Robert Hetzel on the monetary response to Covid19

There are few economists that have had a bigger influence on my thinking about monetary matters than former Richmond Fed economist Robert Hetzel.

Bob is not only one of my biggest intellectual heroes, but also a very a good friend and I am therefore extremely happy that he has allowed to publish some of this insights and thoughts on Fed’s 50bp ’emergency’ rate cut today.

Lars Christensen

Fed and Covid19

By Robert Hetzel

Cutting the funds rate just before an FOMC meeting sends a strong but not necessarily appropriate message.  The fact that the cut came without the discussion from the regional Bank presidents of their respective regions that would come routinely at an FOMC meeting suggests that the FOMC was responding to the decline in the stock market.

That turned out badly for the Fed in October 1987 when the market fell 20% and the FOMC cut the funds rate.  By spring, it was obvious that the economy had continued to grow unsustainably fast.  A more disagreeable interpretation of the last cut is that pre-meeting cuts or messages from the chair that lock the FOMC into cutting are a throwback to the Burns era.  At times, Burns would engineer a cut in the discount rate just before an FOMC meeting to lock in a funds rate cut thereby dispensing with opposition from within the FOMC.

To be clear, the reduction in the funds rate could turn out to be completely appropriate.  Starting with the July 2019 meeting, the FOMC lowered the funds rate by ¾ a percentage point.  It did so based on a forecast that disruption to international trade would weaken the world economy and adversely affect U. S. growth.   If the Trump administration had not pulled back on its tariff threats out of concern for growth in the 2020 election year, the forecast could have been validated.  In a perverse sense, the Fed was “lucky” in that the Covid19 virus validated that forecast and the earlier ¾ percentage point cut.

The world would tear apart if central banks exacerbated a coming recession with contractionary monetary policy.  One analogy is the GM strike in 1959 that produced a sharp decline in output.  The FOMC attributed the weakness in the economy to the strike and missed the fact that monetary policy was contractionary.  The result was a recession in 1960.

As usual, models can organize a discussion without offering answers.  The Covid19 disruption is a negative productivity shock.  If households see the shock as transitory, they draw down their rainy-day savings and there are no consequences for the natural rate of interest.  If households see the shock as long lasting and become pessimistic about the future, they will want to save more.  Equivalently, they will want to transfer consumption from the present to the future.  The intertemporal price of consumption (the price of current consumption in terms of future consumption) will have to decline (the real interest rate decline) to maintain current aggregate demand.

What about the argument that the FOMC can always reverse its cuts in the funds rate, which are now 1 ¼ percentage points?  The first problem is that the FOMC is always reluctant to move at inflection points demarcating persistent reductions to possible persistent increases.  The FOMC is always concerned about how markets will extrapolate the initial increase to future increases.

The second problem concerns whether markets will see an increase as a change in strategy.  The current strategy entails forward guidance that lowers the market’s expectation of the future funds rate path.  That guidance is a result of Powell’s promise not to raise the funds rate until inflation persistently and significantly overshoots the FOMC’s two-percent inflation target.  Markets see no inflation on the horizon and infer that a relatively low funds rate can be maintained for a considerable if not indefinite period.  The vagueness of the criterion of a persistent overshoot in inflation allows almost unlimited discretion to the chairman.

Given all the publicity generated by the FOMC’s monetary policy review, it would be useful to have some discussion of the current strategy.  I assume the current strategy makes the funds rate target into a one-way downward ratchet until inflation rises well above two percent.  Given the bad news first about trade and now about the Covid19 virus, the strategy has worked.  What does the FOMC do with good news?


Books by Robert Hetzel:

The Monetary Policy of the Federal Reserve: A History
The Great Recession: Market Failure or Policy Failure? 




The monetary response to the ‘corona shock’ is (hopefully) underway

The statement the Federal Reserve should publish ASAP

I have been asked about what the Federal Reserve should do in response to ‘corona shock’.

So here we go – I suggest the Federal Reserve immediately put out the following statement:

“The Federal Open Market Committee (FOMC) notes that the global shock from the spreading of the corona virus significantly has changed financial market expectations regarding the outlook for the US economy and particularly regarding financial and monetary conditions.

