All posts tagged Milton Friedman

I can hear Uncle Milty scream from upstairs – at James Bullard

The St. Louis Fed has long been a bastion of monetarist thinking, but something has changed at the Eighth Federal Reserve District. Here is St. Louis Fed president James Bullard in an interview with Bloomberg:

“Treasury yields have gone to extraordinarily low levels. That took some of the pressure off the FOMC since a lot of our policy actions would be trying to get exactly that result.”

I can only imagine how Milton Friedman would have reacted to this kind of statement – most likely he would have said something like this:

“Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy..After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Friedman said that in 1998. 14 years later central bankers still make the same mistakes. It is incredible. It makes you want to scream and it is especially frustrating when you hear it from the president of a Fed district with a strong monetarist traditions. Just sad…

HT Matt O’Brien

Update 1: Josh Hendrickson was so kind to remind me about this Friedman quote from Milton Friedman’s Monetary Framework (1974):

“On still another level, the approach is consistent with much of the work that Fisher did on interest rates, and also the more recent work by Anna Schwartz and myself, Gibson, Kaufman, Cagan, and others.  In particular, the approach provides an interpretation of the empirical generalization that high interest rates mean that money has been easy, in the sense of increasing rapidly, and low interest rates, that money has been tight, in the sense of increasing slowly, rather than the reverse.”

Update 2: Vaidas Urba has the following comment about Bullard:

“Very strange to hear this from Bullard, as he wrote the Seven Faces of the Peril paper where he discussed the low interest rate deflationary equilibrium….Bullard: “To avoid this outcome for the United States, policymakers can react differently to negative shocks going forward. Under current policy in the United States, the reaction to a negative shock is perceived to be a promise to stay low…”

So yes, Bullard once (in 2010) understood and now apparently he seem to have forgot about how monetary policy works.

4 Comments
by Lars Christensen on June 28, 2012  •  Permalink
Posted in Interest rate fallacy, Milton Friedman
Tagged , ,

Posted by Lars Christensen on June 28, 2012

https://marketmonetarist.com/2012/06/28/i-can-hear-uncle-milty-scream-from-upstairs-at-james-bullard/

The ECB has the model to understand the Great Recession – now use it!

By chance I today found an ECB working paper from 2004 – “The Great Depression and the Friedman-Schwartz hypothesis” by Christiano, Motto and Rostagno.

Here is the abstract:

“We evaluate the Friedman-Schwartz hypothesis that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, we first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. We identify a monetary base rule which responds only to the money demand shocks in the model. We solve the model with this counterfactual monetary policy rule. We then simulate the dynamic response of this model to all the estimated shocks. Based on the model analysis, we conclude that if the counterfactual policy rule had been in place in the 1930s, the Great Depression would have been relatively mild.”

It is interesting stuff and you would imagine that the model developed in the paper could also shed light on the causes and possible cures for the Great Recession as well.

Is it only me who is reminded about 2008-9 when you read this:

“The empirical exercise conducted on the basis of the model ascribes the sharp contraction of 1929-1933 mainly to a sudden shift in investors’ portfolio preferences from risky instruments used to finance business activity to currency (a flight-to-safety explanation). One interpretation of this finding could be that households . in strict analogy with commercial banks holding larger cash reserves against their less liquid assets . might add to their cash holdings when they feel to be overexposed to risk. This explanation seems plausible in the wake of the rush to stocks that occurred in the second half of the 1920.s. The paper also documents how the failure of the Fed in 1929-1933 to provide highpowered money needed to meet the increased demand for a safe asset led to a credit crunch which in turn produced deflation and economic contraction.”

The authors also answer the question about the appropriate policy response.

“We finally conduct a counterfactual policy experiment designed to answer the following questions: could a different monetary policy have avoided the economic collapse of the 1930s? More generally: To what extent does the impossibility for central banks to cut the nominal interest rate to levels below zero stand in the way of a potent counter-deflationary monetary policy? Our answers are that indeed a different monetary policy could have turned the economic collapse of the 1930s into a far more moderate recession and that the central bank can resort to an appropriate management of expectations to circumvent – or at least loosen – the lower bound constraint.

