, we talk about production as if the economy only consists of one product, whereas in fact, what we’re looking at is the sum of different products’ production. However, where there are more items in the economy, we may easily re-formulate the equation of exchange.

Assume that the economy contains two goods: good A and good B. As a result, the quantity equation is as follows:

(5) M•V=P_a•Y_a + P_b•Y_b

Where P_a an is the price of good A, Y_a is the production (quantity) of good A, and P_b and Y_b are the price and production of good B, respectively.

Equation (5) can tell us more about a common error made by economists and laypeople when discussing inflation. In particular, a shift in a specific price, such as the price of food or energy, causes inflation.

In other words, can a price increase on good A increase the overall price level?

We get answer when we look at an economy that does not use money at all – a barter economy.

If there is no money in the economy, M equals 0, and (5) is rewritten as follows:

(6) 0•V = P_a•Y_a + P_b•Y_b <=>

(7) 0 = P_a•Y_a + P_b•Y_b <=>

(8) P_a•Y_a = -P_b•Y_b

Equation (8) states that I can “buy” item A if I have a quantity of item B. I can trade myself for an unit of B by exchanging a particular amount of good A.

When we normally discuss prices we usually represent them in monetary terms, such as euros or dollars.

However, in a barter economy, we discuss relative prices, such as how many bananas I must pay for a beer.

If we look at (8) and assume that the production of B declines for whatever reason (e.g., a poor harvest), then the price of good B (P_b) must rise compared to the price of good A (P_a).

But what about the pricing level? So what is the total price of the two goods? Nothing. This is due to the fact that the price is expressed as an exchange ratio rather than in euro or dollars. If the price of item A rises relative to the price of good B, the price of good B must decline relative to the price of item A.

This means that, similarly, we cannot discuss inflation in a barter economy, and thus it follows that we can only discuss inflation in a monetary economy.

In other words, inflation can only be defined as a monetary phenomenon. Price increases can be sustained and widespread only if the money supply (M) grows faster than the demand for money (1/V and Y).

As a result, while central banks around the world may be attempting to absolve themselves of responsibility for rising inflation in 2021-22, the fact, however, remains that the significant increase in inflation in the US and Europe would not be possible without the central banks’ expansion of the money supply in 2020-21.

The Federal Reserve has released the monthly numbers for US monetary growth in February. As we can see from the graph below, and which was indicated from the weekly numbers(and for the components of M2) M2 growth declined further in February. And that is before the recent banking turmoil.

So, the US monetary policy has effectively gone from being extremely inflationary to now being almost deflationary.

It is therefore not surprising that bank problems are now arising. It is a completely natural consequence of the massive monetary tightening.

Given the insane expansion of the money supply in 2020-21, there was no way around tightening monetary policy. It is now quite clear that the Fed has overdone it.

It is therefore now very difficult to see how a recession in the US can be avoided. The damage has been done.

My overall assessment is that US monetary growth should be around 5-7% per year (under normal conditions) to ensure around 4% nominal GDP and therefore around 2% inflation.

And in the last year, M2 has dropped by 2.4%. This is the largest yearly decline in M2 EVER. Or rather since 1960, when the current M2 series began. The annualised monthly growth of M2 has been NEGATIVE since August last year and in January and Febuary M2 has dropped at an annual rate of 6-7 percent.

If we look at the real monetary growth, the decline is almost 8% (year-on-year), which further illustrates how drastic the monetary tightening is.

Back in January, I wrote a blog post “US inflation set to fall sharply in the coming quarters”, where I predicted a significant decline in US inflation. In that blog post, I presented two scenarios for future US M2 growth (a “hawkish” and a “dovish” scenario).

We are now on the tight side of the “hawkish” scenario. That is, monetary policy is becoming far too tight. In the hawkish scenario, the prospects were that US inflation would fall somewhat BELOW 2% in 2024-25. And that was without assuming any drastic changes in the velocity of money. In other words, given that money suppply growth is now even lower, there is now certainly a risk of DEFLATION in the US at some point in 2024-25.

Therefore, the Fed will also have to make a very strong turnaround in monetary policy if a severe recession is to be avoided (it is probably not possible to avoid the recession at this point), and if the Fed is to ensure that inflation does not fall significantly below 2%.

