A simple model for inflation that Jerome Powell should understand

Federal Reserve chairman Jerome Powell today acknowledged that he doesn’t understand inflation. See below.

This is somewhat alarming given the fact that the Fed’s is given operational independence to ensure price stability. If Powell doesn’t have a model for understanding why should the Fed been independent?

So we better help Powell.

Here is a simple model for US inflation.

By defition the following is given:

(1) n = y + p

n: nominal gross income growth

y: real income growth

p: inflation

In the medium to long run we know that y is determined by supply side factors such as productivity growth and labour supply growth.

We call that potential real income growth (y*).

We can use this to define demand inflation (pd):

(2) pd = n – y*

The graph below shows pd and actual US inflation (CPI).

We see that over the past two decades actual inflation and pd as followed each other fairly closely with pd generally leading actual inflation.

This was for example the case during the Great Recession where we see demand inflation slowed significantly starting in 2006, while actual inflation intially stayed elevated (due to a negative supply).

If we look at the situation over the past two years we see that initially we saw a sharp drop in pd, but also a fast and sharp recovery followed by a massive spike in demand inflation – peaking above 16% in Q2 2021. Demand inflation has since slowed but continue to grow fairly strongly. Annualized demand inflation in Q1 2022 was around 10%.

If we compare this with actual inflation we see that actual inflation slowed in 2020, but only moderately compared to demand inflation. This negative demand shock was instead reflected in a sharp rise in unemployment.

However, as demand recovered fast in 2020 so did real income growth and as we entered 2021 the level of real gross domestic income rose above potential real gross domestic income. In textbook lingo we hit the vertical long-run supply curve and consequently we should expect any growth in nominal income above this level to cause an increase in inflation.

And this was exactly the time when actual inflation started to accelerate – around April-May 2021 and ever since then US inflation has continued to rise.

There should be nothing surprising in this – if the central bank tries to push real income (Y) above the potential real income (Y*) then we should expect increased inflation.

And we should expect actual inflation to continue to increase as long as demand inflaion is above actual inflation.

We have not yet closed the gap between demand inflation and actual inflation, but we are getting closer and we should expect inflation to start to level off in the coming months.

What the Fed can do

Our simple model for US inflation hence seems to pretty well expain the development in actual inflation and we can conclude that the sharp increase in inflation in the US primarily has been caused by a sharp increase in nominal income growth.

The question is what drive nominal income growth. Again lets go back to the textbook.

The equation of exchange (in growth rates) is defined in the following fashion:

(3) m + v = p + y (= n)

Where m is money supply growth (for example M2) and v is money-velocity growth.

We can therefore also alternatively define demand inflation in the following way:

(4) pd = m + v* – y*

Where v* is the trend-growth rate of v* (for example 10-year moving average).

The graph below shows this alternative defintion of pd.

We are using monthly data where we have used real and nominal personal consumption expenditure (PCE) as proxies for n and y*.

This graph should make Powell optimistic – even though he apperantly do not understand the causes of inflation he has nonetheless managed to slow demand inflation in the last couple of months and in May pd growth had declined to around 6% – hence below the actual rate of inflation.

Consequently, assuming that Powell doesn’t speed up money supply growth going forward or a negative supply shock hits the US economy then we should expect inflation relatively soon to start to level off and gradually start to decline towards 6%.

Back in April last year I warned US inflation could hit double-digit numbers and we might still get there in the next 1-3 months, but it is encouraging that the Fed now has stepped on the brakes and money supply growth has slowed considerably.

As the graph above shows M2 has basically been flat in the past six-seven months and it therefore should not be a surprise that we are also beginning gross domestic income growth slowing, which is causing a drop in demand inflation and we there should expect actual inflation also to slow. To some extent the slowdown likely is also due to a decline not only in the money supply growth but also due to a decline in money demand due to higher interest rates.

The slowdown in M2 growth in 2022 has actually been faster than I assumed in my inflation call from April 2020 and furthermore, even though money-velocity is trending upwards the uptrend is rather muted and more muted than I had expected.

So even though Powell claims not to understand the reasons for inflation it seems like at least in terms of slowing money supply growth and therefore slowing gross nominal income growth he is doing the right thing – at least at the moment.

It is, however, still rather alarming that he apperantly doesn’t know why and how he is doing the right thing.

Hence, the Fed continues to need a proper framework for ensuring nominal stability in the US economy. I hope this blog post can inspire the Fed to re-learn that inflation is a monetary phenomenon and that it is the task of the Fed to control money supply growth in such away that nominal income growth is stable so inflation ultimately is low, stable and predictable.

