Advertisements
Advertisements

If anything the Bank of Canada should ease monetary conditions

While the Federal Reserve – rightly or wrongly – has initiated a rate hiking cycle it is not given the the central bank in neighboring Canada should follow suit. In fact, according to our our composited indicator for Canada monetary conditions monetary policy is too tight for the the Bank of Canada to hit its 2% inflation over the medium-term.

The Bank of Canada will announce its rate decision on Wednesday and we should stress that our indicator does not say what the BoC will do, but rather what it ought to do to ensure it will hit its 2% inflation over the medium-term (2-3 years).

Four key monetary indicators

In February we – Markets & Money Advisory – will start to publish our Global Monetary Conditions Indicator covering monetary conditions in around 30 countries around the globe. Canada is one of that those countries.

In the Monitor we will publish a composite indicator for monetary conditions in each of these 30 countries and indicator will be based on four sub-indicators – broad money supply growth (typically M2 or M3), nominal GDP growth, exchange rate developments and the level of the key policy rate.

For these four sub-indicators we define what we call a policy-consistent growth rate, which mean that this would be the needed growth rate of for example M2 or nominal GDP to ensure that a given central bank hits its inflation target over the medium-term given the development in factors outside of the direct control of the central bank – for example money velocity, trend real GDP or foreign price developments.

The composite indicator is then an weighted average of these four sub-indicators and the indicator is calibrated so that a zero score in the indicator indicates that it is likely that inflation will be in line with the inflation target (in the case of Canada 2%) within the next 2-3 years.

Below you see the four sub-indicators for Canadian monetary conditions.

skaermbillede-2017-01-17-kl-07-28-02

skaermbillede-2017-01-17-kl-07-28-11

skaermbillede-2017-01-17-kl-07-28-18

skaermbillede-2017-01-17-kl-07-28-25

Overall, we see that while broad money supply growth (M3) is broadly in line with the policy-consistent growth path the three other indicators have been on the “tight side” for the past 1-2 years.

At the root of this excessive tightening of monetary conditions likely is the fact that the drop in global oil prices, which started in 2014 caused the Bank of Canada to essentially hit the Zero Lower Bound on interest rates and as the BoC (so far) has refused to implement monetary easy though the use of other instruments – for example intervention in the FX market – monetary conditions have more less “automatically” become too tight since early 2015.

This is very similar to the development in other countries with otherwise successful monetary policy – Norway and Australia – where monetary conditions also have been tightening excessively over the past 1-2 years.

BoC likely to undershoot its inflation target in the medium-term

The graph below shows our composite indicator for Canadian monetary conditions.

Skærmbillede 2017-01-17 kl. 07.41.07.png

We see that the indicator has been trending downwards since early 2014 – indicating a tightening of monetary conditions and since early 2015 the indicator has been below zero indicating downward risks relative to BoC’s inflation target and recently the indicator has dropped below -0.5.

We overall define the range from -0.5 to +0.5 to be ‘broadly neutral’ monetary conditions. Hence, presently monetary conditions are excessively tight.

Concluding, it might be that the Federal Reserve will hike interest rates further in 2017, but the Bank of Canada certainly should not be in a hurry to hike rates given the fact that monetary conditions presently are too tight to ensure that the BoC will hit its inflation target in the medium-term.

In fact, the most important issue for the BoC seems to much more clearly articulate how it plans to conduct monetary policy at the Zero Lower Bound. A possibility would be to use the exchange rate as a intermediate target/instrument to implement an easing of monetary condition at the Zero Lower Bound. See more on this here and here.

However, one thing is what that BoC ought to do another thing is what the BoC will do and we should stress that the purpose of our Global Monetary Conditions Monitor is not to forecast monetary policy action, but rather to evaluate in a consistent and objective way the monetary stance of a given country such as Canada.

Finally, stay tuned for the publication of our Global Monetary Conditions Monitor in February. For inquiries please drop us a mail (LC@mamoadvisory or LR@mamoadvisory.com).

Advertisements

“Make America Keynesian Again”

Today I was asked to do an interview with a Danish radio station about Donald Trump and about whether one could say anything positive about him or rather about his economic agenda. I declined to do the interview. I frankly speaking has nothing positive to say about Trump.

To me Donald Trump is an absolutely vile person and and his views on immigration and trade are completely the opposite of mine. However, I have also in the run up to the election in presentations and comments stressed that the presidential election from an overall financial market perspective would not be a big deal and judging from the market reaction today this indeed seems to be the case.