Milton Friedman, who recommended that the Fed ensure stable growth in the money supply (e.g. 4-6% per year), would have been just as concerned that we now have very negative M2 growth as he would have been about the very high M2 growth in 2021-22.

Unfortunately, I feel compelled to quote one of my other great heroes, the German-American economist Rudi Dornbusch:

“No postwar recovery has died in bed of old age—the Federal Reserve has murdered every one of them.”

And yes, the Fed will have to sharply lower interest rates in 2023-24. Sharper than what my simulation showed back in January (see here).

Finally the Fed should not concern itself with the so-called banking crisis. The Fed should not ease monetary policy because of that. The Fed is not in the business of saving banks. HOWEVER, the Fed’s job is to ensure nominal stability and consequently the Fed should now move to ease monetary policy fairly aggressively and that will own its own also greatly contribute to ensuring financial stability.

And do I need to say it again? The Fed needs to return to a rule based monetary policy and end the stop-go policies of recent years. My recommendation has for years for the Fed to adopt a 4 percent NGDP level target and I continue to believe that is the best target the Fed could adopt.

10 years ago I wrote a blog post with the title “Firefighter Arsonists – the myth of the central bankers as ‘good’ crisis managers”. Given what is playing out in the global economy it seems fitting to update that post.

So that is what I have done. Here goes…

10 years ago Ezra Klein endorsing Larry Summer argued that Larry Summers would be a good Federal Reserve chairman because he is a good “crisis manager” (he is not):

“Summers knows how to manage a crisis. This White House is particularly attuned to the idea that the economy can fall apart at any moment. Summers, they think, knows what to do when that happens. He was at the center of the Clinton administration’s efforts to fight back the various emerging-markets crises of the 1990s (remember “The Committee to Save the World”?). He was core to the Obama administration’s efforts to fight the financial crisis in 2009 and 2010. Few people on earth are as experienced at dealing with financial crises — both of the domestic and international variety — as Summers.”

What is wrong with this argument?

The key problem with is argument is that the assumption is that crisis is a result of the market economy’s inherent instability and that the regulators’ and the central bankers’ role is to somehow correct these failures.

There is no doubt that central bankers like this image as saviours of the world. However, history shows that again and again we are in fact talking about firefighter arsonists – central banks again and again have caused crisis and afterwards been hailed as the firefighters who flew in and saved the world.

Just take what have happend in the past three years – we have seen a unprecedented in the US money supply and other central banks have been happy to copy the inflationary policies of the Fed. Predictably we have have the highest inflation in the US and Europe since the early 1980s.

And now as the Fed is trying to undo it’s own failures it is likely in the path to tighten monetary policy too much and in the process financial institution that have been benefitted from the excessive growth in the money supply are now getting into trouble…and the Fed is now leading the effort to bailing out these institutions.

Furthermore, describing central bankers as crisis managers and firefighters exactly defines monetary policy as first of all a highly discretionary discipline. There are no rules to follow. A crisis suddenly erupts and the clever and imaginative crisis manager – a Larry Summers, Janet Yellen or Jerome Powell style person – flies in and saves the day. This is often done with the introduction of enormous amounts of moral hazard into the global financial system.  This has certainly been the case during the Great Recession and it was certainly also the case when Summers was on “The Committee to Save the World”.

Did the “The Committee to Save the World” actually save the world or did it introduce a lot more moral hazard into the global financial system?

We don’t need crisis managers – we need strict and predictable monetary policy rules

We need to stop thinking of central bankers as crisis managers. They are not crisis managers and to the extent they try to be crisis managers they are not necessarily good crisis managers.

As long as there is a monopoly on money issuance the central bank’s role is to ensure nominal stability and act of as lender of last resort. Nothing more than that.

To the extent the central bank should play a role in a crisis it should ensure nominal stability by providing an elastic supply of money.

Hence, in the event of a drop in money velocity the central bank should increase the money supply to stabilize nominal GDP.

Second, the central bank shall act as lender-of-last resort and provide liquidity against proper collateral.

Those are the core central bank tasks. Often central banks have failed on these key roles – the Fed certainly failed on that in 2008 when the Primary Dealer system broke down and the Fed effectively failed to act as a lender-of-last resort and allowed money-velocity to collapse without increasing the money base enough to offset it.

On the other hand the Fed got involved in tasks that it should never have gotten itself into – such as bank rescue and credit policies.