The FOMC also notes that financial market expectations regarding the outlook for nominal spending growth and inflation have deteriorated significantly and to such a degree that the US economy risks entering a potentially severe recession in the coming quarters and that there is a serious risk that inflation will further undershoot the Federal Reserve’s 2% inflation in the medium-term.

Consequently, the Federal Reserve will take imitate policy actions to ensure nominal stability and to avoid a recession.

First, of all the Federal Reserve will immediately undertake unlimited asset purchases in global bond, FX and commodity markets to ensure that market inflation expectations measured as TIPS inflation expectations (2, 5 and 10 year horizons) will permanently be in the range of 2-3%.

The policy is open-ended and permanent. Furthermore, the Federal Reserve will no longer try to ‘peg’ the Federal Funds rate. Rates will be determined by market forces.

Second, the FOMC wants to remind market participants that the Federal Reserve has the ability to expand the dollar money base unlimited to offset any increase in the demand for base money and to ensure hitting the 2% inflation target on any time horizon.

Third, the Federal Reserve will act in accordance with its mandate as a lender of last resort to the banking system and provide dollar liquidity to any financial institution domestic or foreign with proper collateral.

Fourth, the Federal Reserve is already in close contact with major central banks around the world to ensure that if necessary ample dollar liquidity is provided to the global financial system to avoid an unwarranted and disruptive hoarding of dollars. If necessary, the Federal Reserve will expand dollar-swap agreements with central banks around the world.  

Finally, the Federal Reserve is closely monitoring exchange rate developments, commodity prices as well as global inflation expectations so to stand ready to offset any potential negative shock to dollar-demand. The Federal Reserve will under no circumstances allow a potentially deflationary decline in money-velocity.

The Federal Reserve cannot mitigate the disruptions to the global supply chain resulting from the coronavirus, but the Federal Reserve will use all powers at its disposal to ensure that nominal stability is maintained.”

This is not my “optimal” policy proposal (that would include a NGDP target), but it is nonetheless what I believe to be the “right” policy given the Federal Reserve’s present policy framework.




The scary risk that central banks will turn the ‘corona shock’ into a global recession

This week the corona virus has hit global financial markets hard and it is now clear to everyone that this is a significant and hard negative shock to the global economy and a shock that likely requires a response from central banks around the world. The question is how to react. I will try to answer this in this blog post.

Overall, one can start out by noting that central banks have the responsibility of broadly speaking ensuring nominal stability.

I would generally prefer this to be some kind of nominal GDP (level) target for most central banks, but for most central banks nominal stability is interpreted to be some kind of inflation target – in the case of the ECB and the Federal Reserve 2% inflation.

So here I will take the inflation target as given and I will also take it as given that the normal modus operandi for central banks like the ECB and the Fed is some kind of interest rates targeting – the central bank controls the money base in such a fashion to hit an short-term money market interest rate to in turn ensuring hitting the inflation target in the ‘medium-term’.

Supply shock or demand shock?

The central question when assessing how to react to the ‘corona shock’ is answer whether the shock is a (nominal) demand shock or a (real) supply shock. This is important as the (correct) textbook answer is that central banks has 100% control over nominal demand in the economy (remember M*V=P*Y=NGDP) so if the shock in any way lowers nominal demand the task of the central banks is to offset this shock to ensure nominal demand (nominal GDP) stays on track and does not cause inflation expectations to decline below the central bank’s inflation target.

On the other hand, central banks cannot – at least not for the longer run – control the real side (the supply side) of the economy (the Phillips curve is vertical in the long run) and hence the textbook tells us that central banks should not react to supply shocks. But what does “not react” really mean? Let’s answer that question first.

Don’t turn a supply shock into a demand shock

It is pretty clear that the imitate effect of the ‘corona shock’ has been to shot down production in the affected areas in China and as China is a subcontractor to the global manufacturing industry this in turn becomes a supply shock not only to the Chinese economy, but also to the global economy.

In a AS-AD framework a negative supply shock shifts the AS curve to the left causing production (Y) to drop and push up prices (and as long as the supply unfolds also inflation).

If the central bank is focused very much on present headline inflation such a shock might cause the central bank to tighten monetary policy by for example hiking its key policy rate. This is the mistake the ECB did in 2011 when rising oil prices caused headline inflation to increase in the euro zone.

