Draghi and European dollar demand – an answer to JP Irving’s puzzle

Yesterday, ECB chief Mario Draghi hinted quite clearly that monetary easing would be forthcoming in the euro zone. In fact he said the ECB would do everything to save the euro. However, something paradoxical happened on the back of Draghi’s comments. Here is JP Irving on his blog Economic Sophisms:

“Something interesting happened yesterday. The Euro strengthened  after Draghi hinted at easier policy. Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply.  I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.”

I can understand that JP is puzzled. Normally we would certainly expect monetary easing to mean that the currency should weaken. However, I think there is a pretty straightforward explanation to this and it has to do with the monetary linkages between the US and the euro zone. In my post Between the money supply and velocity – the euro zone vs the US from earlier in the week I described how I think the origin of the tightening of US monetary conditions in 2008 was a sharp rise in European dollar demand. When European investors in 2008 scrambled to increase their cash holdings they did not primarily demand euros, but US dollars. As a result US money-velocity dropped much more than European money-velocity, but at the same time the ECB failed to curb the drop in money supply growth. The sharp increase in dollar demand caused EUR/USD to plummet (the dollar strengthened).

What happened yesterday was exactly the opposite. Draghi effectively announced that he would increase the euro zone money supply and hence reduce the risk of crisis. With an escalation of the euro crisis less likely investors did move to reduce their demand for cash and since the dollar is the reserve currency of the world (and Europe) dollar demand dropped and as a result EUR/USD spiked. Hence, yesterday’s market action is fully in line with the mechanisms that came into play in 2008 and have been in play ever since. In that regard, it should be noted that Mario Draghi not only eased monetary policy in Europe yesterday, but also in the US as his comments led to a drop in dollar demand.

Finally this is a very good illustration of Scott Sumner’s point that monetary policy tends to work with long and variable leads. The expectational channel is extremely important in the monetary transmission mechanism, but so are – as I have often stressed – the international monetary linkages. In that regard it is paradoxical that University of Chicago (!!) economics professor Casey Mulligan exactly yesterday decided to publish a comment claiming that monetary policy does not have an impact on markets. Casey, did you see the reaction to Draghi’s comments? Or maybe it was just a technology shock?

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Related posts:

Between the money supply and velocity – the euro zone vs the US
International monetary disorder – how policy mistakes turned the crisis into a global crisis

Between the money supply and velocity – the euro zone vs the US

When crisis hit in 2008 it was mostly called the subprime crisis and it was normally assumed that the crisis had an US origin. I have always been skeptical about the US centric description of the crisis. As I see it the initial “impulse” to the crisis came from Europe rather than the US. However, the consequence of this impulse stemming from Europe led to a “passive” tightening of US monetary conditions as the Fed failed to meet the increased demand for dollars.

The collapse in both nominal (and real) GDP in the US and the euro zone in 2008-9 was very similar, but the “composition” of the shock was very different. In Europe the shock to NGDP came from a sharp drop in money supply growth, while the contraction in US NGDP was a result of a sharp contraction in money-velocity. The graphs below illustrate this.

The first graph is a graph with the broad money supply relative to the pre-crisis trend (2000-2007) in the euro zone and the US. The second graph is broad money velocity in the US and the euro zone relative to the pre-crisis trend (2000-2007).

The graphs very clearly illustrates that there has been a massive monetary contraction in the euro zone as a result of M3 significantly undershooting the pre-crisis trend. Had the ECB kept M3 growth on the pre-crisis trend then euro zone nominal GDP would long ago returned to the pre-crisis trend. On the other hand the Federal Reserve has actually been able to keep M2 on the pre-crisis path. However, that has not been enough to keep US NGDP on trend as M2-velocity has contracted sharply relative the pre-crisis trend.

Said in another way a M3 growth target of for example 6.5% would basically have been as good as an NGDP level target for the euro zone as velocity has returned to the pre-crisis trend. However, that would not have been the case in the US and that I my view illustrates why an NGDP level target is much preferable to a money supply target.

The European origin of the crisis – or how European banks caused a tightening of US monetary policy

Not surprisingly the focus of the discussion of the causes of the crisis often is on the US given both the subprime debacle and the collapse of Lehman Brothers. However, I believe that the shock actually (mostly) originated in Europe rather than the US. What happened in 2008 was that we saw a sharp rise in dollar demand coming from the European financial sector. This is best illustrated by the sharp drop in EUR/USD from close to 1.60 in July 2008 to 1.25 in early November 2008. The rise in dollar demand is obviously what caused the collapse in US money-velocity and in that regard it is notable that the rise in money demand in Europe primarily was an increase in demand for dollar rather than for euros.

This is why I stress the European origin of the crisis. However, the cause of the crisis nonetheless was a tightening of US monetary conditions as the Fed (initially) failed to appropriately respond to the increase in dollar demand – mostly because of the collapse of the US primary dealer system. Had the Fed had a more efficient system for open market operations in 2008 then I believe the crisis would have been much smaller and would have been over already in 2009. As the Fed got dollar-swap lines up and running and initiated quantitative easing the recovery got underway in 2009. This triggered a brisk recovery in both US and euro zone money-velocity. In that regard it is notable that the rebound in velocity actually was somewhat steeper in the euro zone than in the US.

The crisis might very well have ended in 2009, but new policy mistakes have prolonged the crisis and once again European problems are causing most headaches and the cause now clearly is that the ECB has allowed European monetary conditions to become excessively tight – just have a look at the money supply graph above. Euro zone M3 has now dropped more than 15% below the pre-crisis trend. This policy mistake has to some extent been counteracted by the Fed’s efforts to increase the US money supply, but the euro crisis have also led to another downleg in US money velocity. The Fed once again has failed to appropriately counteract this.

Both the Fed and the ECB have failed

In the discussion above I have tried to illustrate that we cannot fully understand the Great Recession without understanding the relationship between US and euro zone monetary policy and I believe that a full understanding of the crisis necessitates a discussion of European dollar demand.

Furthermore, the discussion shows that a credible money supply target would significantly have reduced the crisis in the euro zone. However, the shock to US money-velocity shows that an NGDP level target would “perform” much better than a simple money supply rule.

The conclusion is that both the Fed and the ECB have failed. The Fed failed to respond appropriately in 2008 to the increase in the dollar demand. On the other hand the ECB has nearly constantly since 2008/9 failed to increase the money supply and nominal GDP. Not to mention the numerous communication failures and the massively discretionary conduct of monetary policy.

Even though the challenges facing the Fed and ECB since 2008 have been somewhat different in nature I would argue that proper nominal targets (for example a NGDP level target or a price level target) and better operational procedures could have ended this crisis long ago.

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Related posts:

Failed monetary policy – (another) one graph version
International monetary disorder – how policy mistakes turned the crisis into a global crisis

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

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PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

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