A stable monetary and financial system is strictly rule based. There should be very clear rules for what tasks the central bank are undertaking and how they are doing it. The central bank’s reaction function should be clearly defined. Furthermore, bank resolution, supervision and enforcement of capital requirements etc. should also be strictly rule based.

If we have a strictly rule based monetary policy and rule-based financial regulation (for example very clearly defined norms for banking resolution) then we will strongly reduce the risk of economic and financial crisis in the first place.  That would completely eliminate the argument for central banking firefighters. Public Choice theory, however, tells us that that might not be in the interest of firefighters – because why would we need firefighters if there are not fires?

Finally let me quote Robert Hetzel’s conclusion on the Asian crisis from his book on the history of the Fed (pp 215):

“…market irrationality was not the source of the financial crisis that began in 1997. The fundamental source was the moral hazard created by the investor safety net put together by the no-fail policies of governments in emerging-market economies for their financial sectors and underwritten by the IMF credit lines. The Fed response to the Asia crisis would propagate asset market volatility by exacerbating a rise in U.S. equity markets”

Hence, the firefighters created the conditions for the Asian crisis and following stock market bubble. And we should remember that today.

Because central bankers over the past year years (actually since 2008) have acted as discretionary firefighters (the Larry Summers playbook) they rather than acting within a rule based monetary policy framework might instead very well have laid the foundation for the next crisis by further increasing moral hazard problems in the global financial system.

Paradoxically enough central bankers have been extremely reluctant about doing what they are meant to do – ensuring nominal stability by providing an elastic money supply – but have happily ventured into credit policies and bailouts.

PS Given the discussion some might be wrongly led to conclude that I think monetary easing is the same as moral hazard. That, however, is not the case. See a discussion of that topic here. Easing monetary policy when monetary policy has become too tight to ensure the central bank hits its nominal target is not moral hazard. Instead that is proper monetary policy.

I am fully aware of what is going on in the world as we have moved from an inflation crisis to a bank crisis, and I have shared my views on social media. You can follow me on LinkedIn (see here) or Twitter (see here) to stay updated.

I will also share my views on the implications of the bank crisis and how it will play out in the near future. However, today, I want to share a bit of information regarding what the US money supply is telling us about the “tightness” of US monetary policy. This is highly relevant for understanding the ongoing banking crisis.

Back in January, I wrote a post about my P-star model and what it was telling us about the outlook for US inflation.

In that post, I argued that as a consequence of the monetary tightening implemented by the Federal Reserve during 2022, it was likely that inflation would drop sharply during 2023 (remember, monetary policy works with long and variable lags…).

In my post, I presented two scenarios for the growth in the US money supply – a hawkish and a dovish scenario. See the graph below.

In the hawkish scenario, I assumed that US M2 would continue to “flatline” as it has done through 2022 for some time to come, so M2 would return to the pre-2020 trend in M2.

In the dovish scenario, I assumed that enough was enough, and that the Fed would ease monetary policy from the beginning of 2023. Therefore, the growth rate of M2 would return to the pre-2020 growth rate (comparable to 2 percent inflation in the long run).

I used these two scenarios to simulate the future US inflation rate. The graph below shows these two scenarios.

In the dovish scenario, we would see a benign return to 2 percent inflation in the next couple of years.

However, in the hawkish scenario, we would see a sharp drop in inflation that would continue into 2024 and cause inflation to significantly undershoot the Federal Reserve’s 2 percent inflation target. Therefore, in the hawkish scenario, monetary policy would become too hawkish, which would likely cause a large US recession. Additionally, in that kind of scenario, financial distress and a banking crisis would become more likely.

Back in January, I wrote the following about the likelihood of each scenario:

“The most likely scenario is probably a combination of the two scenarios, where the Fed is likely to follow a stop-go or go-stop policy. Hence, with inflation likely to drop significantly in the next 3-4 months, the Fed is also likely, in that period, to end its hiking cycle and gradually start to re-accelerate money supply growth.”

Therefore, I didn’t argue which of the scenarios was more likely, but today we can compare the development in M2 since January to the two scenarios.

The graph below shows the development in M2 and bank deposits in the US:

Bank deposits, of course, are a significant part of the total money supply, and I am here showing the weekly deposit numbers. The latest observation is March 8.

