Mark Carney comes close to endorsing NGDP level targeting

Here is Mark Carney present governor of Bank of Canada and the next governor of Bank of England:

If yet further stimulus were required, the policy framework itself would likely have to be changed.19 For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP (Chart 4).

Bank of Canada research shows that, under normal circumstances, the gains from better exploiting the expectations channel through a history-dependent framework are likely to be modest, and may be further diluted if key conditions are not met.  Most notably, people must generally understand what the central bank is doing – an admittedly high bar.20

However, when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.21

Of course, the benefits of such a regime change would have to be weighed carefully against the effectiveness of other unconventional monetary policy measures under the proven, flexible inflation-targeting framework.

I stole this from Nick Rowe. Thanks for the very good news Nick – it seems like Carney will try to move Bank of England in the right direction and there is no doubt that a number of Cabinet members in Cameron’s government has sympathy for NGDP targeting.

The Bank of England showed the way in 1931 – could it do it again in 2013? I certainly hope so – now we just need an official endorsement of NGDP level targeting from the UK government. George Osborne what are you waiting for?

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Scott Sumner also comments on the good news – as do Britmouse.

Bank of England should leave forecasting to Ladbrokes

Last week former Federal Reserve economist David Stockton’s report on Bank of England’s forecasting track record was published. City AM had this wrap-up (I didn’t read the report yet):

“INFLATION has been damaging British living standards and dragging down the economy – but the officials who are meant to keep a lid on prices didn’t do enough to help because their forecasts were too often wrong, according to a Bank of England report out today.

And even though the Bank was consistently worse at predicting changes in growth and inflation than other economists, it stuck with its flawed model, making excuses for its errors instead of trying to improve its forecasts.”

I would probably be less critical about that Bank of England’s forecasting abilities – or rather I know how hard it is to forecast anything, but I am not surprised to learn that Stockton find that BoE’s forecasts are biased. In fact I would be surprised if he had found that it was not biased. Central banks have strong incentives to do biased forecasts – and sometimes that might actually be what you want central banks to do. I for example find it very odd when central bank forecast that they will fail in achieving their policy objectives, but I also realize that central banks fail to hit their policy targets all the time.

David Stockton has 21 ideas to improve BoE’s forecasting abilities. Some of Stockton’s ideas are probably good, but I think that there is a more fundamental problem – and that is that central banks’ in-house forecasts very likely always will be biased. Therefore central banks should outsource forecasting – not because other institutions or companies (like banks!) necessarily are better at making forecasts than central banks, but because the forecasts of “outside” agents is likely to be much less biased than a in-house forecast.

One way would be to simply to outsource the forecasting to a private research company. Another possibility would be to base the forecast on a survey of professional forecasts – or even better as I have suggested numerous times that the central bank simply set-up a prediction market. In Britain that would be extremely easy – I don’t think there is a country in the world with so many bookmakers. The Bank of England could simply ask a company like Ladbrokes or a similar company to set-up betting markets for key macro economic variables – such as inflation and nominal GDP. It would be extremely cheap and the forecast created from such prediction market would likely be at least as good as what is presently produced by the otherwise clever staff at the BoE.

Related posts:

Yet another argument for prediction markets: “Reputation and Forecast Revisions: Evidence from the FOMC”
Benn & Ben – would prediction markets be of interest to you?
Prediction markets and government budget forecasts
Central banks should set up prediction markets
Scott’s prediction market
Ben maybe you should try “policy futures”?
What can Niskanan teach us about central bank bureaucrats?
Robin Hanson’s brilliant idea for central bank decision-making
Please fasten your seatbelt and try to beat the market

The “Dajeeps” Critique and why I am skeptical about QE3

Dajeeps is a frequent commentator on this blog and the other Market Monetarist blogs. Dajeeps also writes her own blog. Dajeeps’s latest post – The Implications of the Sumner Critique to the current Monetary Policy Framework – is rather insightful and highly relevant to the present discussion about whether the Federal Reserve should implement another round of quantitative easing (QE3).

Here is Dajeeps:

“How I came to understand the meaning of the Sumner Critique was in applying it to the question of whether the Fed should embark on another round of QE. I agree with the opponents of more QE, although violently so, because under the current policy framework, the size, duration or promises that might come with it do not matter at all. It will be counteracted as soon as the forecast of expectations breach the 2% core PCE ceiling, if it not before. But in ensuring that policy doesn’t overshoot, which it must do in order to improve economic circumstances, the Fed must sell some assets at a loss or it needs some exogenous negative shock to destroy someone else’s assets. In other words, it has no issue with destroying privately held assets in a mini-nominal shock to bring inflation expectations back down to the 48 month average of 1.1% (that *could be* the Fed-action-free rate) and avoid taking losses on its own assets.”

Said in another way – the Fed’s biggest enemy is itself. If another round of quantitative easing (QE3) would work then it likely would push US inflation above the quasi-official inflation target of 2%. However, the Fed has also “promised” the market that it ensure that it will fulfill this target. Hence, if the inflation target is credible then any attempt by the Fed to push inflation above this target will likely meet a lot of headwind from the markets as the markets will start to price in a tightening of monetary policy once the policy starts to work. We could call this the Dajeeps Critique.

I strongly agree with the Dajeeps Critique and for the same reason I am quite skeptical about the prospects for QE3. Contrary to Dajeeps I do not oppose QE3. In fact I think that monetary easing is badly needed in the US (and even more in the euro zone), but I also think that QE3 comes with some very serious risks. No, I do not fear hyperinflation, but I fear that QE3 will not be successful exactly because the Fed’s insistence on targeting inflation (rather than the price LEVEL or the NGDP LEVEL) could seriously hamper the impact of QE3. Furthermore, I fear that another badly executed round of quantitative easing will further undermine the public and political support for monetary easing – and for NGDP targeting as many wrongly seem to see NGDP targeting as monetary easing.

Skeptical about QE3, but I would support it anyway 

While I am skeptical about QE3 because I fear that Fed would once again do it in the wrong I would nonetheless vote for another round of QE if I was on the FOMC. But I must admit I don’t have high hopes it would help a lot if it would be implemented without a significant change in the way the Fed communicates about monetary policy.

A proper target would be much better

At the core of the problems with QE in the way the Fed (and the Bank of England) has been doing it is that it is highly discretionary in nature. It would be much better that we did not have these discussions about what discretionary changes in policy the Fed should implement. If the Fed had a proper target – a NGDP level target or a price level target – then there would be no discussion about what to expect from the Fed and even better if the policy had been implemented within the framework of a futures based NGDP level target as Scott Sumner has suggested then the money base would automatically be increased or decreased when market expectations for future level of nominal GDP changed.

For these reasons I think it makes more sense arguing in favour of a proper monetary target (NGDP level targeting) and a proper operational framework for the Fed than to waste a lot of time arguing about whether or not the Fed should implement QE3 or not. Monetary easing is badly needed both in the US and the euro zone, but discretionary changes in the present policy framework is likely to only have short-term impact. We could do so much better.

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Related posts:

Steve Horwitz on why he oppose QE3. I disagree with Steve on his arguments and is not opposing QE3, but I understand why he is skeptical

David Glasner on why Steve is wrong opposing QE3. I agree with David’s critique of Steve’s views.

My own post on why NGDP level targeting is the true Free Market alternative – we will only convince our fellow free marketeers if we focus on the policy framework rather than discretionary policy changes such as QE3.

My post on QE in the UK. In my post I among other things discuss why Bank of England’s inflation target has undermined the bank’s attempt to increase nominal spending. This should be a lesson for the Federal Reserve when it hopefully implements QE3.

See also my old post on QE without a proper framework in the UK.

“The impact of QE on the UK economy — some supportive monetarist arithmetic”

Over the last 1-2 decades so-called DSGE (dynamic stochastic general equilibrium) models have become the dominate research tool for central banks around the world. These models certainly have some advantages, but it is notable that these models generally are models without money. Yes, that is right the favourite models of central bankers are not telling them anything about money and the impact of money on the economy. That is not necessarily a major problem when everything is on track and interest rates are well above zero. However, in the present environment with interest rates close to zero in many countries these models become completely worthless in assessing monetary policy.

I was therefore pleasantly surprised this week when I discovered a relatively new working paper – “The impact of QE on the UK economy — some supportive monetarist arithmetic” from the Bank of England (BoE) in which the authors Jonathan Bridges and Ryland Thomas estimate what they call a “broad” monetarist model and use their model(s) to evaluate the impact on the UK economy of BoE’s quantitative easing over the past four years. Here is the paper’s abstract:

“This paper uses a simple money demand and supply framework to estimate the impact of quantitative easing (QE) on asset prices and nominal spending. We use standard money accounting to try to establish the impact of asset purchases on broad money holdings. We show that the initial impact of £200 billion of asset purchases on the money supply was partially offset by other ‘shocks’ to the money supply. Some of these offsets may have been the indirect result of QE. Our central case estimate is that QE boosted the broad money supply by £122 billion or 8%. We apply our estimates of the impact of QE on the money supply to a set of ‘monetarist’ econometric models that articulate the extent to which asset prices and spending need to adjust to make the demand for money consistent with the increased broad money supply associated with QE. Our preferred, central case estimate is that an 8% increase in money holdings may have pushed down on yields by an average of around 150 basis points in 2010 and increased asset values by approximately 20%. This in turn would have had a peak impact on output of 2% by the start of 2011, with an impact on inflation of 1 percentage point around a year later. These estimates are necessarily uncertain and we show the sensitivity of our results to different assumptions about the size of the shock to the money supply and the nature of the transmission mechanism.”

I draw a number of conclusions from the paper. First, the authors clearly show that monetary policy is highly potent. An increase in the money supply via QE will increase nominal GDP and in the short-run also real GDP. Second, the paper has a very good discussion of the monetary transmission mechanism stressing that monetary policy does not primarily work through the central bank’s key policy rate, but rather through changes in a number of asset prices.

The authors’ discussion of the transmission mechanism and the empirical results also clearly refute that money and other assets are perfect substitutes. Therefore, unlike what for example has been suggested by Steven Williamson open market operations will impact nominal income.

I particularly find the discussion of the so-called buffer stock theory of money interesting. The Buffer stock theory, which was developed by among others David Laidler, has had a particularly large impact on British monetarists and in general Bridges and Thomas seem to write in what Tim Congdon has called the British monetarist tradition which stresses the interaction between credit and money more than traditional US monetarists do. British monetarists like Tim Congdon, Gordon Pepper and Patrick Minford – as do Bridges and Thomas – also traditionally have stressed the importance of broad money more than narrow money.

Furthermore, Bridges and Thomas also stress the so-called “hot-potato” effect in monetary policy, something often stressed by Market Monetarists like Nick Rowe and myself for that matter. Here is Bridges and Thomas:

“A further key distinction is the difference between the individual agent’s or sector’s attempt to reduce its money holdings and the adjustment of the economy in the aggregate. An individual can only reduce his surplus liquidity by passing that liquidity on to someone else. This is the genesis of ‘hot potato’ effects where money gets passed on among agents until ultimately the transactions underlying the transfers of deposits lead to sufficient changes in asset prices and/or nominal spending that the demand for money is made equal to supply.”

Even though I think the paper is extremely interesting and clearly confirms some key monetarist positions I must say that I miss a discussion of certain topics. I would particularly stress three topics.

1) A discussion of the property market in the UK monetary transmission mechanism. Traditionally UK monetarists have stressed the importance of the UK property market in the transmission of monetary policy shocks. Bridges and Thomas discuss the importance of the equity market, but the property market is absent in their models. I believe that that likely leads to an underestimation of the potency of UK monetary policy. Furthermore, Bridges and Thomas use the broad FTSE All Shares equity index as an indicator for the stock market. While this obviously makes sense it should also be noted that the FTSE index likely is determined more by global monetary conditions rather than UK monetary conditions. It would therefore be interesting to see how the empirical results would change if a more “local” equity index had been used.

2) The importance of the expectational channel is strongly underestimated. Even though Bridges and Thomas discuss the importance of expectations they do not take that into account in their empirical modeling. There are good reasons for that – the empirical tools are simply not there for doing that well enough. However, it should be stressed that it is not irrelevant under what expectational regime monetary policy operates. The experience from the changes in Swiss monetary and exchange rate policy over the last couple of years clearly shows that the expectational channel is very important. Furthermore, it should be stressed that the empirical results in the paper likely are strongly influenced by the fact that there was significant nominal stability in most of the estimation period. I believe that the failure to fully account for the expectational channel strongly underestimates the potency of UK monetary policy. That said, the BoE has also to a very large degree failed to utilize the expectational channel. Hence, the BoE has maintained and even stressed its inflation target during the “experiments” with QE. Any Market Monetarist would tell you that if you announce monetary easing and at the same time say that it will not increase inflation then the impact of monetary easing is likely to be much smaller than if you for example announced a clear nominal target (preferably an NGDP level target).

In regard to the expectational channel it should also be noted that the markets seem to have anticipated QE from the BoE. As it is noted in the paper the British pound started to depreciate ahead of the BoE initiating the first round of QE. This presents an econometric challenge as one could argue that the start of QE was not the time it was officially started, but rather the point in time when it was being priced into the market. This of course is a key Market Monetarist position – that monetary policy (can) work with long and variable leads. This clearly complicates the empirical analysis and likely also leads to an underestimation of the impact of QE on the exchange rate and hence on the economy in general.

3) The unexplained odd behavior of money-velocity. One of my biggest problems with the empirical results in the paper is the behaviour of money-velocity. Hence, in the paper it is shown that velocity follows a V-shaped pattern following QE. Hence, first velocity drops quite sharply in response to QE and then thereafter velocity rebounds. The authors unfortunately do not really discuss the reasons for this result, which I find hard to reconcile with monetary theory – at least in models with forward-looking agents.

In my view we should expect velocity to increase in connection with the announcement of QE as the expectation of higher inflation will lead to a drop in money demand. So if anything we should expect an inverse V-shaped pattern for velocity following the announcement of QE. This is also quite clearly what we saw in the US in 1933 when Roosevelt gave up the gold standard or in Argentina following the collapse of the currency board in 2002. I believe that Bridges and Thomas’ results are a consequence of failing to appropriately account for the expectational channel in monetary policy.

A simple way to illustrate the expectational channel is by looking at Google searches for “QE” and “Quantitative Easing”. I have done that in Google Insights and it is clear that the expectation (measured by number of Google searches) for QE starts to increase in the autumn of 2008, but really escalates from January 2009 and peaks in March 2009 when the BoE actually initiated QE. It should also be noted that BoE Governor Mervyn King already in January 2009 had hinted quite clearly that the BoE would indeed introduce QE (See here). That said, M4-velocity did continue to drop until the summer of 2009 whereafter velocity rebounded strongly – coinciding with the BoE’s second round of QE.

Despite reservations…

Despite my reservations about parts of Bridges and Thomas’ paper I think it is one of the most insightful papers on QE I have seen from any central bank and I think the paper provides a lot of insight to the monetary transmission mechanism and I think it would be tremendously interesting to see what results a similar empirical study would produce for for example the US economy.

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Related post:

Josh Hendrickson has a great post on his blog The Everyday Economist on the monetary transmission mechanism.

See also my earlier post “Ben Volcker” and the monetary transmission mechanism.

Vince Cable gives me hope

It is very easy to get frustrated about the discussion of monetary policy in today’s world. However, this morning we got something to cheer about as Vince Cable British Minister for Business, Innovation and Skills gave a speech on the UK recovery in the 1930s and the parallels to today’s crisis at the think tank Centre Forum. The entire speech is very uplifting.

Here is Cable:

“you learn far more about our recovery in the 1930s from looking at monetary conditions that you can from examining fiscal policy.”

Yes, yes, yes! We should stop wrangling about fiscal policy. What brought Britain out of the Great Depression was the decision to give up the gold standard in 1931 and what will bring the UK economy out of this crisis is monetary easing. Fiscal policy in that regard is basically irrelevant. Luckily Vince Cable seems to comprehend that – as do Chancellor of the Exchequer George Osborn. Bank of England Governor Mervyn King might also (finally) get it.  

Back to Cable’s speech:

“… It is worth recalling just how brutal were the first dozen years after the First World War.  Britain attempted to return to its pre War gold level, which meant chronic deflation to bring us back with world prices (what Southern Europe is attempting today).  As a result, the price index which had risen from 100 in 1914 to 250 in 1920, fell to 180 in a couple of years and continued falling all the way below 150 in 1930.”

Yes again! The British economy was struggling to get out of the crisis because of a misguided commitment to the gold standard. Once the gold standard was given up it was recovery time. And luckily Vince Cable fully well knows that monetary easing also would do the trick today.

And he knows that fiscal easing is not the important thing – monetary policy will do the job:

“without a noticeable relaxation in fiscal policy, the economy surged into strong growth which was becoming apparent mid 1933. As I said earlier the obvious explanation was a sharp loosening of monetary policy”

Can it get much more Market Monetarist than that? Yes in fact it can:

“What tools does the Government have? The first is continued use of monetary policy, and stronger communication of the policy aim it is meant to achieve – robust recovery in money spending and GDP. “

Cable calls for an NGDP targeting regime!

And even better Cable seems to want a Market Monetarist as the next Bank of England Governor – or at least somebody in favour of NGDP targeting:

“I am sure that all the candidates to take over from Mervyn King are thinking very hard about how best to do this [a robust recovery in money spending and GDP].”

In 1931 the British government showed the way. I hope that today’s British government will show the same kind of resolve. Vince Cable gives me a lot of hope to be optimistic about that.

Thank you Vince, you’ve made my day!

Britmouse just came up with the coolest idea of the year

Our good friend and die hard British market monetarist Britmouse has a new post on his excellent blog Uneconomical. I think it might just be the coolest idea of the year. Here is Britmouse:

“Will the ECB will stand by and let Spain go under?  Spain is a nice country with a fairly large economy.  It’d be a… shame, right?   So if the ECB won’t do anything, I think the UK should act instead.

David Cameron should immediately instruct the Bank of England to print Sterling, exchange it for Euros, and start buying up Spanish government debt.  Spain apparently has about €570bn of debt outstanding, so the Bank could buy, say, all of it.

We all know that the Bank of England balance sheet has no possible effect on the UK economy except when it is used to back changes in Bank Rate.  Right?  So these actions by the Bank can make no difference to, say, the Sterling/Euro exchange rate, and hence no impact on the demand for domestically produced goods and services in the UK.  Right?

Sure, the Bank would take on some credit risk and exchange rate risk.  But they can do all this in the Asset Purchase Facility (used for conventional QE), which already has a indemnity from the Treasury against losses.”

Your reaction will probably be that Britmouse is mad. But you are wrong. He is neither mad nor is he wrong. British NGDP is in decline and the Bank of England need to go back to QE as fast as possible and the best way to do this is through the FX market. Print Sterling and buy foreign currency – this is what Lars E. O. Svensson has called the the foolproof way out of a liquidity trap. And while you are at it buy Spanish government debt for the money. That would surely help curb the euro zone crisis and hence reduce the risk of nasty spill-over to the British economy (furthermore it would teach the ECB as badly needed lesson…). And by the way why do the Federal Reserve not do the same thing?

Obviously this discussion would not be necessary if the ECB would take care of it obligation to ensure nominal stability, but unfortunately the ECB has failed and we are now at a risk of a catastrophic outcome and if the ECB continues to refuse to act other central banks sooner or later are likely to step in.

You can think of Britmouse’ suggestion what you want, but think about it and then you will never again say that monetary policy is out of ammunition.

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Update – this is from a reply below. To get it completely clear what I think…

“Nickikt, no I certainly do not support bailing out either bank or countries. I should of course have wrote that. The reason why I wrote that this is a “cool idea” is that is a fantastic illustration of how the monetary transmission mechanism works and that monetary policy is far form impotent.

So if you ask me the question what I would do if I was on the MPC of Bank of England then I would clearly have voted no to Britmouse’s suggestion. I but I 100% share the frustration that it reflects. That is why I wrote the comment in the way I did.

So again, no I am strongly against bail outs and I fear the consequences in terms of moral hazard. However, Spain’s problems – both in terms of public finances and the banking sector primarily reflects ECB’s tight monetary policy rather than banking or public finance failure. Has there been mistake made in terms and public finances and in terms of the banking sector? Clearly yes, but the main cause of the problems is a disfunctional monetary union and monetary policy failure.”

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