Reading the markets

But what exactly are the markets telling us today about the economic consequences of a Trump presidency combined with the fact that GOP now has the majority in both the House and the Senate?

First, of all we should concluded that the markets are fairly relaxed about the outcome of the election. This to me is an indication that Trump really will never be able (or seriously want to) implement many of the bizarre “promises” on trade and immigration he made during the election campaign.

Second the markets certainly do not expect the outcome of the election to cause a US recession or a global economic crisis. After all US stock markets are in fact trading in positive territory today. We get the same message from the currency markets where the dollar is little changed over the past 24 hours.

The Republican Keynesians

However, there is one market where we have seen a significant reaction to the outcome of the election and that is in the bond market. Just take a look at the graphs below.

image004

image003.png

The first graph is the yield on 10-year Treasury bonds and the second graph is 2-year yields.

We see that the 10-yield has increased around 10bp overnight. This certainly is a significant reaction, but it is equally notable that 2-yields in fact is slightly down.

What this is telling me is that more than anything else the markets expect Trump to be an old-school Keynesian. We know that Trump has already promised to increase Federal spending on infrastructure and he has of course also promised major tax cuts. With the Republicans controlling both the House and the Senate he should be able to deliver on some of these promises.

In fact there would be nothing unusual about having a Republican president who is also a “keynesian” (yes, I know he has no clue about what that is). In fact historically public spending has grown faster under Republican administrations than under Democrat administrations. Just take a look at the graphs below.

Since the Second World War public spending has grown by around a quarter of a percent per year faster when the president has been Republican than when there has been a Democrat president.

The picture is even more clear when we look at Federal government investments:

…and on the budget deficit:

So based on history we can certainly say that Republican presidents tend to be less fiscally conservative than Democrat presidents and judging from the action in the bond markets today there is little reason to believe that Trump should be any different from former Republican presidents.

And what will Trump spend money on? There is little doubt what the markets think – infrastructure! This is from Trump’s victory speech:

We are going to fix our inner cities, and rebuild our highways, bridges, tunnels, airports, schools, hospitals,” he said. “We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.

And see what effect that kind of speech had on copper prices today:

image002

Keynesian president + Keynesian Fed chair = No monetary offset

So it seems like the markets expect Trump to push for an expansionary fiscal policy agenda and this is visible in the bond market. However, it is also notable that it is only long-term bond yields, which have increased while 2-year yields haven’t increased overnight.

That tells me that the markets do not expect the Federal Reserve to (fully) offset the impact on nominal demand from a more expansionary fiscal policy.

This effectively means that an easier fiscal policy stance will cause monetary conditions to be eased. The reason is that if fiscal policy is eased then that will push up the equilibrium interest rate level. If the Fed does not hike interest rates to reflect this then it will automatically ease monetary policy by keeping the fed funds rate below the equilibrium interest rate.

This of course is the standard result in a New Keynesian model when interest rates are at the Zero Lower Bound (see for example here).

Does this mean that the so-called Sumner Critique does not apply? According to the Sumner Critique an easing of fiscal policy will not have (net) impact on aggregate demand if the central bank has an inflation target (or a nominal GDP) as the central bank will act to offset any impact on aggregate demand from a easier fiscal policy.

However, the Sumner Critique does not necessarily apply if the central bank’s inflation target is not credible and/or central bank is not willing to “enforce” it. And this seems relevant to the present situation. Hence, US core inflation continue to be below the Fed’s inflation target so one can certainly argue that there is room for an increase in aggregate demand without the Federal Reserve having to tighten monetary conditions.

Obviously the Fed could have done this on it own by for example not signaling a rate hike in December or signaling that it would re-introduce quantitative easing if inflation once again started to trend downwards.

However, the Fed clearly has “mental” problems with this. It is clear that most key Fed policy makers are worried about the consequences of keeping interest rates “low for longer” and more QE clearly seems to be a no-go.

In other words the Fed has put itself in a situation where further monetary easing is off the table and this is of course the reason why a number of Fed officials in the last couple of months have called for old-school keynesian fiscal stimulus.

It all seems to have started in August. This is Janet Yellen at the Jackson Hole symposium on August 26:

Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy.25 For example, steps could be taken to increase the effectiveness of the automatic stabilizers, and some economists have proposed that greater fiscal support could be usefully provided to state and local governments during recessions. As always, it would be important to ensure that any fiscal policy changes did not compromise long-run fiscal sustainability.