Alternatively, the central bank can observe the drop in economic activity (lower Y) and conclude it needs to offset this by increasing aggregate demand and hence need to ease monetary conditions. This is essentially what central banks did in the 1970s when they reacted to lower structural growth rates and numerous oil prices shocks. These shocks clearly were negative supply shocks which didn’t warrant an easing of a monetary response.

Hence, the textbook on this is clear – central banks shouldn’t try to shift the AD curve when the AS curve moves. Rather the central bank should singlehandedly focus on keeping nominal demand (the AD curve/NGDP growth) on track.

This leads us to the conclusion that as long as the ‘corona shock’ is a negative supply then central banks shouldn’t (as they really can’t) try to do anything about it.

However, that is much less straight forward than it sounds because what does “doing nothing” really mean?

Take for example the People’s Bank of China (PBoC). The PBoC really doesn’t have a clear monetary policy target, but it is clear that it at least to some extent both is trying to keep inflation anchored but also has some time clearly have preferences regarding the level and fluctuations of the Chinese currency the renminbi (CNY).

So, for the sake of the argument lets assume that PBoC is targeting a level for CNY against either the dollar or a basket of currencies.

Now imagine the ‘corona shock’ hits. As this is a negative supply shock it is essentially also a negative terms-of-trade shock, which would cause a freely floating CNY to weaken (rather significantly).

If we look at the CNY it is notable just how stable it has been since we got the first reports regarding the corona virus.

This is particularly remarkable given the fact that all indications are that economic activity in China has plummeted. Had the CNY been freely floating we surely should have seen the CNY weakening a lot. That hasn’t happened. There can only be on reason for that – the PBoC is effectively intervening to stop the CNY from falling sharply.

However, if we look at the commentary regarding the PBoC’s actions we get the impression that the PBoC has been injecting cash into the financial markets in a response to the crisis. That of course to some extent is correct, but it is only part of the story as it is not everything we see.

I am for example pretty sure that the PBoC actively is telling banks and major investors in China not to sell the CNY (or hedge it) and further more China is also operating currency controls, which keeps the sell-off of the CNY in check.

A place where we see this monetary tightening is in M1 growth. Hence, in January M1 dropped sharply compared to December, which in my view is a clear indication of the effective tightening of monetary conditions in China.

Said in another way, the PBoC by not allowing the CNY to drop (enough) is by default engineering a rather unwarranted tightening of Chinese monetary conditions. Consequently, the PBoC is turning a negative supply shock into a negative demand shock.

Interest rate targeting is causing monetary tightening in the US and the euro zone

And the same is the case in the euro zone and the US, but here the mechanism is not exchange rate targeting, but rather interest rate targeting. Hence, both the Fed and the ECB are primarily conducting monetary policy by trying to control the short-term money market rates. Effectively, what the Fed and the ECB is trying to ‘shadow’ the natural interest rate to keep monetary conditions neutral.

The natural interest rate is not constant. It moves for all kind of reasons – for example risk appetite, demographics and structural growth trends.

This also means that the natural interest rate should be expected to be moving in response to supply shocks. Hence, we should expect the real natural interest to move down when the economy is hit by a negative supply shock.

Consequently, an interest rate-targeting bank should cut rates to reflect the drop in the real natural interest rate triggered by a negative supply shock.

This is NOT an easing of monetary conditions. It just ensures that monetary conditions are keep unchanged.

This is an extremely important point. If the central bank does not want to do “anything” then it needs to cut interest rates in response to a negative supply shock.

This can seem paradoxical but is a logic consequence of the kind of interest rate targeting regime both the ECB and the Fed operate.

That being said, the question still is how large this negative supply shock really is on the US and European economies and whether it has caused the real natural interest rate to drop.

A way to look at this is to look at the market pricing.

Hence, if we for example look at the nominal 5-year US Treasury bond yield minus 5-year market inflation expectations then we see that real yields – a proxy for the real natural interest rate – has drop significantly since the beginning of the year.

5year real rate

This to me is a rather clear indication that the Federal Reserve needs to cut its key policy rate significantly soon, but it is important to note that this essentially is a policy of ‘doing nothing’ as it just will align the real policy rate with the actual drop in the (short-term) real natural rate we have seen. And the same goes for the ECB.