The counterfactual monetary policy that we study temporarily expands the growth rate in the monetary base in the wake of the money demand shocks that we identify. To ensure that this policy does not violate the zero lower-bound constraint on the interest rate, we consider quantitative policies which expand the monetary base in the periods a shock. By injecting an anticipated inflation effect into the interest rate, this delayed-response feature of our policy prevents the zero bound constraint from binding along the equilibrium paths that we consider. At the same time, by activating this channel, the central bank can secure control of the short-term real interest rate and, hence, aggregate spending.

The conclusion that an appropriately designed quantitative policy could have largely insulated the economy from the effects of the major money demand shocks that had manifested themselves in the   late 1920s is in line with the famous conjecture of Milton Friedman and Anna Schwartz (1963).”

So what policy rule are the authors talking about? Well, it is basically a feedback rule where the money base is expanded to counteract negative shocks to money-velocity in the previous period. This is not completely a NGDP targeting rule, but it is close – at least in spirit. Under NGDP level targeting the central bank will increase in the money base to counteract shocks to velocity to keep NGDP on a stable growth path. The rule suggested in the paper is a soft version of this. It could obviously be very interesting to see how a real NGDP rule would have done in the model.

Anyway, I can highly recommend the paper – especially to the members of the ECB’s The Governing Council and I see no reason that they should not implement a rule for the euro zone similar to the one suggested in the paper. If the ECB had such a rule in place then Spanish 10-year bond yields probably would not have been above 7% today.

PS Scott Sumner has been looking for a model for some time. Maybe the Christiano-Motto-Rostagno model would be something for Scott…


 

6 Comments
by Lars Christensen on June 18, 2012  •  Permalink
Posted in Anna Schwartz, Deflation, ECB, Economic and monetary history, euro crisis, Federal Reserve, Milton Friedman, MM Research agenda, Monetary policy rules, The Great Depression, The Great Recession
Tagged , ,

Posted by Lars Christensen on June 18, 2012

https://marketmonetarist.com/2012/06/18/the-ecb-has-the-model-to-understand-the-great-recession-now-use-it/

“Free to Choose” now republished in Danish

This is mostly for my Danish readers. The Danish translation of Milton Friedman’s classic “Free to Choose” (Det Frie Valg) has now been republished by the Danish Free Market think thank Cepos. I am honnored to have written the preface for the new edition of the book.

See the English translation of the preface here.

2 Comments
by Lars Christensen on June 4, 2012  •  Permalink
Posted in Milton Friedman, Reading recommendations
Tagged ,

Posted by Lars Christensen on June 4, 2012

https://marketmonetarist.com/2012/06/04/free-to-choose-now-republished-in-danish/

Jens Weidmann, do you remember the second pillar?

Today the ECB is very eager to stress it’s 2% inflation target. However, a couple of years ago the ECB in fact had two targets – the so-called two pillars of monetary policy. The one was the inflation target and the other was a money supply target – the so-called reference value for the growth rate of M3.

The second pillar in many ways made a lot of sense – at least as a instrument for monetary analysis. The second pillar was put into the ECB tool box by the Bundesbank which insisted that monetary analysis was as important as a pure inflation target. Read for example former ECB chief economist and Bundesbanker Otmar Issing’s defense of the two-pillar set-up here.

The starting point for calculating the reference value for M3 was the equation of exchange:

(1) MV=PY

or in growth rates:

(2) m+v=p+y

(2) of course can be re-written to:

(2)’ m=p+y-v

If we assume trend real GDP growth (y) is 2% you can calculate the reference value for m that will ensure 2% inflation over the medium term. You of course also have to make an assumption about velocity. ECB used to think that trend growth in v was -0.5 to -1%.

This give us the following reference growth rate for M3 (m-target):

(3) m-target=2+2-(-1)=5% (4.5% if you assume velocity growth of -0.5%)

Said in another way if the ECB keeps M3 growing at 5% year-in and year-out then inflation should be around 2% in the medium term. An yes, this is of course exactly what Milton Friedman recommend long ago.

2.5% M3 growth is hardly inflationary

Today we got the latest M3 numbers for the euro zone. The calvinists should be happy – M3 decelerated sharply to 2.5% y/y in April. Half of what should be the reference growth rate for M3 – and that is ignoring the fact that velocity has collapsed.

What does that tells us about the inflationary risks in the euro zone? Well, there are no inflationary risks – there are only deflationary risks.

Using the assumptions above we can calculate the long-term inflation if M3 keeps growing by 2.5% – from (2)’ we get the following:

(4) p=m-y+v

(4)’ p=2.5-2+(-1)=-0.5%

So it is official! Monetary analysis as it used to be conducted in the Bundesbank is telling you that we are going to have deflation in the euro zone in the medium term! And don’t tell me about monetary overhang – the ECB is in the business of letting bygones be bygones (otherwise the ECB would target the NGDP LEVEL or the price LEVEL) and by the way the ECB spend lots of time in 2004-7 to explain why money supply growth overshot the target.

Jens Weidmann – monetarist or calvinist?

The Bundesbank brought in monetary analysis and a money supply focus to the ECB so I think it is only fair to ask whether Bundesbank chief Jens Weidmann still believe in monetary analysis? If he is true to the strong monetarist traditions at the Bundesbank then he should come out forcefully in favour of monetary easing to ensure M3 growth of at least 5% – in fact it should be much higher as velocity has collapsed, but at least to bring M3 back to 5% would be a start.

I hope the Bundesbank will soon refind it’s monetarist traditions…please make Milton Friedman and Karl Brunner proud!

PS I of course still want the ECB to introduce a NGDP level target, but less would make me happy – a 5-10% target range for M3 (the range prior to the crisis) and a minimum price on European inflation linked bonds would would clearly be enough to at least avoid collapse.

7 Comments
by Lars Christensen on May 30, 2012  •  Permalink
Posted in ECB, euro crisis, Jens Weidmann, Milton Friedman, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting
Tagged , , , , , ,

Posted by Lars Christensen on May 30, 2012

https://marketmonetarist.com/2012/05/30/jens-weidmann-do-you-remember-the-second-pillar/

Tight money = low yields – also during the Great Recession

Anybody who ever read anything Milton Friedman said about monetary policy should know that low interest rates and bond yields mean that monetary policy is tight rather than easy. And when bond yields drop it is normally a sign that monetary policy is becoming tighter rather than easier.

Here is Friedman on what he called the interest rate fallacy in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Unfortunately the old fallacy is still not dead and it is still very common to associate low interest rates and low bond yields with easy monetary policy. Just think of the ECB’s insistence that it’s monetary policy stance is “easy”.

In my previous post I demonstrated that all the major changes in the S&P500 over the past four years can be explained by changes in monetary policy stance from either the ECB or the Federal Reserve (and to some extent also PBoC). Hence, it is not animal spirits, but rather monetary policy failure that can explain the volatility in the markets over the past four years.

What holds true for the stock market holds equally true for the bond market and the development in the US fixed income markets over the past four years completely confirms Milton Friedman’s view that tighter monetary policy is associated with lower bond yields. See the graph below. Green circles are monetary easing. Red circles are monetary tightening. (See more on each “event” in my previous blog post)

I think the graph very clearly shows that Friedman was right. Every time either the ECB or the Federal Reserve have moved to tighten monetary policy long-term US bonds yields have dropped and when the same central banks have moved to ease monetary policy yields have increased.

Judging from the level of US bond yields – and German bond yields for that matter – monetary policy in the US (and the euro zone) can hardly be said to be  easy. In fact it is very clear that monetary policy remains excessively tight in both the US and the euro zone. Unfortunately neither the Fed nor the ECB seem to acknowledge as they still seem to be of the impression that as long interest rates are low monetary policy is easy. I wonder what Friedman would have said? Well, I fact I am pretty convinced that he would have been very clear and would have been arguing with the Market Monetarists that monetary disorder is to blame for this crisis and we only will move out of the crisis once the Fed and the ECB move to fundamentally ease monetary conditions and adopt a rule based monetary policy rather than the present zig-zagging.

PS See also my early post on the connection between monetary policy and the bond market: Understanding financial markets with MV=PY – a look at the bond market
Update: Scott Sumner just made me aware of one of his post addressing the same topic. See here.