So judging from the deposit numbers, M2 has continued to drop in the first quarter of the year – likely around 2 percent compared with Q4 2022. This is the fastest contraction in M2 quarter-to-quarter at any point since the Fed initiated its monetary tightening in 2022 (effectively already in the latter part of 2021).

Said in another way, the Fed has stepped up monetary tightening just as it looked like the effects of the monetary tightening in 2022 were about to set in.

If we compare this to the two scenarios I presented in January, monetary policy has turned even more TIGHT than what we assumed in the hawkish scenario.

Consequently, it now looks like inflation will drop even faster than forecasted in the hawkish scenarios.

I haven’t done a new “super hawkish” scenario and not a “super hawkish plus bank crisis” scenario, but it is pretty clear that monetary policy in the US has become far too tight and it is hard not to see the banking crisis that has been playing out globally over the past two weeks in the light of this, and I might say that there are some eerie similarities between what is happening now and what happened during the summer of 2008.

The task of the Federal Reserve is not to save banks, but to ensure nominal stability. In my view, that implies that the Fed should conduct monetary policy in such a way that nominal GDP growth is around 4 percent, which will ensure 2 percent inflation (more or less). To do that, the Fed should ensure that the money supply does not grow too fast (as in 2020-21) or too slowly (as clearly is the case now).

It is therefore time for the Fed to acknowledge that monetary conditions have become too tight.

Another very important message is that the Fed should not become preoccupied with the distress in the banking sector. Rather, the Fed should do its job on monetary policy, and that job is to ensure nominal stability. If the Fed is doing that job well, then financial stability is automatically ensured as well.

I also believe that this means that it is now most likely that the Fed will not hike its key policy rate at its upcoming FOMC meeting later this week. In fact, it is likely advisable to cut rates right now. That said, I would much rather that the Fed communicated a proper nominal GDP level target of 4 percent.

Unfortunately, the Fed failed massively on the overly easy side in 2021-22, so it is now impossible to bring back NGDP to its pre-2020 4 percent trend without a massive US recession and global financial crisis.

The Fed should therefore not try to bring NGDP back to the pre-2020 trend, but rather re-set its implied target NGDP target at a level comparable to the actual level of US NGDP in Q4 2024.

If the Fed announced this week that it would implement a 4 percent NGDP level target and ensure a growth rate in M2 to achieve this, it would first of all prevent inflation from dropping sharply below 2 percent. It would also ensure that there would not be a re-acceleration in inflation, but rather an orderly continued decline, and at the same time, this would clearly stabilize the global financial markets and significantly reduce the risk of further banking problems emerging.

Yes, it is back to the policy recommendations that market monetarists like Scott Sumner, David Beckworth, and I gave back in 2008-9 and have continued to argue for ever since. If the Fed had focused on keeping NGDP on a 4 percent path in 2020, we would not have seen the massive overshooting of the 2 percent inflation target in 2021-22, and we likely would have avoided banking distress. To achieve 4 percent nominal GDP growth, we would likely need to see M2 growth of 6-7 percent year-on-year, given the long-term trend in M2 velocity. But given the likely shock we have seen to money demand on the back of the banking crisis, even higher M2 growth might be necessary for a period, depending on what happens to money demand/velocity in the US.

It is not too late to do the right thing. The Fed can do it this week, but unfortunately, it may not, and therefore, stop-go policies will continue for some time.

Finally, a friendly reminder: In another follow-up post from January, I made a simulation for US interest rates based on an inflation forecast where I took the simple average of the hawkish and the dovish scenarios for inflation. The graph shows that simulation, given what we have seen since March, rates need to drop below this rate path, and it needs to happen faster. The Fed hiked in 50bp steps; it might be forced to cut in 100bp steps.

Contact:

Lars Christensen

Phone: (+45) 52 50 25 06

Mail: lacsen@gmail.com

For booking of speaker engagements see my speaker agency (both Danish and international) here.

I have spent quite a bit of time recently playing around with ChatGPT and other AI tools like Midjourney.

One thing that I, like a lot of other people, am curious about is how I can use AI to improve what I am doing in economics and finance.

My answer to that question is “quite a bit.” I am not particularly impressed with ChatGPT when I ask it about economics and finance, but that really isn’t a disappointment.

Rather, I see ChatGPT as an excellent tool to do things more effectively, and what I have particularly found is that AI is helping me generate new ideas, to ask new questions in the area in which I am already doing research and advisory work – in general economics, monetary policy, finances, and the economics of sports.

