Yet another year of asymmetrical monetary policy – revisiting the Weidmann rule

Nearly a year ago – January 2 – I wrote a blog post on what I termed the Weidmann rule. In the blog post I argued that the ECB is basically following a rule – named after Bundesbank boss Jens Weidmann – which is asymmetrical. The ECB will tighten monetary conditions in the event of a positive aggregate demand (velocity) shock, but will not ease in the event of a negative demand (velocity) shock to the euro zone economy.

This means that the ECB monetary policy set-up basically ensures that we are in a classical world when demand is picking (the budget multiplier is zero), but is in a basically keynesian world when we have negative demand shocks (the budget multiplier is positive). The world is not “naturally” keynesian, but the ECB’s policy regime makes the euro zone economy is essentially 50% keynesian.

A year ago I argued that the Weidman rule would be deflationary. Hence, “if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).”

This is of course exactly what we have seen over the past year – US NGDP remains on its 4% path, while euro zone has averaged less than 1% over the past year and the gap between US and euro zone NGDP is therefore growing larger and larger.

Add to that that euro zone has seen as least two negative demand shocks in 2014. First of all and likely most important the Russian (Ukrainian) crisis, which is likely to lead to a double-digit contraction in Russian real GDP in 2015 and second renewed concerns over the political situation in Greece and other Southern European countries (particularly separatist worries in Spain). These shocks are so far not major shocks and with a proper monetary policy set-up would like have very limited impact on the European economy. However, we do not have a proper monetary policy set-up and therefore every even smaller negative demand shock will just push Europe deeper and deeper into a deflationary spiral.

It is correct that the ECB has done a bit to offset these shocks – which in quantity theoretical context essentially are negative velocity shocks – by cutting interest rates and indicated that we will get some sort of quantitative easing in 2015.

However, with the euro zone money base basically still contracting, M3 growth being lacklustre, inflation expectations declining and NGDP growth being very weak it is hard to argue that the ECB has done a lot. In fact it has not really done anything to even offset the negative velocity/demand shocks we have seen in 2015.

Therefore, we unfortunately have to conclude that the Weidmann rule still the name of the game in Frankfurt and all indications are that the Bundesbank remains strongly opposed to any quantitative easing.

What the ECB needs to do is of course to once and for all to demonstrate that it will indeed offset any shock to velocity – both negative and positive to ensure nominal stability. A 4% NGDP target rule would do the job (see here) and would be fully within ECB’s mandate.

PS These days Jens Weidmann is arguing that things will be a lot better in the euro zone because the drop in oil prices is a positive demand shock (yes, this is basically what he is saying) and that monetary easing therefore is not needed. In 2011 the Bundesbank of course was eager to see interest rate hikes in response to increased oil prices because the risk of “second-round effects” (horrible expression!). It is hard to get any better illustration of the just how asymmetrical the Bundesbank’s preferred monetary policy rule is.

PPS Tim Worstall has an excellent post on Jens Weidmann and the Bundesbank here.

One step closer to euro zone deflation

This is from CNBC:

Euro zone consumer inflation came in lower than expected in December, adding to concerns that the euro zone could be heading towards a period of deflation.

Consumer prices rose by 0.8 percent year-on-year in December, below the 0.9 percent expected by economists. It comes after inflation increased by 0.9 percent in November.

Day by day it is becoming more and more clear that the euro zone is heading for deflation and despite of this the ECB so far has failed to act and it is blatantly obvious that the ECB is in breach of its own mandate to secure “price stability” defined as 2% inflation.

The failure to act is also a clear demonstration that the ECB in fact has an asymmetrical monetary policy rule (what I have called the Weidmann rule). The ECB will tighten monetary policy when inflation increases, but will not ease when inflation drops.

Depressing…

The “Weidmann rule” and the asymmetrical budget multiplier (is the euro zone 50% keynesian?)

During Christmas and New Years I have been able to (nearly) not think about monetary policy and economics, but I nonetheless came across some comments from Bundesbank chief Jens Weidmann from last week, which made me think about the connection between monetary policy rules and fiscal austerity in the euro zone. I will try address these issues in this post.  