This also means that by not changing their policy rates in response to lower real natural rates the ECB and the Fed effectively at the moment are tightening monetary conditions – effectively pushing the AD curve to the left (pushing down NGDP growth).

This is very visible when we look at market inflation expectations – they have dropped significantly in recent weeks in response to the unfolding of the ‘corona shock’ and the hesitant communication from central banks around the world.

5y inflation expectations

Said in another way because the ECB and the Fed are hesitant in their communication regarding the ‘corona crisis’ they have caused an unwarranted tightening of monetary conditions, which greatly is exacerbating the global economic consequences of the ‘corona shock’.

Foot-dragging central banks might turn this into a global recession

Central banks never act fast and there are often good reasons for this and I am certainly not arguing that central banks should be sitting and micromanage the global economy with a joystick, but the problem is that when central banks insist on either targeting the exchange rate or interest rates then negative supply shocks turns into negative demand shocks if central banks either don’t allow exchange rates or interest rates to drop sufficiently to reflect the negative supply shock.

Ideally, I would like central banks to control monetary conditions by setting permanent growth targets for the money base (relative to money demand) to hit a NGDP level target, but we do not live in my ideal world.

We live in a world of very imperfect inflation targeting and interest rate controls. In that world central banks need to keep a close eye market inflation expectations and market real rates.

Right now, the market is telling us that a major global negative supply shock has hit us and that that should cause the CNY to weakening sharply and real policy rates should drop in significantly in the euro zone and the US.

However, due to the conservativism of the PBoC, the ECB and the Fed (and most other central banks for that matter) we are likely to see this crisis becoming a fairly large negative demand shock and we know that negative demand shocks (lower NGDP) always causes financial distress (that is why for example VIX is sharply up this week).

I do think central banks eventually will react to this, but they will be foot-dragging and therefore this will get worse before it gets better.

Therefore, we are in my view likely to see more financial distress, but I also think that that will trigger central banks around the world to act – sooner or later – and I think that we within weeks very well could see coordinated global actions from central banks to ease monetary conditions (they will call it ‘inject emergency funds in the financial system’ or something like that).

But this would not be necessary if central banks just did their job and ensured market inflation expectations are kept close to their inflation targets. They are not doing that right now.

Christine Largard and Jerome Powell could send out a join statement today that both the ECB and the Fed are targeting 2% inflation and that both central banks will increase their money bases enough to ensure that for example 5y5y market inflation expectations hit 2%. That would end the negative demand shock part of the ‘corona shock’ immediately and likely would ensure that does not turn into a global recession.

Quants should pay a lot more attention to monetary matters – a tale of two Chicago traditions

This morning I was reminded on some comments I made on my Youtube channel (remember to follow) I did back in 2018 on the so-called quants and on the problems with so-called factor investment.

Have a look here.




Revisiting the P-star model

I read Milton Friedman’s book “Free to Choose” at an age of 16 years old and ever since then I have been more or less obsessed with monetary theory and particularly the equation of exchange:


My view of the world obviously has developed over the 32 years since I read “Free to Choose”, but I am still fully convinced that monetary policy failure historically has been the main cause of macroeconomic problems – whether it is inflation or recessions and depressions. In fact I am more so than ever.

When I started studying economics at the University of Copenhagen in the early 1990s my obsession with monetary matters continued. That more or less coincided with the publication of a paper, which had quite an impact on my general thinking of how to empirically think about monetary analysis.

The paper “M2 per unit of potential GNP as an anchor for the price level” was written by Jeffrey J. Hallman, Richard D. Porter and David H. Small and first published in 1989.

In the paper the authors introduced the concept of P-star as a measure of where the price level would be in the “long run” (when monetary velocity and GDP was at their long term equilibrium levels). An updated version of the paper was also published in 1991.

Based on the equation of exchange this price level – P-star or P* – was calculated:

P* = M•V*/Y*

Where M is the present level of some monetary aggregate (in Hallman et al.’s paper M2 for the US), V* is the long-term trend level of money-velocity and Y* is potential GDP.

Hallman et al. argued that the actual price level, P, over time should converge towards P*.

Consequently, the gap between P and P* should be a useful indicator of future inflation. Hence, if P*>P then we should expect inflation to accelerate and if P<P* then inflation should decelerate.