It really isn’t that hard.

PS 4% nominal gross domestic income growth would more or less ensure 2% over the medium-term. I have earlier suggested that the Fed over the coming 5-10 years gradually bringes the NGDP level path back to a 4% path starting in Q1 2017.


Interview with RIAIntel

I have been interviewed by Eric Uhlfelder for RIAIntel, which is published by Institutional Investor.

The focus is on the outlook for the global economy and markets – and a lot of frank talk about Putin’s war on Ukraine.

Read the interview here.

Hetzel on “Learning from the Pandemic Monetary Policy Experiment”

Robert Hetzel undoubtebly is one of the most important monetary thinkers of our time and for more than five decades he has been involved in US monetary policy making and has furthermore greatly contributed to monetary theory and monetary history.

And he is one of my absolut biggest idols in the world of monetary thinking and I am proud to call Bob my friend.

Luckily Bob and I rarely disagree, but I continue to learn from Bob and anybody interested in monetary matters should read Bob’s papers.

Bob now has a new paper out – published by the Mercatus Center where he now is Senior Affiliated Scholar.


In response to the COVID-19 pandemic, which unfurled starting in March 2020 and raised unemployment dramatically, the Federal Open Market Committee (FOMC) adopted a highly expansionary monetary policy. The policy restored the activist policy of aggregate demand management that had characterized the 1970s. It did so in two respects. First, the FOMC rejected the prior Volcker-Greenspan policy of raising
the funds rate preemptively to preserve price stability. Second, through quantitative easing, it created an enormous amount of money by monetizing government debt. Inthe 1970s, the activist policy was destabilizing. Reflecting the “long and variable lags”phenomenon highlighted by Milton Friedman, a temporary reduction in unemployment from monetary stimulus gave way in time to a sustained increase in inflation. In response, the succeeding Volcker-Greenspan FOMCs rejected an activist monetary
policy in favor of a neutral policy. That neutral policy concentrated on achieving low trend inflation and abandoned any attempt to lower unemployment by exploiting the inflation-unemployment tradeoffs promised by the Phillips curve. The success or failure of the FOMC’s activist monetary policy offers yet another opportunity to understand what types of monetary policies stabilize or destabilize the economy.

Read Bob’s paper here.

The Fed is still way behind the curve – what an “implied NGDP level target” is telling us

I started this blog more than a decade ago in 2011 primarily because I was frustrated with the way monetary policy was conducted around the world.

At that time it was my clear view that both the Federal Reserve and the ECB had far too TIGHT monetary policy and that the reason that the 2008 shock to the global financial system had developed into a deep recession because the Fed has failed to react appropriately to the sharp rise in dollar demand during the Autumn of 2008.

My analysis of the situation at that time was based on a fundamental monetarist analysis combined with what financial market indicators were telling me about the outlook/expectations for nominal demand in the economy.

Other econ bloggers like Scott Sumner, David Beckworth and Marcus Nunes were using – and still are – a similar approach. This approach – or school of thought – later became know as Market Monetarism. A term I coined in a paper back in 2011.

At the core of market monetarist thinking is also advocacy of the use of a NGDP level target. Hence, market monetarists like Scott Sumner and myself have argued that at the core of what central banks should do is to keep nominal GDP (NGDP) on a “straight line”. Or rather, the for example the Fed should ensure that over time NGDP growth at a fixed rate – for example 4% – and that it should be level targeting meaning if the target is undershot one year – NGDP growth is below 4% – then Fed needs to ensure that it will be above the target in the following period and there by ensure that NGDP returns to the targeted level.

There are a number advances with NGDP level targeting over traditional inflation targeting.

First of all, it is the general consensus that central banks should not respond (try to increase nominal demand) to supply shocks. A narrow focus on inflation – even when corrected for energy and food price fluctuation – risk causing central banks to nonetheless to respond such supply shocks. A good example of this if the ECB catastrophic interest rate hikes in 2011, which essentially was a response to an increase in energy prices driven by a supply shock (the 2011 Japanese tsunami).

Contrary to this an NGDP target would allow for inflation to rise temporarily in the case of a negative supply shock while keeping nominal demand growth on track.

Second, by targeting the level rather than the growth of NGDP (or prices) the central bank will signal that it will make up for past mistakes. This ensures that the market will do a lot of the lifting in terms of conduct of monetary policy and thereby ensure a faster return to the target.

