Donald Trump will replace Janet Yellen with a DOVE in 2018

Some have suggested that when Janet Yellen’s term as Federal Reserve chair expires in 2018 then Donald Trump will try to replace her with a more “hawkish” chairman. Some even has suggested that he could try to re-introduce the gold standard and appoint the king of monetary policy rules John Taylor as new Fed chairman.

I, however, believe that is completely wrong. Donald Trump doesn’t care about the Gold Standard (luckily) and certainly he does not care about a rule-based monetary policy.

The fact is that Trump’s entire policy agenda is inflationary. On the supply side his anti-immigration stance will push up US labour cost and this protectionist agenda will push up import prices.

On the demand side his call for underfunded tax cuts and massive government infrastructure investments also increase inflationary pressures.

So if unchecked (should write un-offset by the Fed?) Trump’s economic policy agenda will push inflation up. However, Trump does not – yet – control monetary policy and if the Federal Reserve is serious about it’s 2% inflation target it sooner or later will have to offset the Trumpflationary policies by hiking interest rates potentially aggressively and allow the dollar to strengthen significantly.

I have argued (see here and here) that initially the Federal Reserve will welcome a “fiscal boost” to support aggregate demand as the Fed for some odd reason is not willing to use monetary policy to hit the 2% inflation target. However, the alliance between the Trump administration and the Federal Reserve could be short-lived if inflation expectations really start to take off.

So in a situation where the Fed moves to hike interest rates more aggressively – for example in the second half of 2017 or in early 2018 it will become clear even to Trump that the Fed is “undermining” his promise of doubling US growth and “create millions of jobs”.

That could very well create a conflict between the Fed and the Trump administration and it is very likely that Trump will accuse Yellen of have too tight a monetary policy. Furthermore, with mid-term elections due in 2018 the Republicans in the Senate and the House are unlikely to be cheering for a “growth killing” tightening of monetary policy.

As I have repeated on the social media over the last couple days – the GOP is (deflationary) “Austrians” when they are in opposition and (inflationary) “Keynesians” when they are in power – they never really favour monetarist and rule-based policies.

After all it was Richard Nixon who famously said “we are all keynesians now” – or rather this is how Milton Friedman interpreted what Nixon said.

Nixon of course had the utterly failed Fed chair Arthur Burns (see more on Burns and Nixon here) to do the dirty work of easing monetary policy when monetary policy already was far too easing.

If Trump reminds me of any US president it is Nixon. So why should we believe Trump would replace Janet Yellen with John Taylor when he can find his own Arthur Burns to help him support his agenda with overly easy monetary policy ahead of the 2020 presidential elections?

If this hypothesis just has a small probability of being right then the market certainly is right is to price in higher inflation during a Trump presidency. I certainly hope I am totally wrong.

PS for a discussion of Nixon and Burns’ relationship seen Burton Abrams very good (and scary) paper How Richard Nixon Pressured Arthur Burns: Evidence From the Nixon Tapes.

PPS Paul Krugman once called for Ben Bernanke to show up for a FOMC press conference in a Hawaii shirt to signal that he would be “irresponsible” and thereby push inflation expectations up and lift interest rates from the ZLB. Maybe Trump is that Hawaiian shirt.

“Make America Keynesian Again” part 2

In yesterday’s blog post I wrote about why I believe it is the combination of Donald Trump’s fiscal stimulus plans (infrastructure investments and tax cuts) combined with the Federal Reserve’s willingness not to (fully) offset this, which has pushed inflation expectations in the bond markets up very significantly since Tuesday.

If the Fed’s inflation target was fully credible fiscal stimulus would be fully offset by the expectations of a tightening of monetary policy to “neutralize” the impact on aggregate demand from fiscal stimulus. This of course is known as the so-called Sumner Critique.

I would normally think that the Sumner Critique would hold and announced fiscal stimulus or fiscal contraction would not impact inflation expectations. This is for example what I argued in 2012 and 2013 in relationship to the so-called fiscal cliff (see here, here and here).

That argument of course turned out to be completely right – the fiscal contraction did not cause inflation expectations to drop and the US economy did not fall into recession contrary to what was argued buy arch-Keynesians such as Paul Krugman.

However, as I have often argued the causality in the economy as well as the impact of fiscal shocks depend critically on what kind of monetary policy rule the central bank has (see fore example here, here, here and here).

The standard textbook example is the Flemming-Mundell model where the budget multiplier is zero in a free floating exchange rate regime, but positive (“keynesian”) in a fixed exchange rate regime.

The important point in relationship to the expected fiscal easing from the Trump administration is that the Federal Reserve explicitly have called for the kind of fiscal stimulus that Trump now wants to deliver meaning that the Fed effectively have signaled that they will not fully offset the impact on aggregate demand.

Furthermore, it is clear that the Fed has a preference for higher nominal interest rates – disregarding the level of inflation expectations. The Fed simply don’t like interest rates at this level. However, the Fed also realizes that it is not really possibly both to deliver higher inflation than presently (which is necessary to hit the 2% inflation target) and increase interest rates. But they can get both by allowing fiscal policy to increase aggregate demand.

This, however, necessitates that the Fed will not increase interest rates quite as fast as the rise in the equilibrium interest rates caused by easier fiscal policy. This means that the Fed effective will need to peg the interest rate level.

Trumponomics in A simple IS/LM model with two different policy rules

These consideration have made me think about how to illustrate this in a simple model that even first-year economics students can understand.

That model is a rudimentary IS/LM model. While drawing with my 6-year old son tonight I put the equations on a paper (yes, I know am sometimes a nerdy dad…).  Here they are:

ISLM model Trump.jpg

What we have here is two equations. One for aggregate demand (AD) and one for money demand as well as a monetary policy rule – or rather three different monetary policy rule.

Equation (1) simply says that aggregate demand is composed of private spending/investment, which dependent on the interest rate level (r) and of government “spending”. Higher interest rates causes private spending/investment to drop.

Equation (2) is a standard textbook money demand function, where money demand (m) depends on nominal GDP (P*Y) and the interest rate level. Higher interest rates causes money demand to drop.

In the standard IS/LM model we use this to construct the LM and the IS curves. However, we also need some monetary policy rules. Introducing a monetary policy rule is what I earlier has termed a IS/LM+ model (See here and here).

The two policy rules for the Fed I here look at is an interest rate target rule – (3)’ – and a nominal GDP target rule – (3)”.

In the interest rates targeting case we simply assume that the Fed will increase (decrease) the money base (m) if the interest is higher (lower) than the interest rate target (rT). If the coefficient lambda is set to be equal to infinity it means that the Fed will not accept any change in the interest rate from the target.

Our nominal GDP target rule (3)” essentially works in the same way. If nominal GDP is below (above) the target then the money base is increased (decreased) to push up (down) nominal GDP.

We can also illustrate this with graphs – again a bit from the kitchen table:

Graphs Trump fiscal easing.jpg


Lets first start in the standard IS/LM model. Here fiscal easing – higher g in the model and in real-life it is Trump’s tax cuts and infrastructure investments – causes the IS curve to shift to the right.

This pushes up nominal GDP. In fact in the textbook prices are assumed to be fixed so P=1. We don’t have to make that assumption here. The increase in g also push up the interest rate (r) because it in the standard IS/LM model is assumed that the money base (m) is fixed. In the graphs above this is the move from 1 to 2.

The NGDP rule – full crowding out of Trump’s fiscal easing

However, if we have an NGDP rule we will see that nominal GDP (PY) has now been pushed above the NGDP target. This will cause the Fed to reduce the money base (m) and the Fed will continue to reduce the money base until NGDP is back on target. This causes the LM curve to shift to the left – the the lower graph that is the shift from 2 to 3 causing a further increase in interest rates.

This increase in interest rates will – see equation (1) – cause private spending/investment to drop exactly as much as government spending/investment (g) has increase. Said in another way we have full crowding out and the budget multiplier is zero. In this case the Sumner Critique obviously applies.

Therefore, if the Fed follows a NGDP targeting rule then this model tells us that Trump’s infrastructure investments will just crowd out private consumption and investment and hence not create the millions of jobs he has promised and it will not increase inflation.

The interest rate rule – Trump’s boom (and bust)

However, since Tuesday we have seen inflation expectations increase significantly. Just take a look at 5-year/5-year swap forward inflation expectations.


Long-term inflation expectations are up more than a quarter of a percentage point since Tuesday morning. In fact this is the largest two-day increase in inflation expectations since April 2015. This is certainly not a small change in inflation expectations.

Therefore the markets are telling us that we should not expect full crowding out of Trump’s fiscal easing.

Lets turn to the explanation – interest rate pegging. This is what we have in the upper graph.

Trump eases fiscal policy. This pushes the IS curve from 1 to 2. This increases (nominal) GDP growth and push up interest rates.

However, if the Fed effectively has an interest rate rule then it will not try to offset the increase in GDP, but rather will try to offset the increase interest rates by increasing the money base (rather than reducing it). This is the shift in the LM curve to the right in the upper graph, which causes nominal GDP to increase further.

Obviously in real-life the Fed will not keep the interest rate completely fixed, but it might choose to increase interest rates less than the increase the equilibrium rate caused by massive fiscal stimulus.