Today, for the first time, I tried to use ChatGPT to help me code. I must say that my coding skills have been declining over the years as a result of using primarily Excel and having research assistants.

But over the last couple of years, I have been playing a little bit around with coding in Python, but I have found it hard to get started again and to use it frequently. So I have frankly been giving up on Python.

Something I do use a lot, however, is the St. Louis Fed’s FRED database with economic and financial data. That is a great resource – and it is free.

So today I got the idea – why not try to combine ChatGPT, Python, and FRED to answer some questions about the global economy?

And of course, as a market monetarist, I wanted to have a look at nominal GDP in different countries – more specifically on what I will here term the “NGDP gap.”

So I simply asked ChatGPT to write me a code for Python that, based on data, creates time series for the NGDP gap for the US, the euro area, Sweden, and Denmark based on data from the FRED database.

I asked ChatGPT to write a code that calculates the trend in NGDP with an HP-filter (it figured out itself that Lambda should be 1600 on quarterly data) and asked it to write the code to calculate the NGDP gap as the percentage difference between the actual level of NGDP and the trend-NGDP level and create graphs for this. I didn’t ask it to make any specific design recommendations regarding the graphs.

The graphs below are the result of this.

I am quite happy with the results, and I did not expect that I – along with ChatGPT, Python, and FRED – would be able to achieve this with just a couple of hours of work.

What really took time was ensuring that there was proper “communication” between the programs. But it all worked out in the end, and for the next project, I’m sure it will be a lot less time-consuming.

But why am I doing this? Not because I’m an AI enthusiast – I’m not – but because it makes it easier (and less time-consuming) to ask questions and find answers.

Returning to economics, what interesting results does this produce? Well, take a look at the graphs. The Great Recession of 2008-9 is certainly visible in all of the graphs above, as are the “lockdown shocks” of 2020 and the very strong and swift recovery in 2020-21. Most importantly, we see that in all four currency areas, there has been a massive overshooting, and the NGDP gap has turned strongly positive over the past 1-2 years.

This is particularly noticeable in my home country of Denmark, where the NGDP gap has now reached +6 percent, indicating extremely loose monetary conditions. This also suggests that it could take some time before inflation returns to 2 percent in Denmark.

It’s also worth noting that the NGDP gap in the Eurozone is somewhat smaller than in Denmark, indicating that the need for monetary tightening is greater in Denmark than in the Eurozone. However, given Denmark’s peg to the Euro, it is impossible to tighten monetary policy relative to the Eurozone – unless, of course, the krone is revalued against the Euro. That is not currently on the table and is not something being advocated by the Danish government or the Danish central bank. However, as inflation has spiked over the past year, the discussion of whether the peg should be maintained in its present form has begun to emerge.

In my opinion, the main reason that the NGDP gap has become higher in Denmark than in the Eurozone is primarily due to relative terms-of-trade shocks. While most Eurozone countries, like Germany, have been hit by negative terms-of-trade shocks due to the rise in energy prices in Europe, Denmark, on the other hand, has seen its export prices, such as shipping and pharma prices, skyrocket. If Denmark had had a floating krone, it would likely have appreciated against the Euro. Instead, we are now seeing a real appreciation of the krone via higher Danish inflation.

Anyway, I thought my readers might find it interesting that AI can help us – or at least help a soon-to-be 52-year-old economist – become a bit more productive, or at least answer familiar questions with new tools (or toys…).

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Contact my speaker agent? Then see my page at Youandx here.

Last week I wrote a blog post in which I updated my outlook for US inflation based on the so-called P-star model.

In that blog post, I argued that my forecast in April 2021 for much higher US inflation essentially had been spot on, but also that inflation now is set to start to inch down relatively fast in the US.

The P-star model basically is a monetarist model that states that inflation is a result of money supply growth being faster than money demand growth.

However, the Federal Reserve normally does not communicate about monetary policy in terms of money supply growth but rather in terms of setting its policy rate.

I am as a (market) monetarist very skeptical about thinking about monetary conditions in terms of interest rates. Instead, I believe that central banks cannot in the longer run control interest rates. Rather, interest rates are determined by structural factors – essentially to clear the market for savings and investment.

What central banks can do is to set a policy rate that is comparable with what the Swedish economist Knut Wicksell called a natural interest rate, R*.

However, to set a policy rate below R* then the central bank will have to increase the amount of money in circulation in the economy. This will, however, cause an acceleration in inflation, which sooner or later will cause the central bank to revise its policy.

When central banks communicate in terms of their policy rate rather than in terms of for example money supply growth (or growth in nominal demand) then it becomes key to understanding the level of R*.

In that sense, we can understand the state of monetary policy by looking at the key policy rate relative to R*.

The problem of course is that we cannot observe R* directly, but we can try to estimate R* from the historical relationship between macroeconomic variables and the policy rate.

Back in February 2021, I presented such a model in a blog post “R* strikes back: The Fed will hike sooner rather than later”.

I have now updated that model and will use the updated model to evaluate US monetary policy over the past two years and to look ahead.

The R* model

This is how I described the variables in my R* model for the US back in February 2021:

“First of all, I look at potential nominal GDP growth (relative to population) growth.

This of course partly reflects the Fed’s inflation target and that we know from the so-called Fisher Equation that high inflation should cause higher nominal interest rates. Furthermore, this also captures the fact that higher productivity growth should be expected to lead to higher interest rates – as we for example recognize it from the so-called Solow growth model.

Second, I use population growth to capture both growth trends as well as for example the impact of changes in savings and risk appetite as a consequence of changes in demographic trends.

Third, even though the Fed’s task is to ensure ‘price stability’ it has not always succeeded in that. The opposite of price stability is price volatility and we, therefore, use a 10-year moving average of yearly changes in inflation to capture the degree of price (in)stability.

Finally, we also want to capture changes in investors’ and consumers’ optimism and pessimism and the general ‘business cycle’, and the general level of economic activity. I could have used unemployment or the output gap, but I also wanted to capture structural-demographic trends so I have used the so-called employment-population ratio as an explanatory variable.”

Furthermore, I took into account in the model that there apparently since 2008 has been a structural shift down in interest rates and yields globally – likely reflecting to a large extent banking regulation.

The graph below shows the effective Fed Funds rate since 1960 and until today and my estimate for R*. The model has been estimated until 2019 so as not to be influenced by lockdowns etc. from 2020.

We see that the model overall fits the development in the Fed funds rate quite well for more than six decades.

Below I will zoom in on the development in the Fed funds rate over the past five years and compare that with R*.

The Fed got it right in 2020, but failed massively in 2021

The US and the global economy and markets were hit by an unprecedented shock in early 2020 when the Covid pandemic spread around the world and governments – also in the US – moved to contain the virus by lockdown the economies and introducing draconian restrictions on civil and economic life.

In the initial phase, the reaction in the financial markets was very close to what we saw in the Autumn of 2008 and all indications were that the US economy would fall into a deep and potentially deflationary recession.

If we look at the model’s prediction of R* then we see that R* dropped sharply in the US in early 2020. In fact, the drop in R* was as sharp and as deep as in 2008 and as in 2008 R* turned negative. In fact R* became even more negative than in 2008.

Contrary to 2008 the Federal Reserve reacted swiftly to the drop in R* and cut the Fed Funds rate to zero and introduced massive quantitative easing. Hence, the Fed surely had learned the lesson from 2008 – when R* drops below zero it is not enough to cut the policy rate to zero – quantitative easing (money printing) is also needed.

The swift policy reaction from the Fed certainly worked – the US economy rebounded strongly as did financial markets.

The recovery was so impressive that I in May 2020 in a blog post argued that US unemployment would drop to 6% by November 2020. When I made that forecast US unemployment was at 15%. My forecast turned out to be nearly right – we got to 6.7% in November 2020.

The swift recovery let me to start thinking that the Fed would soon have to revise it policy stance and start hiking interest rates and undoing quantitative easing and that was very much driven by what I observed in terms of the development in R* relative to Fed’s actual policy.

This was also very visible in the graph above. We see that R* bottomed out around April 2020 close to -4%, but in months following that we saw R* increasing quite fast and by the end of 2020 R* was back to zero.

This would imply that the Fed would have ended its quantitative easing by the end of 2020 and have started interest rate hikes already in early 2021. And this is in fact what I thought the Fed would do – or at least start a process of “normalization”.

As I wrote back in my original R* blog post in February 2021:

“This means that we in 2021 are likely to see the Fed being forced to change its message quite a bit. I am tempted to say that this smells of the stop-go policies of the 1970s and even though the outcome is likely to be less catastrophic than during the 1970s we could very likely see an increase in financial market volatility as a result of this.”

