No tapering, but no rule either. Net, net that is bad

I just arrived in New York and I will spend the next couple of days in the New York and Boston. For once my timing is good – the Federal Reserve just announce that there is not going to be any tapering.

Scott Sumner is happy, but I must admit that I for once disagree with the Fed on the hawkish side (kind of). Not that I am not favouring monetary easing, but I don’t really think that the important thing is the amount of quantitative easing the Fed is doing in the sense of 10 or 20 billion dollars more or less per month relative to Fed communication.

Blackrock’s Larry Fink is speaking on CNBC as I am writing this. He is saying that minor tapering with better guidance would have been better. I agree on that. I would much more have liked to see the Fed coming out today spelling out its monetary policy much more clearly. The fact is that the US economy is getting better – slowly, but surely so tapering is justified sooner or latter.

After all the Fed has now spend months getting the markets ready for the tapering and now it didn’t “deliver”. Not that I want tightening US monetary policy, but I want much better communication and better rules. The Fed didn’t move in that direction today. That is a missed opportunity. Today the fed could have tapered by 10 or 20 billion dollars, but at the same time clearly spelled out a rule for money base growth. It didn’t do tapering, but didn’t spell out a rule. Remember – Market Monetarism is not about monetary “stimulus”. It is about a rule based monetary policy. And remember the Fed could actually have eased today with a clear rule AND done tapering at the same time.

There is still good arguments for monetary easing in the US, but relative to the need for spelling a clear monetary policy rule that it unimportant.

Unfortunately I don’t have more time for blogging now – I am off to dinner with a good friend who happens to be another Market Monetarist. Try to guess who it is…

PS Larry Fink is also talking on CNBC about the debt celling. I don’t care about that. Lets just ignore it. Phew Larry Fink thinks Larry Summers would be a great Fed chairman. I don’t.


Helmut Reisen on the “China as monetary superpower” hypothesis

I have in a number of blog posts argued that China is a global or at least an Asian monetary superpower, which is exporting monetary tightening across Asia.

In a new very good blog post the former head of research at the OECD’s Development Centre Helmut Reisen discusses this hypothesis:

Usually, the current travails in emerging markets are blamed on expectations of slowing open market purchases by the US Federal Reserve System. Lars Christensen, head of emerging market research at Danske Bank, however, blames China´s monetary tightening as at least as important as the expected US Fed ´tapering´.  I have myself, with former colleagues, pointed to the growing impact that China´s growth has exerted since the last decade on GDP growth in middle- and low-income countries[1], pointing to the growing raw material, trade and production links of increasingly China centric emerging countries. So I shall have a lot of sympathy for Lars Christensen’s earlier proposition that China has also grown into a monetary superpower in a Sino monetary transmission mechanism with the rest of Asia. China´s monetary tightening, however, can hardly explain the current slump in Asian markets, on closer inspection.

So I nearly got Helmut convinced, but not quite. Here is Helmut again:

First, let us consider  the expected monetary stance in the US and in China. Graph 1 clearly shows that the market has formed expectations since May that the Fed would not continue open market purchases at the pace witnessed over the last years, partly fueled by Bernanke´s taper talk that month to US Congress. China´s monetary tightening, by contrast, occurred during late 2010 to early 2012 from when the Bank of China[2]. Since then, minimum reserve requirements were repeatedly reduced. Further, the PBC reduced its benchmark deposit and loan rates in June 2012. In addition, the PBC has also used a mix of monetary policy instruments to appropriately increase market liquidity. Even considering huge time lags, the current turmoil of Asia stock and bond markets cannot be blamed on China´s monetary tightening.

Hence, Helmut’s argument is that this is mostly caused by the Fed rather than by the People’s Bank of China. I do not disagree that the discussion of Fed tapering is having a negative impact on market sentiment in Asia. My view is just that that is not the whole story. China remains very important.

Furthermore, this is a good illustration of the Market Monetarist view of how to “measure” the monetary policy stance. While Helmut stresses that the PBoC has cut reserve requirements and interest rates recently Market Monetarists would instead focus on what markets are telling us about the monetary policy stance.

This discussion of course is similar to what happened in the euro zone and the US in 2008. Did the Fed ease or tighten monetary policy? Well, despite cutting nominal interest rates inflation expectations plummeted as did expectations for NGDP growth. That was indeed monetary tightening. And if we had good indicators for NGDP growth or inflation in China I would expect them to indicate a continued tightening of the Chinese monetary policy stance did the cut in official interest rates and reserve requirements.  The best market indicators for Chinese NGDP growth are probably copper and the Aussie dollar – and the Chinese stock market.