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans’ living standards. Though outside the narrow field of monetary policy, many possibilities in this arena are worth considering, including improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.

“Promoting capital investment” of course means government infrastructure spending.

Since August we have heard this again and again from Fed officials. This is Federal Reserve Vice Chairman Stanley Fischer at the New York Economic Club on October 17:

Some combination of more encouragement for private investment, improved public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards.

Said in another way – the Fed chair and the Vice chairman are both old-school keynesians and now we will have a keynesian in the White House as well.

The consequence is that if we get massive government infrastructure investments then that will push up the equilibrium interest rate, which will allow the Fed to hike interest rates (which they for some reason so desperately want to) without really tightening monetary conditions if interest rates are increased slower than the increase in the equilibrium rate.

This means that we de facto could have a keynesian alliance between the Trump administration and the Federal Reserve, which would mean that will get both monetary and fiscal easing in 2017 and this might be what the markets now are realizing.

Just take a look at what have happened in 5-year/5-year inflation expectations over the paste 24 hours:

image001-1

Over the past 24 hours long-term inflation expectations hence have increased by nearly a quarter of a percentage point.

Hence, Donald Trump just eased US monetary conditions significantly by pushing down the difference between the Fed fund target rate and the equilibrium rate. Paul Krugman should love Donald Trump.

The Sumner Critique strikes back – A future conflict between the Fed and Trump?

Obviously this is only possible because the Federal Reserve has not been willing to ensure nominal stability by clearly defining its nominal target and has been overly eager to increase interest rates, but I do think that this keynesian stimulus implemented could increase aggregate demand in 2017 and likely push core inflation above 2%.

But if this happens then the keynesian alliance between the Federal Reserve and Trump Administration might very well get tested. Hence, if fiscal-monetary easing push unemployment below the natural rate of unemployment and inflation (and inflation expectations) start to accelerate above 2% then the Federal Reserve sooner or later will have to act and tighten monetary conditions, which could be setting the US economy up for a boom-bust scenario with the economy initially booming one-two years and then the Fed will kill the boom by hiking interest rates aggressively.

Knowing Trump’s temperament and persona that could cause a conflict between the Fed and the Trump administration.

This is of course pure speculation, but even though the Trump administration and the Fed for now seem to favouring the same policy mix – aggressive fiscal easing and gradual rate hikes (slower than the increase the in equilibrium rate) it is unlike that this kind of old-school keynesian stop-go policies will end well.

2017 – a year of inflation?

Given these factors and others I for the first time since 2008 think that we could see inflation increase more significantly in 2017 in the US. This is of course what we to some extent want, but I am concerned that we are getting higher inflation not because the Federal Reserve has moved towards a more rule-based monetary policy framework, which ensure nominal stability, but because we are moving back towards old-school keynesian stop-go demand “management”.

PS I apologize to serious (New) Keynesians about using the term “keynesian” here. I here use the term as to refer to the kind demand management policy, which so failed during the 1970s. They where inspired by Keynesian economic think and was as such keynesian. However, that is not say that present day keynesians would necessarily agree with these policies.

PPS See also my comment over at Geopolitical Intelligence Service on why the US is “Still the Greatest”– also after Trump has become president.

Update: Read my follow-up post here.

Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call

In a very surprising move the Swedish Riksbank this morning cut its key policy rate by 50bp to 0.25%. It was about time! The Riksbank has for a very long time undershot its 2% inflation target and inflation expectations have consistently been below 2% for a long time as well.

The interesting question now is what is next? The Riksbank is now very close to the Zero Lower Bound and with inflation still way below the inflation target one could argue that even more easing is needed.

I have earlier addressed how to conduct monetary policy at the ZLB for small-open economies like Sweden. Traditional quantitative easing obviously is an option, but it is also possible to get some inspiration from the works of such great economists as Lars E. O. Svensson or Bennett McCallum.

Already back in 2012 I wrote a post about what advice Bennett would give to the Riksbank in a situation like it now find itself in. This is from my blog post Sweden, Poland and Australia should have a look at McCallum’s MC rule

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? …

…What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target…

…The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

…So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank … should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

…Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank…can.. avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

That is it – now back to writing on the Polish central bank’s failure to do the right thing at it’s rate decision yesterday.