The story now is the opposite of in 2008

Neither the Fed nor the ECB implemented a NGDP target following the shock in 2008. However, I think it is fair to say that market monetarist thinking have had a substantial impact on monetary policy discussion and both in Europe and North America over the past decade.

But we didn’t quite make it all the way. The ECB has maintained its inflation target with a few adjustments, while the Fed essentially has been through a process of nearly continuous adjustments to its monetary target.

It should also be noted that the Fed actually did not officially have an inflation target prior to 2008. However, from 2012 the Fed has officially had a 2% inflation which have been adjusted numerous times.

That being said I have earlier argued that de facto the Fed had introduced an 4% NGDP level target in the summer of 2009 – basically with out announcing it.

The graph below illustrates that quite clearly.

The graph shows us that starting at the end of 2015 NGDP started to undershoot the “target” but later returned to the target by the end of 2017.

The undershooting was casused by then Fed chair Janet Yellen’s premature monetary tigthening that was initiated (announced) in October 2015. A decision that I strongly criticised at the time. See for example this blog post from 2016.

However, over all from early 2010 to early 2020 the US NGDP level was kept close to 4% path.

The Covid/Lockdown shock of 2020, however, caused NGDP to drop substaintially below the unannounced NGDP level target and even though the lockdowns likely significantly has distorted the US economic data it seemed pretty clear that aggressive monetary easing was warranted in the US to ensure that we would not have a repeat of the 2008-9 deflationary shock.

And the Fed reacted – fast and aggressively – and consequently we saw a swift recovery in NGDP to the previous 4% path.

So HAD the Fed officially been targeting a 4% path like the one we see in the graph then one would have to argue that the Fed’s policy reaction had been appropriate and that the Fed had done it’s job.

And I have certainly said so – the Fed did the right thing initially and the operation worked.

However, during the second half of 2020 I became increasingly concerned that the Fed was overdoing it in terms of monetary easing and in April 2021 I warned that the US might be heading for double-digit inflation. This of course quite closely coincided with the actually NGDP level starting to move above the 4% path “target” level.

But the Fed do not have a NGDP level target

While we clearly can use NGDP (and NGDP expectations) as a very useful indicator of the monetary policy stance the Fed do not in fact target the level of NGDP.

Rather officially the Fed now has an “Average Inflation Target” (AIT). The AIT was announced by Fed chief Jay Powell in August 2020.

The word “average” is important as it means that the Fed should  “achieve inflation that averages 2 percent over time” as stated by Powell.

This essentially means that the Fed is moving towards “level targeting” in the sense that if inflation has been below 2% for some time then the Fed needs to make up for this by ensure inflation above 2% in the following period.

And as the Fed also is fairly clear that it should not respond to supply shocks we are moving closer to a NGDP level target.

The problem of course is that the Fed has failed to announce what is the starting point of this regime. It is therefore unclear whether we should look at “average” inflation going back one, five or ten years and it is unclear for how long the Fed can take to bring the average back to 2%.

Furthermore, we cannot just look at for example a five-year moving-average of inflation as monetary policy clearly should be forward-looking.

So is the Fed for example targeting the average inflation over the past three-year plus the expected average inflation in the coming two years?

All this is unclear.

Introducing an “Implied NGDP level target”

So the AIT is actually not giving us a very clear indication of whether or not monetary policy is too easy or too tight presently in the US.

We can of course from the communication from the Fed conclude that the Fed presently see a need for monetary tightening, but again it is really unclear what makes the Fed come to this conclusion.

So maybe the Fed needs a bit of help from market monetarist thinking.

I have therefore tried to construct a measure that we (and the Fed) can use to assess for monetary tightening in the US.

I call this measure an “Implied NGDP level target”.

The idea is that the target over time will ensure that “average inflation” is at 2%.

NGDP (N) by definition is real GDP (Y) times the price level (P):


Based on this we can calculate an implied level of NGDP – or what we could call N-star (inspired by the P-star model)

We define N-star in the following way:

N-star = (P-target level) * (Potential Y).

The “P-target level” is simply a 2% path for the US GDP deflator (hence the inflation target as defined in level), while “Potential Y” is potential real GDP as calculated by the US Congressional Budget Office (CBO).

If the Fed conduct monetary policy in such a way as to keep actual NGDP close to N-star over time then it will at the same time ensure that inflation (measured by the GDP deflator) more or less will average 2% over time. Hence, this is a NGDP target that is consistent with the Fed’s 2% Average Inflation Target.