This is Jens Weidmann:

“The euro zone is recovering only gradually from the harshest economic crisis in the post-war period and there are few price risks. This justifies the low interest rate…Low price pressure however cannot be a licence for arbitrary monetary easing and we must be sure to raise rates at the right time should inflation pressure mount.”

It is the second part of the quote, which is interesting. Here Weidmann basically spells out his preferred reaction function for the ECB and what he is saying is that he bascially wants an asymmetrical monetary policy rule – when inflation drops below the ECB’s 2% inflation target the ECB should not “arbitrary” cut its key policy rate, but when inflation pressures increase he wants the ECB to act imitiately.

It is not given that the ECB actually has such a policy rule, but given the enormous influence of the Bundesbank on ECB policy making it is probably reasonable to assume that that is the case. That in my view would mean that Summer Critique does not apply (fully) to the euro zone and as a result we can think of the euro zone as being at least 50% “keynesian” in the sense that fiscal shocks will not be fully offset by monetary policy. As a result it would be wrong to assume that the budget multiplier is zero in the euro zone – or rather it is not always zero. The budget multiplier is asymmetrical.

Let me try to illustrate this within a simple AS/AD framework.

First we start out with a symmetrical policy rule – an inflation targeting ECB. Our starting point is a situation where inflation is at 2% – the ECB’s official inflation target – and the ECB will move to offset any shock (positive and negative) to aggregate demand to keep inflation (expectations) at 2%. The graph below illustrates this.

ASAD AD shock

If the euro zone economy is hit by a negative demand shock in the form of for example fiscal tightening across the currency union the AD curve inititally shifts to the left (from AD to AD’). This will push inflation below the ECB’s 2% inflation target. As this happens the ECB will automatically move to offset this shock by easing monetary policy. This will shift the AD curve back (from AD’ to AD). With a credible monetary policy rule the markets would probably do most of the lifting.

The Weidmann rule – asymmetry rules

However, the Weidmann rule as formulated above is not symmetrical. In Weidmann’s world a negative shock to aggregate demand – for example fiscal tightening – will not automatically be offset by monetary policy. Hence, in the graph above the negative shock aggregate demand (from AD to AD’) will just lead to a drop in real GDP growth and in inflation to below 2%. Given the ECB’s official 2% would imply the ECB should move to offset the negative AD shock, but that is not the case under the Weidmann rule. Hence, under the Weidmann rule a tightening of fiscal policy will lead to drop in aggregate demand. This means that the fiscal multiplier is positive, but only when the fiscal shock is negative.

This means that the Sumner Critique does not hold under the Weidman rule. Fiscal consolidation will indeed have a negative impact on aggregate demand (nominal spending). In that sense the keynesians are right – fiscal consolidation in the euro zone has likely had an negative impact on euro zone growth if the ECB consistently has followed a Weidmann rule. Whether that is the case or not is ultimately an empirical question, but I must admit that I increasingly think that that is the case. The austerity drive in the euro zone has likely been deflationary. However, it is important to note that this is only so because of the conduct of monetary policy in the euro area. Had the ECB instead had an fed style Evans rule with a symmetrical policy rule then the Sumner Critique would have applied also for the euro area.

The fact that the budget multiplier is positive could be seen as an argument against fiscal austerity in the euro zone. However, interestingly enough it is not an argument for fiscal stimulus.  Hence, according to Jens Weidmann the ECB “must be sure to raise rates at the right time should inflation pressure mount”. Said in another way if the AD curve shifts to the right – increasing inflation and real GDP growth then the ECB should offset this with higher interest rates even when inflation is below the ECB’s 2% inflation target.

This means that there is full monetary offset if fiscal policy is eased. Therefore the Sumner Critique applies under fiscal easing and the budget multiplier is zero.

The Weidmann rule guarantees deflation 

Concluding, with the Weidmann rule fiscal tightening will be deflationary – inflation will drop as will real GDP growth. But fiscal stimulus will not increase aggregate demand. The result of this is that if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).

This is of course exactly what we have seen over the past five years. But don’t blame fiscal austerity – blame the Weidmann rule.

NGDP euro zone USA

PS I should really acknowledge that this is a variation over a theme stressed by Larry Summers and Brad Delong in their paper Fiscal Policy in a Depressed Economy. See my discussion of that paper here.

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