There’s no such thing as “out of ammo”

This really misses the point:

It’s time for central bankers to ask for help.

As the International Monetary Fund prepares to downgrade its outlook for the world economy again, monetary policy makers are running low of ammunition to fight a fresh downturn. Bank of America Merrill Lynch calculates they have reduced interest rates more than 600 times since the 2008 collapse of Lehman Brothers Holdings Inc. with theReserve Bank of India extending the run on Tuesday by cutting its benchmark more than expected.

While the European Central Bank and Bank of Japan haven’t ruled out buying even more bonds, there are doubts over how much more quantitative easing can achieve given yields are already around record lows and inflation still remains beneath the target of most policy makers. Even easier monetary policy may just end up propelling asset markets rather than economies.

That leaves economists and investors increasingly looking toward governments to lead the rescue efforts should the China-led slowdown in emerging markets infect developed nations. BofA Merrill Lynch sees a 25 percent chance of a recession-like slump this year.

“Monetary policy is basically exhausted in terms of producing real growth and even inflation,” billionaire Bill Gross of Janus Capital Management LLC told Bloomberg Television this month. “Fiscal policy is the second piece of the leg that has to take place in order to get us back to where we want to go.”

Almost every day something happens that refutes the claims made here.  First of all, there is no evidence that central bankers are not achieving their goals.  The Fed is about to raise rates.  The ECB seems satisfied with its progress in promoting a eurozone recovery.  I don’t think it should seem satisfied, but it does.  Ditto for the BOJ.  Just weeks ago Draghi said he’d do more QE if necessary.  And yet if you believe what I just quoted above, Draghi’s recent announcement should have had no impact on the markets, either because there are no more bonds to buy (out of ammo) or because QE has no effect. Instead here’s what happened to the euro:

Screen Shot 2015-09-30 at 4.58.54 PMIf Bill Gross were correct then it should be impossible to guess what time of day Draghi made his announcement.  But I’ll bet even Ray Lopez can guess.  (Hint, easier than expected money usually makes a currency depreciate in value.)

A beggar thy neighbor policy?  Let’s see how Wall Street reacted:

Wall Street has also welcomed Mario Draghi’s pledge to take more stimulus measure if needed.

The Dow Jones industrial average, and the broader S&P 500, are both up by almost 1%.

The following sounds appealing, until you think about the implications:

If the world economy enters a downdraft, Steven Englander, global head of G-10 FX strategy at Citigroup Inc., proposes a more revolutionary response, akin to the “helicopter money” once advocated by Milton Friedman.

In what he calls “cold fusion,” politicians would cut taxes and boost spending. Central banks would then cover the resulting increase in borrowing by purchasing more bonds as part of a commitment to permanently expand their balance sheets. The easier fiscal policy would be covered by QE Infinity.

“Politically it is difficult for central banks to outright endorse monetization of government debt, but faced with another slump and armed with ineffective policy tools, we expect that central banks will quickly give the wink and nod to fiscal measures,” Englander said in a report to clients last week.

The upshot would be greater purchasing power would be injected straight into the economy, increasing activity and inflation. Long-term bond yields would rise, yet short-term yields adjusted for inflation would turn negative.

Give him credit for recognizing that easier money can end up raising long term bond yields.  And “cold fusion” sounds pretty cool. But otherwise this makes no sense. What does it mean to promise the injections will be permanent?  That suggests you are targeting the monetary base, which could have catastrophic results.  You need to make just enough of the injections permanent to hit your NGDP target.  But if you do that, then the fiscal stimulus is pointless.  Even Paul Krugman claims that monetary policy ineffectiveness occurs when central banks cannot make credible promises to make monetary injections permanent.  But if you assume the promises are made and believed, then the fiscal part of the policy does nothing other than increase the national debt, worsening a problem that is already becoming increasingly worrisome as the population ages.

The Fed proposes, the bond market disposes

Here’s what almost everyone is wrong about.  There’s a debate about whether the Fed should gradually “normalize” interest rates over the next few years.  And indeed the Fed has laid out a plan to raise rates into the 3% to 4% range over the next three years.

Unfortunately, the Fed doesn’t get to decide the path of interest rates.  It looks like they do, but that’s a cognitive illusion. The bond market determines the path of interest rates, reflecting factors such as global credit markets, as well as NGDP growth and the level of NGDP in the US.  If the Fed tried to independently determine the path of interest rates it would lead to hyperinflation or hyperdeflation.

Today was another lesson in humility for the Fed.  Bond yields have been plunging, which is the bond market’s way of saying, “Oh no you don’t, there’s going to be no normalization of interest rates over the next few years.”