But the Fed did not change its message. Hence, in early 2021 Fed chairman Jerome Powell, again and again, stated the pickup in inflation was temporary and in July 2021 Powell now famously stated the Fed did not even think about thinking about hiking interest rates.

If we compare this to our model for R* we see that by the summer of 2021 R* had increased to 4% – indicating that by the summer of 2021 US monetary policy had become extremely easing.

In fact, if we look at the difference between the actual Fed funds rate and R* – what we could call the R-gap – then this is the easiest US monetary policy has been since 1974. It therefore hardly should have been a surprise to anybody that we would see a sharp spike in inflation in 2021-22.

Hence, the R-gap is telling us the exact the same story as the P-star model – US monetary policy became excessively in 2021 and this is the main reason why we saw a sharp pickup in inflation in 2021-22.

Said in another way we got into 2022 the Fed was way behind the curve and there was a very urgent need to initiate monetary tightening. The Fed started signaling this in October-November 2021 and then initiated the rate-hiking cycle in 2022.

As we see from the graph above R* basically levelled off around 5% in mid-2020 and since then the gap between the actual Fed funds rate and R* has been closing as the Fed has continued to hike rates.

And with the expected rate hike this week from the Fed we are now very close to having closed the gap between the Fed funds rate and R* and it is safe to say that based on the R-gap US monetary policy is now close to being neutral.  

Next: Fed will start cutting rates as inflation comes down

The Fed got way behind the curve in 2021, but during 2022 the Fed has been fast catching up and based on our analysis above is clear that the Fed likely will end its interest rate hiking cycle in the near future.

The next question becomes when the Fed will start cutting interest rates and here we can also get a bit of guidance from our R* model.

What we essentially need to do is to make a forecast for R*, which to an extent gets us into endogenous problems – hence if the Fed keeps Fed funds too high for too long then inflation will drop faster and economic activity slow, which both will push R* down. On the other hand, if the Fed cuts rates too fast then it will cause inflation to come down at a slower pace and economic activity will be higher, which will push up R*.

This, of course, illustrates on of the problems with a policy of interest rate targeting – it is to a large extent a process of trail-and-error and given how much out of whack US monetary policy has been it is easy for the Fed to err in this process.

But on the other hand it is probably reasonable to assume that the Fed eventually will get it right – and bring inflation down towards 2%, while keeping unemployment close to its structural level (NAIRU). If we use this as input in out R* we can simulate a scenario for the Fed funds rate in the coming years.

This is what I have done below. In terms of inflation, I have used our P-star model from my previous blog post to make some assumptions for the development in inflation in the coming years. My base scenario for inflation is a simple average for the two inflation scenarios (“hawkish” and “dovish”) in my previous post.

The graph below shows the simulated Fed Funds rate, which we assume follows R*, based on our assumed scenario for US inflation going forward.

This is no doubt a very benign scenario where inflation comes down back to the Fed’s 2% inflation target gradually over the next couple of years and the Fed funds rate is cut gradually to reflect the drop in inflation.

There is of course a lot of room for mistakes and as such, it is very hard to make anything else than a conditional forecast for the Fed funds rate going forward. That being said given that I expect inflation to start declining rather significantly in the coming six months it is also clear that we are very close to the end of the hiking cycle and eventually the Fed will start cutting rates.

The Fed most definitely will not get it perfectly right, but I am actually somewhat more optimistic that the Fed will manage the next ‘stage’ of this episode better than what it did in 2021 so my ‘best estimate’ is that by 2025-6 we would probably see the Fed funds rate around 1.5% – more or less at the level we hade during the period 2015-2019.

Finally compared to market pricing the scenario above is not significantly different from market pricing. Hence, the market expectation is also for the Fed to initiate rate cuts during 2024, and even though my simulations are actually indicating that we could get rate cuts already in the second half of 2023 given the rather large uncertainties this is not a major difference. Note here that this is not because I assume the US economy will fall into recession – in fact, I have assumed it will not.

The overall conclusion is that while the Fed clearly erred on the overly easing side in 2021 and did right in tightening monetary policy during 2022 we are now entering a period where we have risks on both sides and the Fed can and likely will err in both directions in the coming 1-2 years.