The Jedi mind trick – Matt O’Brien’s insightful version of the Chuck Norris effect

Our friend Matt O’Brien has a great new comment on the Atlantic.com. Matt is one of the most clever commentators on monetary matters in the US media.

In Matt’s new comment he set out to explain the importance of expectations in the monetary transmission mechanism.

Here is Matt:

“These aren’t the droids you’re looking for.” That’s what Obi-Wan Kenobi famously tells a trio of less-than-with-it baddies in Star Wars when — spoiler alert! — they actually were the droids they were looking for. But thanks to the Force, Kenobi convinces them otherwise. That’s a Jedi mind trick — and it’s a pretty decent model for how central banks can manipulate expectations. Thanks to the printing press, the Fed can create a self-fulfilling reality. Even with interest rates at zero.

Central banks have a strong influence on market expectations. Actually, they have as strong an influence as they want to have. Sometimes they use quantitative easing to communicate what they want. Sometimes they use their words. And that’s where monetary policy basically becomes a Jedi mind trick.

The true nature of central banking isn’t about interest rates. It’s about making and keeping promises. And that brings me to a confession. I lied earlier. Central banks don’t really buy or sell short-term bonds when they lower or raise short-term interest rates. They don’t need to. The market takes care of it. If the Fed announces a target and markets believe the Fed is serious about hitting that target, the Fed doesn’t need to do much else. Markets don’t want to bet against someone who can conjure up an infinite amount of money — so they go along with the Fed.

Don’t underestimate the power of expectations. It might sound a like a hokey religion, but it’s not. Consider Switzerland. Thanks to the euro’s endless flirtation with financial oblivion, investors have piled into the Swiss franc as a safe haven. That sounds good, but a massively overvalued currency is not good. It pushes inflation down to dangerously low levels, and makes exports uncompetitive. So the Swiss National Bank (SNB) has responded by devaluing its currency — setting a ceiling on its value at 1.2 Swiss francs to 1 euro. In other words, the SNB has promised to print money until its money is worth what it wants it to be worth. It’s quantitative easing with a target. And, as Evan Soltas pointed out, the beauty of this target is that the SNB hasn’t even had to print money lately, because markets believe it now. Markets have moved the exchange rate to where the SNB wants it.”

This is essentially the Star Wars version of the Chuck Norris effect as formulated by Nick Rowe and myself. The Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.

It is pretty simple. It is all about credibility. A central bank has all the powers in the world to increase inflation and nominal GDP (remember MV=PY!) and if the central bank clearly demonstrates that it will use this power to ensure for example a stable growth path for the NGDP level then it might not have to do any (additional) money printing to achieve this. The market will simply do all the lifting.

Imagine that a central bank has a NGDP level target and a shock to velocity or the money supply hits (for example due to banking crisis) then the expectation for future NGDP (initially) drops below the target level. If the central bank’s NGDP target is credible then market participants, however, will know that the central bank will react by increasing the money base until it achieves it’s target. There will be no limits to the potential money printing the central bank will do.

If the market participants expect more money printing then the country’s currency will obviously weaken and stock prices will increase. Bond yields will increase as inflation expectations increase. As inflation and growth expectations increase corporations and household will decrease their cash holdings – they will invest and consume more. The this essentially the Market Monetarist description of the monetary transmission mechanism under a fully credible monetary nominal target (See for example my earlier posts here and here).

This also explains why Scott Sumner always says that monetary policy works with long and variable leads. As I have argued before this of course only is right if the monetary policy is credible. If the monetary target is 100% credible then monetary policy basically becomes endogenous. The market reacts to information that the economy is off target. However, if the target is not credible then the central bank has to do most of the lifting itself. In that situation monetary policy will work with long and variable lags (as suggested by Milton Friedman). See my discussion of lag and leads in monetary policy here.

During the Great Moderation monetary policy in the euro zone and the US was generally credible and monetary policy therefore was basically endogenous. In that world any shock to the money supply will basically be automatically counteracted by the markets. The money supply growth and velocity tended to move in opposite directions to ensure the NGDP level target (See more on that here). In a world where the central bank is able to apply the Jedi mind trick the central bankers can use most of their time golfing. Only central bankers with no credibility have to work hard micromanaging things.

“I FIND YOUR LACK OF A TARGET DISTURBING”

So the reason European central bankers are so busy these days is that the ECB is no longer a credible. If you want to test me – just have a look at market inflation expectations. Inflation expectations in the euro zone have basically been declining for more than a year and is now well below the ECB’s official inflation target of 2%. If the ECB had an credible inflation target of 2% do you then think that 10-year German bond yields would be approaching 1%? Obviously the ECB could solve it’s credibility problem extremely easy and with the help of a bit Jedi mind tricks and Chuck Norris inflation expectations could be pegged at close to 2% and the euro crisis would soon be over – and it could do more than that with a NGDP level target.

Until recently it looked like Ben Bernanke and the Fed had nailed it (See here – once I believed that Bernanke did nail it). Despite an escalating euro crisis the US stock market was holding up quite well, the dollar did not strengthen against the euro and inflation expectations was not declining – clear indications that the Fed was not “importing” monetary tightening from Europe. The markets clearly was of the view that if the euro zone crisis escalated the Fed would just step up quantitative ease (QE3). However, the Fed’s credibility once again seems to be under pressures. US stock markets have taken a beating, US inflation expectations have dropped sharply and the dollar has strengthened. It seems like Ben Bernanke is no Chuck Norris and he does not seem to master the Jedi mind trick anymore. So why is that?

Matt has the answer:

“I’ve seen a lot of strange stuff, but nothing quite as strange as the Fed’s reluctance to declare a target recently. Rather than announce a target, the Fed announces how much quantitative easing it will do. This is planning for failure. Quantitative easing without a target is more quantitative and less easing. Without an open-ended commitment that shocks expectations, the Fed has to buy more bonds to get less of a result. It’s the opposite of what the SNB has done.

Many economists have labored to bring us this knowledge — including a professor named Ben Bernanke — and yet the Fed mostly ignores it. I say mostly, because the Fed has said that it expects to keep short-term interest rates near zero through late 2014. But this sounds more radical than it is in reality. It’s not a credible promise because it’s not even a promise. It’s what the Fed expects will happen. So what would be a good way to shift expectations? Let’s start with what isn’t a good way.”

I agree – the Fed needs to formulate a clear nominal target andit needs to formulate a clear reaction function. How hard can it be? Sometimes I feel that central bankers like to work long hours and want to micromanage things.

UPDATE: Marcus Nunes and Bill Woolsey also comments on Matt’s piece..

Lets concentrate on the policy framework

Here is Scott Sumner:

I’ve noticed that when I discuss economic policy with other free market types, it’s easier to get agreement on broad policy rules than day-to-day discretionary decisions.

I have noticed the same thing – or rather I find that when pro-market economists are presented with Market Monetarist ideas based on the fact that we want to limit the discretionary powers of central banks then it is much easier to sell our views than when we just argue for monetary “stimulus”. I don’t want central bank to ease monetary policy. I don’t want central banks to tighten monetary policy. I simply want to central banks to stop distorting relative prices. I believe the best way to ensure that is with futures based NGDP targeting as this is the closest we get to the outcome that would prevail under a truly free monetary system with competitive issuance of money.

I have often argued that NGDP level targeting is not about monetary stimulus (See here, here and here) and argued that NGDP level targeting is the truly free market alternative (see here).

This in my view is the uniting view for free market oriented economists. We can disagree about whether monetary policy was too loose in the US and Europe prior to 2008 or whether it became too tight in 2008/9. My personal view is that both US and European monetary policy likely was (a bit!) too loose prior to 2008, but then turned extremely tight in 2008/09. The Great Depression was not caused by too easy monetary policy, but too tight monetary policy. However, in terms of policy recommendations is that really important? Yes it is important in the sense of what we think that the Fed or the ECB should do right now in the absence of a clear framework of NGDP targeting (or any other clear nominal target). However, the really important thing is not whether the Fed or the ECB will ease a little bit more or a little less in the coming month or quarter, but how we ensure the right institutional framework to avoid a future repeat of the catastrophic policy response in 2008/9 (and 2011!). In fact I would be more than happy if we could convince the ECB and the Fed to implement NGDP level target at the present levels of NGDP in Europe and the US – that would mean a lot more to me than a little bit more easing from the major central banks of the world (even though I continue to think that would be highly desirable as well).

What can Scott Sumner, George Selgin, Pete Boettke, Steve Horwitz, Bob Murphy and John Taylor all agree about? They want to limit the discretionary powers of central banks. Some of them would like to get rid of central banks all together, but as long as that option is not on the table they they all want to tie the hands of central bankers as much as possible. Scott, Steve and George all would agree that a form of nominal income targeting would be the best rule. Taylor might be convinced about that I think if it was completely rule based (at least if he listens to Evan Koeing). Bob of course want something completely else, but I think that even he would agree that a futures based NGDP targeting regime would be preferable to the present discretionary policies.

So maybe it is about time that we take this step by step and instead of screaming for monetary stimulus in the US and Europe start build alliances with those economists who really should endorse Market Monetarist ideas in the first place.

Here are the steps – or rather the questions Market Monetarists should ask other free market types (as Scott calls them…):

1) Do you agree that in the absence of Free Banking that monetary policy should be rule based rather than based on discretion?

2) Do you agree that markets send useful and appropriate signals for the conduct of monetary policy?

3) Do you agree that the market should be used to do forecasting for central banks and to markets should be used to implement policies rather than to leave it to technocrats? For example through the use of prediction markets and futures markets. (See my comments on prediction markets and market based monetary policy here and here).

4) Do you agree that there is good and bad inflation and good and bad deflation?

5) Do you agree that central banks should not respond to non-monetary shocks to the price level?

6) Do you agree that monetary policy can not solve all problems? (This Market Monetarists do not think so – see here)

7) Do you agree that the appropriate target for a central bank should be to the NGDP level?

I am pretty sure that most free market oriented monetary economists would answer “yes” to most of these questions. I would of course answer “yes” to them all.

So I suggest to my fellow Market Monetarists that these are the questions we should ask other free market economists instead of telling them that they are wrong about being against QE3 from the Fed. In fact would it really be strategically correct to argue for QE3 in the US right now? I am not sure. I would rather argue for strict NGDP level targeting and then I am pretty sure that the Chuck Norris effect and the market would do most of the lifting. We should basically stop arguing in favour of or against any discretionary policies.

PS I remain totally convinced that when economists in future discuss the causes of the Great Recession then the consensus among monetary historians will be that the Hetzelian-Sumnerian explanation of the crisis was correct. Bob Hetzel and Scott Sumner are the Hawtreys and Cassels of the day.

How much QE is needed with a NGDP target?

Today I got an interesting question: “does NGDP targeting equate to more quantitative easing (QE) of monetary policy?”.

The simple answer is that it all depends on Chuck Norris, or rather on the Chuck Norris effect. I have earlier defined the Chuck Norris effect in the following way:

“You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.”

Let’s say we have a central bank – for example the Federal Reserve that tomorrow announces a target for the level of nominal GDP (NGDP) 15% higher than the present level and that it will hit that target within 24 months.

The “clever” reader would of course ask how you can achieve that target with interest rates at near zero. Well, through quantitative easing, of course – by printing money. Or rather by increasing the supply of money more than the demand for money.

So the relevant measure is not the supply of money, but rather the supply of money relative to demand for the dollar. The demand for money of course is extremely dependent on the expectation of the future value of money.

So let’s assume that the announcement of the +15% NGDP level target is credible – what would happen? This announcement would effectively mean that the central bank would try to reduce the purchasing power of the money it issues, which effectively of course would equate to “burning” households and companies cash holdings. If we know that the value of cash we have today will be worth less tomorrow we would course do everything to get rid of that cash – that goes for households, banks, companies and institutions.

This is key for how the transmission mechanism works under credible NGDP level targeting. The expectation of a 15% increase in NGDP would cause de-hoarding of cash, which is the same as to say that private consumption and investments would increase, banks would increase lending (ease credit conditions) and the currency would weaken, which would spur exports. This would automatically lead to an increase in NGDP.

Hence, if the Chuck Norris effect is strong enough then the central bank could achieve its NGDP target without undertaking any QE at all.

In the “real world” it is unlikely that any central bank will be able to raise NGDP by 15% without actually increasing money supply. After all, the problem in the present crisis is exactly that the major central banks of the world are lacking credibility about their targets – otherwise for example market expectations in the eurozone would not be below 2%. Therefore, to get the needed credibility the central bank would probably need to announce clearly that it would undertake unlimited amounts of QE if needed to achieve its +15% NGDP target level and probably also define through which channel the increase in the money supply would occur – for example, through the buying of foreign currency (which in our view would probably be the most effective as you would circumvent the crisis-hit banking sector), or through buying or government or corporate bonds, etc.

However, if this were done it is likely that the goal of lifting NGDP by 15% could be achieved by printing significantly less “extra” money than if it simply implemented QE without a clear target of what it wants to achieve. So once again, the central banks need to call in Chuck Norris. It’s all about the anchoring of expectations and you will only achieve this by announcing a credit NGDP and credible strategy of how to achieve it.

Six central banks take action, but where is Chuck Norris?

Today, the Federal Reserve, the ECB, Bank of Canada, Bank of England, Bank of Japan and the Swiss National Bank announced a coordinated action to lower the pricing on the existing temporary US dollar liquidity swap arrangements by 50bp.

This is especially important the European financial sector, which remains underfunded in US dollars and as such the move from the central banks easing strains in the European financial markets.

Judging from the initial market reaction this is rightly taken to be monetary easing – especially easing of US monetary policy – stock prices rose, the dollar weakened and commodities prices spiked.

Monetary policy, however,  works primarily through expectations and since the six central banks who took action today have said nothing about what they want to achieve in terms of monetary policy targets we are unlikely to have a strong and long lasting impact of this. What we are missing here is the Chuck Norris effect. The central banks need to announce a target – for example that they want to increase NGDP in the euro zone by 10 or 15%.

I have already discussed a “crazy idea” to for the major global central banks to take action to ease monetary policy with a coordinated “devaluation” of the dollar, the euro, the yen etc. against a basket of commodities. Today’s action from the six central banks show that it can be done. Monetary policy is very powerful – so why not use it?
——
Update 1: Scott Sumner also has a comment on the global monetary action.

Update 2: I have in a number of previous post argued against discretionary monetary “stimulus” and argued that NGDP targeting is not about “fine tuning”. In that regard Market Monetarists should be skeptical about today’s monetary easing even though it is helpful in demonstrating the power of monetary policy and is at least helps curb the crisis – at least in the short-term. See my earlier comments: “Adam Posen calls for more QE – that’s fine, but…”, “NGDP targeting is not a Keynesian business cycle policy” and “Roth’s Monetary and Fiscal Framework for Economic Stability”

The Vitali Klitschko effect and “speculative attacks”

Here is Hungarian central bank governor Andras Simor:

“As for speculative attacks, I keep saying that [Ukrainian heavy weight champion boxer] Vitali Klitschko doesn’t get smacked on the street corner but the scrawny, bespectacled kid who is exempt from physical education classes does get beaten up, because they reckon he won’t hit back”

Recently the Hungarian forint has been “smacked”. Mr. Simor seems to indicate that the forint is no “Klitschko currency” – or rather that the reason for the sell-off in the forint is bad Hungarian fundamentals.

Hence, what Mr. Simor is saying is that there is no such thing as a “speculative attack”. Currencies does not just weaken out of the blue – there is always a reason and conspiracy theories rarely can explain market movements. Luckily for Hungary the country has a central bank governor who understand economics and markets.

The question is, however, who is the strongest – Chuck Norris or Vitali Klitschko? So while the Chuck Norris effect is saying that “You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target” the Vitali Klitschko effect says that “a central bank can only be credible if it has the proper firepower”.

 

Adam Posen calls for more QE – that’s fine, but…

Adam Posen who sits on the Bank of England’s Monetary Policy Committee (MPC) has a comment in on New York Times’ website.

Adam Posen is known to favour aggressive quantitatively easing in the present situation and in his piece he argues strongly that both the ECB and the Federal Reserve should follow the lead from the BoE and step up aggressive QE.

Posen rightly criticize the Fed, the BoE and the ECB with being too reluctant to do the “right thing” and in many ways his comments resembles my own critique of policy makers as being “Calvinist” in their thinking.

Posen is also right in arguing that more definitely is needed in both Europe and the US in terms of easing monetary conditions, but I have often argued that Market Monetarists are not in favour of discretionary policies (See here and here). We want to see QE within a proper framework of NGDP level targeting and not discretionary monetary “stunts”. The experience with both QE1 and QE2 in the US shows that unless is anchored within a proper framework then the impact on NGDP expectations are likely to be relatively short-lived.

I think that there might be some disagreement among Market Monetarists here and I guess that for example Scott Sumner would be happy to take whatever we can get, while I personally is more skeptical. If QE is done in an ad hoc fashion outside of a clearly defined policy framework then I fear it will undermine the longer-term arguments for NGDP level targeting. Some are already arguing that QE did not work – I think QE works very well if it is done within a proper framework, but how can we convince the skeptics?

That does of course not mean that I would vote against more QE if I for example was on the BoE’s MPC or the FOMC (there is no chance that will ever happen…). And it is quite obvious that the ECB need to ease monetary policy right now and rather aggressively – even within ECB’s present framework.

Anthony Evans seem to share my concerns about QE without a proper framework. See Anthony’s comment here and here.

See also Marcus Nunes and Scott Sumner on Adam Posen’s comment.

PS Theoretically I also disagree quite a bit with Posen as it seems like he think that the monetary transmission mechanism works primarily via lower bond yields. It’s basic MM knowledge that successful monetary easing (increased NGDP expectations) will increase bond yields. See my previous comment the transmission mechanism here. Even though I am skeptical about Posen’s call for ad hoc monetary easing I in fact think that monetary policy with the help of the Chuck Norris Effect is much more powerful than Posen seems to think.

Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief

Recently I in a post came up with what I described as a crazy idea – that might in fact not be so crazy.

My suggestion was based on what I termed the Chuck Norris effect of monetary policy – that a central banks can ease monetary policy without printing money if it has a credible target. The Swiss central bank’s (SNB) actions to introduce a one-sided peg for the Swiss franc against the euro have demonstrated the power of the Chuck Norris effect.

The SNB has said it will maintain the peg until deflationary pressures in the Swiss economy disappears. The interesting thing is that the markets now on its own is doing the lifting so when the latest Swiss consumer prices data showed that we in fact now have deflation in Switzerland the franc weakened against the euro because market participants increased their bets that the SNB would devalue the franc further.

In recent days the euro crisis has escalated dramatically and it is pretty clear that what we are seeing in the European markets is having a deflationary impact not only on the European economy, but also on the global economy. Hence, monetary easing from the major central banks of the world seems warranted so why do the ECB not just do what the SNB has done? For that matter why does the Federal Reserve, the Bank of England and the Bank of Japan not follow suit? The “crazy” idea would be a devaluation of euro, dollar, pound and yen not against each other but against commodity prices. If the four major central banks (I am leaving out the People’s Bank of China here) tomorrow announced that their four currencies had been devalued 15% against the CRB commodity index then I am pretty sure that global stock markets would increase sharply and the positive effects in global macro data would likely very fast be visible.

The four central banks should further announce that they would maintain the one-sided new “peg” for their currencies against CRB until the nominal GDP level of all for countries/regions have returned to pre-crisis trend levels around 10-15% above the present levels and that they would devalue further if NGDP again showed signs of contracting. They would also announce that the policies of pegging against CRB would be suspended once NGDP had returned to the pre-crisis trend levels.

If they did that do you think we would still talk about a euro crisis in two months’ time?

PS this idea is a variation of Irving Fisher’s compensated dollar plan and it is similar to the scheme that got Sweden fast and well out of the Great Depression. See Don Patinkin excellent paper on “Irving Fisher and His Compensated Dollar Plan” and Claes Berg’s and Lars Jonung’s paper on Swedish monetary policy in 1930s.

PPS this it not really my idea, but rather a variation of an idea one of my colleagues came up with – he is not an economist so that is maybe why he is able to think out of the box.

PPPS I real life I am not really a big supporter of coordinated monetary action and I think it has mostly backfired when central banks have tried to manipulate exchange rates. However, the purpose of this idea is really not to manipulate FX rates per se, but rather to ease global monetary conditions and the devaluation against CRB is really only method to increase money velocity.

The Chuck Norris effect, Swiss lessons and a (not so) crazy idea

Here is from The Street Light:

“You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?

It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September — most of which was after the announcement of the exchange rate minimum — the SNB’s foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB’s foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB’s purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.”

This is a very strong demonstration of the power of monetary policy when the central bank is credible. This is the Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target. (Nick Rowe and I like this sort of thing…)

And now to the (not so) crazy idea – if the SNB can ease monetary policy by announcing a devaluation why can’t the Federal Reserve and the ECB do it? Obviously some would say that not all central banks in the world can devalue at the same time – but they can. They can easily do it against commodity prices. So lets say that the ECB, the Federal Reserve, the Bank of Japan, the Bank of England and the SNB tomorrow announced a 15% devaluation against commodity prices (for example the CRB index) and that they will defend that one sided “peg” until the nominal GDP level returns to their pre-Great Recession trend levels. Why 15%? Because that is more or less the NGDP “gap” in the euro zone and the US.

The clever reader will notice that this is the coordinated and slightly more sexy version of Lars E. O. Svensson’s fool-proof way to escape deflation and the liquidity trap.

Is a coordinated 15% devaluation of the major currencies of the world (with the exception of RMB) a crazy idea? Yes, it is quite crazy and it could trigger all kind of political discussions, but I am pretty sure it would work and would very fast bring US and European NGDP back towards the pre-crisis trend. And for those who now scream at the screen “How the hell will higher commodity prices help us?” I will just remind you of the crucial difference between demand and supply driven increases in commodity prices. But okay, lets say we don’t want to do that – so lets instead do the following. The same central banks will “devalue” 15% against a composite index for stock prices in the US, the UK, the euro zone and Japan. Ok, I know you are very upset now. How can he suggest that? I am not really suggesting it, but I am arguing that monetary policy can easily work and all this “crazy idea” would actually do the trick and bring back NGDP back on track in both the US and Europe.  But you might have a better idea.

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