This made a lot of sense in the late 1980s when we where in a situation where the Federal Reserve and other central banks had not formulated their nominal targets in any clear fashion and where monetary policy partly still was conducted through money base control.

However, starting from the early 1990s more and more central banks introduced inflation targeting and operationally started being exclusively focused on conducting monetary policy through interest rate controls it became (gradually!) clear to me that the P-star concept might not be useful any more as the price level would be anchored by the inflation target alone and causality in the model would be turned around and velocity would hence become a function of the inflation target.

Therefore, I more or less gave up on the P-star model and only occasionally revisited it when doing analysis of different Emerging and ‘Frontier’ markets, but for some reason my previous post on the McCallum rule made me think it could be fun to have a look at the P-star model using the ‘outside base’ (the money base minus excess reserves) as a measure of M in the model.

So this is what I am going to do in this blog post.

Calculating P-star based on the outside base

To calculate P-star we need an estimate of V* and Y*.

Y* is simply potential GDP and I here I use CBO’s estimate of potential GDP, which I get from St. Louis Fed’s FRED database.

In terms of V* I calculated V based on actual nominal GDP and the outside base (V=NGDP/Outside base).

And then I have de-trended that. I could have used a HP-filter or something similar, but instead I simply estimated a trend based on a linear, squadric and an inverse trend of V.

Velocity trend.jpg

So now I have both V* and Y* and using the outside base as a measure of M I can calculate P*.

The graph below shows my measure of US P* since 1984 and the actual price level P (the GDP deflator).


The orange line, P, is the actual price level while the blue line is P* (P-star). The gap (%) between the two, is the green bars (p-gap).

One can think of the p-gap as a measure of excess liquidity in the economy and when p-gap is positive (negative) monetary conditions are ‘easy’ (‘tight’) and one should expect nominal demand and inflation to pick up (slow down).

It is notable that the p-gap turned negative ahead of the US recessions of ’90-’91, 2000-1 and 2008-9 and in that sense has been a reliable leading indicator of recessions in the US for more than three decades.

But is it also a reliable indicator of inflation?

The simple answer is YES.

To test this I run a simple OLS-regression.

dp(t) = a + b•pE(t-1) + c•p-gap(t-4)

Where dp(t) is the quarterly change in the price level, pE(t) is inflation expectations of consumers (University of Michigan survey) and p-gap(t-4) is the price gap 4 quarters earlier. a, b and c are coefficients.

And here is the model output.

Model p-star.jpg

This isn’t rocket science and will certainly not win me the Nobel Prize, but it is good enough for a blog post. What we see here is that p-gap is statistically significant and hence can be used to predict changes in inflation.

This makes me think that p-star could be a useful indicator for inflation also going forward and maybe it deserves a bit more attention that it has been getting – at for the past 20 year.

In fact I am tempted to say that p-star is no worse (or better) an indicator of the inflationary outlook than i was back in 1989 when it was first suggested.

I will try to do a bit more work on the p-star model going forward and maybe try to model p-star with other money supply measures and maybe for the euro zone as well.

The McCallum rule is back – and so am I

It has been some time since I posted anything on The Market Monetarist – primarily because I have been doing other thing – among other things been running my consultancy Markets & Money Advisory (which I still do) and for a year have been the editor-in-chief of the Danish financial website Euroinvestor (which I no longer do).

However, I missed blogging and I have particularly missed having an outlet for my (casual?) thinking on monetary matters.

Consequently, I have reluctantly decided that I want to start blogging a bit again on The Market Monetarist.

How much I will be blogging the in the future is unclear as I also have to make a living doing other things – continuing my consultancy working (on international economics, markets and money), academic work as well as doing a lot of speaking engagements.

If you are interesting in getting in contact with me regarding these topics then feel free to drop me a mail on

But now back to the monetary blogging.

The Fed has de facto targeted 4% NGDP growth since 2010

Officially the Federal Reserve targets to 2% inflation (measured as PCE core inflation). However, looking at the numbers it is clear that the Fed has consistently failed to deliver on this target.

Instead it actually seems like the Fed – consciously or not – have followed a nominal GDP level targeting rule as long favoured by market monetarists like Scott Sumner and David Beckworth and of course myself.