Hence, judging from for example the Chinese stock market monetary conditions have not become easier. Rather the opposite. And if the PBoC really had eased monetary conditions the Renminbi would have weakened significantly – it has not.

Furthermore, I would argue that communication about future changes in the money base is at least – in fact more – important than present changes to for example reserve requirements or interest rates. Hence, the communication from the Chinese authorities over the last couple of months has been decisively hawkish and if one wants to forecast the future path of the money base or the money supply in China one surely would have to conclude that the PBoC now plans a much slower rate of growth in the money supply than market participants had expected only a few months ago.

Furthermore, the PBoC’s rather clumsy handling of money market distress back in May-June left the impression that the Chinese authorities were quite happy about the impact it had on parts of the Chinese banking sector. In fact the turmoil gave reason to question that the PBoC really would act as lender-of-last-resort. That in my view was a very clear signal that the PBoC was quite happy with monetary conditions becoming tighter.

So yes, the PBoC has eased reserve requirements and cut official interest rates, but given the PBoC’s continued hawkish rhetoric market participants are not seeing the PBoC’s monetary policy stance becoming more accommodative – rather the opposite and judging from market pricing monetary contraction continues in China. That is having a clearly negative impact on the financial market sentiment across Asia.

That of course does not mean that Fed tapering is not important for what is going on in Asia at the moment. I think it is very important and it is for example clear that the sell-off in the Asian markets accelerated further this morning after the release yesterday of minutes from the latest FOMC meeting.

My point is just that the Fed is not the only monetary superpower in the world. The PBoC is also tremendously important. And on that I think Helmut and I are in total agreement.

This is why we need an NGDP futures market

Until recently the global financial markets were on an one-way trip to recovery. Basically since the Federal Reserve in September implicitly announced the Bernanke-Evans rule investors have been betting on an US economic recovery – higher real and nominal GDP growth – and the Bank of Japan’s decisive actions to implement a 2% inflation target also have helped the sentiment. However, the picture has become a lot more confusing in recent weeks as turmoil has returned to the global financial markets.

The key problem is that we do not exactly know why there has been a sharp spike in market volatility. There is a number of competing theories. The most popular theory is that this is all Ben Bernanke’s fault as he has announced the “tapering” of quantitative easing – that according to the critiques has caused markets to price in tighter monetary conditions in the future and that is the reason why bond yields are rising while inflation expectations and stock markets are declining. A competing theory is that the real reason for this is not really Bernanke, but rather monetary tightening in China, which is forcing Chinese investors to liquidate investments – including in US Treasuries. I have a lot of sympathy for the later theory even though I think it is also right that Bernanke’s comments over the past months have been having an negative impact.

So why is it important what is the cause of these market moves? It’s it enough to note that all indications are that we globally are now seeing a contraction in aggregate demand and central banks should respond to that by easing monetary conditions? Yes and no. Yes because it is clear that monetary conditions are indeed getting tighter everywhere. However, no because that was not necessarily clear until last week.

Low inflation expectations is necessarily not a monetary easing

Interestingly enough it seems like everybody have become Market Monetarists recently in the sense that they think that it is the fed that is driving the markets via (bad) communication and the commentators are exactly looking at market indicators monetary conditions – for example market expectations for inflation.

And it is of course the sharp drop in inflation expectations, which is causing a lot of concern and I obviously agree that central banks should keep an very close eye on inflation expectations as an indicator for monetary conditions. HOWEVER, we should never forget that inflation expectations could drop either because of tighter monetary conditions or because of a positive supply shock.

Market Monetarists of course argue that central banks should not respond to supply shocks – positive or negative – and I would in fact argue that the drop in inflation expectations we have seen recently in the US (and other places) is to a large extent driven by a positive supply shock. That is good news for  real GDP growth. That is consistent with higher real bond yields and it not necessarily a problem (David Beckworth has been making that argument here). Hence, if the drop in inflation expectations had instead been primarily caused by tighter US monetary conditions then we should have expected to see the US stock markets plummet and the dollar should have strengthened.

That is of course what we have seen over the past week or so, but not in the month leading up to that. In that period the dollar was actually weakening moderately and the US stock market was holding up fairly well. That to me is an indication that the drop in inflation expectations have not only been about tighter US monetary condition.

Instead I think that we have seen a serious tightening of Chinese monetary condition and that has caused global commodity prices to drop. That is of course a negative demand shock in China, but it is a positive supply shock to the US economy. If that ONLY had been the case then it would be hard to the argument from a Market Monetarist perspective that the Federal Reserve should move to ease monetary conditions further. See my arguments from mid-May against monetary easing in responds to positive supply shocks here.

Avoid the confusion – set up an NGDP futures market

Sometimes it is pretty easy to “read” the markets to get an understanding of what is going on – it is for example pretty clear right now that Chinese monetary conditions are getting a lot tighter, but it is harder to say how much tighter US monetary conditions really have gotten over the past month or so and the bond market is certainly not a good indicator on its own (liquidity/flow effects vs expectational effects).

Hence, what should be the appropriate US monetary response? There is a significant difference between the appropriate respond to what is primarily a supply shock and what is primarily a demand shock. And it is of course not only me who is slightly confused about what is going on in the markets. Policy makers are likely to be at least as confused (likely a lot more…).

The best way to avoid any confusion is of course to set-up a market for exactly what the central bank is targeting. Hence, for an inflation targeting central bank there is of course inflation-linked bonds. However, that is not really a good guide for monetary policy if you want to avoid responding to supply shocks. Instead what we really need is NGDP-linked bonds. In the case of the US the US Treasury therefore should issue such bonds.

Had we had an US NGDP-linked bond now it would be very easy to see whether or not the markets where indeed pricing in tighter US monetary conditions and whether or not this should be a cause for concern. Furthermore, that would get us away from the constant discussion about whether higher bond yields is an indication of tighter or easier monetary conditions (it can in fact be both).

And finally if the there was an US NGDP-linked government bond then the fed could leave the time of “tapering” complete to the markets (See more on that here).

HT Cthorm


PS Scott Sumner and Evan Soltas have similar discussions

Chinese monetary policy failure

“Fed tapering” seems to be repeated in every single story in the financial media over the last couple of days. However, I am afraid that the financial media – as often is the case – is overly US centric. We might want to look at another central bank than the Fed. We should instead pay some (a lot!) of attention to the People’s Bank of China (PBoC).

This is from CNBC:

“China’s central bank continued to test the resilience of local lenders to withstand a cash crunch on Thursday, as money market rates soared once again and short-term rates hit record highs.

The seven-day repo rate, which is seen as gauge of confidence to lend in the interbank market, rose to a record high above 10 percent. China’s overnight repo rate jumped to as high as 30 percent, analysts said.

Chinese money markets have suffered a severe liquidity strain in the past week, due to seasonal factors and a sharp slowdown in foreign exchange inflows, raising concerns about the financial risks facing the world’s second largest economy.

But to the surprise of many market participants, the central bank has held back from pumping cash into the market to ease the credit squeeze and analysts said a spike in the rates at which banks lend money to each other was also a concern. “

I can’t help thinking that we have seen this before. The fed and ECB actions in 2008 come to mind.

This is what I said in my post “Dangerous bubbles fears” in October last year:

“…the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.”

It seems to me that the PBoC is just continuing the excessive tightening and that seems to be the real culprit behind the stream of bad economic data we have got out of China recently. It looks like Chinese monetary policy failure.

So yes, Bernanke might have a communication problem, but at the moment it seems like the biggest monetary policy failure is Chinese rather than American.

PS it seems like the Bank of Japan is regaining some credibility – the Nikkei has been remarkably resilient in recent days.

Leave it to the market to decide on “tapering”

The rally in the global stock markets has clearly run into trouble in the last couple of weeks. Particularly the Nikkei has taken a beating, but also the US stock market has been under some pressure.

If one follows the financial media on a daily basis it is very clear that there is basically only one reason being mentioned for the decline in global stock markets – the possible scaling back of the Federal Reserve’s quantitative easing.

This is three example from the past 24 hours. First CNBC:

“Stocks posted sharp declines across the board Wednesday, with the Dow ending below 15,000, following weakness in overseas markets and amid concerns over when the Fed will start tapering its bond-buying program on the heels of several mixed economic reports.”

And this is from Bloomberg:

“U.S. stocks fell, sending the Standard & Poor’s 500 Index to a one-month low, as jobs and factory data missed estimates and investors speculated whether the Federal Reserve will taper bond purchases.”

And finally Barron’s:

“Fear that the central bank may start scaling back its $85 billion in monthly bond purchases has helped trigger a sharp increase in market volatility over the last couple of weeks both here and overseas.”

I believe that what we are seeing in the financial markets right now is telling us a lot about how the monetary transmission mechanism works. Market Monetarists say that money matters and markets matter. The point is that the markets are telling us a lot about the expectations for future monetary policy. This is of course also why Scott Sumner likes to say that monetary policy works with long and variable LEADS.

Hence, what we are seeing now is that US monetary conditions are being tightened even before the fed has scaled back asset purchases. What is at work is the Chuck Norris effect. It is the threat of “tapering” that causes US stock markets to decline. Said in another way Ben Bernanke has over the past two weeks effectively tightened monetary conditions. I am not sure that that was Bernanke’s intension, but that has nonetheless been the consequence of his (badly timed) communication.

This is also telling us that Market Monetarists are right when we say that both interest rates and money supply data are unreliable indicators of monetary conditions – at least when they are used on their own. Market indicators are much better indicators of monetary conditions.

Hence, when the US stock market drops, the dollar strengthens and implied market expectations of inflation decline it is a very clear signal that US monetary conditions are becoming tighter. And this is of course exactly what have happened over the last couple of weeks – ever since Bernanke started to talk about “tapering”. The Bernanke triggered the tightening, but the markets are implementing the tigthening.

Leave it to the market to decide when the we should have “tapering”

I think it is pretty fair to say that Market Monetarists are not happy about what we are seeing playing out at the moment in the US markets or the global markets for that matter. The reason is that we are now effectively getting monetary tightening. This is certainly premature monetary tightening – unemployment is still significantly above the fed’s unofficial 6.5% “target”, inflation is well-below the fed’s other unofficial target – 2% inflation – and NGDP growth and the level NGDP is massively below where we would like to see it.

It is therefore hardly the market’s perception of where the economy is relative to the fed’s targets that now leads markets to price in monetary tightening, but rather it is Bernanke’s message of possible “tapering” of assets purchases, which has caused the market reaction.

This I believe this very well illustrates three problems with the way the fed conducts monetary policy.

First of all, there is considerable uncertainty about what the fed is actually trying to target. We have an general idea that the fed probably in some form is following an Evans rule – wanting to continue to expand the money base at a given speed as long as US unemployment is above 6.5% and PCE core inflation is below 3%. But we are certainly not sure about that as the fed has never directly formulated its target.

Second, it is clear that the fed has a clear instrument preference – the fed is uncomfortable with conducting monetary policy by changing the growth rate of the money base and would prefer to return to a world where the primary monetary policy instrument is the fed funds target rate. This means that the fed is tempted to start “tapering” even before we are certain that the fed will succeed in hitting its target(s). Said, in another way the monetary policy instrument is both on the left hand and the right hand side of the fed’s reaction function. By the way this is exactly what Brad DeLong has suggested is the case. Brad at the same time argues that that means that the fiscal multiplier is positive. See my discussion of that here.

Third the fed’s policy remains extremely discretionary rather than being rule based. Hence, Bernanke’s sudden talk of “tapering” was a major surprise to the financial markets. This would not have been the case had the fed formulated a clear nominal target and explained its “reaction function” to markets.

Market Montarists of course has the solution to these problems. First of all the fed should clearly formulate a clear nominal target. We obviously would prefer an NGDP level target, but nearly any nominal target – inflation targeting, price level targeting or NGDP growth targeting – would be preferable to the present “target uncertainty”.

Second, the fed should leave it to the market to decide on when monetary policy should be tightened (or eased) and leave it to the market to actually implement monetary policy. In the “perfect world” the fed would target a given price for an NGDP-linked bond so the implied market expectation for future NGDP was in line with the targeted level of NGDP.

Less can, however, do it – the fed could simply leave forecasting to either the markets (policy futures and other forms of prediction markets) or it could conduct surveys of professional forecasters and make it clear that it will target these forecasts. This is Lars E. O. Svensson’s suggestion for “targeting the forecast” (with a Market Monetarist twist).

Concluding, the heightened volatility we have seen in the US stocks markets over the last two weeks is mostly the result of monetary policy failure – a failure to formulate a clear target, a failure to be clear on the policy instrument and a failure of making it clear how to implement monetary policy.

Bernanke don’t have to order the printing of more money. We don’t need more or less QE. What is needed is that Bernanke finally tells us what he is really targeting and then he should leave it to the market to implement monetary policy to hit that target.

PS I could have addressed this post to Bank of Japan and governor Kuroda as well. Kuroda is struggling with similar troubles as Bernanke. But he could start out by reading these two posts: “Mr. Kuroda please ‘peg’ inflation expectations to 2% now” and “A few words that would help Kuroda hit his target”. Kuroda should also take a look at what Marcus Nunes has to say.

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