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PBoC should stop the silliness and float the RMB

This is morning we got this news (from Bloomberg):

China’s central bank conducted the biggest reverse-repurchase operations since September, adding funds to the financial system after money-market rates surged and equities slumped.

The People’s Bank of China offered 130 billion yuan ($19.9 billion) of seven-day reverse repos on Tuesday at an interest rate of 2.25 percent. The monetary authority suspended the operations in the last auction window on Dec. 31, ending a six-month run of cash injections that helped drive borrowing costs lower in an economy estimated to grow at the slowest pace in more than two decades.

The People’s Bank of China (PBoC) continues to behave as if there is not Tinbergen constraint, but the PBoC soon has to realize it cannot continue to try to ease monetary conditions through liquidity injects into the money markets, lowering of reserve requirements and cutting interest rates, while at the same time trying to maintain an artificially strong Renminbi.

What the PBoC effectively is doing it trying to ease monetary policy with the one hand, while at the same time tightening monetary policy with the other hand by intervening in the currency market to prop up the Renminbi.

Instead it is about time that PBoC either let the Renminbi float completely freely (which effectively would cause a significant depreciation of RMB) or implement a large devaluation – for example 30% – so to avoid any speculation of further devaluations and then introduce a peg to a basket of currency as hinted in December.

The problem with the present policy is that everybody in the market realizes that this is what we will get eventually and that has caused an escalation of the currency outflow from China and this outflow is likely to continue until the PBoC bites the bullet and introduce a completely new monetary regime. This halfway house will not stand for long and if the PBoC keeps fighting it the central bank will just do even more harm to the Chinese economy and potentially also cause an major banking crisis.

PBoC is not alone in making this mistake and the Tyranny of the Status Que is strong within central banks around the world. Two good example are Kazakhstan and Azerbaijan. Both countries have in recent months given up the tighten link to the US Dollar and devalued their currencies significantly. This in my view has been the right decision as both of these oil exporting countries have been suffering significantly from the continued decline in oil prices.

But neither the Kazakhstani nor the Azerbaijani central banks (and governments) have introduce new rule based monetary policy regimes. So one can say they have left the Dollar peg, but forgot to finish the job. Therefore policy makers in both countries should now focus on what regime should replace the Dollar peg. I would recommend an Export Price Norm for both countries, where their currencies are pegged to a basket of the oil prices and the currencies of the countries’ main trading partners.

And China need to do the same thing – not introducing an Export Price Norm, but rather let the Renminbi float and then introduce an NGDP target or a nominal wage growth target and it need to do it very soon to avoid an escalation of the financial distress.

The PBoC has the power to end this crisis right now by floating the Renminbi, but the longer this decision is postponed the bigger the risk of something blowing up becomes.

PS notice that despite the sharp rise in tensions between Saudi Arabia and Iran oil prices are now lower than on at the close of trading last week. That to me is a pretty strong indication just how worried that markets are about China.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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Malaysia has a freely floating Renggit – and thank god for that!

The Chinese surprise devaluation yesterday and has put currencies across Asia further under pressure. This is only a natural and the most stupid thing local Asian central bankers could do would be to fight it. Rather as China moves closer to a freely floating exchange rate it should inspire other Asian countries to do the same thing and I am therefore happy to see that the Vietnamese central bank this morning has widened the fluctuation band for the Dong and in that sense moved a bit closer to a freely floating Dong. Even though the hand has been forced somewhat by the PBoC’s devaluation yesterday it is nonetheless positive that we are seeing a move towards more freely floating exchange rates in Asia.

In that since it is not a “currency war”, but rather a liberation war, which in the end hopefully will secure monetary sovereignty to Asian nations such as Vietnam.

The floating Renggit is a blessing – also when it drops

This morning we are also seeing big moves in the Malaysian Renggit and the Renggit has already been under some pressure recently on the back of a worsening of Malaysia’s terms-of-trade and increased political uncertainty.

The sell-off in the Renggit has sparked some local concerns and the demands for the central bank to “do something” to prop up the Renggit are surely on the rise. However, it is extremely important to remember that the problem for Malaysia is not that the Renggit is weakening. Rarther the Renggit-weakness is a symptom of the shocks that have hit the Malaysian economy – lower commodity prices (Malaysia is a commodity exporter), increased political uncertainty and Chinese growth concerns.

None of this is good news for the Malaysian economy, but the fact that this is reflected in the Renggit is not a problem. Rather it would be a massive problem if Malaysia today had had a fixed exchange rate regime has was the case during the Asian crisis in 1997.

So the Malaysian central bank (BNM) should be saluted for sticking to the floating exchange rate policy, which has served Malaysia very well for nearly exactly a decade.

In fact BNM should move even closer to a purely free float and waste no opportunity to stress again and again that the value of the Renggit is determined by market forces and that the BNM’s sole purpose of monetary policy is to ensure nominal stability. The BNM should of course observe exchange rate developments in the sense it gives useful information about the monetary stance, but never again should the BNM try to peg or quasi-peg the Renggit to a foreign currency. That would be the recipe for disaster. As would such stupid ideas as currency and capital controls.

My friend Hishamh over at the Economics Malaysia blog has an extremely good post on his take on the Renggit situation. You should really read all of it. The post not only tells you why the freely floating Renggit is the right thing for Malaysia, but it is also extremely good in terms of making you understand why every (ok most…) countries in Asia should move in the direction of the kind of currency regime that they have in Malaysia.

Here is a bit of Hishamh’s excellent comments:

Another week, another multi-year low for the Ringgit. Since BNM appears to have stopped intervening, the Ringgit has continued to weaken against the USD, to what appears to be everyone’s consternation. There is this feeling that BNM should do something, anything, to halt the slide – cue: rumours over another Ringgit peg and capital controls.