We, however, have one challenge and that is to determine what should be our “starting date” for this target. Should be go back to 2010? Should we start in 2012 when the Fed first offcially introduced the 2% inflation target or should we start in August 2020 when the AIT was introduced?

The best starting point in my view is a starting where there are no imbalances in the REAL economy.

Hence, basically at a point where monetary policy is neutral. This would mean that we should find a recent date where real GDP is close to potential real GDP and/or unemployment is close to the structural level of unemployment (NAIRU).

The Fed officially has a “dual mandate” meaning that is officially should ensure “price stability” (that is the AIT) and “maximum sustainable employment”.

We already got “price stability” covered with our implied NGDP target and if we base the “starting point” on “maximum sustainable employment” then we have a NGDP target that is consistent with Fed’s dual mandate.

The graph above shows the actual US unemployment rate (the blue line) and the CBO’s estimate for the noncyclical rate of unemployment (NAIRU).

We see that just prior to the shock of 2020 unemployment was in fact below CBO’s estimate of NAIRU. Therefore, we need to go further back to find our starting point for our implied NGDP level target.

Last time prior to 2020 that the unemployment rate was equal to NAIRU was in the first quarter of 2017 with unemployment of just above 4.5%.

So now we have both our starting point and our implied growth rate of our implied NGDP level target.

The graph below show the actual NGDP level and our implied NGDP level target as well as the “NGDP gap” with it the percentage difference between the two. A positive NGDP gap implies that monetary policy is too easy.

The first thing to note is that US monetary policy became excessively easy during the Trump presidency. Whether this reflects president Trump’s very public pressure on the Fed to ease monetary conditions or not is a matter that is open for discussion, but at least based on our implied NGDP level target US monetary policy was indeed too easy during this period.

That being said this “easiness” was within a reasonable “uncertainty band” and in general it is hard to argue that monetary policy became unanchored in this period.

It is also clear that PRIOR to the Covid-lockdown-shock in 2020 NGDP returned to the level target in late 2019 and by the beginning of 2020 the monetary stance was more or less perfectly calibrated.

We, however, also see that the shock of 2020 was very substaintial, but also that the Fed’s appropriate (initial) monetary easing fast brought the NGDP level back towards the target level as also discussed above.

From early 2021 we see that NGDP started to overshoot the target level and hence at that time monetary conditions clearly had become too easy.

In fact as monetary policy works with long and variable leads as Scott Sumner likes to say the Fed obviously should have initiated monetary tightening somewhat earlier.

Hence, in the Autumn of 2020 it was becoming increasingly clear from watching the financial markets that NGDP growth would be very robust and the Fed could easingly have forecasted that actual NGDP would overshoot the target level in early 2021.

However, during that period the Fed rather downplayed this risks and continued to argue that inflationary pressures were temporary and was due to supply side factors.

Looking at the graph above we have to conclude that that was a major policy mistake and the Fed’s reluctance to initiate monetary tightening has caused NGDP to very significantly overshoot the implied NGDP level target.

Based on this it is hardly surprising that US inflation has spiked and market inflation expectations have increased significantly.

Therefore, it is also blatantly wrong when for example President Biden blame the increase in US inflation on geopolitical factors. Vladimir Putin is to blame for a lot of bad things, but not higher US inflation.

As Milton Friedman used to say “Inflation is always and everywhere a monetary phenomenon and that is certainly also the case this time around.

The Federal Reserve has allowed nominal GDP growth to grow far too fast and consequently we have over the past 12-18 seen a substaintial acceleration in inflation.

Positive and negative supply shocks obviously can influence the inflation data from month to month or even quarter to quarter, but supply side factors should not be used to ignore the fact that monetary conditions remain far to easy in the US.

Bring back NGDP to the target over the next five years

The way forward for the US monetary policy right now is for the Fed to clearly announce that to maintain price stability it necessitates that the Fed ensures that NGDP grows at a rate over the medium-term, which is consistent with 2% inflation.

Furthermore, as the Fed is targeting AVERAGE inflation then it needs to “undo” previous mistakes. Hence, NDGP needs to be brought back to the implied target level for example within the next five years.

Below I have simulated such a scenario.

I have assumed that potential real GDP growth in the US will be around 2% in the coming five years. This is also more or less CBO’s forecast and as we target 2% inflation our implied yearly NGDP target growth rate is 4%.

To close the NGDP gap over a five year period actual NGDP growth should hence be slower than 4%.

In fact my simulation shows that NGDP growth need to be slowed to less than 3% (to 2.8%) on average over the next five years.

The graph below shows that simulation.