This sounds like something out of the 1970s’ insane “keynesian” policy mistakes, but I actually think it is pretty much what Janet Yellen would like to see.

This is what she said a few weeks ago:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market.

Effectively Yellen is saying she would like to see the US economy “overheat”. Trump would like the same thing and the markets understand that.

The coming conflict between Stanley Fischer and Donald Trump

I overall think that these very simple models pretty well discuses the connection between monetary policy (rules) and fiscal policy and how different rules can significantly impact how the US economy response to Trump’s planned fiscal stimulus.

And I am mostly inclined to think that the Fed will implicitly collude with the Trump administration to create exactly the kind of high-pressure economy that Yellen was talking about and hence in the next couple of months we might want to think about the US economy as the interest rate targeting case in my model.

However, it is also very clear that anybody who remembers the 1960s and particularly the 1970s knows that this could be an extremely dangerous strategy. In fact Fed Vice Chairman Stanley Fischer has already warned against it.

This is what Fischer said a couple of weeks ago:

“If you go below the full employment rate, or peoples’ estimates of full employment, by a couple of tenths of percentage points, I don’t think there’s any danger in that…But saying we should keep going until the inflation rate shows us we’re wrong, then you’re going to change too late.”

Said in another way Fischer might be willing to go along with keeping interest rates below the equilibrium interest rate for some period, but he clearly fear that such a strategy soon could cause inflation to spike.

And I would certainly agree with him. Monetary policy in the US has certainly more or less consistently been too tight since 2008, but we have recently moved towards a more neutral monetary policy stance and the combination of Yellen’s ideas about a “high-pressure economy” and Trump’s fiscal expansion could be what pushes inflation expectations significantly above 2%.

If that where to happen I would expect Yellen and the Fed to reverse cause and start tightening monetary conditions rather aggressively. Donald Trump certainly would not like that and that might be setting us up for a conflict at some point in 2017 or 2018 between the Federal Reserve and the Trump administration.


“Make America Keynesian Again”

Today I was asked to do an interview with a Danish radio station about Donald Trump and about whether one could say anything positive about him or rather about his economic agenda. I declined to do the interview. I frankly speaking has nothing positive to say about Trump.

To me Donald Trump is an absolutely vile person and and his views on immigration and trade are completely the opposite of mine. However, I have also in the run up to the election in presentations and comments stressed that the presidential election from an overall financial market perspective would not be a big deal and judging from the market reaction today this indeed seems to be the case.

Reading the markets

But what exactly are the markets telling us today about the economic consequences of a Trump presidency combined with the fact that GOP now has the majority in both the House and the Senate?

First, of all we should concluded that the markets are fairly relaxed about the outcome of the election. This to me is an indication that Trump really will never be able (or seriously want to) implement many of the bizarre “promises” on trade and immigration he made during the election campaign.

Second the markets certainly do not expect the outcome of the election to cause a US recession or a global economic crisis. After all US stock markets are in fact trading in positive territory today. We get the same message from the currency markets where the dollar is little changed over the past 24 hours.

The Republican Keynesians

However, there is one market where we have seen a significant reaction to the outcome of the election and that is in the bond market. Just take a look at the graphs below.



The first graph is the yield on 10-year Treasury bonds and the second graph is 2-year yields.

We see that the 10-yield has increased around 10bp overnight. This certainly is a significant reaction, but it is equally notable that 2-yields in fact is slightly down.

What this is telling me is that more than anything else the markets expect Trump to be an old-school Keynesian. We know that Trump has already promised to increase Federal spending on infrastructure and he has of course also promised major tax cuts. With the Republicans controlling both the House and the Senate he should be able to deliver on some of these promises.

In fact there would be nothing unusual about having a Republican president who is also a “keynesian” (yes, I know he has no clue about what that is). In fact historically public spending has grown faster under Republican administrations than under Democrat administrations. Just take a look at the graphs below.

Since the Second World War public spending has grown by around a quarter of a percent per year faster when the president has been Republican than when there has been a Democrat president.

The picture is even more clear when we look at Federal government investments:

…and on the budget deficit:

So based on history we can certainly say that Republican presidents tend to be less fiscally conservative than Democrat presidents and judging from the action in the bond markets today there is little reason to believe that Trump should be any different from former Republican presidents.

And what will Trump spend money on? There is little doubt what the markets think – infrastructure! This is from Trump’s victory speech:

We are going to fix our inner cities, and rebuild our highways, bridges, tunnels, airports, schools, hospitals,” he said. “We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.

And see what effect that kind of speech had on copper prices today:


Keynesian president + Keynesian Fed chair = No monetary offset

So it seems like the markets expect Trump to push for an expansionary fiscal policy agenda and this is visible in the bond market. However, it is also notable that it is only long-term bond yields, which have increased while 2-year yields haven’t increased overnight.

That tells me that the markets do not expect the Federal Reserve to (fully) offset the impact on nominal demand from a more expansionary fiscal policy.

This effectively means that an easier fiscal policy stance will cause monetary conditions to be eased. The reason is that if fiscal policy is eased then that will push up the equilibrium interest rate level. If the Fed does not hike interest rates to reflect this then it will automatically ease monetary policy by keeping the fed funds rate below the equilibrium interest rate.

This of course is the standard result in a New Keynesian model when interest rates are at the Zero Lower Bound (see for example here).

Does this mean that the so-called Sumner Critique does not apply? According to the Sumner Critique an easing of fiscal policy will not have (net) impact on aggregate demand if the central bank has an inflation target (or a nominal GDP) as the central bank will act to offset any impact on aggregate demand from a easier fiscal policy.

However, the Sumner Critique does not necessarily apply if the central bank’s inflation target is not credible and/or central bank is not willing to “enforce” it. And this seems relevant to the present situation. Hence, US core inflation continue to be below the Fed’s inflation target so one can certainly argue that there is room for an increase in aggregate demand without the Federal Reserve having to tighten monetary conditions.

Obviously the Fed could have done this on it own by for example not signaling a rate hike in December or signaling that it would re-introduce quantitative easing if inflation once again started to trend downwards.

However, the Fed clearly has “mental” problems with this. It is clear that most key Fed policy makers are worried about the consequences of keeping interest rates “low for longer” and more QE clearly seems to be a no-go.

In other words the Fed has put itself in a situation where further monetary easing is off the table and this is of course the reason why a number of Fed officials in the last couple of months have called for old-school keynesian fiscal stimulus.

It all seems to have started in August. This is Janet Yellen at the Jackson Hole symposium on August 26:

Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy.25 For example, steps could be taken to increase the effectiveness of the automatic stabilizers, and some economists have proposed that greater fiscal support could be usefully provided to state and local governments during recessions. As always, it would be important to ensure that any fiscal policy changes did not compromise long-run fiscal sustainability.

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans’ living standards. Though outside the narrow field of monetary policy, many possibilities in this arena are worth considering, including improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.

“Promoting capital investment” of course means government infrastructure spending.

Since August we have heard this again and again from Fed officials. This is Federal Reserve Vice Chairman Stanley Fischer at the New York Economic Club on October 17:

Some combination of more encouragement for private investment, improved public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards.

Said in another way – the Fed chair and the Vice chairman are both old-school keynesians and now we will have a keynesian in the White House as well.

The consequence is that if we get massive government infrastructure investments then that will push up the equilibrium interest rate, which will allow the Fed to hike interest rates (which they for some reason so desperately want to) without really tightening monetary conditions if interest rates are increased slower than the increase in the equilibrium rate.

This means that we de facto could have a keynesian alliance between the Trump administration and the Federal Reserve, which would mean that will get both monetary and fiscal easing in 2017 and this might be what the markets now are realizing.

Just take a look at what have happened in 5-year/5-year inflation expectations over the paste 24 hours:


Over the past 24 hours long-term inflation expectations hence have increased by nearly a quarter of a percentage point.

Hence, Donald Trump just eased US monetary conditions significantly by pushing down the difference between the Fed fund target rate and the equilibrium rate. Paul Krugman should love Donald Trump.

The Sumner Critique strikes back – A future conflict between the Fed and Trump?

Obviously this is only possible because the Federal Reserve has not been willing to ensure nominal stability by clearly defining its nominal target and has been overly eager to increase interest rates, but I do think that this keynesian stimulus implemented could increase aggregate demand in 2017 and likely push core inflation above 2%.

But if this happens then the keynesian alliance between the Federal Reserve and Trump Administration might very well get tested. Hence, if fiscal-monetary easing push unemployment below the natural rate of unemployment and inflation (and inflation expectations) start to accelerate above 2% then the Federal Reserve sooner or later will have to act and tighten monetary conditions, which could be setting the US economy up for a boom-bust scenario with the economy initially booming one-two years and then the Fed will kill the boom by hiking interest rates aggressively.

Knowing Trump’s temperament and persona that could cause a conflict between the Fed and the Trump administration.

This is of course pure speculation, but even though the Trump administration and the Fed for now seem to favouring the same policy mix – aggressive fiscal easing and gradual rate hikes (slower than the increase the in equilibrium rate) it is unlike that this kind of old-school keynesian stop-go policies will end well.

2017 – a year of inflation?