To me, this is all a bit silly. Why should BNM lift a finger? Both economic theory and the empirical evidence is very clear – in the wake of a terms of trade shock, the real exchange rate should depreciate, even if it overshoots. NOT doing so would create a situation where the currency would be fundamentally overvalued, and we would therefore be risking another 1997-98 style crisis. Note the direction of causality here – it isn’t the weakening of the exchange rate that gave rise to the crisis, but rather the avoidance of the adjustment.

Pegging the currency under these circumstances would be spectacularly stupid. I’ll have more to say about this in my next post.

….

In the present circumstances, it’s not even clear why BNM should in fact intervene. You can make the argument that the Ringgit is fundamentally undervalued, and the FX market has overshot; but I have no idea why this is considered “bad”. If you want to live in a world of free capital flows, FX volatility is the price you pay.

… Malaysia’s latest numbers puts reserve cover at 7.6 months retained imports, and 1.1 times short term external debt, versus the international benchmark of 3 months and 1 times. Malaysia is at about par for the rest of the region, apart from outliers like Singapore and Japan.

Australia and France on the other hand, have just two months import cover, while the US, Canada and Germany keep just one month. You might argue that since these are advanced economies, there’s little concern over their international reserves. I would argue that that viewpoint is totally bogus. Debt defaults and currency crises were just as common in advanced economies under the Bretton Woods system. The lesson here is more about commitment to floating rather than the level of reserves. One can’t help but see the double standards involved here.

…All in all, this alarmism betrays a lack of general economic knowledge in Malaysia, even among people who should know better. Or maybe I’m being too harsh – it’s really a lack of knowledge of international macro and monetary economics.

…The Bank of Canada, the Reserve Bank of Australia, and the Reserve Bank of New Zealand, have all aggressively cut interest rates and talked down their own currencies – it’s the right thing to do in the face of a commodity price crash. BNM on the other hand has to walk and talk softly, softly, because Malaysians seem to think the Ringgit ought to defy economic laws.

Bravo! Please follow Hishamh! His blog posts are always good and insightful.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

The Euro – A Fiscal Strangulation Mechanism (but mostly for monetary reasons)

In my earlier post The Euro – A Fatal Conceit I argued that had the euro not be introduced and had we instead had freely floating exchange rates then “European taxpayers would (not) have had to pour billions of euros into bailing out Southern European and Eastern European government”. Said in another way had we not had the euro then there would not have been a European “debt crisis” or at least it would have been significantly smaller.

A simple way of illustrating this is to have a look at the debt development in the euro countries (and the countries pegged to the euro) and comparing that with the debt development in the European countries with floating exchange rates.

I use the same countries as in my previous post – The Euro – A Monetary Strangulation Mechanism. 21 euro countries (and countries pegged to the euro) and 10 countries with more or less floating exchange rates.

The graph below shows the development in (median) gross public debt (% of GDP) in the two groups of countries. (All countries are hence equally weighted).

debt change 2007 20014 floaters peggers

The picture is very clear – while both the floaters and the euro countries saw their public debt ratios increase sharply on the back of the 2008 shock (albeit less extremely for the floaters than for the euro countries) – from 2011 there is a very clear difference in the debt development.

Hence, from 2011 the floaters have seen as seen a gradual decline in gross public debt (as share of GDP), while the euro countries (and the peggers) have seen a steep increase in public indebtedness.

So while the floaters have seen their public debt increase by just above 10% of GDP from 2007 to 2014 the euro countries have seen a rise in public debt of more than 25% of GDP!

The graph below shows the individual breakdown of the data.

Publ debt green red

Again the picture is very clear – the euro countries (and the euro peggers) have had significantly more negative debt dynamics than the European floaters. Even if we disregard the PIIGS countries then the euro countries are on average doing a lot worse than the floaters in terms of public debt dynamics .

The euro countries are trying harder, but are succeeding less

One could of course argue that the difference in debt development simply reflects that some countries are just less prudent than other. However, the graph below shows that this is not a very good explanation.

Fiscal tightening

The graph shows the annual change in the fiscal stance (measured as the annual change in IMF’s estimate for the structural public balance as share of GDP). Positive (negative) values are a fiscal easing (tightening).

A few interesting conclusions emerge. First of all overall both euro countries and floaters seem to have had rather pro-cyclical fiscal policies – hence, both groups of countries eased fiscal policy in the ‘good years’ (2005-2009), but tightened the fiscal stance in the ‘bad years’ (2010-14.)

Second, it is notable that the fiscal stance of the euro countries and the floaters is highly correlated and is of a similar magnitude.

So even if the fiscal stance has an impact on growth in both groups of countries it seems a bit far-fetched to in general attribute the difference in real GDP growth between the two groups of countries to difference in the fiscal stance. That said, it seems like overall the euro countries and peggers have had a slightly more austere fiscal stance than the floaters after 2010. (Some – like Greece of course have seen a massive tightening of fiscal policy.)

This of course makes it even more paradoxical that the euro countries have had a significantly more negative debt dynamics than the floaters.

It is not a debt crisis – it is an NGDP crisis  

So we can conclude that the reason that the euro countries’ debt dynamics are a lot worse than the floaters is not because of less fiscal austerity, but rather the problem seems to be one of lacking growth in the euro countries. The graph below illustrates that.

NGDP debt

The graph plots the debt dynamics against the growth of nominal GDP from 2007 to 2014 for all 31 countries (both euro countries and the floaters).