—-

See also A scary story: The Zero Lower Bound and exchange rate dynamics

A scary story: The Zero Lower Bound and exchange rate dynamics

I was in Sweden last week and again yesterday (today I am in Norway). My trips to Sweden have once again reminded me about the dangers of conducting monetary policy with interest rates at the Zero Lower Bound (ZLB). The Swedish central bank – Riksbanken – has cut is key policy rate to 1% and is like to cut it further to 0.75% before the end of the year so we are inching closer and closer to zero.

Riksbanken is just one of a number of European central banks close to zero on interest rates – most notably the ECB is at 0.25%. In the Czech Republic the key policy rate stands at 0.05%. And even Poland, Hungary, Norway are moving closer and closer to the ZLB.

Most of these central banks seem to be quite unprepared for what might happen at the Zero Lower Bound. In this post I will particularly focus on the exchange rate dynamics at the ZLB.

A Taylor rule world

Lets say we can describe monetary policy with a simple Taylor rule:

r = rN+a*(p-pT)+b(ygap)

In a “normal” world where everything is fine and the key policy rate (r) is well-above zero the central bank will hike or cut r in response to increasing or declining inflation (p) relative to the inflation target (pT) or in response to the output gap (ygap) increasing or decreasing. If the output gap is closed and inflation is at the inflation target then the central bank will set it’s key policy rate at the “natural” interest rate rN.

What happens at the ZLB?

However, lets assume that we are no longer in a normal world. Lets instead assume that p is well below the inflation target and the output gap is negative. As we know this is the case in most European countries today.

So if we plug these numbers into our Taylor rule above we might get r=1%. As long as r>0 we are not in trouble yet. The central bank can still conduct monetary policy with its chosen instrument – the key policy interest rate. This is how most inflation targeting central banks in the world are doing their business today.

But what happens if we get a negative shock to the economy. Lets for example assume that an overheated property markets starts to cool gradually and real GDP starts to slow. In this case the central bank according to it’s Taylor rule should cut its key policy rate further. Sooner or later the central bank hits the ZLB.

An then suddenly the currency starts strengthening dramatically

In fact imagine that the interest rate level needed to close the output gap and keep inflation at the inflation target is -2%.

We can say that monetary policy is neutral when the central bank sets interest rates according to the Taylor rule, but if interest rates are higher than the what the Taylor rule stipulates then monetary policy is tight. So if the Taylor rule tells us that the key policy rate should be -2% and the actual policy rate is zero then monetary policy is of course tight. This is what many central bankers fail to understand. Monetary policy is not necessarily easy just because the interest rate is low in a historical or absolute perspective.

And this is where it gets really, really dangerous because we now risk getting into a very unstable economic and financial situation – particularly if the central bank insists that monetary policy is already easy, while it is in fact tight.

What happens to the exchange rate in a situation where monetary policy is tightened? It of course appreciates. So when the “stipulated” (by the Taylor rule) interest rate drops to for example -2% and the actual interest rate is at 0% then obviously the currency starts to appreciates – leading to a further tightening of monetary conditions. With monetary conditions tightening inflation drops further and growth plummets. So now we might need an interest rate of -4 or -7%.

With that kind of monetary tightening you will fast get financial distress. Stock markets start to drop dramatically as inflation expectations plummets and the economy contracts. It is only a matter of time before the talk of banking troubles start to emerge.

The situation becomes particularly dangerous if the central bank maintains that monetary policy is easy and also claim that the appreciation of the currency is a signal that everything is just fine, but it is of course not fine. In fact the economy is heading for a massive collapse if the central bank does not change course.

This scenario is of course very similar to what played out in the US in 2008-9. A slowdown in the US property market caused a slowdown in the US economy. The Fed failed to respond by not cutting interest rates aggressive and fast enough and as a consequence we soon hit the ZLB. And what happened to the dollar? It strengthened dramatically! That of course was a very clear indication that monetary conditions were becoming very tight. Initially the Fed clearly failed to understand this – with disastrous consequences.

But don’t worry – there is a way out

The US is of course special as the dollar is a global reserve currency. However, I am pretty sure that if a similar thing plays out in other countries in the world we will see a similar exchange rate dynamics. So if the Taylor rule tells you that the key policy rate should be for example -4% and it is stuck at zero then the the currency will start strengthening dramatically and inflation and growth expectations will plummet potentially setting off financial crisis.

However, there is no reason to repeat the Fed’s failure of 2008. In fact it is extremely easy to avoid such a scenario. The central bank just needs to acknowledge that it can always ease monetary policy at the ZLB. First of all it can conduct normal open market operations buying assets and printing its own currency. That is what we these days call Quantitative Easing.