Update 2: Jason Rave has kindly reminded me of this Milton Friedman article, which also deals with the interest rate fallacy.

26 Comments
by Lars Christensen on May 27, 2012  •  Permalink
Posted in ECB, euro crisis, Federal Reserve, Milton Friedman
Tagged , , , , , ,

Posted by Lars Christensen on May 27, 2012

https://marketmonetarist.com/2012/05/27/tight-money-low-yields-also-during-the-great-recession/

Allen Sanderson on Milton Friedman

Allen Sanderson has collected a number of anecdotes and stories about Milton Friedman. I most admit reading stories like this about Milton Friedman always make me smile.

But please take a look for yourself. Here is Remembering Milton. 

HT Marcus Nunes.

1 Comment
by Lars Christensen on April 28, 2012  •  Permalink
Posted in Milton Friedman
Tagged ,

Posted by Lars Christensen on April 28, 2012

https://marketmonetarist.com/2012/04/28/allen-sanderson-on-milton-friedman/

“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression

Even though I am a Danish economist I am certainly no expert on the Danish economy and I have certainly not spend much time blogging about the Danish economy and I have no plans to change that in the future. However, for some reason I today came to think about what would have been the impact on the Danish economy if the Danish krone had been pegged to the price of bacon rather than to gold at the onset of the Great Depression in 1929. Lets call it the Bacon Standard – or a the PIG PEG (thanks to Mikael Bonde Nielsen for that suggestion).

Today less than 10% of Danish export revenues comes from bacon export – back during in the 1920s it was much more sizable and agricultural products dominated export revenues and Denmark’s main trading partner was Great Britain. Since bacon prices and other agricultural product were highly correlated (and still are) the bacon price probably would have been a very good proxy for Danish export prices. Hence, a the PIG PEG would basically have been similar to Jeff Frankel’s Peg the Export Price (PEP) proposal (see my earlier posts on this idea here and here).

When the global crisis hit in 1929 it put significant downward pressure on global agricultural prices and in two years most agricultural prices had been halved. As a consequence of the massive drop in agricultural prices – including bacon prices – the crisis put a serious negative pressures on the Danish krone peg against gold. Denmark had relatively successfully reintroduced the gold standard in 1927, but when the crisis hit things changed dramatically.

Initially the Danish central bank (Danmarks Nationalbank) defended the gold standard and as a result the Danish economy was hit by a sharp monetary contraction. As I argued in my post on Russian monetary policy a negative shock to export prices is not a supply shock, but rather a negative demand shock under a fixed exchange rate regime – like the gold standard. Said in another way the Danish AD curve shifted sharply to the left.

The shock had serious consequences. Hence, Danish economic activity collapsed as most places in the world, unemployment spiked dramatically and strong deflationary pressures hit the economy.

Things got even worse when the British government in 1931 decided to give up the gold standard and eventually the Danish government decided to follow the lead from the British government and also give up the gold standard. However, unlike Sweden the Danish authorities felt very uncomfortable to go it’s own ways (like today…) and it was announced that the krone would be re-pegged against sterling. That strongly limited the expansionary impact of the decision to give up the gold standard. Therefore, it is certainly no coincidence that Swedish economy performed much better than the Danish economy during the 1930s.

The Danish economy, however, started to recovery in 1933. Two events spurred the recovery. First, FDR’s decision to give the gold standard helped the US economy to begin pulling out of the recovery and that helped global commodity prices which certainly helped Danish agricultural exports. Second, the so-called  Kanslergade Agreement – a political agreement named after the home address of then Prime Minister Thorvald Stauning in the street Kanslergade in Copenhagen – lead to a devaluation of the Danish krone. Both events effectively were monetary easing.

What would the Bacon standard have done for the Danish economy?

While monetary easing eventually started to pull Denmark out of the Great Depression it didn’t happen before four year into the crisis and the recovery never became as impressive as the development in Sweden. Had Denmark instead had a Bacon Standard then things would likely have played out in a significantly more positive way. Hence, had the Danish krone been pegged to the price of bacon then it would have been “automatically” devalued already in 1929 and the gradual devaluation would have continued until 1933 after, which rising commodity prices (and bacon prices) gradually would have lead to a tightening of monetary conditions.

In my view had Denmark had the PIG PEG in 1929 the crisis would been much more short-lived and the economy would fast have recovered from the crisis. Unfortunately that was not the case and four years was wasted defending an insanely tight monetary policy.

Monetary disequilibrium leads to interventionism   

The Danish authorities’ decision to maintain the gold standard and then to re-peg to sterling had significant economic and social consequences. As a consequence the public support for interventionist policies grew dramatically and effectively lay the foundation for what came to be known as the danish “Welfare State”. Hence, the Kanslergade Agreement not only lead to a devaluation of the krone, but also to a significant expansion of the role of government in the Danish economy. In that sense the Kanslergade Agreement has parallels to FDR’s policies during the Great Depression – monetary easing, but also more interventionist policies.

Hence, the Danish experience is an example of Milton Friedman’s argument that monetary disequilibrium caused by a fixed exchange rate policy is likely to increase interventionist tendencies.

Bon appetite – or as we say in Danish velbekomme…

19 Comments
by Lars Christensen on April 20, 2012  •  Permalink
Posted in Exchange rate policy, Gold Standard, Jeffrey Frankel, Monetary institutions, Monetary policy rules, Peg the Export Price (PEP), The Great Depression
Tagged , , , , , ,

Posted by Lars Christensen on April 20, 2012

https://marketmonetarist.com/2012/04/20/the-bacon-standard-the-pig-peg-would-have-saved-denmark-from-the-great-depression/

Glasner on “Friedman and Schwartz on James Tobin”

David Glasner is a very nice and friendly person, but I have to admit that David always scares me a bit – especially when I disagree with him. For some reason when David is saying something I am inclined to agree with him even if I think he is wrong. There are two areas where David and I see things differently. One the “hot potato” theory of money and two our view of Milton Friedman. I tend to think that the way Nick Rowe – inspired by Leland Yeager – describes the monetary disequilibrium theory make a lot of sense. David disagrees with Nick. Similiarly I have an (irrational?) love of Milton Friedman so I tend to think he is right about everything. David on the other hand is much more skeptical about Friedman.

Now David has post in which he makes the argument that Friedman nearly had the same view as James Tobin on the hot potato theory of money – which of course is stark opposition to Nick’s view. So now I have a problem – if he is right I must either betray uncle Milt or revise my view of the hot potato theory of money. Ok, that is not entirely correct, but you get the drift.

Anyway I don’t have a lot of time to write a long post and David’s discussion is much more interesting than what I can come up with. So have a look for yourself here.

I will be traveling quite a bit in the coming weeks so I am not sure how much blogging I will have time for. I will be in Riga, Stockholm, London, Dublin, Moscow and New York in the next couple of weeks so I might run into some of my local readers.

PS David sent me Tobin’s article long ago and I must admit that I have not read it carefully enough to be able to argue strongly for or against it.

1 Comment
by Lars Christensen on April 16, 2012  •  Permalink
Posted in David Glasner, Milton Friedman, Nick Rowe
Tagged , , ,

Posted by Lars Christensen on April 16, 2012

https://marketmonetarist.com/2012/04/16/glasner-on-friedman-and-schwartz-on-james-tobin/

Remember the mistakes of 1937? A lesson for today’s policy makers

Since the ECB introduced it’s 3-year LTRO on December 8 the signs that we are emerging from the crisis have grown stronger. This has been visible with stock prices rebounding strongly, long US bond yields have started to inch up and commodity prices have increased. This is all signs of easier monetary conditions globally.

We are now a couple of months into the market recovery and especially the recovery in commodity prices should soon be visible in US and European headline inflation and will likely soon begin to enter into the communication of central bankers around the world. This has reminded me of the “recession in the depression” in 1937. After FDR gave up the gold standard in 1933 the global economy started to recover and by 1937 US industrial production had basically returned to the 1929-level. The easing of global monetary conditions and the following recovery had spurred global commodity prices and by 1937 policy makers in the US started to worry about inflationary pressures.

However, in the second half of 1936 US economic activity and the US stock market went into a free fall and inflationary concerns soon disappeared.