The graph clearly shows that the countries, which have seen a sharp drop in nominal GDP such as Ireland and Greece have also seen the steepest increasing the public debt ratios. In fact Greece is nearly exactly on the estimated regression line, which implies that Greece has done exactly as good or bad as would be expected given the steep drop in Greek NGDP. This leaves basically no room for a ‘fiscal irresponsibility’ explanation for the rise in Greek public debt after 2007.

This of course nearly follows by definition – as we define the debt ratio as nominal public debt divided by nominal GDP. So when the denominator (nominal GDP) drops it follows by definition that the (debt) ratio increases. Furthermore, we also know that public sector expenditure (such as unemployment benefits) and tax revenues tend to be rather sensitive to changes in nominal GDP growth.

As a consequence we can conclude that the so-called ‘Europe debt crisis’ really is not about lack of fiscal austerity, but rather a result of too little nominal GDP growth.

And who controls NGDP growth? Well, overall NGDP growth in the euro zone is essentially under the full control of the ECB (remember MV=PY). This means that too tight monetary policy will lead to too weak NGDP growth, which in turn will cause an increase in public debt ratios.

In that regard it is worth noticing that it is hardly a coincidence that the ECB’s two unfortunate rate hikes in 2011 also caused a sharp slowdown in NGDP growth in certain euro zone countries, which in turn caused a sharp rise in public debt ratios as the first graph of this post clearly shows.

Consequently it would not be totally incorrect to claim that Jean-Claude Trichet as ECB-chief in 2011 played a major role in dramatically escalating the European debt crisis.

Had he not hiked interest rates in 2011 and instead pursued a policy of quantitative easing to get NGDP growth back on track then it seems a lot less likely that we would have seen the sharp increase in public debt ratios we have seen since 2011.

Of course that is not the whole story as the ECB does only control overall euro zone NGDP growth, but not the NGDP growth of individual euro zone countries. Rather the relative NGDP growth performance within the euro is determined by other factors such as particularly the initial external imbalances (the current account situation) when the shocks hit in 2008 (Lehman Brothers’ collapse) and 2011 (Trichet’s hikes.)

Hence, if a country like Greece with a large current account deficit is hit by a “funding shock” as in 2008 and 2011 then the country will have to have an internal devaluation (lower prices and lower wage growth) and the only way to achieve that is essentially through a deep recession.

However, that is not the case for countries with a floating exchange rate as a floating exchange country with a large current account deficit does not have to go through a recession to restore competitiveness – it just has to see a depreciation of its currency as Turkey as seen since 2008-9.

Concluding, the negative debt dynamics in the euro zone since 2008 are essentially the result of two things. 1) The misguided rate hikes in 2011 and 2) the lack of ability for countries with large current account deficits to see a nominal exchange rate depreciation.

The Euro is Fiscal Strangulation Mechanism, but for monetary reasons 

We can therefore conclude that the euro indeed has been a Fiscal Strangulation Mechanism as fiscal austerity has not been enough to stabilize the overall debt dynamics in a numbers of euro zone countries.

However, this is only the case because the ECB has first of all failed to offset the fiscal austerity by maintaining nominal stability (hitting its own inflation target) and second because countries, which initially had large current account deficits like Greece and Spain have not – contrary to the floaters – been able to restore competitiveness (and domestic demand) through a depreciation of their currencies as they essentially are “pegged” within the euro zone.

PS I have excluded Croatia from the data set as it is unclear whether to describe the Croatian kuna as a dirty float or a dirty peg. Whether or not Croatia is included in the sample does not change the conclusions.

Update: My friend Nicolas Goetzmann pointed out the Trichet ECB also hiked interest rates in 2008 and hence dramatically misjudged the situation. I fully agree with that, but my point in this post is not necessarily to discuss that episode, but rather to discuss the fiscal implications of the ECB’s failures and the problem of the euro itself.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

The high cost of currency (rouble) stability

This is from Reuters today:

“The Russian currency has opened higher Thursday, continuing its recovery from the biggest intraday drop since 1998 default on so-called ‘Black Tuesday’. The dollar was down 65 kopeks at the opening on the Moscow Exchange, while on the stock market, the dollar-denominated RTS index was up 6.5 percent. That’s was hours before President Vladimir Putin commenced his much-anticipated Q&A marathon, in which he’s expected to face tough economic questions about the ruble and turmoil in the financial markets. ….On Wednesday, the ruble jumped 6 percent against the US dollar to finish trading at 60.51 against the Greenback. On ‘Black Tuesday’ the ruble dipped to as low as 80 rubles against the US dollar and hit a threshold of 100 against the euro.”

So after a terrible start to the week the Russian rouble has stabilised over the past two days. However, the (temporary?) stabilisation of the rouble has not been for free. Far from it in fact. Just take a look at this story from ft.com also from today:

Russian banks are getting cautious about lending each other money, with the interest rate on three-month interbank loans hitting its highest since at least 2005. The three-month “mosprime” interbank lending rate has soared to 28.3 per cent, which is its highest since it hit its financial crisis peak of 27.6 in January 2009. The rate is also sharply higher than it reached on Wednesday – the day after the Central Bank of Russia hiked interest rates to 17 per cent to stem a plunge in the rouble – when it closed at 22.33. Stresses have been building in Russian economy because of Western sanctions and a sharp fall in the oil price But another reason for the mosprime spike is that Russian banks are unsure about the state of each other’s businesses. Russian bank customers have been rushing to withdraw their roubles out of their bank accounts and convert them to dollars or euros.

Hence, the rouble might have stabilised, but monetary conditions have been tightened dramatically. So the question is whether the benefits of a (more) stable rouble outweigh the costs of tighter monetary conditions?

We might get the answer by looking that the graph below. The consequence of higher interest rates in 2008-9 was a 10% contraction in real GDP. This week’s spike in money market rates is even bigger (and steeper) than the spike in rates in 2008-9. Is there any good reason why we should not expect a similar contraction in real GDP this time? I think not… MosPrime 3m RGDP

PS obviously I would be the first to acknowledge that money market rates is not the entire story about monetary contraction and money market rates are only used for illustrative purposes here. There are also some differences between 2008-9 and now, but it should nonetheless be noted that the recent drop in oil prices is similar to what we saw in 2008-9.

Turning the Russian petro-monetary transmission mechanism upside-down

Big news out of Moscow today – not about the renewed escalation of military fighting in Eastern Ukraine, but rather about Russian monetary policy. Hence, today the Russian central bank (CBR) under the leadership of  Elvira Nabiullina effectively let the ruble float freely.

The CBR has increasing allowed the ruble to float more and more freely since 2008-9 within a bigger and bigger trading range. The Ukrainian crisis, negative Emerging Markets sentiments and falling oil prices have put the ruble under significant weakening pressures most of the year and even though the CBR generally has allowed for a significant weakening of the Russian currency it has also tried to slow the ruble’s slide by hiking interest rates and by intervening in the FX market. However, it has increasingly become clear that cost of the “defense” of the ruble was not worth the fight. So today the CBR finally announced that it would effectively float the ruble.

It should be no surprise to anybody who is reading my blog that I generally think that freely floating exchange rates is preferable to fixed exchange rate regimes and I therefore certainly also welcome CBR’s decision to finally float the ruble and I think CBR governor Elvira Nabiullina deserves a lot of praise for having push this decision through (whether or not her hand was forced by market pressures or not). Anybody familiar with Russian economic-policy decision making will know that this decision has not been a straightforward decision to make.

Elvira has turned the petro-monetary transmission mechanism upside-down

The purpose of this blog post is not necessarily to specifically discuss the change in the monetary policy set-up, but rather to use these changes to discuss how such changes impact the monetary transmission mechanism and how it changes the causality between money, markets and the economy in general.

Lets first start out with how the transmission mechanism looks like in a commodity exporting economy like Russia with a fixed (or quasi fixed) exchange rate like in Russia prior to 2008-9.

When the Russian ruble was fixed against the US dollar changes in the oil price was completely central to the monetary transmission – and that is why I have earlier called it the petro-monetary transmission mechanism. I have earlier explained how this works:

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

This effectively means that in such a set-up the CBR will have given up monetary sovereignty and instead will “import” monetary policy via the oil price and the exchange rate. In reality this also means that the global monetary superpower (the Fed and PBoC) – which to a large extent determines the global demand for oil indirectly will determine Russian monetary conditions.

Lets take the case of the People’s Bank of China (PBoC). If the PBoC ease monetary policy – increase monetary supply growth – then it will increase Chinese demand for oil and push up oil prices. Higher oil prices will push up currency inflows into Russia and will cause appreciation pressure on the ruble. If the ruble is pegged then the CBR will have to intervene to keep the ruble from strengthening. Currency intervention of course is the same as sell ruble and buying foreign currency, which equals an increase in the Russian money base/supply. This will push up Russian nominal GDP growth.

Hence, causality runs from the monetary policy of the monetary superpowers – Fed and the PBoC – to Russian monetary policy as long as the CBR pegs or even quasi-peg the ruble. However, the story changes completely when the ruble is floated.

I have also discussed this before:

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

If today’s announced change in monetary policy set-up in Russia is taken to be credible (it is not necessary) then it would mean the completion of the transformation of the monetary transmission which essentially was started in 2008 – moving from a pegged exchange/manage float regime to a floating exchange rate.

This will also means that the CBR governor Elvira Nabiullina will have ensured full monetary sovereignty – so it will be her rather than the Federal Reserve and the People’s Bank of China, who determines monetary conditions in Russia.

Whether this will be good or bad of course fully dependent on whether Yellen or Nabiullina will conduct the best monetary policy for Russia.

One can of course be highly skeptical about the Russian central bank’s ability to conduct monetary policy in a way to ensure nominal stability – there is certainly not good track record, but given the volatility in oil prices it is in my view also hard believe that a fully pegged exchange rate would bring more nominal stability to the Russian economy than a floating exchange rate combined with a proper nominal target – either an inflation target or better a NGDP level target.

Today Elvira Nabiullina has (hopefully) finalized the gradual transformation from a pegged exchange to a floating exchange rate. It is good news for the Russian economy. It will not save the Russia from a lot of other economic headaches (and there are many!), but it will at least reduce the risk of monetary policy failure.

PS I still believe that the Russian economy is already in recession and will likely fall even deeper into recession in the coming quarters.

 

 

Monetary sovereignty is incompatible with inflation targeting

When I started working in the financial sector nearly 15 years ago – after 5 years working for government – one thing that really puzzled me was how my new colleagues (both analysts and traders) where thinking about exchange rates.

As a fairly classically thinking economist I had learned to think of exchange rates in terms of the Purchasing Power Parity. After all why should we expect there to be a difference between the price of a Big Mac in Stockholm and Brussels? Obviously I understood that there could be a divergence from PPP in the short-run, but in the long-run PPP should surely expected to hold.

Following the logic of PPP I would – in the old days – have expected that when an inflation number was published for a country and the number was higher than expected the currency of the country would weaken. However, this is not how it really was – and still is – in most countries. Hence, I was surprised to see that upside surprises on the inflation numbers led to a strengthening of the country’s currency. What I initially failed to understand was that the important thing is not present inflation, but rather the expected future changes to monetary policy.

What of course happens is that if a central bank has a credible inflation target then a higher than expected inflation number will lead market participants to expect the central bank to tighten monetary policy.