For small open economies there is an even simpler way out. The central bank can simply intervene directly in the currency market to weak its currency and remember the market can never beat the central bank in this game. The central bank has the full control of the printing press.

So imagine we now hit the ZLB and we would need to ease monetary policy further. The central bank could simply announce that it will weaken its currency by X% per months until the output gap is close and inflation hits the inflation target. It is extremely simple. This is what Lars E.O. Svensson – the former deputy central bank governor in Sweden – has termed the foolproof way out of deflation.

And even better any central bank, which is getting dangerously close to the ZLB should pre-announce that it will in fact undertake such Svenssonian monetary operations to avoid the dangerous of conducting monetary policy at the ZLB. That would mean that as the economy is moving closer to the ZLB the currency would automatically start to weaken – ahead of the central bank doing anything – and in that sense the risk of hitting the ZLB would be much reduced.

Some central bankers understand this. For example Czech central bank governor Miroslav Singer who recently has put a floor under EUR/CZK, but unfortunately many other central bankers in Europe are dangerously ignorant about these issues.

PS I told the story above using a relatively New Keynesian framework of a Taylor rule, but this is as much a Market Monetarist story about understanding expectations and that the interest rate level is a very bad indicator of the monetary policy stance.

Tick tock…here comes the Zero Lower Bound again

This week have brought even more confirmation that we are still basically in a deflationary world – particularly in Europe. Hence, inflation numbers for October in a number of European countries published this week confirm that that inflation is declining markedly and that we now very close to outright deflation in a number of countries. Just take the case of the Czech Republic where the so-called monetary policy relevant inflation dropped to 0.1% y/y in October or even worse Sweden where we now have outright deflation – Swedish consumer prices dropped by 0.1% in October compared to a year ago.

And the picture is the same everywhere – even a country like Hungary where inflation notoriously has been above the central bank’s 3% inflation target inflation is now inching dangerously close to zero.

Some might say that there is no reason to worry because the recent drop in inflation is largely driven by supply side factors. I would agree that we shouldn’t really worry about deflation or disinflation if it is driven by a positive supply shocks and central banks would not react to such shocks if they where targeting nominal GDP rather than headline consumer price inflation. In fact I think that we are presently seeing a rather large positive supply shock to the global economy and in that sense the recent drop in inflation is mostly positive. However, the fact is that the underlying trend in European prices is hugely deflationary even if we strip out supply side factors.

Just the fact that euro zone money supply growth have averaged 0-3% in the past five years tells us that there is a fundamental deflationary problem in the euro zone – and in other European countries. The fact is that inflation has been kept up by negative supply shocks in the past five years and in many countries higher indirect taxes have certainly also helped kept consumer price inflation higher than otherwise would have been the case.

So yes supply side factors help drag inflation down across Europe at the moment – however, some of this is due to the effect of earlier negative supply side shocks are “dropping out” of the numbers and because European governments are taking a break from the austerity measures and as a result is no longer increasing indirect taxes to the same extent as in earlier years in the crisis. Hence, what we are no seeing is to a large extent the real inflation picture in Europe and the fact is that Europe to a very large extent is caught in a quasi-deflatonary trap not unlike what we had in Japan for 15 years.

Here comes the Zero Lower Bound

Over the past five years it is not only the ECB that stubbornly has argued that monetary policy was easy, while it in fact was über tight. Other European central banks have failed in a similar manner. I could mention the Polish, the Czech central banks and the Swedish Riksbank. They have all to kept monetary policy too tight – and the result is that in all three countries inflation is now well-below the central bank’s inflation targets. Sweden already is in deflation and deflation might very soon also be the name of the game in the Czech Republic and Poland. It is monetary policy failure my friends!

In the case of Poland and Sweden the central banks have had plenty of room to cut interest rates, but both the Polish central bank and the Swedish Riksbank have been preoccupied with other issues. The Riksbank has been busy talking about macro prudential indicators and the risk of a property market bubble, while the economy has slowed and we now have deflation. In fact the Riksbank has consistently missed its 2% inflation target on the downside for years.

In Poland the central bank for mysteries reasons hiked interest rates in early 2012 and have ever since refused to acknowledged that the Polish economy has been slowing fairly dramatically and that inflation is likely to remain well-below its official 2.5% inflation target. In fact yesterday the Polish central bank published new forecasts for real GDP growth and inflation and the central bank forecasts inflation to stay well-below 2.5% in the next three years and real GDP is forecasted to growth much below potential growth.

