Is Karnit Flug jeopardizing Stan Fischer’s “straight line policy”? Not yet, but…

It is no secret that I think that Stanley Fischer did a good job as governor of the Bank of Israel from 2005 to 2013. He basically saved Israel from the Great Recession by essentially keeping Israeli nominal GDP “on a straight line”. During his time in office the Israeli NGDP level diverged no more than 1-1.5% from what we could call the Fischer-trend.

However, Fischer is no longer at the BoI. Instead former deputy governor Karnit Flug has taken over – effectively from July 2013 and officially from November 2013. The question then is has Mrs. Flug been able to maintain Fischer’s “straight line policy” in place? The graph below gives us the answer.

Karnit Flug NGDP

The picture is pretty clear – essentially coinciding with Flug taking over as BoI governor the slowdown in NGDP growth (already started in 2012) has accelerated and we have now dropped somewhat below the Fischer-trend. It would be foolish to say that this in any way is catastrophic, but the change is nonetheless visible and should give reason for serious concern if it is allowed to continue to “drift off”.

Are inflation expectations becoming un-anchored? 

I have earlier warned that there is a risk that we are seeing inflation expectations becoming un-anchored in for example the euro zone because policy makers are preoccupied with everything else than focusing on their nominal target (for example an inflation target).

On the other hand I have also praised the Bank of Israel for always communicating in terms of (market) inflation expectations relative to the BoI’s 1-3% inflation target (range). However, one could argue that the Bank of Israel is beginning to look more like the Swedish Riksbank (which is preoccupied with household debt and  property prices) or the ECB (which is preoccupied by “everything else”).

A look at inflation expectations can tell us whether these fears are justified or not.

Inflation expectations Israel

The graph shows five different measures of inflation expectations. The first four are inflation expectations based on financial market pricing (BoI’s calculations) and the last one is based on a survey of professional forecasters.

Most of the measures show that there has been a pretty consistent downtrend in most of the measures of inflation expectations for little more than a year. However, it is also notable that we are still within the BoI’s 1-3% inflation target range and 5-year and 10-year inflation expectations are still close to 2% and as remained fairly stable.

Therefore, it is too early to say that inflation expectations have become un-anchored, but it should also be noted that we might be risking a sneaking un-anchoring of inflation expectations if policy actions is not taken to avoid it.

Bringing us back on the “straight line”

The recent rate cuts from the Bank of Israel shows that the BoI is not completely ignorant to these risks and I believe that particularly the latest rate cut to 0.25% on August 25 is helping in curbing deflationary pressures. However, more could likely be done to insure against the deflationary risks.

So what should Karnit Flug and her colleagues at the Bank of Israel do to bring us back to the Fischer-trend and to avoid an un-anchoring inflation expectations?

I have three suggestions:

1) Avoid repeating the mistakes of the Riksbank. The Swedish Riksbank has consistenly for some time now undershoot its official inflation target and in my view this has very much been the result of a preoccupation with household debts and property prices. Historical the Bank of Israel has avoided making this mistake, but there are undoubtedly voices within the BoI that what monetary policy to be more dependent on the development household debt and property prices (these voices are within all central banks these days…)

That said, the Bank of Israel is far from being the Riksbank and so far the emphasis on property market developments in communication about monetary policy has not been overly problematic, but that could change in the future and if the BoI became more focused on these issues then I fear that that could led to a more fundamental un-anchoring of inflation expectations and therefore a more unstable economic development.

2) Avoid repeating the mistakes of the ECB. While the Riksbank has been preoccupied with property prices the ECB has been preoccupied with fiscal policy. There are some signs that the Bank of Israel is getting a bit too focused on fiscal policy rather than focusing on monetary policy. Hence, Mrs. Flug has recently been in a bit of war of words with Finance Minister Yair Lapid about the public budget deficit (see for example here).

While I have sympathy for Mrs. Flug’s fiscal conservatism it is not really the task of any central bank to have a view on fiscal policy other than just take fiscal policy as an exogenous factor when setting policy instruments to hit the central bank’s target. The Bank of Israel should make this completely clear so market participants do not come to think that the BoI will keep monetary policy overly tight (ECB fashion) to punish the Israeli government for overly easy fiscal policy.

3) Pre-announce what to at the Zero Lower Bound. With the BoI’s key policy rates at 0.25% we are effectively at the Zero Lower Bound (ZLB). It is no secret that (Market) Monetarists like myself don’t think that the ZLB is a binding constraint on the possibility for further easing monetary policy. However, the ZLB is often a mental constraint on monetary policy makers.

I think that most observers of the BoI knows that the BoI does not have major “mental” problem with using other instruments – than the interest rate – to ease monetary. Hence, the BoI has since 2008 both bond quantitative easing by buying government bonds and intervened in the currency market to weaken the Israeli shekel. It could easily do that again and I think most market participants full well knows this. Hence, in that sense Israel is in a much better than for example the euro zone.

However, instead of letting the market guessing what it might do in the future if necessary the BoI should already today announce what instrument it would be using to conduct monetary policy at the ZLB. Personally I think the most suitable “instrument” to use for small open economy is the exchange rate channel either in the way it has been done for years by the Monetary Authority of Singapore (MAS) or in recent years by the Swiss and Czech central banks.

I think the best option would simply be for the BoI to announce that it – if needed – could put a floor under USD/ILS and at the same time announce that it will keep the door open for moving up this floor until inflation expectations on all relevant time horizons are between 2 and 2.5%. That in my view would likely lead to a weakening of the shekel of a magnitude to bring inflation expectations immediately in line with this narrow “target” range.

Karnit Flug doesn’t have an easy job to do, but she has a solid foundation to build on

There is no doubt that there is a risk that Stan Fischer’s achievements as Bank of Israeli governor could be jeopardized. However, Karnit Flug has not failed yet and she still have the opportunity to continue the success of Stan Fischer.

But then this has to focus on bringing back the “straight line policy” and ensuring that inflation expectations do not become un-anchored. Hence, she needs to not allow herself to be distracted by the development in property prices and fiscal policy and instead focus on how to conduct monetary policy in a transparent and efficient way at the Zero Lower Bound.

PS I am well-aware that Stan Fischer no longer officially is a proponent of NGDP level targeting and that the BoI does not have an NGDP level target, but rather an inflation target. However, thing of a NGDP target as an intermediate target to implement the “ultimate” target – the inflation target. If the BoI for example keeps the NGDP level on a 5% path and we assume that potential real GDP growth is 2% then the outcome will be 2% over the cycle.


The monetary transmission mechanism – causality and monetary policy rules

Most economists pay little or no attention to nominal GDP when they think (and talk) about the business cycle, but if they had to explain how nominal GDP is determined they would likely mostly talk about NGDP as a quasi-residual. First real GDP is determined – by both supply and demand side factors – and then inflation is simply added to get to NGDP.

Market Monetarists on the other hand would think of nominal GDP determining real GDP. In fact if you read Scott Sumner’s excellent blog The Money Illusion – the father of all Market Monetarist blogs – you are often left with the impression that the causality always runs from NGDP to RGDP. I don’t think Scott thinks so, but that is nonetheless the impression you might get from reading his blog. Old-school monetarists like Milton Friedman were basically saying the same thing – or rather that the causality was running from the money supply to nominal spending to prices and real GDP.

In my view the truth is that there is no “natural” causality from RGDP to NGDP or the other way around. I will instead here argue that the macroeconomic causality is fully dependent about the central bank’s monetary policy rules and the credibility of and expectations to this rule.

In essenssens this also means that there is no given or fixed causality from money to prices and this also explains the apparent instability between the lags and leads of monetary policy.

From RGDP to NGDP – the US economy in 2008-9?

Some might argue that the question of causality and whilst what model of the economy, which is the right one is a simple empirical question. So lets look at an example – and let me then explain why it might not be all that simple.

The graph below shows real GDP and nominal GDP growth in the US during the sharp economic downturn in 2008-9. The graph is not entirely clearly, but it certainly looks like real GDP growth is leading nominal GDP growth.

RGDP NGDP USA 2003 2012

Looking at the graph is looks as if RGDP growth starts to slow already in 2004 and further takes a downturn in 2006 before totally collapsing in 2008-9. The picture for NGDP growth is not much different, but if anything NGDP growth is lagging RGDP growth slightly.

So looking at just at this graph it is hard to make that (market) monetarist argument that this crisis indeed was caused by a nominal shock. If anything it looks like a real shock caused first RGDP growth to drop and NGDP just followed suit. This is my view is not the correct story even though it looks like it. I will explain that now.

A real shock + inflation targeting => drop in NGDP growth expectations

So what was going on in 2006-9. I think the story really starts with a negative supply shock – a sharp rise in global commodity prices. Hence, from early 2007 to mid-2008 oil prices were more than doubled. That caused headline US inflation to rise strongly – with headline inflation (CPI) rising to 5.5% during the summer of 2008.

The logic of inflation targeting – the Federal Reserve at that time (and still is) was at least an quasi-inflation targeting central bank – is that the central bank should move to tighten monetary condition when inflation increases.

Obviously one could – and should – argue that clever inflation targeting should only target demand side inflation rather than headline inflation and that monetary policy should ignore supply shocks. To a large extent this is also what the Fed was doing during 2007-8. However, take a look at this from the Minutes from the June 24-25 2008 FOMC meeting:

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards. In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation… 

…Conditions in some financial markets had improved… the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen. Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. 

Hence, not only did some FOMC members (the majority?) believe monetary policy was easy, but they even wanted to move to tighten monetary policy in response to a negative supply shock. Hence, even though the official line from the Fed was that the increase in inflation was due to higher oil prices and should be ignored it was also clear that that there was no consensus on the FOMC about this.

The Fed was of course not the only central bank in the world at that time to blur it’s signals about the monetary policy response to the increase in oil prices.

Notably both the Swedish Riksbank and the ECB hiked their key policy interest rates during the summer of 2008 – clearly reacting to a negative supply shock.

Most puzzling is likely the unbelievable rate hike from the Riksbank in September 2008 amidst a very sharp drop in Swedish economic activity and very serious global financial distress. This is what the Riksbank said at the time:

…the Executive Board of the Riksbank has decided to raise the repo rate to 4.75 per cent. The assessment is that the repo rate will remain at this level for the rest of the year… It is necessary to raise the repo rate now to prevent the increases in energy and food prices from spreading to other areas.

The world is falling apart, but we will just add to the fire by hiking interest rates. It is incredible how anybody could have come to the conclusion that monetary tightening was what the Swedish economy needed at that time. Fans of Lars E. O. Svensson should note that he has Riksbank deputy governor at the time actually voted for that insane rate hike.

Hence, it is very clear that both the Fed, the ECB and the Riksbank and a number of other central banks during the summer of 2008 actually became more hawkish and signaled possible rates (or actually did hike rates) in reaction to a negative supply shock.

So while one can rightly argue that flexible inflation targeting in principle would mean that central banks should ignore supply shocks it is also very clear that this is not what actually what happened during the summer and the late-summer of 2008.

So what we in fact have is that a negative shock is causing a negative demand shock. This makes it look like a drop in real GDP is causing a drop in nominal GDP. This is of course also what is happening, but it only happens because of the monetary policy regime. It is the monetary policy rule – where central banks implicitly or explicitly – tighten monetary policy in response to negative supply shocks that “creates” the RGDP-to-NGDP causality. A similar thing would have happened in a fixed exchange rate regime (Denmark is a very good illustration of that).

NGDP targeting: Decoupling NGDP from RGDP shocks 

I hope to have illustrated that what is causing the real shock to cause a nominal shock is really monetary policy (regime) failure rather than some naturally given economic mechanism.

The case of Israel illustrates this quite well I think. Take a look at the graph below.


What is notable is that while Israeli real GDP growth initially slows very much in line with what happened in the euro zone and the US the decline in nominal GDP growth is much less steep than what was the case in the US or the euro zone.

Hence, the Israeli economy was clearly hit by a negative supply shock (sharply higher oil prices and to a lesser extent also higher costs of capital due to global financial distress). This caused a fairly sharp deceleration real GDP growth, but as I have earlier shown the Bank of Israel under the leadership of then governor Stanley Fischer conducted monetary policy as if it was targeting nominal GDP rather than targeting inflation.

Obviously the BoI couldn’t do anything about the negative effect on RGDP growth due to the negative supply shock, but a secondary deflationary process was avoid as NGDP growth was kept fairly stable and as a result real GDP growth swiftly picked up in 2009 as the supply shock eased off going into 2009.

In regard to my overall point regarding the causality and correlation between RGDP and NGDP growth it is important here to note that NGDP targeting will not reverse the RGDP-NGDP causality, but rather decouple RGDP and NGDP growth from each other.

Hence, under “perfect” NGDP targeting there will be no correlation between RGDP growth and NGDP growth. It will be as if we are in the long-run classical textbook case where the Phillips curve is vertical. Monetary policy will hence be “neutral” by design rather than because wages and prices are fully flexible (they are not). This is also why we under a NGDP targeting regime effectively will be in a Real-Business-Cycle world – all fluctuations in real GDP growth (and inflation) will be caused by supply shocks.

This also leads us to the paradox – while Market Monetarists argue that monetary policy is highly potent under our prefered monetary policy rule (NGDP targeting) it would look like money is neutral also in the short-run.

The Friedmanite case of money (NGDP) causing RGDP

So while we under inflation targeting basically should expect causality to run from RGDP growth to NGDP growth we under NGDP targeting simply should expect that that would be no correlation between the two – supply shocks would causes fluctuations in RGDP growth, but NGDP growth would be kept stable by the NGDP targeting regime. However, is there also a case where causality runs from NGDP to RGDP?

Yes there sure is – this is what I will call the Friedmanite case. Hence, during particularly the 1970s there was a huge debate between monetarists and keynesians about whether “money” was causing “prices” or the other way around. This is basically the same question I have been asking – is NGDP causing RGDP or the other way around.

Milton Friedman and other monetarist at the time were arguing that swings in the money supply was causing swings in nominal spending and then swings in real GDP and inflation. In fact Friedman was very clear – higher money supply growth would first cause real GDP growth to pick and later inflation would pick-up.

Market monetarists maintain Friedman’s basic position that monetary easing will cause an increase in real GDP growth in the short run. (M, V and NGDP => RGDP, P). However, we would even to a larger extent than Friedman stress that this relationship is not stable – not only is there “variable lags”, but expectations and polucy rules might even turn lags into leads. Or as Scott Sumner likes to stress “monetary policy works with long and variable LEADS”.

It is undoubtedly correct that if we are in a situation where there is no clearly established monetary policy rule and the economic agent really are highly uncertain about what central bankers will do next (maybe surprisingly to some this has been the “norm” for central bankers as long as we have had central banks) then a monetary shock (lower money supply growth or a drop in money-velocity) will cause a contraction in nominal spending (NGDP), which will cause a drop in real GDP growth (assuming sticky prices).

This causality was what monetarists in the 1960s, 1970s and 1980s were trying to prove empirically. In my view the monetarist won the empirical debate with the keynesians of the time, but it was certainly not a convincing victory and there was lot of empirical examples of what was called “revered causality” – prices and real GDP causing money (and NGDP).

What Milton Friedman and other monetarists of the time was missing was the elephant in the room – the monetary policy regime. As I hopefully has illustrated in this blog post the causality between NGDP (money) and RGDP (and prices) is completely dependent on the monetary policy regime, which explain that the monetarists only had (at best) a narrow victory over the (old) keynesians.

I think there are two reasons why monetarists in for example the 1970s were missing this point. First of all monetary policy for example in the US was highly discretionary and the Fed’s actions would often be hard to predict. So while monetarists where strong proponents of rules they simply had not thought (enough) about how such rules (also when highly imperfect) could change the monetary transmission mechanism and money-prices causality. Second, monetarists like Milton Friedman, Karl Brunner or David Laidler mostly were using models with adaptive expectations as rational expectations only really started to be fully incorporated in macroeconomic models in the 1980s and 1990s. This led them to completely miss the importance of for example central bank communication and pre-announcements. Something we today know is extremely important.

That said, the monetarists of the times were not completely ignorant to these issues. This is my big hero David Laidler in his book Monetarist Perspectives” (page 150):

“If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

Macroeconomists to this day unfortunately still forget or ignore the wisdom of David Laidler.

HT DL and RH.

How Stan Fischer predicted the crisis and saved Israel from it

Today I talked to an Israeli friend about the state of the Israeli economy and particularly about the importance of monetary policy. One can really characterise the Israeli economy as being ‘boring’ in the sense that growth, inflation and markets have been quite stable in recent years – despite of the “normal” political (and geopolitical) uncertainty in Israel.

My friend told me a very interesting anecdote, which in my view quite well explains why things have been so ‘boring’ in Israel in recent years. He told me that in 2007 as the first financial jitters had hit the global economy Bank of Israel (BoI) governor Stanley Fischer had explained what was going to happen.

According to my friend Stan Fischer said two things. First, Fischer had warned that what was underway in the global financial markets and the global economy would become very bad. In that sense Fischer rightly ‘predicted’ the crisis. Second, and more importantly in my view Fischer had demonstrated just how well he understand monetary theory and policy. Hence, my friend had asked how it would be possible to offset an external (demand) shock to the Israel if interest rates would drop to zero.

Fischer had explained that there would be no problem at the Zero Lower Bound. The BoI would always be able to ease monetary policy – even if interest rates were stuck at zero. And Fischer then went on to explain how you could do quantitative easing and/or intervene in the currency market.

It should of course be noted that this account is second-hand and my friend might have not gotten everything exactly right from something Fischer said five years ago. However, subsequent events actual tend to show that Fischer was not only well-prepared for the crisis, but also knew exactly what to do when crisis hit. This can hardly be said for European and US central bankers who in general completely failed to do the right thing in 2008.

And note here that I am not praising anybody for acting in a discretionary fashion. What I am praising Fischer for is that he fully well understood that the “liquidity trap” only is a mental constraint in the heads of central bankers (Just listen here to Fischer explaining this on Bloomberg TV back in 2010 when the Fed had announced QE2 – he is also bashing those central bankers who complain about ‘currency war’).

And Fischer did exactly what he had said could be done if necessary when it in fact became necessary in 2009 to ensure nominal stability. Hence, in February 2009 the BoI started to conducted quantitative easing. The graph below illustrates Fischer’s remarkable success.

NGDP Israel

That is a straight line if you ever saw one! And there was no dip in NGDP in 2008 or 2009. Just straight on. Israel never had a Great Recession.

While Stan Fischer in recent years has voiced some scepticism about nominal GDP targeting and instead praised flexible inflation targeting, looking at the data actually shows that the Bank of Israel under his leadership from 2005 to 2013 effectively had a NGDP target. And it is also clear that Fischer quite openly pointed out – particularly in 2009 – that he would not mind temporarily overshooting on the BoI’s official inflation target if the increased inflation was driven by a negative supply shock (depreciation of the Israeli shekel).

I believe that Fischer’s de facto NGDP targeting rule is exactly what has ensured a very high level of nominal stability in the Israeli economy over the past decade. This is a remarkable result given the very sizeable negative shock in 2008-9 and the ever present political and geopolitical shocks to the Israel economy and markets.

Another very important element in my view is that the BoI under Fischer’s leadership has been tremendously forward-looking compared to other central banks in the world. Hence, it is very clear that the BoI has been focused on targeting the forecast rather than targeting present inflation (in the way for example the ECB is doing). Just read nearly any statement from the Bank of Israel. There will nearly always be an reference not only to inflation expectations, but to market inflation expectations. In that sense the BoI is doing exactly what Market Monetarists have been arguing central banks should – use the market to ‘predict’ the outlook for nominal variables whether inflation or nominal GDP.

Furthermore, as market participants realise that the BoI is effectively targeting the (market) forecast the market will do a lot of the implementation of monetary policy. Hence, if market expectations of inflation is too high (low) compared to the BoI’s official inflation target then the market will expect the BoI to tighten (ease) monetary policy. That causes investors to buy (sell) shekel on the expectation of future appreciation (depreciation) as the BoI is expected to move toward monetary tightening (easing). This is of course what I have called the Chuck Norris effect of monetary policy. Under a credible monetary policy regime the markets will more or less “automatically” implement monetary policy to ensure that the monetary policy target is hit – all the central bank has to do is to clearly define its target and to follow the lead from the market.

 Can other central bankers do the same as Fischer?

The economic development in Israel over the past decade is surely remarkable. Few – if any – other countries have achieved anything close to what Stanley Fischer ensured in Israel. The question of course is whether other countries can do the same thing.

Surely I would be the first to acknowledge that luck (and unlock) is important for the success of central bankers. However, I believe that central bankers can indeed copy the success of Fischer by sticking to four general principles:

1) There is no liquidity trap if you just use other instruments to ease monetary policy than the interest rate (in fact central banks should completely stop communicating about the monetary policy in terms of interest rates).

2) Target the forecast. Central banks should not be backward-looking. Instead central banks should follow the example of Fisher’s BoI and focus on the expected future inflation or the level of NGDP rather than looking at present or paste inflation/NGDP level.

3) Let the markets do most of the lifting. By clearly targeting the forecast the market can effectively do most of the actual implementation of monetary policy – and the central bank should encourage this.

4) Be clear on the target. To allow the markets to implement monetary policy the central bank needs to be completely clear about what the central bank actually wants to achieve. And this is probably where I think Fischer did worst during his years at the BoI. It is clear that he de facto was targeting NGDP rather than inflation, but he has never publically acknowledged this.

Luckily Stan Fischer is not retired. Instead he has moved on to become vice-Chairman at the Federal Reserve. If we are lucky he will help Fed boss Janet Yellen do the the right thing on monetary policy and if the US can achieve the same kind of nominal stability as Israel did during Fischer’s term as BoI governor then the outlook for the global economy is quite rosy.

Stanley Fischer – this guy can keep NGDP on a straight line

This is from Reuters:

Stanley Fischer, who led the Bank of Israel for eight years until he stepped down in June, has been asked to be the Federal Reserve’s next vice chair once Janet Yellen takes over as chief of the U.S. central bank, a source familiar with the issue said on Wednesday.

Fischer, 70, is widely respected as one of the world’s top monetary economists. At the Massachusetts Institute of Technology, he once taught current Fed Chairman Ben Bernanke and Mario Draghi, the European Central Bank president.

Yellen, the current Fed vice chair, is expected to win approval from the U.S. Senate next week to take the reins from Bernanke, whose term ends in January.

Fischer, as an American-Israeli, was widely credited with guiding Israel through the global economic crisis with minimal damage. For the Fed, he would offer the fresh perspective of a Fed outsider yet offer some continuity as well.

Good news! Stanley Fischer certainly is qualified for the job. He knows about monetary theory and policy. And even better he used to have some sympathy for nominal income targeting. Just take a look at this quote from his 1995 American Economic Review article “Central Bank Independence Revisited” (I stole this from Evan Soltas):

“In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run–albeit with long-run targets and consequences in mind. Nominal- income-targeting provides an automatic answer to the question of how to combine real income and inflation targets, namely, they should be traded off one-for-one…Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to implya better automatic response of monetary policy to supply shocks…I judge that inflation-targeting is preferable to nominal-income-targeting, provided the target is adjusted for supply shocks.”

While at the Bank of Israel Fischer certainly conducted monetary policy as if he was targeting the level of nominal GDP. Just take a look at the graph below and note the “missing” crisis in 2008.

NGDP Israel

Undoubtedly Fischer had some luck, while at the BoI, and I must also say that I think he from time to time had a problem with his “forward guidance”, but his track-record speaks for itself – while Bank of Israel  governor, Stanley Fischer provided unprecedented nominal stability, something very rare in Israeli economic history. Lets hope he will help do that at the Fed as well.
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