Or rather the Fed has done so after the 2008-9 crisis hit – exactly because the Fed failed to maintain the de facto NGDP level targeting regime of the pre-2008 Great Moderation period.

Roughly speaking the Fed was de facto targeting 5% NGDP growth from 2000 until 2007-8 and 4% NGDP growth since 2010 as the graph below illustrates.


In it is rather remarkable just how close actual US nominal GDP has been to a 4% NGDP path since the beginning of 2010.

I personally, therefore, also think that the Fed should finally acknowledge this and replace its inflation target with a 4% NGDP level target – from the present level of GDP.

But what about the instrument?

In the past 25 years or so it has become the norm to think in terms of the conduct of monetary policy in the terms of the so-called Taylor rule as first proposed by John Taylor back in 1993.

Just to refresh the readers memory – this is the Taylor rule:

r = p + .5y + .5(p-2) + 2

Where r is the monetary policy interest rate “set” by the central bank, p is the rate of inflation and y is the output gap. The first “2” refers to the inflation target (assumed by Taylor to be 2%) and the second “2” refers to the natural interest rate (also assumed by Taylor to be 2%)

The Taylor rule was meant to be a simple representation of how the Fed actually conducted monetary policy, but later certainly also by many central banks – including the Fed – has been seen as a rule for how central banks actually should conduct monetary policy.

There is nothing surprising about this as the Taylor rule essentially have been seen by central banks as a way to implement the inflation targets, which was introduced by central banks around the world since the early 1990’s.

However, a lot of things have happened since the 1990’s.

First of all the natural interest rate likely is not 2% in the US – it is much lower.

Second, the Fed’s 2% inflation target is not being hit consistently and more and more monetary commentators are questioning whether an inflation target is a good idea in the first place and whether it should be 2%.

That all have to do with the right-hand side of the equation, but what about the left hand side. Why is it just assumed that the central bank “sets” the interest rate?

Monetarists and in recent year market monetarists have argued that the central bank in fact is not determining interest rates – or at least that central banks cannot maintain an interest rate, which is different from what essentially is the natural rate without either causing a sharp rise in inflation or a recession.

Consequently, monetarists such as Milton Friedman argued that central banks primarily should conduct monetary policy by controlling the growth rate of the money base and leave the determination of interest rates to the market.

This view of course over the last decade has made somewhat of a comeback as central banks have been forced by events – or rather by the simple fact that the natural interest rate has dropped significantly – to look at alternatives to interest rate “targeting” as the monetary policy instrument.

However, no central bank anywhere has taken the consequence of this and switched from interest rate controls to monetary base control – at least not consistently.

That said, when Taylor first introduced his rule there certainly was not a consensus that this was the right way to do things as a central banker.

A competing rule to the Taylor rule was the so-called McCallum rule first suggested by Bennett McCallum in 1987.

The McCallum Rule – time for a comeback

The McCallum rule is hardly taught at universities these days and my guess is that few central bankers know what the McCallum rule is, but it might nonetheless be time for a comeback for the McCallum rule. In fact it might already have made a comeback.

But lets first have a look at the McCallum rule:

b = x* – v* + .5(x* – x(t-1))

Where b is the quarterly growth rate of the money base, v* is the trend quarterly growth money base velocity (16 quarters moving average) and x* is the targeted quarterly growth rate of nominal GDP, while x(t-1) is the quarterly growth rate of nominal GDP in the previous quarter.

One can see why the McCallum rule should be of interest to present day practitioners and observers of monetary policy.

First of all, due to the zero lower bound issue with interest rates and uncertainty regarding the actual level of the natural interest rate money base control has become necessary even though central banks are very reluctant to acknowledge this.

Second, as I discussed above it looks like the Federal Reserve has been targeting NGDP rather than inflation and it is therefore natural to actually focus on a monetary policy rule where we have nominal GDP – rather than inflation – on the right hand side of the equation.

The question is – how has actual Fed policy been compared to a McCallum rule.

I have tested that by a simple simulation of the McCallum rule using the parametres suggested by McCallum and assumed that the Fed had a 5% NGDP growth target from 2000 to 2010 and then from 2010 and until today a 4% NGDP growth target.

I have, however, made one adjustment. Since, 2008 the Fed has paid interest rates on excess reserves held at the Fed, which greatly have distorted the money base numbers. I therefore, have constructed a series for what Jeff Hummel has called “outside money base”, which is the money base minus excess reserves.

This is how the actual development in outside money base quarterly growth (4qma) compares to the McCallum rule.

McCallum rule

It should be noted that this is not an estimated, but rather a simulated relationship based on the parametres suggested more than 30 years ago and it might obviously be possible to get a better fit, but the point here is that the McCallum rule does a remarkably good job in tracking actual monetary policy in the US both prior to and after the Great Recession hit in 2008-9.

In fact it is notable that it seems like the McCallum rule has been an even better indicator after 2008-9 than before – the difference between actual money base growth and the rule has been small after 2008-9 than before.

If we look at the difference between the rule and the actual money base growth we get a simple measure of excessively easy or tight monetary policy and we can use this to evaluate US monetary policy over the past decade.

We can for example see that the Fed was overly eager to “normalize” monetary policy in 2010 and hence caused money base growth to slow too much.

Likewise in 2011-13 during the euro crisis money base growth was slightly to slow and finally Janet Yellen’s obsession with the Phillips curve and the labour market caused the Fed to allow money base growth to slow too much.

Contrary to this, Fed chief Jay Powell was right slowing money base growth in 2017-18, but we can also see he in 2019 has overdone a bit and presently money base growth remains slightly too slow (around 4.5% y/y) compared to what the McCallum rule tells us it should be (6-6.5% y/y).

Time for the Fed to be serious about money base control

Concluding, we can see that using the McCallum rule as an indicator of monetary stance will be helpful and while I do not necessarily think the Fed should introduce a McCullum rule I nonetheless think the Fed – and Fed watchers – should pay a lot more attention to the McCallum rule and other similar money base rule.

Furthermore, I think it is about time that the Fed acknowledge that low rates are here to stay (it’s structural, stupid!) and consequently should think about how to start using the (outside) money base as the primary monetary policy instrument rather than continuing to mess around with interest rate targeting.

Furthermore, the Fed should make it de facto 4% NGDP target official and hence, use operational targets for permanent money base growth to hit this target.

This might seem a bit revolutionary, but when the market monetarists a decade ago started arguing for NGDP targeting that also sounded crazy. Now it has been the decade policy for nearly a decade.

Let me hear what you think of my comeback blog post and remember to follow me on Twitter.

And finally some sad news. One of my great heroes Marvin Goodfriend – long-time economist at the Richmond Fed and Professor at Carnegie Mellon University’s Tepper School of Business – has passed away. Marvin without a doubt was one of the greatest monetary thinkers of his generation and he will be greatly missed. (Remembering Marvin Goodfriend)




MTB Cast #3: Inflation worries hitting the markets?

Spring has come to Denmark, but a bit of jitters overnight in the global stock markets. Is it inflation fears? See my comments here.

Reflections on the Fed hike

Have a look at my comments on yesterday’s Fed hike.


And see our “country page” on the Fed, which will also feature in our soon-to-be-published Global Monetary Conditions Monitor. (In PDF here)

Skærmbillede 2017-03-15 kl. 07.20.51

FOMC preview – please hike, but be careful going forward

The Federal Reserve is widely expected to hike the Fed funds target rate by 25bp today. The real question is how much more the Fed will deliver going forward.

To get an idea about we are happy to give you a sneak preview on the “country page” for the US monetary policy from our soon to be launched Global Monetary Conditions Monitor (GMCM).

See here (in PDF here):

Skærmbillede 2017-03-15 kl. 07.20.51.png

Just to explain what we are doing in GMCM we do not try to forecast what central bankers will do, but rather we assess or measure monetary conditions. This is a lot less straight forward than people often think. For example the actually level of the key policy rate – in the case of the Fed the Fed funds target rate – on its own says very little about the monetary stance.

Overall, the price level and nominal demand in the economy is determined by the interaction between the money supply and money demand.

It is the task of the central bank to use whatever instrument(s) it uses to to ensure that this interaction between money supply and money demand causes the target – for example inflation – to be hit.

Therefore our starting point in GMCM is to assess monetary conditions relative to the given central bank’s target. In the case of the Fed a 2% inflation target.

Said in another way in our composite indicator for monetary conditions a zero “score” indicates that the Fed will hit its 2% inflation target in the medium-term (2-3 years). If the score is above (below) the then it indicates that the central bank will overshoot (undershoot) its inflation target.

Similar we say that monetary policy is too easy (tight) if the composite indicator is above (below) zero.

The composite indicator is a weighted average of four sub-indicators – broad money supply growth (in the case of the US Divisia M4-), nominal demand growth (often nominal GDP, but in the case of the US Private Consumption Expenditure growth), exchange rate developments and finally the key policy rate (the Fed funds target rate in the US).

For all of these sub-indicators we calculate a growth rate or level, which we believe is what we call “policy-consistent” meaning the growth rate of for example broad money supply growth, which is necessary to hit the central bank’s inflation target.

In the case of the US we see that broad money supply growth (here measured as Divisia M4- growth) presently is more or less in line with the policy-consistent growth rate meaning that looking at money supply growth along we should expect the Fed to hit it’s 2% inflation target in the medium-term.

For the money supply we calculate the policy-consistent growth rate based on the Equation of Exchange (in growth rates):

(1) m + v = p + y

Where m is the growth rate of the broad money supply, v is money-velocity growth, p is inflation and y is real GDP growth

We can re-arrange that:

(1)’ m-target = p-target + y* – v*

m-target is our policy-consistent growth rate for broad money growth, p-inflation is the inflation target (in the case of the US 2%), y* is the strutural trend in real GDP growth and v* is the structural trend in money-velocity. We generally use HP-filters to estimate y* and v*.

In the graph broad money supply growth on the US “country page” the dark green line is actually broad money supply growth and the light green line is m-target (the policy-consistent growth of m).

The difference between the two is essentially a measure of the monetary stance. This is the bars in the graph. Taking into account that monetary policy works with “long and variable lags” we take an 3-year weighted moving average of this gap. That is also the input into the composite indicator.

We use the same kind of method for the three other sub-indicators.

In the case of the US we see that money supply growth and nominal demand growth are pretty much in line with the policy-consistent growth rates, while the rate of appreciation of the dollar is (or rather has been) slightly too fast and the interest rate level is slightly too high.

Overall, we see that the composite indicator for the US is quite close to zero, but still below. This indicates that US monetary conditions are what we term “broadly neutral”, but also that inflation risks in the medium-term are twisted slightly to the downside relative to Fed’s 2% inflation target.

We also see this from our inflation forecast graph. The inflation “forecast” is essentially a simulation of the most likely path for inflation given the present monetary stance (not to be confused with Fed’s key policy rate) and the recent trends in inflation.

We see that the forecast is for US inflation to continue to inch up, but it will not quite get to 2%. This is pretty much also what for example TIPS breakeven inflation expectations show.

What does this mean for market pricing?

When assessing the overall monetary stance it is always very important to remember that we have to look at for example interest rates or the exchange rate relative to expectations. Hence, a 25bp interest rate hike today from the Fed in itself is not monetary tightening is it is completely priced in already.

Therefore, if we want to assess future monetary developments in the US we need to look at market pricing.

Overall the markets are presently pricing in somewhere between two and three 25bp hikes from the Fed this year – including the hike expected for today.

The purpose of our framework in Global Monetary Conditions Monitor is not to forecast how many rate hikes the Fed will deliver this year. But it can tell us about the consequences of difference paths for interest rates.

Hence, one can say that since our composite indicator for US monetary conditions indicates that the Fed is likely to slightly undershoot its 2% inflation target then it would be better for the Fed to deliver a little be less in terms of rate hikes than is presently priced by the markets.

This is not a forecast as central banks often do things they shouldn’t – if they didn’t it would be very easy to forecast their actions – but it nonetheless tells us something about the potential risks relative to market pricing if we assume that the Fed at least in he end will end up doing the right thing.

Looking for reviewers

We are looking forward to publishing Global Monetary Conditions Monitor very soon, but we are also still looking for input. So we are looking for “reviewers” of what we call the country pages of the 25 countries covered in GMCM.

So if you are interested in getting a sneak preview on parts of the GMCM in return for comments please let us know. Mail LC@mamoadvisory or We prefer policy makers/central bankers and market participants, but don’t be shy to drop us a mail.



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