If a central bank fails to hit its inflation target blame the central bank and if a central bank forecasts three years of failure to hit the target something is badly wrong. Polish monetary policy remains overly tight according to it own forecasts!

The stubbornly tight monetary stance of the Polish, the Czech and the Swedish central banks over the past couple of years have pushed these countries into a basically deflationary situation. That mean that these central banks now have to ease more than would have been the case had they not preoccupied themselves with property prices, the need for structural reforms and fiscal policy in recent years. However, as interest rates have been cut in all three countries – but too late and too little – we are now inching closer and closer to the Zero Lower Bound on interest rates.

In fact the Czech central bank has been there for some time and the Polish and the Swedish central bank might be there much earlier than policy makers presently realise. If we just get one “normal size” negative shock to the European economy and then the Polish and Swedish will have eventually to cut rates to zero. In fact with Sweden already in deflation one could argue that the Riksbank already should have cut rates to zero.

The Swedish and the Polish central banks are not unique in this sense. Most central banks in the developed world are very close to the ZLB or will get there if we get another negative shock to the global economy. However, most of them seem to be completely unprepared for this. Yes, the Federal Reserve now have a fairly well-defined framework for conducting monetary policy at the Zero Lower Bound, but it is still very imperfect. Bank of Japan is probably closer to having a operational framework at the ZLB. For the rest of the central banks you would have to say that they seem clueless about monetary policy at the Zero Lower Bound. In fact many central bankers seem to think that you cannot ease monetary policy more when you hit the ZLB. We of course know that is not the case, but few central bankers seem to be able to answer how to conduct monetary policy in a zero interest rate environment.

It is mysteries how central banks in apparently civilised and developed countries after five years of crisis have still not figured out how to combat deflation with interest rates at the Zero Lower Bound. It is a mental liquidity trap and it is telling of the serious institutional dysfunctionalities that dominate global central banking that central bankers are so badly prepared for dealing with the present situation.

But it is nonetheless a fact and it is hard not to think that we could be heading for decades of deflation in Europe if something revolutionary does not happen to the way monetary policy is conducted in Europe – not only by the ECB, but also by other central banks in Europe. In that sense the track record of the Swedish Riksbank or the Polish and Czech central banks is not much better than that of the ECB.

We can avoid deflation – it is easy!

Luckily there is a way out of deflation even when interest rates are stuck at zero. Anybody reading the Market Monetarists blogs know this and luckily some central bankers know it as well. BoJ chief Kuroda obviously knows what it takes to take Japan out of deflation and he is working on it. As do Czech central bank chief Miroslav Singer who last week – finally  – moved to use the exchange rate as policy instrument and devalued the Czech kurona by introducing a floor on EUR/CZK of 27. By doing this he copied the actions of the Swiss central bank. So there is hope.

Some central bankers do understand that there might be an Zero Lower Bound, but there is no liquidity trap. You can always avoid deflation. It is insanely easy, but mentally it seems to be a big challenge for central bankers in most countries in the world.

I am pretty optimistic that the Fed’s actions over the past year is taking the US economy out of the crisis. I am optimistic that the Bank of Japan will win the fight against deflation. I am totally convinced that the Swiss central bank is doing the right thing and I am hopeful that Miroslav Singer in the Czech Republic is winning the battle to take the Czech economy out of the deflationary trap. And I am even optimistic that the recent global positive supply shock will help lift global growth.

However, the ECB is still caught in its own calvinist logic and seems unable to realise what needs to be done to avoid a repeat of the past failures of the Bank of Japan. The Swedish central bank remains preoccupied with macro prudential stuff and imaginary fears of a property market bubble, while the Swedish economy now caught is in a deflationary state. The Polish central bank continues to forecast that it will fail to meet its own inflation target, while we are inching closer and closer to deflation. I could mention a number of other central banks in the world which seem trapped in the same kind of failed policies.

Ben Bernanke once argued that the Bank of Japan should show Rooseveltian resolve to bring Japan out of the deflationary trap. Unfortunately very few central bankers in the world today are willing to show any resolve at all despite the fact that we at least Europe is sinking deeper and deeper into a deflationary trap.

—-

Update: Former Riksbank deputy governor Lars E. O. Svensson comments on the Swedish deflation. See here.

%d bloggers like this: