The un-anchoring of inflation expectations – 1970s style monetary policy, but now with deflation

In country after country it is now becoming clear that we are heading for outright deflation. This is particularly the case in Europe – both inside and outside the euro area – where most central banks are failing to keep inflation close to their own announced inflation targets.

What we are basically seeing is an un-anchoring of inflation expectations. What is happening in my view is that central bankers are failing to take responsibility for inflation and in a broader sense for the development in nominal spending. Central bankers simply are refusing to provide an nominal anchor for the economy.

To understand this process and to understand what has gone wrong I think it is useful to compare the situation in two distinctly different periods – the Great Inflation (1970s and earlier 1980s) and the Great Moderation (from the mid-1980s to 2007/8).

The Great Inflation – “Blame somebody else for inflation”

Monetary developments were quite similar across countries in the Western world during the 1970s. What probably best describes monetary policy in this period is that central banks in general did not take responsibility for the development in inflation and in nominal spending – maybe with the exception of the Bundesbank and the Swiss National Bank.

In Milton Friedman’s wonderful TV series Free to Choose from 1980 he discusses how central bankers were blaming everybody else than themselves for inflation (see here)

As Friedman points out labour unions, oil prices (the OPEC) and taxes were said to have caused inflation to have risen. That led central bankers like then Fed chairman Arthur Burns to argue that to reduce inflation it was necessary to introduce price and wage controls.

Friedman of course rightly argued that the only way to curb inflation was to reduce central bank money creation, but in the 1970s most central bankers had lost faith in the fundamental truth of the quantity theory of money.

Said in another way central bankers in the 1970s simply refused to take responsibility for the development in nominal spending and therefore for inflation. As a consequence inflation expectations became un-anchored as the central banks did not provide an nominal anchor. The result was predictable (for any monetarist) – the price level driffed aimlessly, inflation increased, became highly volatile and unpredictable.

Another thing which was characteristic about monetary policy in 1970s was the focus on trade-offs – particularly the Phillips curve relationship that there was a trade-off between inflation and unemployment (even in the long run). Hence, central bankers used high unemployment – caused by supply side factors – as an excuse not to curb money creation and hence inflation. We will see below that central bankers today find similar excuses useful when they refuse to take responsibility for ensuring nominal stability.

The Great Moderation – “Inflation is always and everywhere monetary phenomenon” 

That all started to change as Milton Friedman’s monetarist counterrevolution started to gain influence during the 1970s and in 1979 the newly appointed Federal Reserve chairman Paul Volcker started what would become a global trend towards central banks again taking responsibility for providing nominal stability and in the early 1990s central banks around the world moved to implement clearly defined nominal policy rules – mostly in the form of inflation targets (mostly around 2%) starting with the Reserve Bank of  New Zealand in 1990.

Said in the other way from the mid-1980s or so central banks started to believe in Milton Friedman’s dictum that “Inflation is always and everywhere monetary phenomenon” and more importantly they started to act as if they believed in this dictum. The result was predictable – inflation came down dramatically and became a lot more predictable and nominal spending/NGDP growth became stable.

By taking responsibility for nominal stability central banks around the world had created an nominal anchor, which ensured that the price mechanism in general could ensure an efficient allocation of resources. This was the great success of the Great Moderation period.

The only problem was that few central bankers understood why and how this was working. Robert Hetzel obvious was and still is a notable exception and he is telling us that reason we got nominal stability is exactly because central banks took responsibility for providing a nominal anchor.

That unfortunately ended suddenly in 2008.

The Great Recession – back to the bad habits of the 1970s

If we compare the conduct of monetary policy around the world over the past 5-6 years with the Great Inflation and Great Moderation periods I think it is very clear that we to a large extent has returned to the bad habits of the 1970s. That particularly is the case in Europe, while there are signs that monetary policy in the US, the UK and Japan is gradually moving back to practices similar to the Great Moderation period.

So what are the similarities with the 1970s?

1) Central banks refuse to acknowledge inflation (and NGDP growth) is a monetary phenomenon.

2) Central banks are concerned about trade-offs and have multiple targets (often none-monetary) rather focusing on one nominal target. 

Regarding 1) We have again and again heard central bankers say that they are “out of ammunition” and that they cannot ease monetary policy because interest rates are at zero – hence they are indirectly saying that they cannot control nominal spending growth, the money supply and the price level. Again and again we have heard ECB officials say that the monetary transmission mechanism is “broken”.

Regarding 2) Since 2008 central banks around the world have de facto given up on their inflation targets. In Europe for now nearly two years inflation has undershot the inflation targets of the ECB, the Riksbank, the Polish central bank, the Czech central bank and the Swiss National Bank etc.

And to make matters worse these central banks quite openly acknowledge that they don’t care much about the fact that they are not fulfilling their own stated inflation targets. Why? Because they are concerning themselves with other new (ad hoc!) targets – such as the development in asset prices or household debt.

The Swedish Riksbank is an example of this. Under the leadership of Riksbank governor the Stefan Ingves the Riksbank has de facto given up its inflation targeting regime and is now targeting everything from inflation, credit growth, property prices and household debt. This is completely ad hoc as the Riksbank has not even bothered to tell anybody what weight to put on these different targets.

It is therefore no surprise that the markets no longer see the Riksbank’s official 2% inflation target as credible. Hence, market expectations for Swedish inflation is consistency running below 2%. In 1970s the Riksbank failed because it effectively was preoccupied with hitting an unemployment target. Today the Riksbank is failing – for the same reason: It is trying to hit another other non-monetary target – the level of household debt.

European central bankers in the same way as in the 1970s no longer seem to understand or acknowledge that they have full control of nominal spending growth and therefore inflation and as a consequence they de facto have given up providing a nominal anchor for the economy. The result is that we are seeing a gradual un-anchoring of inflation expectations in Europe and this I believe is the reason that we are likely to see deflation becoming the “normal” state of affairs in Europe unless fundamental policy change is implemented.

Every time we get a new minor or larger negative shock to the European economy – banking crisis in Portugal or fiscal and political mess in France – we will just sink even deeper into deflation and since there is nominal anchor nothing will ensure that we get out of the deflationary trap. This is of course the “Japanese scenario” where the Bank of Japan for nearly two decade refused to take responsibility for providing an nominal anchor.

And as we continue to see a gradual unchoring of inflation expectations it is also clear that the economic system is becomimg increasingly dysfunctional and the price system will work less and less efficiently – exactly as in the 1970s. The only difference is really that while the problem in 1970s was excessively high inflation the problem today is deflation. But the reason is the same – central banks refusal to take responsibility for providing a nominal anchor.

Shock therapy is needed to re-anchor inflation expectations

The Great Inflation came to an end when central banks around the world finally took responsibility for providing a nominal anchor for the economy through a rule based monetary policy based on the fact that the central bank is in full control of nominal spending growth in the economy. To do that ‘shock therapy’ was needed.

For example example the Federal Reserve starting in 1979-82 fundamentally changed its policy and communication about its policy. It took responsibility for providing nominal stability. That re-anchored inflation expectations in the US and started a period of a very high level of nominal stability – stable and predictable growth in nominal spending and inflation.

To get back to a Great Moderation style regime central banks need to be completely clear that they take responsibility for for ensuring nominal stability and that they acknowledge that they have full control of nominal spending growth and as a consequence also the development in inflation. That can be done by introducing a clear nominal targeting – either restating inflation targets or even better introducing a NGDP targeting.

Furthermore, central banks should make it clear that there is no limits on the central bank’s ability to create money and controlling the money base. Finally central banks should permanently make it clear that you can’t have your cake and eat it – central banks can only have one target. It is the Tinbergen rule. There is one instrument – the money base – should the central bank can only hit one target. Doing anything else will end in disaster. 

The Federal Reserve and the Bank of Japan have certainly moved in that direction of providing a nominal anchor in the last couple of years, while most central banks in Europe – including most importantly the ECB – needs a fundamental change of direction in policy to achieve a re-anchoring of inflation expectations and thereby avoiding falling even deeper into the deflationary trap.

—-

PS This post has been greatly inspired by re-reading a number of papers by Robert Hetzel on the Quantity Theory of Money and how to understand the importance of central bank credibility. In that sense this post is part of my series of “Tribute posts” to Robert Hetzel in connection with his 70 years birthday.

PPS Above I assume that central banks have responsibility for providing a nominal anchor for the economy. After all if a central bank has a monopoly on money creation then the least it can do is to live up to this responsibility. Otherwise it seems pretty hard to argue why there should be any central bank at all.

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..

The thinking of a ”Great Moderation” economist

Imagine you are ”born” as a macroeconomists in the US or Europe around 1990. You are told that you are not allowed to study history and all you your thinking should be based on (apparent) correlations you observe from now on and going forward. What would you then think of the world?

First, you all you would see swings in economic activity and unemployment as basically being a result of swings in inventories and moderate supply shocks when oil prices drop or increase due to “geo-political” uncertainty in the Middle East. What is basically “white noise” in economic activity in a longer perspective (going back for example a 100 years) you will perceive as business cycles.

Second, inflation is anchored around 2% and you know that inflation normally tend to move back to this rate, but you really don’t care why that is the case. You will tell people that “globalisation” is the reason inflation remains low. But you also think that when inflation diverges from the 2% rate it is because geo-political uncertainty pushes oil prices up. Sometimes you will also refer to a rudimentary version of the Phillips curve where inflationary pressures increase when GDP growth is above what you define as trend-growth around 2-3%. But basically you don’t spend much time on the inflation process and even though you know that central banks target inflation you don’t really think of inflation as a monetary phenomenon.

Third, monetary policy is a focal point when you talk about economic policy. You will say things like “the Federal Reserve is increase interest rates because growth is strong”. For you think monetary policy is about controlling the level of interest rates. You never look at money supply numbers and have no real idea about how monetary policy is conduct (and you really don’t see why you should care). Central banks just cut or hike interest rates and central bankers have the same model as you so they move interest rates up or down according to a Taylor rule. And if somebody would to ask you about the “monetary transmission mechanism” you would have no clue about what they are talking about. But then you would explain that the central bank sets interest rates thereby control “the price of money” (this is here the Market Monetarist will be screaming!) and that this impact the investment and private consumption.

Forth, your world is basically “stationary” – GDP growth moves up and down 1-2%-point relative to trend growth of 2%. The same with inflation – inflation would more or less move around 2% +/- 1%-point. Given this and the Taylor rule it follows that interest rates will be moving up and down around what you will call the natural interest rate (you don’t know anything about Wicksell – and you don’t care what determine the natural interest rate). So sometimes interest rates moves up to 5-6% and sometime down to 2-3%.

What you off course does not realise is that what you are doing has nothing to do with macroeconomics. You are basically just observing “white noise” and trying to make sense of it and your economic analysis is basically empirical observations. You never heard of the Lucas critique so you don’t realise that observed empirical regularities is strictly dependent on what monetary policy regime you are in and you don’t realise that nominal GDP (NGDP) is growing closely around a 5% growth path and that mean that “macroeconomics” basically has disappeared. Everything is now really just about microeconomics.

And then disaster hits you right in the face! Nominal GDP collapses (you think it is a financial crisis). You are desperate because now the world is no longer “stationary”. All you models are not working anymore. What is happening? You are starting to make theories as you go alone (most of them without any foundation in logic analysis – crackpots have a field day). Now interest rates hit 0%. Your Taylor rule is telling you that central banks should cut interest rates to -7%. They can’t do that so that mean we are all doomed.

Then enters the Market Monetarists…they tell you that interest rates is not the price of money, that we are not doomed and central bank can ease monetary policy even with interest rates at zero if we just implement NGDP level targeting. You look at them and shake your head. They must be crazy. Haven’t they studied history?? They indeed have, but their history book started in 1929 and not in 1990.

The inverse relationship between central banks’ credibility and the credibility of monetarism

A colleague of mine today said to me ”Lars, you must be happy that you can be a monetarist again”. (Yes, I am a Market Monetarists, but I consider that to be fully in line with fundamental monetarist thinking…)

So what did he mean? In the old days – prior to the Great Moderation monetarists would repeat Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” and suddenly by the end of the 1970s and 1980s people that started to listen. All around the world central banks put in place policies to slow money supply growth and thereby bring down inflation. In the policy worked and inflation indeed started to come down around the world in the early 1980.

Central banks were gaining credibility as “inflation fighters” and Friedman was proven right – inflation is indeed always and everywhere a monetary phenomenon. However, then disaster stroke – not a disaster to the economy, but to the credibility of monetarism, which eventually led most central banks in the world to give up any focus on monetary aggregates. In fact it seemed like most central banks gave up any monetary analysis once inflation was brought under control. Even today most central banks seem oddly disinterested in monetary theory and monetary analysis.

The reason for the collapse of monetarist credibility was that the strong correlation, which was observed, between money supply growth and inflation (nominal GDP growth) in most of the post-World War II period broke down. Even when money supply growth accelerated inflation remained low. In time the relationship between money and inflation stopped being an issue and economic students around the world was told that yes, inflation is monetary phenomenon, but don’t think too much about it. Many young economists would learn think of the equation of exchange (MV=PY) some scepticism and as old superstition. In fact it is an identity in the same way as Y=C+I+G+X-M and there is no superstition or “old” theory in MV=PY.

Velocity became endogenous
To understand why the relationship between money supply growth and inflation (nominal GDP growth) broke down one has to take a look at the credibility of central banks.

But lets start out the equation of exchange (now in growth rates):

(1) m+v=p+y

Once central bankers had won credibility about ensure a certain low inflation rate (for example 2%) then the causality in (1) changed dramatically.

It used to be so that the m accelerated then it would fast be visible in higher p and y, while v was relatively constant. However, with central banks committed not to try to increase GDP growth (y) and ensuring low inflation – then it was given that central banks more or less started to target NGDP growth (p+y).

So with a credible central that always will deliver a fixed level of NGDP growth then the right hand side of (1) is fixed. Hence, any shock to m would be counteracted by a “shock” in the opposite direction to velocity (v). (This is by the way the same outcome that most theoretical models for a Free Banking system predict velocity would react in a world of a totally privatised money supply.) David Beckworth has some great graphs on the relationship between m and v in the US before and during the Great Moderation.

Assume that we have an implicit NGDP growth path target of 5%. Then with no growth in velocity then the money supply should also grow by 5% to ensure this. However, lets say that for some reason the money supply grow by 10%, but the “public” knows that the central bank will correct monetary policy in the following period to bring back down money to get NGDP back on the 5% growth path then money demand will adjust so that NGDP “automatically” is pushed back on trend.

So if the money supply growth “too fast” it will not impact the long-term expectation for NGDP as forward-looking economic agents know that the central bank will adjust monetary policy to bring if NGDP back on its 5% growth path.

So with a fixed NGDP growth path velocity becomes endogenous and any overshoot/undershoot in money supply growth is counteracted by a counter move in velocity, which ensures that NGDP is kept on the expected growth path. This in fact mean that the central banks really does not have to bother much about temporary “misses” on money supply growth as the market will ensure changes in velocity so that NGDP is brought back on trend. This, however, also means that the correlation between money and NGDP (and inflation) breaks down.

Hence, the collapse of the relation between money and NGDP (and inflation) is a direct consequence of the increased credibility of central banks around the world.

Hence, as central banks gained credibility monetarists lost it. However, since the outbreak of the Great Recession central banks have lost their credibility and there are indeed signs that the correlation between money supply growth and NGDP growth is re-emerging.

So yes, I am happy that people are again beginning to listen to monetarists (now in a improved version of Market Monetarism) – it is just sad that the reason once again like in the 1970s is the failure of central banks.

%d bloggers like this: