Archive for the Category Monetary Policy


If you do it they will believe

Paul Krugman has a post discussing the recent Swiss move to sharply appreciate their currency, despite deflation in Switzerland.  I agree with much of what he has to say, but not everything:

Two things to bear in mind. First, having in effect thrown away its credibility – in today’s world, the crucial credibility central banks need involves, not willingness to take away the punch bowl, but willingness to keep pushing liquor on an abstemious crowd – it’s hard to see how the SNB can get it back.

That’s not quite right.  It’s very easy to see how they could get it back—simply re-peg the SF at 1.20/euro. The second peg would be much stronger than the first, because the markets would think the following:

“Wow, what a humiliating reversal from the SNB! The result of letting the SF float must truly have been catastrophic for them to do such an embarrassing about face after 3 days.  Obviously they won’t ever make that mistake again.  The new peg will be solid as a rock!”

It’s easy to see how they “can” get it back.  Rather what Krugman should have said is “it’s hard to see them getting it back.”  And he would have been right.  I can’t imagine the SNB re-pegging at 1.2, and hence future SNB promises will be less likely to be believed.  Ditto for promises from other central banks.

Update:  Andy Harless beat me to it.  And several commenters pointed out the SNB is already thinking about depreciating the SF.  But you know they won’t go all the way back to 1.20, which means they’ll have to try much harder.

But the real problem is not lack of credibility; it is that central banks have the wrong target.  If they would actually target inflation at 2%, or NGDP growth at 5%, the markets would believe them. Why wouldn’t they be believed?  The markets aren’t stupid.  Yes, they’ll get blind-sided occasionally as we all were by the Swiss, but (on average) markets will forecast central banks to do exactly what they will do.  Do it and markets will believe.

Back to Krugman:

These days it’s fairly widely accepted that it’s very hard for central banks to get traction at the zero lower bound unless they can convince investors that there has been a regime change – that is, changing expectations about future policy is more important than what you do now. That’s what I was getting at way back in 1998, when I argued that the Bank of Japan needed to “credibly promise to be irresponsible,” something it has only managed recently.

Krugman thinks the problem is the zero bound, but that claim is simply no longer plausible.  The Fed is itching to raise rates around mid-year, despite 10-year inflation forecasts that are far below 2%, and even worse the Fed is officially targeting PCE inflation, which run 0.3% to 0.4% below the CPI inflation embedded in TIPS spreads.  There’s a reason markets don’t expect 2% inflation; the Fed is behaving as if it is targeting inflation at slightly below 2%.  When we were at the zero bound you could have made a semi-plausible claim that it was all due to monetary policy impotence (even though that claim was false) but that view no longer has any plausibility in a world where the Fed is about to raise rates.

(In my monetary offset posts I used to get hammered by the argument, “but surely you agree the Fed would prefer inflation to be higher?”  OK, where are you guys now that the Fed is about to raise rates?)

I wish I could recall the post I did around 2009 or 2010 where I said the validity of market monetarist arguments would be much more obvious when we finally exited from the zero bound. (I based that on the fact that the causes of the Great Depression became much easier to see during the long recovery period.)

The “promise to be irresponsible” argument is also false.  Central banks need to promise to be responsible.  They need to set a price or NGDP level target, and promise to do whatever it takes to hit that target.  Krugman is wrong when he claims the BOJ has recently been irresponsible (meaning that it has generated high inflation.)  It has not done so.  Apart from the one-time boost from higher sales taxes, Japanese inflation has been running around 1%.  That’s better than the deflation they used to suffer, but it falls short of their 2% target.  Being irresponsible has nothing to do with it.  BTW, the Swiss move makes me more inclined to believe the Japanese will quietly give up on their 2% inflation target.

In my comment sections I see continued confusion about central bank balance sheets.  People seem to think that the Swiss needed to let their currency float to avoid a big balance sheet.  Over at Econlog I explain why letting the currency float will lead to a bigger balance sheet than the previous peg (especially if you hold IOR constant—recall they could have lowered the IOR to negative 0.75% without breaking the exchange rate peg.)

Maybe the following analogy will help.  Imagine a teenage girl that is depressed about her looks, and spends all day lying on the couch eating Ben and Jerry’s ice cream, and watching TV.  She doesn’t want to change her behavior, but wants to look slim and pretty.  What do you tell her?

Now imagine a central bank that wants to run a deflationary monetary policy, but insists it doesn’t want a big balance sheet.  What do you tell it?  The SNB reminds me of that teenage girl.

PS.  Tyler Cowen has a good post on the ECB’s anticipated QE program.  I am equally skeptical. It will probably help a little, but the good that will result is probably already priced into the euro/dollar exchange rate.  That’s not nothing, but it’s far short of what’s needed in the eurozone.

PPS.  Some commenters have criticized my support of fixed exchange rates.  I oppose fixed exchange rates.  It’s just that the Swiss 1.20 peg was less bad that what came before or after.  There are degrees of badness.

If it walks like a duck and quacks like a duck . . .

Whenever something really bizarre happens some people look for deep explanations.  Conspiracy theories.  There must be inside information.  Etc., etc.  Sorry, but sometimes the obvious explanation is the right one.

Yesterday I read dozens of comments from pundits all over the world on the SNB’s surprise abandonment of the currency peg. Every single one thought it was a stupid move.  The markets thought it was a stupid move.  I thought it was a stupid move.

Many of the theories I see commenters putting forward are based on public information.  Keep in mind that everyone knew the ECB was likely to do QE.  That was already priced into the euro/dollar exchange rate.  And the markets still expect deflation in the eurozone, despite the recent depreciation of the euro caused by expectations of QE.

The explanation for the SNB move is quite simple—stupidity.  It’s stupid to throw away 3 1/3 years of credibility.  I won’t even say “hard-earned credibility,” as it was pathetically easy to peg the SF for 3 1/3 years.  The SNB will now miss their price level target.  (Actually they were already going to miss it—the currency was too strong at 1.2.)  They’ve also thrown away one of their most powerful monetary policy tool, exchange rates.  They will now rely more on QE, exactly what they were trying to avoid with the currency peg.  Even if they thought the SF needed to be a bit stronger for some bizarre reason, why not appreciate it by 5% and then re-peg?  Why let the SF rise by more than 15% against a currency that is itself plunging into deflation?  That makes no sense.

I sometimes receive back channel communication from very-well informed people in Europe. Believe me, just as with the earlier nonsense in Sweden, there is no “rational explanation.”  People are appalled.

But there is a lesson here. Just as war is too important to leave to the generals, monetary policy is too important to leave to the central bankers.  Once again we see the markets are way ahead of the central bankers.  One more example of why we need market monetarism.  Let markets determine the money supply, interest rates and exchange rates.  Peg your currency to NGDP futures prices. And if you are not going to do that, then for God’s sake level target SOMETHING.

PS.  After writing this post I came across a Tyler Cowen post that speculates the SNB might know something we don’t know.  I could not disagree more strongly.  There are very few secrets in the world of central banking.  The Swedes didn’t know something we don’t know a few years ago when they foolishly tightened to stop “bubbles.”  Nor did the ECB when they tightened monetary policy sharply in 2011.  Nor did the BOJ when they tightened in 2000 and again in 2006.  Tyler says the following:

The Swiss central bank, had it continued the peg, probably would have had a balance sheet larger than Swiss gdp.  But does this matter?”

Actually, growth of the balance sheet slowed sharply after they adopted the 2011 peg.  Without the peg they’ll have to rely on QE.  So Tyler’s worry about the size of the balance sheet is actually an argument for keeping the peg.  (And/or also an argument for a higher inflation target in Switzerland.) 

PS.  If you’ve ever wanted to boss me around, here’s your chance.  (If MF or Ray get the job, I’ll shoot myself.)

The SNB on the SNB’s recent move

I’ve been asked to comment on the recent Swiss decision to tighten monetary policy.  I’ll just quote from the SNB statement, which tells us all we need to know about why it was a bad decision to return the SF to a level of “exceptional overvaluation”:

The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation.

Yup, it worked.  So . . . . ?????

It’s only logical; NGDPT is the next big thing

Let’s filter out the noise and look at three big turning points:

1.  The 1930s:  A deep and prolonged deflation from 1929 to 1933 was associated with sharply higher unemployment.  Economists drew the conclusion that policymakers needed to err on the side of expansionary policies, to prevent a repeat of the Great Depression.  They did.  And it worked.

2.  The Great Inflation (1966-81):  Higher and unstable inflation was associated with several problems such as unstable unemployment and distortions in capital markets.  Though not as bad as the Great Depression, economists agreed that the Fed needed to hold inflation at low and stable levels.  They continued to view business cycles as a significant problem, but noticed that the worst cycle in recent decades (the recession of 1981-82) was caused by a sharp slowdown in inflation. Thus inflation targeting should also stabilize growth, killing two birds with one stone.  They said we needed a Taylor-Rule type policy to stabilize inflation around 2%.  They succeeded.  No more Great Depressions and no more Great Inflations.

3.  The Great Recession:  Now economists noticed that even if inflation was pretty well anchored, we could have quite a bit of real instability.  Once low rates of inflation were achieved, it seemed like high and unstable unemployment was a much bigger problem than modest variations in inflation (say in the 0% to 4% range.)  Now we need a nominal aggregate that will stabilize output better than an inflation target, while still producing fairly well-anchored inflation over the business cycle.  That’s going to be NGDP targeting, or something closely related.   It will happen. And they will once again succeed.  And then no more Great Depressions and no more Great Inflations and no more Great Recessions.  That’s called progress.