Resistance is futile.  The more the Fed resists and tries to force rates sharply higher, the more the economy slows, and the more downward pressure on rates in the bond market.  In the end, the bond market always wins.

The Fed should stop focusing on trying to hit its interest rate targets, and start focusing on hitting its inflation target.  It’s not the Fed’s job to set interest rates. Even better, we should make their job much simpler by switching to NGDPLT.

PS.  The most noteworthy aspect of today’s jobs report is that the wage acceleration that everyone’s expecting again failed to show up.

PPS.  Can someone find me a link to where I can observe fed funds futures prices? Thanks. (I’d guess they are moving in a “Kocherlakota direction.”)

PPPS.  Some die hard opponents of “The Great Stagnation” had held out hope that a fall in U-6 unemployment (the broadest measure) would propel future growth.  Now even that option is mostly gone, as it plunged to 10.0% in September, the same level as in February 1996.)  It will go a bit lower, but it no longer represents a large cache of workers waiting in the wings to propel us forward.  Get ready for the new normal—3.0% NGDP growth—it’s coming soon.

The Financial Times on Chinese data

A few weeks ago I suggested that Chinese data might be roughly correct.  Here’s the FT:

That China’s official economic data cannot be trusted is now received wisdom among western economists, investors and policymakers. To treat the numbers as authoritative is to invite ridicule: believers are naive at best and, at worst, stooges for Communist propaganda.

The problem with this conventional wisdom is that, aside from the closely watched and politically sensitive real gross domestic product growth rate, other official data vividly depict the slowdown in China’s economy that sceptics insist is being concealed. If there is a conspiracy to disguise the extent of harder times in China, it is an exceedingly superficial affair.

And The Economist:

Amid the extreme pessimism about China’s economy in recent months, it is tempting to conclude that rebalancing has failed. Just look at the car market, usually a good shorthand for the health of consumer demand. Automobile sales fell by 3.4% in August compared with a year ago, the third monthly decline in a row. Yet other forms of consumption are accelerating. A property recovery has stoked demand for furniture, home electronics and renovation materials, with sales rising an average of 17% in August from a year earlier. From jewellery to traditional Chinese medicine, buying has picked up in recent months.

Smartphone sales are down in volume terms but soaring by value, as shoppers move upmarket. Companies hit by the anti-corruption campaign under Xi Jinping, China’s president, are learning to prosper despite the new strictures. Distillers’ profits, which fell last year, have rebounded, pulled along by affordable brands for ordinary consumers rather than the exorbitantly priced bottles previously used as bribes for officials.

Overall, China’s retail sales have increased by 10.5% in real terms this year, well ahead of economic growth (officially 7% but closer to 6% according to many analysts). There are, as ever, doubts about the reliability of China’s data, though in this case it may be that the retail figures are too low. Nicholas Lardy, an expert on Chinese statistics at the Peterson Institute for International Economics, a think-tank, notes that retail numbers do not include services, a glaring omission since surveys show that services account for as much as two-fifths of China’s consumer spending.

Read that again.  An estimated 10.5% growth in real retail sales may be too low, the true figure may be even higher.  As my favorite blogger might say, “Scream it from the rooftops.”

PS.  I wish he’d take the lead from his co-blogger, and “shout it from the rooftops”.  Screaming really gets on my nerves.


An important new paper on NGDP targeting

Many people have sent me an excellent new paper by Wolfgang LECHTHALER, Claire A. REICHER, and Mewael F. TESFASELASSIE, Kiel Institute for the World Economy.  The front page notes that:

This document was requested by the European Parliament’s Committee on Economic and Monetary Affairs.

However it clearly represents the authors’ views, and is not any sort of official statement by the EU.

As far as issues related to implementation are concerned, a strict inflation target can be simpler in certain ways to implement than either a flexible inflation target or a NGDP target, because revisions to the data on inflation are small, while revisions to the data on NGDP or real GDP are larger. Moreover there is considerable uncertainty about potential output growth. These are problems discussed in great detail by Orphanides and Williams (2002), Rudebusch (2002), and Goodhart et al. (2013). However, a counter-argument suggests that a NGDP target, even if in levels, would make it easier to avoid issues related to the measurement of the output gap. Additional arguments in favor of NGDP targeting involve the idea that it is easier to sell more stable nominal incomes to the public during bad times, and that a NGDP level target per se would increase the degree to which monetary policymakers are held accountable, by providing a measurable outcome.

To summarize, the theoretical evidence suggests that an explicit NGDP target, especially in levels, could possibly help the central bank to promote long-run price stability while allowing for a short-run response to output. However, this evidence is still relatively uncertain, and in the meantime, we find it useful to clarify the debate about what should and should not be expected to be achieved with a NGDP target.

I’m not qualified to discuss the data revision question, although Mark Sadowski challenged the conventional wisdom.  I would make two points:

1.  Even if measured inflation is not sharply revised, it remains a very inaccurate measure of the sort of price changes that have macroeconomic significance.  For instance, a large share of the core CPI is based on rent and rental equivalents for housing.  That data isn’t even a true “price”, and has no business influencing monetary policy.  Last time I looked housing was 39% of the core CPI.  This problem is briefly discussed later in their paper.

2.  Revisions to NGDP are not large enough to be of macroeconomic significance, with one exception—changes in methodology.  A recent example is the addition of R&D spending to investment, which caused a jump in NGDP.  But there’s pretty general agreement that monetary policymakers would allow “base drift” in those cases; they’d raise the target by the amount of the upward bump from the new definition of NGDP.  Also note that the Fed should be targeting expected NGDP 12 or 24 months out in the future, which makes near term data revisions much less important.

The theoretical case for NGDP level targeting as a forward guidance tool has been made, among others, by Woodford (2012). Similarly, in a recently published study, Coibion et al. (2012) have found strong theoretical support for price level targeting. Importantly, they take the zero lower bound into account, and they find that under inflation targeting, recessions that are deep enough so that the ZLB becomes binding are rare but costly. They Is nominal GDP targeting a suitable tool for the ECB’s monetary policy? They go on to show that price level targeting would result in less-deep recessions and stronger recoveries than would inflation targeting. Furthermore, price level targeting would imply that the ZLB would become binding less often. Therefore, switching from inflation targeting to price level targeting can lead to a substantial improvement in overall welfare, even if there is no foolproof way for such a target to always avoid hitting the zero lower bound. However, we are not yet aware of a study which compares price level targeting with NGDP level targeting, in light of the other theoretical considerations that we consider to be important. Therefore, we still consider the choice of a level target, were one to be adopted, to be an open question.

Someone should do that study!

In fact, this inability to use monetary policy to fine-tune prices or GDP motivates the debate about Taylor rules. Under a Taylor rule, the ECB would increase interest rates whenever inflation or output is above target. It turns out that something like a Taylor rule could also be used to implement NGDP targeting, at least when the zero lower bound does not bind. As Andolfatto (2013) shows, this would entail adding an additional term to represent the past deviation of the price level from its long-run path. While the specific implementation of this idea would require more thought, this idea would require relatively few changes from current operating procedures, to the extent that current policy resembles a Taylor rule but with equal weight on inflation and on output.

A more ambitious idea would be to set up a futures market in a price index or NGDP, and then for the central bank to either buy and sell these futures, or otherwise adjust monetary policy, in order to use these futures prices (rather than interest rates) as an operating instrument. To the extent that these futures prices represent accurate forecasts, then this approach should minimize fluctuations in the underlying target. Furthermore, this idea would encourage central banks to act proactively to avoid future target misses, rather than act reactively to past target misses. This idea is known as “market monetarism”, in the words of Christensen (2011) and Sumner (2011). While this approach is innovative, the likely consequences of this policy approach are not yet completely clear, and this approach would require the euro area to set up a new array of futures markets. In fact, for these futures markets to make it possible to target NGDP, financial markets would have to be efficient, in the sense of providing accurate forecasts. To the extent that financial markets are not efficient (because of bubbles, market frictions, or policy itself), then targeting futures prices would not completely solve the problems inherent in implementing a NGDP target. Nonetheless, if futures markets were to be set up, they would likely provide some information about the beliefs of market participants, and this information would be useful in implementing the target.

I’m glad they mentioned the usefulness of setting up these markets, even when they are not used as a policy instrument.

Market inefficiency is real, but very unlikely to be large enough to be of macroeconomic significance.  And if I’m wrong at least there’s the silver lining that I’ll get rich trading the futures when the market price is clearly wrong.

Another issue is related to central bank communication. For instance, Sumner (2011) posits the following scenario. During a period of low inflation, an inflation target calls for higher inflation. However, higher inflation might be difficult to communicate to the public, because the public thinks of higher inflation something bad (i.e. a higher cost of living). In contrast, a NGDP target would call for increase in nominal income, and that might sound more acceptable to the broader public. This is because the public thinks of higher income as something good. The opposite would be true when inflation is high. During a period of high inflation an inflation target calls for lower inflation (which sounds good to the public). In contrast, a NGDP target would call for lower nominal income (which sounds bad to the public). In any case, policymakers who wish to implement an inflation target or a NGDP target would have to think about how they communicate these targets to the public.