Understanding exchange rate dynamic is mostly about understanding monetary policy rules

But what if the central bank is not following an inflation-targeting rule? What if the central bank doesn’t care about inflation at all? Would we then expect the market to price in monetary tightening if inflation numbers come in higher than expected? Of course not.

A way to illustrate this is to think about two identical countries – N and C. Both countries are importers of oil. The only difference is that country N is targeting the level of nominal GDP, while country C targets headline inflation.

Lets now imagine that the price of oil suddenly is halved. This is basically a positive supply to both country N and C. That causes inflation to drop by an equal amount in both countries. Realizing this market participants will know that the central bank of country C will move to ease monetary policy and they will therefore move reduce their holdings of C’s currency.

On the other hand market participants also will realize that country N’s central bank will do absolutely nothing in response to the positive supply shock and the drop in inflation. This will leave the exchange of country N unchanged.

Hence, we will see C’s currency depreciate relatively to N’s currency and it is all about the differences in monetary policy rules.

Exchange rates are never truly floating under inflation targeting

I also believe that this example actually illustrates that we cannot really talk about freely floating exchange rates in countries with inflation targeting regimes. The reason is that external shifts in the demand for a given country’s currency will in itself cause a change to monetary policy.

A sell-off in the currency causes the inflation to increase through higher import prices. This will cause the central bank to tighten monetary policy and the markets will anticipate this. This means that external shocks will not fully be reflected in the exchange rate. Even if the central bank does to itself hike interest rates (or reduce the money base) the market participants will basically automatically “implement” monetary tightening by increasing demand for the country’s currency.

This also means that an inflation targeting nearly by definition will respond to negative supply shocks by tightening monetary policy. Hence, negative external shocks will only lead to a weaker currency, but also to a contraction in nominal spending and likely also to a contraction in real GDP growth (if prices and wages are sticky).

Monetary policy sovereignty and importing monetary policy shocks

This also means that inflation targeting actually is reducing monetary policy sovereignty. The response of some Emerging Markets central banks over the past year illustrates well.

Lets take the example of the Turkish central bank. Over the past the year the Federal Reserve has initiated “tapering” and the People’s Bank of China has allowed Chinese monetary conditions to tighten. That has likely been the main factors behind the sell-off in Emerging Markets currencies – including the Turkish lira – over the past year.

The sell-off in Emerging Markets currencies has pushed up inflation in many Emerging Markets. This has causes inflation targeting central banks like the Turkish central bank (TCMB) to tighten monetary policy. In that sense one can say that the fed and PBoC have caused TCMB to tighten monetary policy. The TCMB hence doesn’t have full monetary sovereignty. Or rather the TCMB has chosen to not have full monetary policy sovereignty.

This also means that the TCMB will tend to import monetary policy shocks from the fed and the PBoC. In fact the TCMB will even import monetary policy mistakes from these global monetary superpowers.

The global business cycle and monetary policy rules

It is well-known that the business cycle is highly correlated across countries. However, in my view that doesn’t have to be so and it is strictly a result of the kind of monetary policy rules central banks follow.

In the old days of the gold standard or the Bretton Woods system the global business cycle was highly synchronized. However, one should have expected that to have broken down as countries across the world moved towards officially having floating exchange rates. However, that has not fully happened. In fact the 2008-9 crisis lead to a very synchronized downturn across the globe.

I believe the reason for this is that central banks do in fact not fully have floating exchange rate. Hence, inflation targeting de facto introduces a fear-of-floating among central banks and that lead central banks to import external shocks.

That would not have been the case if central banks in general targeted the level of NGDP (and ignored supply shocks) instead of targeting inflation.

So if central bankers truly want floating exchanges – and project themselves from the policy mistakes of the fed and the PBoC – they need to stop targeting inflation and should instead target NGDP.

PS It really all boils down to the fact that inflation targeting is a form of managed floating. This post was in fact inspired by Nick Rowe’s recent blog post What is a “managed exchange rate”?

Please don’t fight it – the risk of EM policy mistakes

Emerging Markets are once again back in the headlines in the global financial media – from Turkey to Argentina market volatility has spiked from the beginning of the year.

The renewed Emerging Markets volatility has caused some commentators to claim that the crisis back. It migtht be, but also I think it is very important to differentiate between currency movements on its own and the underlying reasons for these movements and in this post I will argue that currency movements in itself is not necessarily a problem. In fact floating exchange rate regimes mean that the currency will move in response to shocks, which ideally should reduce macroeconomic volatility.

Imagine this would have been 1997

I think it is illustrative to think about what is going on in Emerging Markets right now by imagining that the dominant monetary and exchange rate regime had been pegged exchange rates as it was back in 1997 when the Asian crisis hit.

Lets take the case of Turkey and lets assume Turkey is operating a pegged exchange rate regime – for example against the US dollar. And lets at the same time note that Turkey presently has a current account deficit of around 7% of GDP. This current account deficit is nearly fully funded by portfolio inflows from abroad – for example foreign investors buying Turkish bonds and equities.

As long as investors are willing to buy these assets there is no problem. But then one day investors decide to close down their positions in Turkey – for example because of they expect the dollar to appreciate because of the Federal Reserve tightening monetary conditions or because investors simply become more risk averse for example because of concerns about Chinese growth. Lets assume this leads to a “sudden stop”. From day-to-day the funding of Turkey’s 7% current account deficit disappears.

Now Turkey has a serious funding problem. Turkey either needs to attract investors to fund the current account deficit or it needs to close the current account deficit immediately. The first option is unlikely to work in the short-term. So the current account deficit needs to be closed. That can happen either by a collapse in imports and/or through spike in exports.

To “force” this process the central bank will have to tighten monetary conditions dramatically. This happens “automatically” in a fixed exchange rate regime. As money leaves the country the lira comes under pressures. The central bank will then intervene in the market to curb to the currency from weakening thereby reducing the foreign currency reserve and in parallel the money base drops. The drying up of liquidity will also send money market rate spiking. This is a sharp tightening of monetary conditions. The result is a collapse in private consumption, investments, asset prices and increased deflationary pressures (inflation and wage growth drop). An internal devaluation will be underway. The result is normally a sharp increase in public and private debt ratios as nominal GDP collapses.

This process will effectively continue until the current account deficit is gone. This would cause a massive collapse in economic activity and as asset prices and growth expectations drop financial distress also increases dramatically, which could set-off a financial crisis.

This is the kind of scenario that played out during the Asian crisis in 1997, but it is also what happened in Turkey in 2001 and forced the Turkish government to eventually give up a failed pegged (crawling) peg regime.

Luckily we have floating exchange rates in most Emerging Markets

Compare that to what has been going on the Emerging Markets over the past 6-7 months. We have seen widespread sell-off in Emerging Markets and yes we have seen growth expectations being adjusted down (mostly because some EM central banks have been fighting the sell-off by tightening monetary policy). BUT we have not seen financial crisis and we have not seen a collapse in Emerging Markets property markets. We have not seen major negative spill-over to developed markets. Hence, the sell-off in Emerging Markets currencies cannot be called a macroeconomic or a financial crisis.

In fact the sell-off in EM currencies means that we have avoided exactly the 1997 scenario. That is not to say that everything is fine. It is not. Anybody who have been following the still ongoing corruption scandal in Turkey or the demonstrations in Ukraine and Thailand know these countries are struggling with some real fundamental political and economic troubles. In fact I fear that a number of Emerging Markets countries at the moment are seeing an erosion of their long-term growth potential due to regime uncertainty and general macroeconomic mismanagement. But we are not seeing an unnecessary economic, financial and political collapse induced by a foolish exchange rate regime. Luckily most Emerging Markets today have floating exchange rate regimes.

But some foolishness remain   

So yes, I believe we – and the populations in most Emerging Markets – are lucky that fixed exchange rate regimes mostly are a thing of the past in Emerging Markets today, but unfortunately it is not all Emerging Markets central bankers who have learned the lesson. Hence, many central bankers still suffer from a fear-of-floating.

Just take the Turkish central bank (TCMB). On Tuesday it will hold an emergency monetary policy meeting to discuss measures to curb the sell-off in the lira. Officially it about ensuring “price stability”, but the decision to have an emerging meeting only a week after a regular monetary policy meeting smells of desperation on part of the TCMB.

It is widely expected that the TCMB will hike its key policy rate – the market is already pricing a rate hike in the order of 200bp. If the TCMB delivers this then it will only have marginal impact on the lira – if the TCMB delivers more then it could prop up the lira at least for the short-run. But a larger than expected rate hike would also be constitute monetary policy tightening and given the present sentiment in the global Emerging Markets the TCMB likely will have to do something very aggressive to have a major impact on the lira. And what would the outcome be? Well, it is pretty easy – we would get a major contraction in Turkish growth to well-below potential growth in the Turkish economy.

Given the fact that inflation expectations (24 month ahead) is around 7% and hence the TCMB official 5% inflation target there might certainly be a need for a moderate tightening of monetary policy in Turkey, but should that happen as an abrupt tightening, which would send the Turkish economy into recession? I think that would be foolish. The TCMB should instead try to get over its fear-of-floating and focus on ensuring nominal stability. It is failing to do that right now by pursuing what mostly look like 1970s style stop-go policies.

Luckily the stop-go policies of TCMB is no longer the norm for Emerging Markets central banks who generally seem to understand that the level of the exchange rate is best left to the market to determine.

PS see also my preview on Tuesday’s Turkish monetary policy meeting here.

PPS This post is about value of floating exchange rates and even though I think floating exchange rate regimes now substantially reduce the risk of major Emerging Markets financial and economic crisis I am certainly not unworried about the state of Emerging Markets. I already noted my structural concerns in a number of Emerging Markets, but I am even more worried about the monetary induced slowdown in Chinese growth and I am somewhat worried that the PBoC might “mis-step” and cause a major financial and economic crisis in China with global ramifications particularly is it fails to keep the eye on the ball and instead gets preoccupied with fighting bubbles.

Update: My friend in Malaysia Hishamh tells the same story, but focusing on Malaysia.

The antics of FX intervention – the case of Turkey

I have often been puzzled by central banks’ dislike of currency flexibility. This is also the case for many central banks, which officially operating floating exchange rate regimes.

The latest example of this kind of antics is the Turkish central bank’s recent intervention to prop as the Turkish lira after it has depreciated significantly in connection with the recent political unrest. This is from cnbc.com:

“On Monday, the Turkish central bank attempted to stop the currency’s slide by selling a record amount of foreign-exchange reserves in seven back-to-back auctions. The bank sold $2.25 billion dollars, or around 5 percent of its net reserves, to shore up its currency – the most it has ever spent to do so”

A negative demand shock in response to a supply shock

I have earlier described the political unrest in Turkey as a negative supply shock and it follows naturally from currency theory that a negative supply shock is negative for the currency and in that sense it shouldn’t be a surprise that the political unrest has caused the lira to weaken. One can always discuss the scale of the weakening, but it is hard to dispute that increased ‘regime uncertainty’ should cause the lira to weaken.