Given these factors and others I for the first time since 2008 think that we could see inflation increase more significantly in 2017 in the US. This is of course what we to some extent want, but I am concerned that we are getting higher inflation not because the Federal Reserve has moved towards a more rule-based monetary policy framework, which ensure nominal stability, but because we are moving back towards old-school keynesian stop-go demand “management”.

PS I apologize to serious (New) Keynesians about using the term “keynesian” here. I here use the term as to refer to the kind demand management policy, which so failed during the 1970s. They where inspired by Keynesian economic think and was as such keynesian. However, that is not say that present day keynesians would necessarily agree with these policies.

PPS See also my comment over at Geopolitical Intelligence Service on why the US is “Still the Greatest”– also after Trump has become president.

Update: Read my follow-up post here.

Belongia and Ireland on the Fed’s Romanace with the Phillips curve

There is no doubt that I believe that the Federal Reserve under the leadership of Fed Chair Janet Yellen has kept monetary conditions too tight and I have particularly blamed Yellen’s 1970s style obsession with the Phillips curve for this.

Michael Belongia and Peter Ireland have a very good comment over at Manhattan Institute’s E21 site on exactly this topic. Take a look for yourself here.

PS see some of my earlier posts on Yellen and the Phillips curve here and here.


Egypt floats the pound – now it is time to implement a rule-based monetary policy framework

This morning we got some very good news out of Egypt as this statement was released by the Egyptian central bank:


I have to say I agree with everything in the statement and I think it is the only right thing to do.

The pound almost immediately dropped 48% against the US dollar on the news.  There is no doubt that this in many ways will be unpopular in Egypt and we are likely to see a rather sharp initial spike in Egyptian inflation, which certainly will have short-term negative impact on the purchasing power of many Egyptians.

This is certainly regrettable, but we have to remember what the alternative was. The alternative was to continue the present policy of trying to ‘peg’ the Egyptian pound at a far too strong level and by doing so continuing to tighten monetary conditions.

The result of artificially trying to keep the pound (too) strong has been that we have seen a continued rather sharp slowdown in aggregate demand in the Egyptian economy at a time where we also have seen a rather significant negative supply shock from the continued very high level of political uncertainty and the lack of substantial economic reforms.

Therefore we have effectively entered a situation of stagflation in recent years – where a negative supply shock has pushed up inflation and continuous monetary tightening is causing growth to slow.

By floating the pound at least the downward pressure on aggregate demand growth will disappear.

Weak political structures and a weak economy necessitate a weak currency

There is no doubt that the fact that the pound today was halved in values in a matter of minutes will be a major shock to many (most) Egyptians. However, it is important to remember that if a country has weak political institutions and a weak economy then a weak currency is also a necessity.

Hence, the drop in the pound today really is not a result of the fact that the Egyptian central bank has floated the pound. This was not a devaluation – this was the market determining what the fundamental value of the pound should be given the state of the Egyptian economy and quality (or rather lack of quality) of Egyptian institutions.

Therefore, Egyptian policy makers should certainly not try to prop up the pound by returning to FX interventions. Rather Egyptian policy makers should ensure currency stability though economic and political reforms.

Egypt has a massive economic potential with the largest population in Northern Africa and a strongly growing labour force the country should easily be able to grow by at least 6-8% if not faster. The Egyptian government therefore should do everything to unleash this potential by implementing bold economic reforms.

I would particularly focus on eliminating all tariffs on trade and dramatically opening up the Egyptian economy for trade and investments. Furthermore, government-owned companies should be fully privatized as soon as possible and finally the legal framework has to be significantly strengthened so the rule of law applies and the projection of private property is strengthened significantly.

Such reforms would give a marked boost to the supply side of the economy and lift potential growth significantly, which in turn would help boost the currency without having to tighten monetary conditions. Said in another way if you want a stronger currency implement massive structural reforms rather than tightening monetary conditions.

Time to implement a rule-based monetary policy framework

Freeing up capital movements and allowing the pound to float freely is the first step in a necessary monetary reform. However, it should not be the final step. Rather the Egyptian central bank now should focus on formulating a clear rule-based monetary policy framework that will ensure nominal stability in Egypt.

I would certainly recommend a framework where the Egyptian central bank targets nominal GDP growth rather than inflation.

The main reason I prefer a nominal GDP target to an inflation target is that in a low-income country – particularly in one which hopefully undergoing structural reforms – a lot of the short-term movements in inflation is driven by supply side factors (for example changes in food prices and variation in political uncertainty). The central bank should not react to such shock and the best way to avoid that is targeting NGDP rather than inflation.

However, that does not mean that we cannot think of a long-term “inflation target”. Rather it might make sense to set NGDP growth targets for example every five years based on a expectation about trend real GDP growth in the economy and what long-term inflation you might have.

Hence, presently the IMF expect long-term real GDP growth of 5-6% (in 2020-2021). Given the extremely high growth rate in the labour force this is not particularly optimistic. An assumption of 5% real GDP growth therefore does not seem completely unrealistic over the medium-term given the present structures in the economy (but with less political uncertainty).

If we then say that we would like to see inflation of 5% (half of what we have seen in the recent years) then that would mean that the Egyptian central bank should target around 10% nominal GDP growth. 

This is in fact more or less the present growth rate of nominal GDP, which would make it a natural starting point for a new target for the central bank.

There are of course some very serious challenges with targeting nominal GDP in a country like Egypt, but I would not overestimate these challenges and the fact is that targeting inflation in a country with a lot of supply side driven variation in particularly consumer prices is no less of a statistical challenge.

Now lets hope that Egyptian policy makers are open for taking the next steps – massive structural reforms and the implementation of a new monetary policy framework. The sooner the better.


I have noticed that a number of news stories today have said that the Egyptian central bank “devalued” the pound. This is not correct. A devaluation of the currency is an active (typically discretionary) act of the central bank to weaken the currency.

This is not what the Egyptian central bank did today. Rather the the central bank gave up targeting the exchange rate and instead allowed the currency to float freely. The result was a depreciation (not a devaluation) of the currency.


Swedish monetary conditions are becoming too easy

Believe it or not – there is a country in the world where I now believe that monetary policy is becoming (moderately) too easy. Yes, that is correct – I will not always say that monetary policy is too tight. The country I talk about is Sweden. More on that below.

Assessing monetary conditions

I strongly believe that the assessment of the monetary stance of a country should not be based on for example looking at the level of nominal interest rates, but rather on whether or not the country is on track to hitting the central bank’s nominal target in lets say 12-18 months.

A way of assessing that is of course to look at market inflation expectations (if the central bank targets inflation as in the case of Sweden’s Riksbank). If inflation expectations are below (above) the target (for example 2%) then monetary conditions are too tight (easy).

An alternative to this approach is to look at other monetary indicators – for example money supply growth, nominal GDP growth, interest rates and the exchange rate. And this is exactly what we are doing in our (Markets & Money Advisory’s) upcoming publication on Global Monetary Conditions.

Policy consistency  

Hence for all of the nearly 30 country we analyse in the publication we look at the four monetary indicators mentioned above and compare the development in these indicators with what we believe would be consistent with the given central bank’s inflation target.

This means for example in the case of money supply growth we determine what money supply growth rate is consistent with the Riksbank’s inflation target of 2% given the trend in real GDP growth and and then trend in money-velocity. If the actual money supply growth rate is faster than our “policy consistent” growth rate then monetary conditions are too easy.

We have then calibrated the four indicators individually so a “zero” score is the policy consistent monetary stance and we think of the range between -0.5 and +0.5 as a “neutral stance”.

Four Swedish indicators

Below you see the development in the four monetary indicators for Sweden:


What we are seeing is that both money supply growth and nominal GDP growth have been faster than the policy consistent growth rate since 2014-15 and the key policy rate has been below the  policy consistent level since mid-2014.

In terms of the exchange rate it has been the last of the four indicators to turn in a more “accommodative” direction, but recently the exchange rate development has also helped ease monetary conditions in Sweden.

Based on these four indicators we create a composite indicator for Swedish Monetary Conditions.


As mentioned above the indicator is calibrated so that zero is monetary conditions, which is consistent with the Riksbank’s 2% inflation target. If the indicator is above (below) then the Riksbank is more likely to overshoot its inflation target in the medium-term.

We see that Swedish monetary conditions essentially have been too tight since mid-2009, but we also see that since late-2013 monetary conditions have become less tight and in the past two years or so we have been in the “neutral” range (above -0.5) and we are now approaching +0.5 meaning we are moving out of the “neutral” range and into the “too easy”-range.

Riksbanken needs to tighten monetary conditions

Riksbanken without a doubt has been one of the best performing central banks in the world in the post-2009 period and particularly the performance over the last couple of years has been very positive in the sense that inflation expectations seem to have become somewhat unanchored in recent years in the US and the euro zone, while the Riksbank has been able to ensure nominal stability and ensure that inflation expectations have been close to 2%.

However, we now – based on our monetary indicator analysis of Sweden – believe that the Riksbank is beginning to overdo it on the “easy side”. It is certainly not dramatic and there are absolutely no reason for the Riksbank to slam the brakes on and if the Riksbank is credible it is likely that the markets will do most of the job tightening Swedish monetary conditions – most likely through a stronger Swedish krona, but if that does not happen the Riksbank likely will have to more forcefully start to express concerns that monetary conditions are becoming too accommodative.