In a graph this looks like an easy policy to implement, but in reality it would be a lot harder as it would necessitate a very significant slowdown in NGDP growth and a “sudden stop” to NGDP could easily cause the US economy to fall into a recession and potentially also trigger financial distress.

The alternative to slowing NGDP growth, however, is that NGDP growth expectations and therefore inflation expectations permanently shifts up.

This would make it a lot harder (more costly in terms of an increase in unemployment) to re-anchor expectations to ensure 2% in the medium-term.

To me there really isn’t any way around this – the Fed needs to slow NGDP growth and announce a clear target for NGDP for the coming five years. That might hurt in the near-term, but by not doing it the costs will increase sharply going forward.

What will the Fed actually do?

Broadly speaking I believe that Jay Powell and the majority of member of the FOMC understand the logic of my discussion above and understand the risk that if the Fed does not commit to slowing NGDP growth (the Fed will use another language) then it comes with the serious risk of repeating the mistakes of the 1970s.

Therefore, we certainly should expect the Fed to turn more hawkish going forward. However, the problem for the Fed is that it has not defined and announced a clear and transperant target – and the focus of attention for the Fed might change over time.

I therefore think (fear) that the Fed will continue to be behind the curve – tightening monetary conditions too slowly – but at some point the Fed will slam the brakes. That is likely to happen within the next year.

At that time it is too late to avoid a recession or as Rudiger Dornbusch once said economic expansions do not die of natural causes rather “they were all murdered by the Fed over the issue of inflation.” 

A recession – in 2023 or 2024 – then will cause the Fed to do a u-turn even if inflation expectations remain well above 2%.

Hence, I certainly fear that we are entering a period of stop-go or rather go-stop-go monetary policy in the US. And the ECB will likely follow the same path.

With that of course comes more economic and financial uncertainty and it is the badly needed that the Fed (and the ECB) get to work on a proper monetary policy framework.

In this blog post I have outlined such framework. Unfortunately I am not too optimistic that the Fed will listen.

The ruble has appreciated exactly BECAUSE the sanctions are working

The question I have been asked most over the last week is why the Russian ruble is been appreciating despite the fact Russia has been hit by extensive economic sanctions.

I must honestly admit that since the sanctions were introduced I have not spent much time following the development of the ruble – or rather the ruble exchange rate on our screens does not really tell us much as the ruble today cannot really be said to be a convertible currency in the traditional sense.

If, for example. showed up at an European bank with rubles and wanted to exchange them for euros then in practice you would hardly be able to do so.

This is because the Russian central bank (CBR) has been sanctioned and what happens in practice is that if you have to exchange rubles for euros the money is basically deposited in the Russian central bank, which then gives back euros – directly from the Russian foreign exchange reserve.

This can now not be done as the CBR simply does not have access to trade in e.g. euros or dollars. The foreign currency remains in the foreign exchange reserve, but the CBR just cannot use it. This is equivalent to having money in your bank account, but the online banking and credit cards do not work.

At the same time, Russia is largely shut out of the so-called SWIFT system used to conduct international currency transactions. This means e.g. that in practice you cannot transfer money between e.g. Denmark and Russia. So if e.g. If a Danish company sells a product to Russia, it will now in practice not be able to receive payment for the product.

On the contrary, Russia’s oil and gas exports, which are basically the only thing that Russia exports, are not covered by the sanctions, and Russia can continue to receive payment for e.g. gas exports to EU countries.

Slightly simplified, Russia can now not import very much, but the country can continue to export. In other words Russia’s imports have collapsed while exports are less severely affected by sanctions.

Consequently, Russia’s trade balance surplus has increased sharply in the past month.

And that is basically the reason why the ruble has appreciated in recent weeks.

Does that mean that the sanctions do not work?

If you have a mercantilist view of the world – that is if you think that it is always good to export and that imports are bad then the sanctions are great for Russia.

This view, however, corresponds to saying that it is good to work and bad to consume, but there is basically only one reason to work – namely to consume. We do not work for fun – we work to be able to consume – whether it is food or luxury goods.

Right now, Russia is now basically forced to “work”, that is, to sell oil and gas, but at the same time Russia cannot use the revenue.

At the same time, it is part of the stpry that the Russian government has severely restricted the right and opportunity of Russian citizens and businesses to own foreign currency, and citizens and businesses are forced to convert the bulk of their foreign exchange earnings into rubles. This may also to some extent also have supported the value of the ruble.

In addition, it should be noted that Russian interest rates have skyrocketed and that is basically the market compensation for the fact that the ruble has lost value – and is expected to lose additional value in the future.

Finally, the Russian foreign exchange reserve has fallen quite sharply in the past month. Thus, the weekly foreign exchange reserve data from the Russian central bank show that the foreign exchange reserve on February 25 amounted to USD 629.4 billion. By March 25, that number had dropped to USD 604.4 billion.

This is remarkable given that we know that the trade surplus has risen sharply and that Russia cannot trade Western currencies.

Do the sanctions work?

If one is to judge whether the sanctions “work” then one must relate that to what the purpose of the sanctions is.

The purpose of sanctions is not just to “punish” Russia and revenge is certainly not the main purpose. The main purpose must be to sharply reduce Putin’s ability to continue waging war.

Russia needs imports when it comes to waging war. For example Russia must use technology in military production or tires for military vehicles etc. All indications are that these imports have now been severely hampered.

At the same time Putin is dependent on economic growth both to finance the war itself (and possible future “adventures”) and to bribe those he need to support him both in the wider Russian population and among oligarchs, and more importantly in defence and the security apparatus (the so-called Silovik).

Hence, the sanctions hit the Russian economy and Putin regime very hard, but as Russian oil and gas exports are not covered by sanctions the West will be affected to a much lesser extent.

If on the other hand the EU and the West in general closed off imports of Russian oil and gas it would send oil and gas prices skyrocketing and the European economy would be hit quite hard and the European economy would most certainly end up in recession.  

A recession that could potentially threaten popular support for the hard line against Putin and which could create divisions among the EU countries.

On the contrary, Russia is already in a situation where oil and gas revenues, which are typically in euros or dollars, are not worth much, as Russia basically do not have access to spend euros and dollars.

The only thing these foreign exchange earnings today can be used for is basically to service the Russian debt in these foreign currencies. Again, it is primarily the Western investors who own the Russian government bonds that are benefiting rather than the Russian government.

So yes the ruble has appreciated in recent week, but it actually reflects that the sanctions against Russia are quite well calibrated – it maximizes the negative effects on Putin’s ability to wage war and at the same time it minimizes the negative effects on the global economy.

The “black market value” of the ruble has fallen sharply

Finally, it must be said that the ruble exchange rate that we can observe on various financial news sites is not necessarily the actual exchange rate.

In Soviet times, there was an official ruble exchange rate, but it did not have much to do with the real exchange rate. The actual exchange rate was the one you could read if you asked the black market currency traders on the streets of Moscow when exchanging physical dollars for rubles or the other way around.

In currency terms, we are now to a large extent back to the Soviet era, but today we have an easier way of observing the “black market rate” of the ruble. Hence, you can still trade bitcoin and other cryptocurrencies in Russia.

If I want my money out of Russia, then I can exchange my rubles in Russia for bitcoin, and then fly to for example Turkey and get my bitcoin paid out for dollars or Turkish lira on a Turkish crypto exchange.

Thus, by using the “local” Russian bitcoin price, we can calculate what the real value of the ruble is if one were to exchange it for dollars on the “street” in Moscow.

This “premium” which you have to pay for for example Bitcoin in Russia relative to Bitcoin elsewhere has fluctuated between 10-30 percent over the past month. It is smaller now than in the days immediately after the war started, but it is still significant.

Finally, Russian exporters of goods must also accept a discount when they export. Thus, the price of oil from Russia today is about 30 percent lower than what oil otherwise costs on the world market.

We can thus conclude that, paradoxically, it is the sanctions – because it works – that help keep the ruble exchange rate up, but the goods that Russia exports are sold at a significant discount, and at the same time the “street price” of the ruble is significantly below the “official “Exchange rate.

There is therefore no reason to be blinded by the development of the ruble exchange rate, which we can observe on various finance sites, as it does not really say much about the financial flows in and out and Russia and the state of the Russian economy.

Ukrainian default risk drops BELOW Russian default risk

This is a bit of a humiliation of Putin – the so-called Credit Default Swap (CDS) for Ukraine is now LOWER than Russia’s CDS.

A CDS is the price to insure against losing money on a government bond in the event of a government default.

In other words, investors now see it as MORE likely that Russia will default on its sovereign debt than Ukraine will.

Below, the white line is Ukraine’s CDS, while the orange line is the Russian CDS. The green graph at the bottom shows the difference between the two.

It’s a lot of buts and ifs, but it’s probably a pretty good indication of the situation for the two countries.

On the one hand, Russia can look forward to tough economic sanctions from the West for many years to come – unless there is “regime change” in Russia.

On the other hand, Ukraine can probably very much look forward to help from the West when peace comes at some point.

Russia: From crony capitalism to planned economy in three weeks

For more than travel 20 years I have worked professionally and travelled extensively in Central and Eastern Europe – including in Russia and Ukraine.

My Polish and Lithuanian friends again and again over the years have warned me about what have now happened and I must admit that while I 15 years ago was sceptical about this take on Putin I have come to share the view of my Polish and Lithuanian friends and particularly since 2014 I have feared what Putin would do next.

So unfortunately I am not totally surprised by Putin’s invasion of Ukraine.

But this blog post is not about my feeling about the invasion – I am horrified and angry – but rather an attempt of sharing my view on where the Russian economy is going from here.

I a lot of course dependent on what happens on the battlefield in Ukraine and whether or not Putin stays in power and on that I can’t make an informed guess so my assumption here is that we effectively have entered a ‘New Cold War’ and the sanctions implemented against Russia will remain in place for some time to come.

A massive trade and liquidity shock

It is obvious to everybody that the sanctions and the global private sector reaction to Putin’s invasion of Ukraine is a massive direct shock to the Russian economy that completely have paralyzed the Russian financial system and the economy in general and cut the value of the Russian ruble in more than half.

The easiest way to understand that shock is essentially to think of it as a major liquidity shock what hit global economy in 2008. This one is just many times bigger. The implications for the Russian economy is obvious and that shock on its own should be expected to cause a drop in the Russian real GDP of at least 8-10 percent.

However, what I want to discuss in this post is not this from an economic theoretical perspective rather ‘normal’ shock. The purpose of this post is rather to discuss the possible transformation of the Russian economic political system that we likely will see in near future.

From crony capitalism to planned economy

Prior to the collapse of the Soviet Union in 1991 the Russian economy was a communist planned economy with little private ownership of business and essentially no use of the market mechanism.

Over the past three decade the Russian economy has gone through an enormous transformation from the planned economy to what we could call a commodity based crony capitalist economy.

Economic reforms in Russia has been rather imperfect, there is massive corruption and private property is certainly not automatically guaranteed. Furthermore, major business interests – popularly known as Oligarchs – are in bed with the ruling class and government.

Theft rather than trade has been a dominant factor of the Russian economy for decades – or rather centuries.

However, there is – or rather has been – a widespread use of the market mechanism and productive resources are to a large extent allocated based on market principles and therefore Russia can be described as a capitalist economy – but a rather imperfect one or what has come to be known has a crony capitalist economy. In that sense Russia, however, is not much different from many other Emerging Market economies.

Things are, however now set to change dramatically to the worse and while the Russian economy likely will remain a ‘crony economy’ it will likely be without the ‘capitalist’ part in the future.

The sanctions against Russia mean that Russia is now actually totally dependent on barter in foreign trade – oil and gas for cars, spare parts, medicine, technology, etc.

That combined with a ruble that has collapsed means that we may soon be heading towards 75-100% inflation in Russia.

That would be politically unacceptable for the Putin regime. Consequently, we will soon see the introduction of widespread price controls in Russia, where prices are frozen below the market price.

The result of price controls is always the same – soon you will see empty shelves in the supermarket. The regime will blame the sanctions and that will be partly true, but price controls will have an even more devastating effect. This is the kind of thing we have seen in Venezuela for more than a decade.

The political answer will most certainly be rationing.

And since the financial sector has essentially collapsed in Russia all allocation of credits will be state controlled and as companies will not be able to make any money with prices far below the market price, they will soon become completely dependent on government subsidies to survive. Nationalisations follow as a natural economic-political consequence.

In fact the Russian government has already announced that it does not rule out the nationalisation of foreign companies in Russia, and it has already dictated that companies in Russia must convert at least 80% of the companies reserve in foreign currency into rubles.

It is therefore to be expected that in the coming months we will see a wave of de facto nationalisations in Russia.

As foreign exchange reserves are now very limited and all imports essentially will be barter based and Russia will have to pay a price way above global market prices we should expect that all foreign trade soon will be strictly regulated. “Unnecessary” imports will be banned.

It is already happening. Yesterday, Russian Prime Minister Mishustin announced that all exports of sugar will now be banned as Russia is facing a “sugar shortage”.

Military needs will dictate the composition of Russian imports – and therefore also what may be exported.

Young men are also a production resource – a productive resource that is used to wage war, but Russia’s youth have had it with Putin’s regime and the collapse of the economy and the prospect for going to war and dying in Ukraine is causing young Russian to flee the country. It is said that more than 25,000 Russians have already left for Georgia since Putin’s invasion of Ukraine.

The exodus of young Russian in fact started more than a decade ago, but this process is now accelerating dramatically. Polls done even before the war on Ukraine have again and again shown that more than half of the Russian population would like to emigrate. That number is now skyrocketing – particularly among the young.

The Putin’s regime can hardly accept that much longer – and therefore it is only a matter of time before a “Russian wall” is erected – and in the same way as with the Berlin Wall, it is not about keeping enemies out, but about keeping the population confined.

Twitter users have in recent days shared films of Russians fighting over sugar in supermarkets and a lots of empty shelves. There is nothing to celebrate about this, but this is likely to be the reality that Russian will now be facing.


I personally have no joy in seeing regular and innocent Russians suffer because of the crime of Putin. I have travelled – primarily professionally – in Central and Eastern Europe for over 20 years, and know Russians, Poles, Lithuanians, Ukrainians, etc. and over the years they have shared stories with me about the horrors of living in communist dictatorial planned economies. I never met anybody longing for a return to a planned economy.

The free market economy and democracy have lifted millions of people out of poverty in Central and Eastern Europe over the past three decade. Now Putin has beaten 140 million Russians 30 years back economically and politically.

Putin wanted the borders of 1991 back, but he got the economy of 1991 instead. The question remains whether he will survive that.


New Paper: Digital cash, the conduct of monetary policy and the monetary transmission mechanism

I have a new paper out at Center for Corporate Governance at Copenhagen Business School.

Here is the abstract:

More and more central banks around the world are seriously considering introducing so-called Central Bank Digital Currencies (CBDC).

In this paper we discuss the implications of introducing digit cash for the conduct of monetary policy and the monetary transmission mechanism.

It is concluded that the introduction of digital cash will not necessitate a fundamental change in monetary policy operations, but it might nonetheless open the door for policy innovations.

The introduction of digital cash will, however, impact – potentially significantly – the size of the money multiplier and might increase the effective lower bound on interest rates.

Both factors will cause an initial tightening of monetary conditions. However, such tightening can and should be offset by a strict commitment to monetary policy rules and through measures to ease legal requirements for liquidity, capital and reserves.

Read the paper here.

New paper: The financial sector, welfare gains and regulaton – A Danish Perspective

I have a new paper out at Center for Corporate Governance at Copenhagen Business School.

Here is the abstract:

Throughout their lives, all citizens come into contact with the financial sector – whether through
children’s savings accounts, home loans or pension saving – and it is impossible to imagine a wellfunctioning market economy without one.

The financial sector plays a core role as a provider of financial intermediation and payment services, generating liquidity, and in assessing, pricing and allocating financial risk. One often overlooked role of the financial sector is its importance for wealth creation and economic growth.

Very extensive research in the field shows a close correlation between the size of a country’s financial sector and its economic prosperity. One way the financial sector contributes to wealth creation is through the provision of payment services.

Calculations in this paper indicate that Danes on average have an annual welfare gain alone improved payment services of least DKK 8-10,000 per Dane. Another significant channel for wealth creation is the financial sector’s abilityto generate liquidity and capital for entrepreneurs, which crucially depends on well-established and defined property rights.

A good legislative framework is essential for a well-functioning financial sector. The reverse applies as well. Failed regulation can not only lead to excessive risk-taking, but it may also inhibit economic growth by limiting opportunities for financial companies to fulfil their beneficial roles in financial intermediation, payment services and liquidity creation.

Read the paper here.

Paper: Financial regulation, demand for ‘safe assets’, and monetary conditions

I have a new paper out at Center for Corporate Governance at Copenhagen Business School.

Here is the abstract:

In the aftermath of the economic and financial shock of 2008-10, the wider policy debate has often turned on why inflation has remained very subdued and interest rates and bond yields historically low despite a marked drop in interest rates and a significant increase in the money base in the US and the euro zone.

In this paper, we try to explain these developments with a simple model which highlights the importance of growing demand for ‘safe assets’ (government bonds). By its effect on the demand for money, this shift is inherently deflationary. Expansion of the money base is a natural and necessary consequence of inflation-targeting central banks ‘doing their job’.

The model framework can also be applied to the Covid-19 shock of 2020-21 and it is shown that in the absence of growing demand of safe assets (and an increase in the supply of government bonds due to fiscal easing), a sharp increase in the money supply will be inflationary.

Read the paper here.

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