Economists on both the left and the right are gradually moving to NGDPT.  Nick Rowe says that what convinced him is that it would have done much better in the recent severe business cycle. Severe problems are the problems you most want to prevent.  NGDPT does that.  Just today commenter W. Peden pointed to an endorsement of George Selgin’s (closely related) productivity norm by Allister Heath in The Telegraph.   He offers a conservative version of the idea, but center-left economists like Michael Woodford, Christy Romer and Jeffrey Frankel are also switching to NGDP targeting.

This isn’t rocket science–economists learn fairly predictable lessons from each major policy failure. This one is no different.  Central banks are conservative institutions so it will take a while for it to show up in the actual policy.  But you can be sure they are paying attention, and know that NGDPLT would have done better than IT in 2008-09. (Of course when I talk about central banks understanding what went wrong I am excluding the ECB.  There are in an entirely different category–still working on the lessons form the 1930s.)

The intellectual battle is almost over—time to consider what will go wrong under NGDPLT, and start working on the next improvement in monetary policy.  I vote for nominal aggregate labor compensation (per capita) targeting as the next iteration.

PS.  Check out Joe Leider’s blog, which makes some nice market monetarist arguments.

Questions for Keynesians

A number of Keynesian bloggers have recently expressed dismay that the rest of us don’t buy their model.  Maybe it would help if they’d stop ignoring our criticisms of their model, and respond to our complaints.  Here are some questions:

1.  What is the proper measure of austerity?  The textbooks talk about deficits.  But most of the Keynesian bloggers focus on government purchases.  So which is it?  And if it’s purchases, why did these same bloggers claim that austerity would result from big tax increases in the US in 2013, and a big tax increase in Japan in 2014?  And why does the measure chosen (ex post) usually seem to be the one that best supports their argument in that particular case?

2.  Why do Keynesians show cross-sectional graphs of fiscal austerity and growth, mixing in countries that have their own independent monetary policy, with those that do not? (I.e. those lacking monetary offset.)  And why don’t they respond to criticisms of those graphs?  And why tout cross-sectional studies of fiscal policy at the level of American states, when no American state has an independent monetary policy?

3.  Why claim that fiscal policy can be effective in the special case where a country is at the zero bound, and then claim that austerity caused the eurozone double-dip recession even though at the time the eurozone was not at the zero bound?  The eurozone’s positive interest rates were prima facie evidence that the ECB had inflation right where it wanted it until 2013, or else they would have further cut their interest rate target.

4.  When claiming that fiscal austerity reduced aggregate demand, why do Keynesians almost always provide data for RGDP growth, when NGDP growth is a much better proxy for AD?  NGDP is a direct test for AD shocks, whereas RGDP can be impacted by either AD or AS.  RGDP doesn’t show AD changes, it shows aggregate quantity demanded.  RGDP rose in the US between 1865-96, was that more AD, or more quantity demand as supply rose?

5.  The transmission mechanism between AD and RGDP in the Keynesian model runs through jobs.  So why claim that low British RGDP growth was due to austerity when in an accounting sense it was almost all productivity—employment keeps hitting record highs?  Is there a new Keynesian model I don’t know about where austerity kills output without killing jobs?  A sort of reverse neutron bomb?

6.  Why did Keynesians say that 2013 austerity in the US will be a test of market monetarism, and that slow growth in Britain “proves” austerity doesn’t work, but then when 2013 comes out with almost twice the US RGDP growth as 2012 (Q4 over Q4), they suddenly say that anecdotal evidence doesn’t matter?

7.  Why act like anti-Keynesians are bizarre heterodox economists, who reject mainstream macroeconomics, when it is the modern Keynesians who have recently rejected the claim in the #1 monetary textbook in America that monetary policy remains effective at the zero bound. Keynesians have walked away from the standard textbook natural rate model that after 4 or 5 years wages and prices will adjust to a demand shock and employment will go back to the natural rate. Keynesians now talk about “paradox of toil,” and claim that employer-side payroll tax cuts (or wage flexibility) are not expansionary.  Keynesians now claim that extended unemployment insurance doesn’t increase unemployment, even though they once said it did, and empirical studies show that the effect on unemployment was even positive in cities with extremely high unemployment rates.

Here’s Paul Krugman in 1999, a year after he wrote his famous “expectations trap” paper of 1998:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

Yes, and when you are done then please explain it to me.

Update:  I’d also love to know what Keynesians think of the Dems having a socialist as their lead member on the Senate Budget Committee, who then appoints a MMTer to be chief economist. And Krugman says the GOP relies on voodoo economics!

HT:  Jon