Finally, compared to this analysis the Riksbank’s monetary policy announcement last week seems to have been overly dovish. That said given the track-record of the Riskbank I don’t believe that it is about to make a major policy mistake, but I would certainly expect it to scale back on the dovish signal going forward.

Want to know more?

If you want to more on our Global Monetary Conditions publication (we still need a sexy title) and discussion the indicators or have suggestions please contact me ( or my colleague Laurids Rising (

The publication will be a monthly and will likely be priced around EUR 2000 for 12 months.

Read more on the publication here and here.




Venezuela can’t defy gravity

This is from my latest article over at Geopolitical Intelligence Services:

It wasn’t that long ago that socialists all over the world were celebrating Venezuela as an economic success story. But economists knew the country was less a success than a mirage.

The semblance of success was supplied by dumb luck, in the form of a sharp and continuous rise in oil prices during the 2000’s. That created a windfall for Venezuela, which has the biggest proven oil reserves in the world.

By now it should be blatantly obvious to even the most diehard socialist that Venezuela’s “Bolivarian revolution” has been an economic and social disaster.

Since 2013, the country’s real gross domestic product has dropped nearly 20 percent. Inflation has spiked and could very well explode into hyperinflation if President Nicolas Maduro’s regime does not change course – and soon. The Venezuelan bolivar has plummeted and ordinary citizens are above all anxious to get their hands on some good old U.S. doll

Read the rest here.

It’s time to rediscover ECB’s reference value for M3 growth

A couple of days ago I read an interview with ECB’s former chief economist Otmar Issing about the euro crisis. I frankly speaking didn’t find the interview particularly interesting and Issing brings little new to the discussion.

Issing rightly repeats the worries about moral hazard problems and he is critical about the ECB’s credit policies even though it is clear that he fails to point to the difference between credit policies (which central bankers should stay far away from) and monetary policy (which central banks have a mandate to conduct).

Even more depressingly Issing completely fails to recognize the monetary nature of the euro crisis.

This is particularly depressing given Otmar Issing certainly knows his monetarist theory and he used to be know as the monetarist at the ECB.

It was Otmar Issing who famously put monetary analysis based on the quantity theory of money at the centre of thinking in the ECB’s early days. Hence, Issing was the main architect behind ECB’s so-called two pillar strategy. The one pillar was that the ECB should look at a broad range of economic indicators when assessing the monetary policy stance. The second pillar was the monetary pillar which emphasized monetary (essentially montarist) analysis.

What happened to the reference value for M3 growth?

At the core of the monetary pillar was what came to be known as the reference value for M3 growth.

This is how the ECB (read Otmar Issing!) used to define the reference value:

This reference value refers to the rate of M3 growth that is deemed to be compatible with price stability over the medium term. The reference value is derived in a manner that is consistent with and serves the achievement of the Governing Council’s definition of price stability on the basis of medium-term assumptions regarding trend real GDP growth and the trend in the velocity of circulation of M3. Substantial or prolonged deviations of M3 growth from the reference value would, under normal circumstances, signal risks to price stability over the medium term.

So what we are talking about here is the growth rate of M3, which over the medium-term will ensure 2% inflation given the trend-development in money demand (trend real GDP growth and trend-velocity growth).

We can operationalize this by looking at the equation of exchange (in growth rates):

(1) m + v = p + y

Where m is M3 growth, v is the growth rate of M3-velocity, p is inflation (in the GDP deflator) and y is real GDP growth.

If we define v* as trend growth in M3-velocity and y* as trend/potential real GDP growth and finally assume inflation should hit the inflation target of 2% then we can re-write (1):

(1)’ m + v* = 2% + y*

Re-arranging further we can get a target for M3 (m-target), which will ensure 2% inflation over the medium-term:

(2) m-target = 2% + y* – v*

The ECB used (2) to calculate the reference value for M3 growth by assuming v* was around -1/2% and y* was 2%, which would give you a reference value of 4.5%.

The ECB kept this target constant over time despite the fact that neither the trend in velocity nor the trend in real GDP growth are constant over time.

If we instead want to take into account changes in v* and y* over time we can try to “estimate” these variables by applying a Hodrick–Prescott filter (HP filter). Somewhat simply said a HP filter is just a sophisticated moving average.

Introducing the policy-consistent M3 growth rate

While Otmar Issing might have given up on monetary analysis I have not. In fact monetary analysis is at the core of the new publication on Global Monetary Conditions, which my advisory – Markets & Monetary Advisory – will start to publish in the coming months.

In this publication we in fact calculate what we term the policy-consistent M3 (or M2) growth rate for the 25-30 countries, which will be covered in the publication (see more here).

The graph below shows actual M3 growth (the blue line) in the euro zone compared with the policy-consistent M3 growth rate (the red line).


The grey bars are the a 3-year weighted moving averages of the difference between actual and policy-consistent M3 growth and as such is a measure of the monetary policy stance. Negative (positive) bars indicates that M3 growth is too slow (too fast) to ensure that the ECB will hit the 2% inflation target over the medium-term. We can here term this as the ‘money gap’.

In our new  monthly publication we will focus on four different monetary measures to put together one monetary conditions indicator (M3 growth, nominal GDP growth, interest rates and the exchange rate), but if we only focus on our measure of the policy-consistent M3 growth rate we nonetheless get great insight about monetary conditions in the euro zone.

Looking at the development in the ‘money gap’ we see that monetary conditions were broadly speaking from the euro was established in 1999 and until 2006. However, from 2006 monetary conditions clear became too easy.

That, however, change dramatically as M3 started to slow rather dramatically in early 2008 and already at the time should have been clear that soon the M3 would drop below the ECB’s reference value for M3 (and our policy-consistent M3 growth rate). Despite of this the ECB hiked its key policy rate in July 2008! This is of course was the first major policy major the ECB made in the crisis. More disastrous policy mistakes of course followed in 2011 when the ECB hiked interest rate twice!

Hence, had the ECB only focused on M3 the ECB would certainly have tightened monetary policy more aggressively in 2006 and 2007, but even more importantly it would never have hiked interest rates in 2008 and 2011. Rather judging from M3 growth relative to the ECB’s own (old) reference value or our policy-consistent M3 growth rate the ECB should have slashed interest rates aggressively in the Autumn of 2008 and in 2009 and should have initiated quantitative easing once interest rates hit zero.

Otmar Issing should be angry (but for the right reasons)

Hence, Otmar Issing is indeed right to be angry with the ECB, but he should be angry for the right reasons. Issing might point to problems of moral hazard and I certainly share these concerns, but what Otmar Issing really should be angry about is that the ECB complete have given up on taking Issing-style monetary analysis seriously as a result at least six years after 2008 monetary policy far too tight!

Unfortunately Issing seems to have given up on his own analysis as well. That is deeply regrettable.  So we can only hope that Otmar Issing will go back to proper monetary analysis of the typical ‘Calvinist preaching’, which unfortunately is so common among German policy makers – both in Frankfurt and Berlin.

If he did that he would continue to criticize the ECB for trying to distort bond market pricing and encouraging moral hazard, but he would also recognize that ECB chief Mario Draghi has been right pushing for quantitative easing and that it should be continued as long as necessary to keep M3 growth around at least 4.5-5% as this ensures that inflation will be close to ECB’s 2% inflation target.

PS I don’t think re-introducing the reference value for M3 growth would be the best policy framework for the ECB, but it certainly would be better than the present non-policy-framework and very much doubt that we would still would be talking about a euro crisis had the ECB taken the reference value serious.

Rational investors and irrational voters

It seems like there is a bit of a gap opening between prediction markets and opinion polls when it comes to the likely outcome of the US presidential elections in recent days.

Hence, the prediction market Predictit now has a 81% (19%) implied probability that Clinton (Trump) will win, while the opinion poll aggregator over at Nate Silver’s FiveThirtyEight-side has a implied probability of 88.1% (11.9%) that Clinton (Trump) will win.

If we look at the last couple of months it seems clear that the polls have been somewhat more extreme in both direction than the prediction markets.

This to me is interesting as it seems to indicate there is more “animal spirits” in the opinion polls than in the prediction markets. Or said, in another way this could be an indications that when we act as investors – betting on the outcome of presidential election – we behave more rationally than when we are voting?

Obviously opinion polls and prediction markets are not measuring the same thing. Prediction markets “predict” what the outcome will be of an election at a future date, while opinion polls measures how voters think they would vote today. That said, Nate Silver’s models try to do something in between the two.

Anyway, to me it is interesting that it seems like we are voters are much more inclined to be driven be “mood swings”, while we as investors seem a lot more cool-headed. This is of course also what we could learn from Bryan Caplan’s The Myth of the Rational Voter.

PS note that I am not here discussing whether opinion polls are better or worse than prediction markets at forecasting the outcome elections. I am discussion the different decree of rationality we have as voters and investors (or consumers for that matter).

Russia’s economy dodged a bullet, no thanks to Mr. Putin

Se my latest article at Geopolitical Intelligence Services on how a floating exchange rate have helped Russia avoid economic collapse here.

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