There are a number of competing theories about what triggered the 1937 recession. I will especially like to highlight three monetary explanations:

1) Milton Friedman and Anna Schwartz in their famous Monetary History highlighted the fact that the Federal Reserve’s decision to increase reserve requirements starting in July 1936 was what caused the recession of 1937.

2) Douglas Irwin has – in an excellent working paper from last year – claimed that it was not the Fed, but rather the US Treasury that caused the the recession as the Treasury moved aggressively to sterilize gold inflows into the US and thereby caused the US money supply to drop.

3) While 1) and 2) regard direct monetary actions the third explanation regards the change in the communication of US policy makers. Hence, Gauti B. Eggertsson and Benjamin Pugsley in an extremely interesting paper from 2006 argue that it was the communication about monetary and exchange rate policy that caused the recession of 1937. As Scott Sumner argues monetary policy works with long and variables leads. Eggertson and Pugsley argue exactly the same.

In my view all three explanations clearly are valid. However, I would probably question Friedman’s and Schwartz’s explanation on it’s own as being enough to explain the recession of 1937. I have three reasons to be slightly skeptical about the Friedman-Schwartz explanation. First, if indeed the tightening of reserve requirements caused the recession then it is somewhat odd that the market reaction to the announcement of the tightening of reserve requirements was so slow to impact the stock markets and the commodity prices. In fact the announcement of the increase in reserve requirements in July 1936 did not have any visible impact on stock prices when they were introduced. Second, it is also notable that there seems to have been little reference to the increased reserve requirement in the US financial media when the collapse started in the second half of 1937 – a year after the initial increase in reserve requirements. Third, Calomiris, Mason and Wheelock in paper from 2011 have demonstrated that banks already where holding large excess reserves and the increase in reserve requirements really was not very binding for many banks. That said, even if the increase in reserve requirement might not have been all that binding it nonetheless sent a clear signal about the Fed’s inflation worries and therefore probably was not irrelevant. More on that below.

Doug Irwin’s explanation that it was actually the US Treasury that caused the trouble through gold sterilization rather than the Fed through higher reserve requirements in my view has a lot of merit and I strongly recommend to everybody to read Doug’s paper on Gold Sterilization and the Recession 1937-38 in which he presents quite strong evidence that the gold sterilization caused the US money supply to drop sharply in 1937. That being said, that explanation does not fit perfectly well with the price action in the stock market and commodity prices either.

Hence, I believe we need to take into account the combined actions of the of the US Treasury (including comments from President Roosevelt) and the Federal Reserve caused a marked shift in expectations in a strongly deflationary direction. In their 2006 paper Eggertsson and Pugsley “The Mistake of 1937: A General Equilibrium Analysis” make this point forcefully (even though I have some reservations about their discussion of the monetary transmission mechanism). In my view it is very clear that both the Roosevelt administration and the Fed were quite worried about the inflationary risks and as a consequence increasing signaled that more monetary tightening would be forthcoming.

In that sense the 1937 recession is a depressing reminder of the strength of the of the Chuck Norris effect – here in the reserve form. The fact that investors, consumers etc were led to believe that monetary conditions would be tightened caused an increase in money demand and led to an passive tightening of monetary conditions in the second half of 1937 – and things obviously were not made better by the Fed and US Treasury actually then also actively tightened monetary conditions.

The risk of repeating the mistakes of 1937 – we did that in 2011! Will we do it again in 2012 or 2013?

So why is all this important? Because we risk repeating the mistakes of 1937. In 1937 US policy makers reacted to rising commodity prices and inflation fears by tightening monetary policy and even more important created uncertainty about the outlook for monetary policy. At the time the Federal Reserve failed to clearly state what nominal policy rule it wanted to implemented and as a result caused a spike in money demand.

So where are we today? Well, we might be on the way out of the crisis after the Federal Reserve and particularly the ECB finally came to acknowledged that a easing of monetary conditions was needed. However, we are already hearing voices arguing that rising commodity prices are posing an inflationary risk so monetary policy needs to be tighten and as neither the Fed nor the ECB has a very clearly defined nominal target we are doomed to see continued uncertainty about when and if the ECB and the Fed will tighten monetary policy. In fact this is exactly what happened in 2011. As the Fed’s QE2 pushed up commodity prices and the ECB moved to prematurely tighten monetary policy. To make matters worse extremely unclear signals about monetary policy from European central bankers caused market participants fear that the ECB was scaling back monetary easing.

Therefore we can only hope that this time around policy makers will have learned the lesson from 1937 and not prematurely tighten monetary policy and even more important we can only hope that central banks will become much more clear regarding their nominal targets. Any market monetarist will of course tell you that central bankers should not fear overdoing their monetary easing if they clearly define their nominal targets (preferably a NGDP level target) – that would ensure that monetary policy is not tightened prematurely and a well-timed exist from monetary easing is ensured.

PS I have an (very unclear!) idea that the so-called Tripartite Agreement from September 1936 b the US, Great Britain and France  to stabilize their nations’ currencies both at home and in the international FX markets might have played a role in causing a change in expectations as it basically told market participants that the days of “currency war” and competitive devaluations had come to an end. Might this have been seen as a signal to market participants that central banks would not compete to increase the money supply? This is just a hypothesis and I have done absolutely no work on it, but maybe some young scholar would like to pick you this idea?

14 Comments
by Lars Christensen on March 22, 2012  •  Permalink
Posted in Chuck Norris Effect, Commodity prices, Douglas Irwin, ECB, Economic and monetary history, Exchange rate policy, Federal Reserve, Gold Standard, Milton Friedman, Monetary policy, The Great Depression
Tagged , , , , , ,

Posted by Lars Christensen on March 22, 2012

https://marketmonetarist.com/2012/03/22/remember-the-mistakes-of-1937-a-lesson-for-todays-policy-makers/

Understanding financial markets with MV=PY – a look at the bond market

Recently I have been thinking whether it would be possible to understand all financial market price action through the lens of the equation of exchange – MV=PY. In post I take a look at the bond market.

The bond market – its about PY expectations

A common misunderstanding among economic commentators is to equate easy monetary conditions with low bond yields. However, Milton Friedman long ago told us that bond yields are low when monetary policy have been tight – and not when it has been loose. Any Market Monetarist will tell you that monetary conditions are getting easier when nominal GDP growth is accelerating and and getting tighter when NGDP growth is slowing. So with this Friedmanite and market monetarist insight in mind there should be a relationship between higher bond yields and higher nominal GDP growth. Hence, when market participants expect MV to increase then we should also see bond yields increase.

The graph above shows the correlation between 10-year US bond yields and US NGDP growth. The graph illustrates that there is a fairly close correlation between the two series. Higher bond yields and higher NGDP hence seem to go hand in hand and as we know MV=PY we can conclude that higher bond yields is an indication of looser monetary policy. Furthermore, we should expect to see bond yields to increase – rather than decrease – when monetary policy is eased. Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing. 

Therefore, given the present slump we are in we should not be worried that rising bond yields will kill off the recovery – rather we should rejoice when long-term bond yields are rising because that is the best indictor that monetary conditions are becoming easer and that that will push up nominal GDP.

The brief discussion above in my view confirms some key market monetarist positions. First, financial markets are good indicators of the stance of monetary policy. Second, monetary policy works through expectations – with long and variable leads. Third low bond yields is an indication that monetary policy has been tight and not that it is loose.

UPDATE: In my original post I had used some wrong data. Clare Zempel kindly notified me about the mistake(s). I am grateful for the help. As a consequence of the wrong data I have revised part of the original text.

UPDATE 2: David Beckworth has an excellent post arguing the exactly the same as me: “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand.”. And take a look at David’s graph showing the relationship between expected NGDP growth and 10-year bond yields. Great stuff!

19 Comments
by Lars Christensen on March 20, 2012  •  Permalink
Posted in Economic and monetary history, Efficient-Market Hypothesis, Financial markets, Milton Friedman, MV=PY
Tagged ,

Posted by Lars Christensen on March 20, 2012

https://marketmonetarist.com/2012/03/20/understanding-financial-markets-with-mvpy-a-look-at-the-bond-market/

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