Here I add that NGDP communicates more clearly all the time, both when easing and tightening.  The public doesn’t understand the distinction between supply and demand side inflation.  But the authors are correct that the NGDP language would be more popular when the central bank is trying to stimulate.  Of course due to the zero bound problem it is precisely those times when clearer communication is most needed.  When central banks want to tighten they face no zero bound problem, and hence communication is less important.

Read the whole paper, it’s an outstanding survey of the topic, and I’m glad to see that people in Europe are paying attention to this issue.  The current ECB policy regime is clearly not effective in meeting the macroeconomic policy goals of the EU, low and stable inflation plus economic stability.

“Don’t bother me with facts, my model tells me everything I need to know”

That’s a made up quote, and perhaps a bit of hyperbole.  But it illustrates something that really bugs me about the blogosphere.  People make all sorts of claims about monetary policy near the zero bound:

1.  QE has no effect

2.  Negative interest rates would be contractionary

3.  Central banks cannot depreciate their currencies at the zero bound

And then when the theories are actually tested and the results are in, they keep making the same claims, seemingly oblivious to the fact that their theories have been discredited.

Today I’d like to talk about negative interest rates on reserves (IOR).  There are two broad approaches to this topic.  There’s what I’d call the “finance approach”, which claims negative IOR would actually be contractionary, because . . . well I’m not quite sure why. Something about how it interacts with the banking system.  I used to see these articles in the Financial Times.

I tell people to ignore banking when studying monetary policy—focus on the supply and demand for the medium of account (base money).  Negative IOR causes a fall in the demand for base money, and thus is expansionary.  Period.  End of story.

But just to make sure, let’s look at reality.  The Telegraph has a nice story on negative rates on Sweden, which was the first country to adopt the policy I proposed in early 2009.  (I deserve zero credit for NGDP targeting (the idea’s been around forever), but surely at least a tiny bit of credit for negative IOR.)  Before getting to the Telegraph story, let’s look at how markets responded to a recent negative IOR shock:

Updated March 18, 2015 11:14 a.m. ET

STOCKHOLM—Sweden’s central bank has slashed its key policy rate deeper into negative territory and expanded its bond-buying program to prevent the recent appreciation of the Swedish krona from stifling a budding revival in inflation.

The Riksbank, the Swedish monetary authority, lowered its benchmark rate to minus 0.25% from minus 0.1% and said it would buy government bonds worth 30 billion Swedish kronor ($3.45 billion), an extension of bond purchases worth 10 billion kronor announced earlier. The repurchase rate had stood at minus 0.1% since February, the first time it was cut into negative territory.

.  .  .

The Swedish krona fell sharply against the euro, which gained about 1% against the krona in the minutes after the announcement, hitting a high of over 9.34 kroner. Sweden equity markets jumped to a record high with the OMX Stockholm 30 Index up 1.5% at 1,700.

Yup, cutting the IOR is expansionary, even when in negative territory.  And those sorts of market responses (assuming at least partly unexpected, as some of them are) should have been it for the “finance” theories that negative IOR is contractionary, but you can never drive a stake through these zombie theories. There are still those “models” . . .

The Telegraph story looked at some macro data, which at first glance looks like a mixed bag.  Inflation has been running around negative 0.1% to minus 0.2% for 4 years:

Screen Shot 2015-09-29 at 11.50.48 AMIt looks like 3 years, but that’s a quirk of year over year data, the actual CPI shows it’s 4 years:

Screen Shot 2015-09-29 at 11.51.30 AMSo that doesn’t look very good for negative IOR.  But recall that in most countries inflation has recently been falling sharply, due to the plunge in oil prices.  Inflation has never been a reliable indicator.  NGDP growth has recently been accelerating in Sweden (up at a 9% annual rate in 2015, Q2), and the most recent RGDP growth shows 3.2% over the past year, which is higher than in previous years.  The best evidence comes from the unemployment rate, which leveled off at 8% after the Riksbank’s disastrous monetary tightening of 2011, but has recently fallen to 7%.

Screen Shot 2015-09-29 at 11.55.55 AM

One final graph, which is really weird.  While other countries are seeing a surge in currency hoarding, Sweden is experiencing exactly the opposite, despite the negative rates. What’s up in Sweden?  Will the Nordic countries be the first to adopt the sort of cashless 1984-style panopticon state that is so beloved by authoritarians and Puritans everywhere?

PS.  I have a reply to John Cochrane over at Econlog.

Screen Shot 2015-09-29 at 12.08.06 PM