It follows from ‘monetary theory 101’ that central banks should not react to supply shocks – positive or negative. However, central banks are doing that again and again nonetheless and the motivation often is that central banks see market moves as “excessive” or “irrational” and therefore something they need to “correct”. This is probably also the motivation for the Turkish central bank. But does that make any sense economically? Not in my view.

We can illustrate the actions of the Turkish central bank in a simple AS/AD framework.

AS AD SRAS shock Turkey

The political unrest has increased ‘regime uncertainty’, which has shifted the short-run aggregate supply curve (SRAS) to the left. This push up inflation to P’ and output/real GDP drops to Y’.

In the case of a nominal GDP targeting central bank that would be it. However, in the case of Turkey the central bank (TCMB) has reacted by effectively tightening monetary conditions. After all FX intervention to prop up the currency is “reverse quantitative easing” – the TCMB has effectively cut the money base by its actions. This a negative demand shock.

In the graph this mean that the AD curve shifts  to the left from AD to AD’. This will push down inflation to P” and output to Y”.

In the example the combined impact of a supply shock and the demand shock is an increase in inflation. However, that is not necessarily given and dependent the shape of the SRAS curve and the size of the demand shock.

However, more importantly there is no doubt about the impact on real GDP growth – it will contract and the FX intervention will exacerbate the negative effects of the initial supply shock.

So why would the central bank intervene? Well, if we want to give the TCMB the benefit of the doubt the simple reason is that the TCMB has an inflation target. And since the negative supply shock increases inflation one could hence argue that the TCMB is “forced” by its target to tighten monetary policy. However, if that was the case why intervene in the FX market? Why not just use the normal policy instrument – the key policy interest rates?

My view is that this is a simple case of ‘fear-of-floating’ and the TCMB is certainly not the only central bank to suffer from this irrational fear. Recently the Polish central bank has also intervened to prop up the Polish zloty despite the Polish economy is heading for deflation in the coming months and growth is extremely subdued.

The cases of Turkey and Poland in my view illustrate that central banks are often not guided by economic logic, but rather by political considerations. Mostly central banks will refuse to acknowledge currency weakness is a result of for example bad economic policies and would rather blame “evil speculators” and “irrational” behaviour by investors and FX intervention is hence a way to signal to voters and others that the currency sell-off should not be blamed on bad policies, but on the “speculators”.

In that sense the central banks are the messengers for politicians. This is what Turkish Prime Minister Erdogan recently had to say about what he called the “interest rate lobby”:

“The lobby has exploited the sweat of my people for years. You will not from now on…

…Those who attempt to sink the bourse, you will collapse. Tayyip Erdogan is not the one with money on the bourse … If we catch your speculation, we will choke you. No matter who you are, we will choke you

…I am saying the same thing to one bank, three banks, all banks that make up this lobby. You have started this fight against us, you will pay the high price for it.

..You should put the high-interest-rate lobby in their place. We should teach them a lesson. The state has banks as well, you can use state banks.”

So it is the “speculators” and the banks, which are to blame. Effectively the actions of the TCMB shows that the central banks at least party agrees with this assessment.

Finally, when a central bank intervenes in the currency market in reaction to supply shocks it is telling investors that it effectively dislikes fully floating exchange rates and therefore it will effectively reduce the scope of currency adjustments to supply shocks. This effective increases in the negative growth impact of the supply shock. In that sense FX intervention is the same as saying “we prefer volatility in economic activity to FX volatility”. You can ask yourself whether this is good policy or not. I think my readers know what my view on this is.

Update: I was just reminded of a quote from H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”

Friedman, Schuler and Hanke on exchange rates – a minor and friendly disagreement

Before Arthur Laffer got me very upset on Monday I had read an excellent piece by Kurt Schuler on Freebanking.org about Milton Friedman’s position on floating exchange rates versus fixed exchange rates.

Kurt kindly refers to my post on differences between the Swedish and Danish exchange regimes in which I argue that even though Milton Friedman as a general rule prefered floating exchange rates to fixed exchange rates he did not argue that floating exchange rates was always preferable to pegged exchange rates.

Kurt’s comments at length on the same topic and forcefully makes the case that Friedman is not the floating exchange rate proponent that he is sometimes made up to be. Kurt also notes that Steve Hanke a couple of years ago made a similar point. By complete coincidence Steve had actually a couple of days ago sent me his article on the topic (not knowing that I actually had just read it recently and wanted to do a post on it).

Both Kurt and Steve are proponents of currency boards – and I certainly think currency boards under some circumstances have some merit – so it is not surprising they both stress Friedman’s “open-mindeness” on fixed exchange rates. And there is absolutely nothing wrong in arguing that Friedman was pragmatic on the exchange rate issue rather than dogmatic. That said, I think that both Kurt and Steve “overdo” it a bit.

I certainly think that Friedman’s first choice on exchange rate regime was floating exchange rates. In fact I think he even preffered “dirty floats” and “managed floats” to pegged exchange rates. When I recently reread his memories (“Two Lucky People”) I noted how often he writes about how he advised governments and central bank officials around the world to implement a floating exchange rate regime.

In “Two Lucky People” (page 221) Friedman quotes from his book “Money Mischief”:

“…making me far more skeptical that a system of freely floating exchange rates is politically feasible. Central banks will meddle – always, of corse, with the best of intentions. Nevertheless, even dirty floating exchange rates seem to me preferable to pegged rates, though not necessarily to a unified currency”

I think this quote pretty well illustrates Friedman’s general position: Floating exchange rates is the first choice, but under some circumstances pegged exchange rates or currency unions (an “unified currency”) is preferable.

On this issue I find myself closer to Friedman than to Kurt’s and Steve’s view. Kurt and Steve are both long time advocates of currency boards and hence tend to believe that fixed exchange rates regimes are preferable to floating exchange rates. To me this is not a theoretical discussion, but rather an empirical and practical position.

Finally, lately I have lashed out at some US free market oriented economists who I think have been intellectually dishonest for partisan reasons. Kurt and Steve are certainly not examples of this and contrary to many of the “partisan economists” Kurt and Steve have great knowledge of monetary theory and history. In that regard I am happy to recommend to my readers to read Steve’s recent piece on global monetary policy. See here and here. You should not be surprised to find that Steve’s position is that the main problem today is too tight rather than too easy monetary policy – particularly in the euro zone.

PS I should of course note that Kurt is a Free Banking advocate so he ideally prefers Free Banking rather anything else. I have no disagreement with Kurt on this issue.

PPS Phew… it was much nicer to write this post than my recent “anger posts”.

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Related post:
Schuler on money demand – and a bit of Lithuanian memories…

Exchange rates are not truly floating when we target inflation

There is a couple of topics that have been on my mind lately and they have made me want to write this post. In the post I will claim that inflation targeting is a soft-version of what economists have called the fear-of-floating. But before getting to that let me run through the topics on my mind.

1) Last week I did a presentation for a group of Norwegian investors and even thought the topic was the Central and Eastern European economies the topic of Norwegian monetary politics came up. I am no big expert on the Norwegian economy or Norwegian monetary policy so I ran for the door or rather I started to talk about an other large oil producing economy, which I know much better – The Russian economy. I essentially re-told what I recently wrote about in a blog post on the Russian central bank causing the 2008/9-crisis in the Russian economy, by not allowing the ruble to drop in line with oil prices in the autumn of 2008. I told the Norwegian investors that the Russian central bank was suffering from a fear-of-floating. That rang a bell with the Norwegian investors – and they claimed – and rightly so I think – that the Norwegian central bank (Norges Bank) also suffers from a fear-of-floating. They had an excellent point: The Norwegian economy is booming, domestic demand continues to growth very strongly despite weak global growth, asset prices – particularly property prices – are rising strongly and unemployment is very low and finally do I need to mention that Norwegian NGDP long ago have returned to the pre-crisis trend? So all in all if anything the Norwegian economy probably needs tighter monetary policy rather than easier monetary policy. However, this is not what Norges Bank is discussing. If anything the Norges Bank has recently been moving towards monetary easing. In fact in March Norges Bank surprised investors by cutting interest rates and directly cited the strength of the Norwegian krone as a reason for the rate cut.

2) My recent interest in Jeff Frankel’s idea that commodity exporters should peg their currency to the price of the main export (PEP) has made me think about the connect between floating exchange rates and what monetary target the central bank operates. Frankel in one of his papers shows that historically there has been a rather high positive correlation between higher import prices and monetary tightening (currency appreciation) in countries with floating exchange rates and inflation targeting. The mechanism is clear – strict inflation targeting central banks an increase in import prices will cause headline inflation to increase as the aggregate supply curve shots to the left and as the central bank does not differentiate between supply shocks and nominal shocks it will react to a negative supply shock by tightening monetary policy causing the currency to strengthen. Any Market Monetarist would of course tell you that central banks should not react to supply shocks and should allow higher import prices to feed through to higher inflation – this is basically George Selgin’s productivity norm. Very few central banks allow this to happen – just remember the ECB’s two ill-fated rate hikes in 2011, which primarily was a response to higher import prices. Sad, but true.

3) Scott Sumner tells us that monetary policy works with long and variable leads. Expectations are tremendously important for the monetary transmission mechanism. One of the main channels by which monetary policy works in a small-open economy  – with long and variable leads – is the exchange rate channel. Taking the point 2 into consideration any investor would expect the ECB to tighten monetary policy  in responds to a negative supply shock in the form of a increase in import prices. Therefore, we would get an automatic strengthening of the euro if for example oil prices rose. The more credible an inflation target’er the central bank is the stronger the strengthening of the currency. On the other hand if the central bank is not targeting inflation, but instead export prices as Frankel is suggesting or the NGDP level then the currency would not “automatically” tend to strengthen in responds to higher oil prices. Hence, the correlation between the currency and import prices strictly depends on what monetary policy rule is in place.

These three point leads me to the conclusion that inflation targeting really just is a stealth version of the fear-of-floating. So why is that? Well, normally we would talk about the fear-of-floating when the central bank acts and cut rates in responds to the currency strengthening (at a point in time when the state of the economy does not warrant a rate cut). However, in a world of forward-looking investors the currency tends move as-if we had the old-fashioned form of fear-of-floating – it might be that higher oil prices leads to a strengthening of the Norwegian krone, but expectations of interest rate cuts will curb the strengthen of NOK. Similarly the euro is likely to be stronger than it otherwise would have been when oil prices rise as the ECB again and again has demonstrated the it reacts to negative supply shocks with monetary easing.

Exchange rates are not truly floating when we target inflation 

And this lead me to my conclusion. We cannot fundamentally say that currencies are truly floating as long as central banks continue to react to higher import prices due to inflation targeting mandates. We might formally have laid behind us the days of managed exchange rates (at least in North America and Europe), but de facto we have reintroduced it with inflation targeting. As a consequence monetary policy becomes excessively easy (tight) when import prices are dropping (increasing) and this is the recipe for boom-bust. Therefore, floating exchange rates and inflation targeting is not that happy a couple it often is made out to be and we can fundamentally only talk about truly floating exchange rates when monetary policy cease to react to supply shocks.

Therefore, the best way to ensure true exchange rates flexibility is through NGDP level targeting and if we want to manage exchange rates then at least do it by targeting the export price rather than the import price.

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