ONE factor explains most of the differences in Covid19 deaths across countries

As an economist I am not happy about going into having strong views on the causes of why people die from Covid19, but at least I can have a look at correlations.

It has been very clear for some time that very few people younger than 50 years old die from Covid19.

In fact the average of people dying with Covid19 have been around 80 years in most countries and men are more likely to die than women.

These simple facts made me think – how much of this can explain the different mortality rates we observe across countries?

Why has so many people died in Italy and Spain, while mortality rates have been much lower in for example Scandinavia? Similarly why are mortality rates so low in most developing countries?

Can the age composition explain this? The graph below give us the answer.

Covid19 deaths POP

In the graph I have plotted the number of deads with Covid19 per 1 million population versus the share of the male population older than 80 years (%).

The data was collected on Friday April 17 2020 and I have only looked at countries with at least 100 deaths from Covid19 and excluded very small countries like Andorra.

As we see there is a very strong correlation between the two and it is certainly strong enough for me to argue that the absolut most important variable determining whether or not a country will be hard hit or not by the Covid19 crisis is the the age structure in the country.

Countries with a lot of old men will simply suffer a lot bigger blow than countries with younger populations.

It should of course be noted that I here compare countries, which are in different phases of the Covid19 crisis.

Correcting for that might make the “model” more (or less?) precise and we could of course also add more variables – for example air pollution, which think also is an important factor, but what is notable is that age alone is such an important factor.

From that perspective it also seem amazing to me that countries have introduced more or less draconian curfews and lockdowns around the world basically for everybody rather than focusing on protecting the most fragile parts of the population – the elderly.

In fact, if we look at Sweden which have likely has the most liberal approach to combating the Covid19 we see that Sweden’s mortality rate overall is not much different from other countries and if we put a regression line in the graph then Sweden would be more or less smack on that regression line.

Two nations to worry about – Greece and Japan

When looking at the graph it is very clear that two countries are clear outlier – Greece and Japan. Both countries have a quite high share of males older than 80 years (both above 6% – and higher than in Italy).

However, unlike Italy or Spain both Greece and Japan so far have avoided a large number of deaths. The question is why?

I don’t have a clear cut answer, but the Greek government early on put the entire nation on a very strict curfew – essentially locking up the Greek population in their own home.

The Japanese approach has been very different, but at least so far a major Covid19 outbreak have been avoided.

The question is, however, this will remain the case?

It is pretty clear that sooner or later Greek government will have to open up society and at that point there obviously is a risk of a Covid19-Tsunami hitting the country. Greece in that sense seems stuck between a rock and a hard place. Either the country goes bankrupt or the number of Covid19 death will likely increase sharply.

Japan has had a much less draconian approach than Greece or Spain and Italy for that matter and despite of that Japan has been able to avoid the Covid19 Tsunami. So maybe Japan’s approach should be copied by other countries – or maybe Japan so far has just been lucky. I don’t the answer to this.

The purpose of this post is to highlight the very clear relationship between share of the male population older than 80 years and the mortality across countries, but I must say that developments over the past week or so in terms of people being infected with Covid19 in Japan and the number of deaths and my fear clearly is that Japan could catch up with the “pattern” in the rest of the world. I certainly hope that that will not happen.

All set for a fast recovery after the ‘Great Lockdown’

In 2005, Hurricane Katrina hit New Orleans in the US state of Louisiana. The hurricane caused enormous material destruction and about 2,000 people perished.

While Katrina obviously cannot be compared to Covid19 in terms material devastation and death it nonetheless is comparable in terms of the sudden the “shutdown” of the economy.

Katrina was a very clear case of a supply shock. Production facilities were simply shut down. And in the same way as today, it happened from one day to the next.

But nothing really had happened to the fundamentals of the economy – this to a large extent is also the case in terms of the Covid19 around the world.

Katrina was a huge, but very short-lived economic shock

If we look at how things were going for Louisiana’s economy in 2005-6, then you will see that in economic terms, it was a huge negative shock, but the shock was also very short-lived.

We can see that by looking at various indicators of the labor market.

Recently, there has been a lot of focus on US initial jobless claims figures, which have spiked in recent weeks and US unemployment is like to soon hit double digit-figures. This clearly is deeply worrying, but if we look at what we saw in Louisiana in 2005 it might be that we should be less concerned for the longer-term consequences.

When the shock (the hurricane) hit, there was a strong spike in initial claims that is very similar to what we have seen recently – both in speed and scale.

But as the graph below shows, it was a very short-lived shock, and after a few weeks, claims began to subside, and after 3-4 months we were back to normal.

Katrina 1

In this context, we must keep in mind that there was enormous material damage in New Orleans, which greatly affected production in the area affected by the hurricane.

There is no material damage to Covid19. When the lockdowns around the world comes to an end, production can be re-started immediately. Yes, there will of course be a prolonged shock to relative demand for e.g. restaurants and air travel, but it does not change the overall nominal demand in the economy – only the composition of demand. And remember here – nominal demand in the economy is essentially determined by the demand and supply for money. More on that below.

If we look at unemployment in New Orleans, we see that unemployment from one month to another (August to September 2005) rose to more than 15% (more or less what is expected in the US now). But it was a very short-lived shock. 4-5 months later, unemployment had fallen back to the pre-shock level. A similar picture can also be found in employment.

These figures should make you optimistic that the shutdown shock will generally have a very short-term effect on economic activity in the United States – and in the world in general.

So yes, US unemployment is rising sharply right now, but if the lesson from Katrina tells us something, then we should not be surprised if unemployment has dropped back to levels not far from pre-corona levels when Americans vote at the US presidential elections in November.

Katrina 2

That being said, there is a loss of production and activity in the economy, no matter what, it will take time to recover. So, if we look at the economic activity in Louisiana, it took just over a year to get back to “normal”.

But again, it must be remembered that there was very extensive material damage that made production difficult for many months. We do not have that challenge today.

Therefore, when some claim that it will “take years” to get through the Lockdown crisis, I actually think we have to be a lot more optimistic.

Katrina 3

The Corona shock is primarily a lockdown shock to the economy – in the same way as Katrina was in Louisiana in 2005. And as soon as we move out of the lockdowns around world economic activity very will quickly pickup and return to pre-crisis levels.

Market economies – when allowed to – adjust very clearly to supply shocks – whether it is a hurricane or a pandemic.

It looks like we will avoid a major demand shock

It should, however, be remembered that for the price system to work well so the economy swiftly adjusts to changes in relative prices (as demand in certain sector maybe more permanently drops – for example tourism, restaurants and major sports events) it is necessary that nominal demand is kept on track. It is primary a task for central banks to ensure this.

I must, however, admit that I was very worried about this in the beginning of this crisis, as inflation expectations (in the bond markets) dropped very sharply both in the US and the euro zone and that financial distress increased sharply.

Fortunately, however, the Federal Reserve (and partly also the ECB) was quick to respond and although US inflation expectations are still a little too low (way below Fed’s 2% inflation target), the situation has largely stabilized.

Katrina 4

At the same time, major fiscal easing has been adopted in both the US and Europe. So, the risk of a negative demand shock in my opinion now is quite small.

The risk of premature monetary tightening is still there but I believe the risk of that is substantially lower today than in aftermath of the 2008 shock.

Say Law’s and the Fed will ensure a swift recovery

The IMF has dubbed this crisis the Great Lockdown. I think this very well captures the nature of this crisis. It’s primarily a negative supply shock, which at some point also partly looked to developed into a demand shock.

One could illustrate this in a simple AS-AD framework, but I actually think it more fitting to think of this as Say’s Law in action.

John Maynard Keynes formulated Say’s Law to mean that “supply creates its own demand”. Or rather production creates demand.

The Great Lockdown happened because households around the world more or less simultaneously decided to redraw from the labour market – either because of their own voluntary actions or because of government curfews or a combination of these.

In that sense on can also think of this as the first global Real Business Cycle (RBC) recession. But there has always been one problem with RBC models – it is hard to generate year-long recessions in these kinds of models. Recessions are not a result of people of going on vacation – except this time it is actually is. This is an unplanned and partly involuntary “vacation”.

But one can actually question whether this is a recession in the way we normally think about it. Nick Rowe has defined a recession as a situation where there is a general glut (excess supply) of newly-produced goods.

A negative demand shock creates such a general glut, but that is not the case with a negative supply shock – and it not the case with the Great Lockdown.

In the Great Lockdown the problem is not general lack of demand, but lack of production. Changes in relative demand also create problem for certain sector (air travel, restaurants, sport events etc.), but that is not the reason for the crisis – specific sectoral problems is no the reason for the overall decline in economic activity.

Therefore, once we emerge from the “lockdown” phase production­ will pick-up fast and then Say’s Law will take care of demand.

However, as uncertainty might remain heightened for a longer period, we should not rule out that there also will remain a heightened demand for money and safe assets. This could cause money-velocity to decline and push down nominal demand growth.

To avoid this, it is the task of central banks to offset this velocity shock by expanding the money base. Luckily the Federal Reserve seems to have gotten the message and has responded well during this crisis and so far, have succeed in stabilizing market inflation expectations.

The Fed has not done a perfect job, but certainly good enough in my view to ensure that this is not about to turn into a major negative demand shock.

So, in conclusion as long as the Fed keeps nominal demand on track and keep inflation expectations stable then we should expect that Say’s Law will ensure a fast recovery in the US economy (and likely the world economy).

As Hurricane Katrina shows us natural disasters can hit an economy very hard and send economic activity down very sharply and unemployment up extremely quickly, but economic activity also returns fairly quickly.

The imitate contraction in GDP in most countries in the world during this crisis is likely to be larger than during the Great Recession in 2008-9, but duration of the crisis is likely be much shorter – likely months rather than years.

So, let me stick my neck out and give you a forecast on US unemployment – unemployment will rise sharply in April maybe above 15% and is likely to remain elevated in June and July, thereafter unemployment will drop fast and will likely be back to the ‘structural’ level around 5-6% in November. The only conditions I have for this forecast is that the Fed ensures that market inflation expectations does not drop below present levels.

PS I believe that we could best understand the Great Recession by reading Milton Friedman, but to we should rather read F. A. Hayek to understand the mechanism in play during the Great Lockdown – that goes both for his warnings against totalitarianism (“Road to Selfdom“), his opposition to economic planning (The Socialist-calculation debate) and his deep understanding of the The Price System as a Mechanism for Using Knowledge.  2008 was primarily about monetary policy failure – today’s crisis is mostly about regulatory overkill.

A talk with the Icelandic Minister of Finance on the corona crisis

Everyday at 1000 CET I do a Facebook Live Update on the economic and financial consequences of the corona shock.

It is normally in Danish but today I did it in English because I had invited the Icelandic Minister of Finance Bjarni Benediktsson to join me for a talk about Iceland’s response to the corona shock.

You can watch the talk here and you can follow me on Facebook here.

Well done! Decisive actions from global central banks

Sunday night European time global central banks under the leadership of the Federal Reserve moved decisively to calm down market fears of eroding global dollar liquidity and to ease global monetary conditions.

See my comments on the this decisive and positive policy action here.

A (Keynesian-Monetarist) proposal to shock the euro zone out of the crisis

Fundamentally I think central banks have full control of nominal spending and therefore also inflation. Therefore, to me there is no liquidity trap.

However, there can be a mental or an institutional liquidity trap if for example a central bank refuses to take the necessary steps to permanently increase the money base.

I believe we are now in such a situation in the euro zone and therefore I think it is now time to suggest something I never thought I would have suggested – significant keynesian style (with quite a bit of market monetarist influence) fiscal “stimulus”.

So have a look at what I wrote on Twitter earlier today:

tweet 1

tweet 2

tweet 3

I know this is radical and maybe not expected from me, but the seriousness of the global ‘corona shock’ and the ECB’s refusal to act appropriately necessitate policy proposals like this.

Furthermore, proposals like this will not permanently expand the role of government in the economy and it will have an imitate and transparent impact.

Some might argue that this will not work as the Germans would just increase savings. This, however, really doesn’t matter. What is important is that this would decrease net savings in the euro area – through “weaker” public finances in German. This in turn would push up the “real natural interest rate” in the euro area. In line with what we have seen with the Trump tax cuts.

My “guesstimate” is that such measures likely would increase the real natural interest by at least 100bp in the euro zone and hence if the ECB keeps its key policy rate unchanged this would cause an “automatic” easing of monetary conditions in the euro zone. Hence, this proposal is really away to get monetary easing without the ECB actually doing anything (directly and on its own).

It is highly imperfect and not something I am happy about suggesting, but it is certainly better than the deepening of the deflationary pressures in the euro area and potential re-ignition of the euro crisis that we now might be facing.

Remember to have a look at my speaker agency’s web site here and follow me on Twitter here.


Robert Hetzel on the monetary response to Covid19

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

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

Lars Christensen

Fed and Covid19

By Robert Hetzel

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

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

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

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

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

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

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

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


Books by Robert Hetzel:

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




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

The statement the Federal Reserve should publish ASAP

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

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

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

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

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

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

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

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

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

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

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

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

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




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

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

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

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

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

Supply shock or demand shock?

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

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

Don’t turn a supply shock into a demand shock

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

5year real rate

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

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

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

5y inflation expectations

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

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

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

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

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

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

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

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

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

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

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

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

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

Have a look here.




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