Archive for the Category Monetary Policy


Monetary offset in Australia

Stephen Kirchner quotes from Treasurer Wayne Swan’s briefing notes from August 8, 2008:

There are three broad considerations the Government would need to keep in mind in taking a decision to engage in discretionary [fiscal] action:

The Reserve Bank through its control over interest rates, determines the overall level of aggregate demand in the economy, and the Bank would likely take account of any fiscal stimulus in its monetary decisions – that is, more spending would keep interest rates higher than otherwise…

The bottom line is that in the event of a shallow downturn, discretionary [fiscal] action may not achieve any noticeable outcomes in terms of growth and unemployment, but would leave rates higher, erode the [budget] surplus and put at risk the Government’s fiscal credibility.

These costs of course need to be weighed against the potential political costs of being seen to do nothing…

Then Stephen comments:

Needless to say, the ‘political costs’ argument won in the end, with the first discretionary fiscal stimulus announced in October 2008.

Because rates have never been at zero in Australia, I presume Paul Krugman would agree with Stephen and I on this point.  Perhaps someone can search to see if Krugman commented on Australian policy.

Is New Zealand once again leading the way?

In 1990 the Kiwis were the first to adopt inflation targeting, and now there is a report that they may be the first to give the central bank control over both monetary policy and an important tool of fiscal policy:

New Zealand’s main opposition Labour Party plans to change legislation governing the country’s central bank in its first term if it wins next month’s election, finance spokesman David Parker said.

The plans, which include giving the Reserve Bank of New Zealand an alternative tool for managing inflation, have been discussed with Governor Graeme Wheeler, though “not in detail,” Parker told reporters in Auckland today after Labour began its election campaign. The vote takes place Sept. 20.

Labour wants to give the central bank the ability to recommend changes to the rate of contribution to the national pension savings program, Kiwisaver. The RBNZ could use the new tool as an alternative to the official cash rate to “take the heat out of the economy,” Parker said in April, when the policy was announced.

Quick reactions:

1.  It would be better to rely 100% of monetary policy, particular as NZ doesn’t face the zero bound problem.

2.  But if others insist we need a combined monetary/fiscal approach, then this is far, far better than other forms of fiscal policy.  I would think it would appeal to people like Brad DeLong, who focus a lot on the savings/investment imbalance perspective.

Why is the yield curve flattening?

Kevin Erdmann has an interesting post discussing the evolution of interest rate futures over time. In recent months the date of the first anticipated rise in rates has moved from late-2015 to mid-2015.

But, I expected this to correspond to forward rates for June 2016 Eurodollars of just over 2% and for June 2017 of just over 3%.  Instead, rates have trended around a mean of about 1 5/8% and 2 5/8%.  If that had been my target mean, it would have been perfect for this trade.  (Basically, buying when the price declines and selling when it increases, profiting from random movements over time.)  But, the farther the price moves from my target, the harder it is to profit from the position.  Why haven’t the prices followed the market expectation?

The reason is that the slope of the yield curve has declined while the expected date of the rise has moved back.  Late in 2013, the slope was up to around 33 bp.  (Rates would be expected to rise 33 basis points per quarter after the initial rise.)  For reference, in the past two cycles, during the rate recovery period, short term rates rose at a pace of 50 to 75 bp per quarter.

So, what’s going on?  I think that the market has been surprised by how healthy the economy has remained in the face of the tapering of QE3.  This diminishes inflation fears and also signals a hawkish intention from the Fed.

But, I think this reflects the Wizard of Oz view of the Fed’s interest rate policy.  I think that there is a systematic underestimation of how much Fed policy chases the Wickesellian interest rate.  I think the Wickesellian rate is probably already above zero.  This is part of the reason that we have seen an acceleration in economic activity and employment this year.  QE3 appears to have been only slightly accommodative, for reasons I don’t completely understand, and so its taper has probably not changed the objective stance of monetary policy that much.  But, before QE3, a non-QE zero rate policy was probably disinflationary.  The increase in the Wickesellian rate over the past 2 years means that at the end of QE3, a non-QE zero rate policy will probably be inflationary.

This might be right, but let me throw out another possible explanation.  Perhaps the markets are reacting to the disconnect between the unemployment data and the GDP data.  All throughout the recovery the unemployment rate has done better than the GDP data.  Even back as far as 2011 I was doing posts entitled “A job-filled non-recovery.”  But the disconnect has recently gotten worse, with NGDP growth coming in at under 4% over the last 6 quarters, and the unemployment rate falling by 1.7% over 18 months, roughly 0.1% per month.  That’s a very fast decline in the unemployment rate, which suggests we’ll hit full employment fairly soon.  But GDP growth has been really slow.

This pattern has gotten even more pronounced over the past 6 months.  You can write off the first quarter due to bad weather, but weather certainly did not affect second quarter GDP.  And yet NGDP in Q2 was up only 2.5% (annual rate) over 2013:4.  That’s a shockingly low rate of NGDP growth, and yet the rapid decline in the unemployment rate continued.  And we recently had the fastest 6 months of job creation since the late 1990s.  One thing we know for sure is that job growth must slow at some point.  Labor force growth will be exceedingly slow due to retiring boomers, and returning discouraged workers can only do so much.  I’ve suggested 3% is the new normal for NGDP, but if you applied Okun’s Law to the recent data (and account for inflation) you’d get even a lower estimate.

So if you look at the unemployment data and the NGDP data together, rather than separately, you are forced to conclude that trend NGDP growth has slowed very sharply.  If the markets are gradually figuring this out as more data comes in, it could explain the flattening of the yield curve. The rapid fall in unemployment explains why a rate increase is expected within less than a year, and the declining estimates of trend NGDP growth explain why rates are not expected to rise as far after that first rate increase.

PS.  Kevin Erdmann also has a very good post linking school choice, banking regulation, and the right to exit.  Highly recommended.

HT:  TravisV

What the markets are telling us about Japan

In a recent post I suggested that severe demand shortfalls were also market predictions of severe demand shortfalls.  In the comment section Larry quoted me and then asked an interesting question:

“But when it fails, it’s really, really hard to fix the problem, because doing so requires policymakers to be more effective than the markets predict. I won’t say that things are hopeless when markets predict disaster, but I wouldn’t put much hope on stabilization policy.”

This seems quite fatalistic. So if the monetary authority blows it there is nothing to be done? Does this pessimism apply to both monetary and fiscal policy?

Yes, it applies to both monetary and fiscal, but it’s important to distinguish between two types of difficulty:

1.  In both the 1930s and the 2010s the markets believe that monetary stimulus is very easy to do in a technical sense.  Asset prices rally strongly on even rather small stimulus measures from the central bank.  

2.  Asset markets tend to be very pessimistic about the prospects for reflation after monetary policy has had a severe failure.  This suggests that markets believe the political barriers to reflation are formidable.

Japan is a perfect case study.  Asset markets took off after mid-November 2012, when then candidate Abe first indicated he was going to push for a 2% inflation target.  The yen fell from about 80 to the dollar to 103 today, while the Nikkei rose from under 8700 to over 15,300 today.  So the asset price gains have been sustained.  And we did see a rise in the Japanese price level, RGDP and NGDP.  So in one sense Abenomics “worked.”

On the other hand the Japanese 10 year bond yield is 0.51%, vs. 2.50% in the US, and the 30 year bond yield is 1.67%, vs. 3.30% in the US.  That tells me that the bond market probably expects Japanese inflation to remain well below US levels in the long run, perhaps close to zero.  And that suggests that Japanese asset markets believe that the political obstacles remain formidable.  After all, Abe won’t be the prime minister forever.

And yet if the BOJ did another round of stimulus—enough to push the yen down to 120, there is little doubt that stocks would rally again and GDP growth would pick up (at least nominal, and probably real as well.)  The problems are political, not technical.

Here’s an analogy.  The 1924 British expedition to Everest failed to achieve the summit, but did get a couple men above 28,000 feet—a great achievement in those days.  (Unfortunately several died.) So was it a failure or a success?  A bit of both.  Successes were achieved, but it failed to achieve the announced goal.

Of course mountain climbing is not a perfect analogy, as in 1924 people would have laughed if anyone argued that debasing a currency was “difficult” (Germany’s price level rose over a billion fold between 1920 and 1923.)  Again, the difficulties are political, not technical.

Of course asset markets are often wrong, and they might well be wrong about Japan.  It’s also possible that the bond yields are not a forecast of Japanese inflation being much lower than in the US.  (I was not able to find long term forward rates for the yen, and don’t even know if interest parity holds in this case.)

MMs believe that market forecasts are the best we have.  Thus I immediately saw that the policy “worked” in a limited sense, because announcements repeatedly affected asset prices, but also immediately saw the long term doubts about the BOJ’s willingness to carry through with its promises.

A near perfect analogy is the dollar depreciation program of 1933.  FDR abandoned it before hitting his announced price level target (returning prices to pre-depression levels) under intense political pressure.  But it did achieve some important limited objectives.  The stock market rally was comparable to the recent Japanese rally.

So my overall views on Japan are mixed.  I view the depreciation of the yen and the huge stock market rally as signals that the Abe government overcame formidable political odds.  Good for them.  I view the low bond yields as a sign that the markets now expect the BOJ to rest on its laurels, and not try to push the price level even higher.  That’s not so good.  The labor market is no longer the biggest problem in Japan; it’s the debt situation.  As long as nominal interest rates are near-zero the BOJ is needlessly worsening Japan’s long term fiscal situation.

Don’t pay any attention to GDP, which soared in Q1 and will plunge in Q2.  The forex rate and stock prices are the best short term indicator of how the BOJ is doing.  If the yen moves into the 110 to 120 range, that would suggest my political forecast was too pessimistic.  If it moves below 95, I was too optimistic.

PS.  Matt Yglesias points out the absurdity of Obama touting the strong jobs market.  But Yglesias’s post is marred by an unwillingness to mock Obama for saying this while also arguing for bringing back the emergency unemployment insurance program–intended for lousy job markets.

Why macro stabilization policy rarely fixes problems

A big demand slump isn’t just an economic disaster; it’s also a prediction of an economic disaster. And that means it’s a prediction of policy failure.   At least that’s the implication of the Woodfordian view of macro (which I accept.)  Changes in current AD are mostly driven by changes in the future path of AD.  Changes in near-term NGDP are mostly driven by changes in expected NGDP 1, 2, 5 and 10 years out in the future.  Call it the term structure of NGDP.  And those are driven by the future expected path of monetary policy.

And of course whenever we have crashes like 1920-21, 1929-30, 1937-38, 2008-09, we also tend to have asset market crashes.  Asset markets aren’t perfect (1987) but when there’s a very big economic slump on the way they are pretty good at sniffing it out.

So here’s the problem for macro policy.  It’s good at preventing disasters, as we saw with the Great Moderation.  But when it fails, it’s really, really hard to fix the problem, because doing so requires policymakers to be more effective than the markets predict.  I won’t say that things are hopeless when markets predict disaster, but I wouldn’t put much hope on stabilization policy.  In the textbooks, the purpose of stabilization policy is to “fix problems.”  In reality it will usually fail at that.  Rather it’s good at preventing problems.  If you’ve got a problem, you’ve already failed.  Like the old joke—”if you are headed there, I wouldn’t start from here.”

I was reminded of all this while reading a Brad DeLong post that discusses a debate between Nick Rowe and Simon Wren-Lewis.  DeLong looks at the possibilities offered by monetary and fiscal stimulus when you have a “deficiency in demand.”

Let’s look at this from a different perspective.  The problem is not “demand deficiency” it’s expected demand deficiency.  Policymakers try to steer the nominal economy, they implicitly or explicitly target NGDP one or two years out in the future.  If 12 month forward expected NGDP is right on target, then no policy changes are needed.  And if 12 month forward NGDP is below target, then the markets have predicted policy will fail, and their forecast counts for far more than the views of any academic economist or government policymaker.  At that point, we really shouldn’t expect much from macro policy.  It’s likely to fail.  No wonder people are so pessimistic about monetary policy! Markets have observed the behavior of the relevant central bank (Fed, ECB, etc.) and come up with the optimal forecast of the result.  If there’s an expected demand shortfall, markets have already given a vote of no confidence to the policymaking apparatus.

From that perspective, DeLong is asking the wrong question.  It’s not, “how do we fix this problem?”  It’s, “how to we make it so that Brad DeLong and Simon Wren-Lewis never ask, ‘how do we fix this problem.’”  I see two ways, and only two ways of doing that.  Both methods involve abandoning the Keynesian policy of interest rate targeting.  Interest rate targeting doesn’t work at the very moment when good monetary policy is most essential—in a very deep demand slump. Would you buy a car that had a brake that failed just 1% of the time—only on twisty mountain roads with no guardrail? Then why do you (Keynesians) buy interest rate targeting as the appropriate policy instrument?

1.  One method would have the central bank peg the price of one year forward NGDP futures, and do OMOs until the market price is right on target.  Now you don’t have to worry about what to do if there is an expected demand deficiency, because there never is an expected demand deficiency.  At least not one expected by the market.  There may be a current demand deficiency, but if it isn’t expected to persist, then stabilization policy is right on target.

2.  Let’s say you don’t buy the “market” part of market monetarism.  You think markets are irrational.  ”Better leave this to the wise mandarins who will control policy in the optimal fashion.” What then?  It’s very simple, you do what Lars Svensson suggested, you set the monetary instrument at a position where the central bank’s internal forecast is equal to the policy target.  But which instrument?  Recall that we have abandoned interest rate targeting.  Don’t ask me, I’m the NGDP futures market guy–ask the mandarins.  Anything with no zero bound.  It might be the monetary base, it might be the trade-weighted exchange rate, it might be the nominal price of zinc. There is an infinity of possible choices.  (Now do you see why I’d rather let the markets set policy?)

In his post, DeLong cites Wren-Lewis saying he’s heard the MM arguments, but doesn’t buy them. Then he goes on to conclusively show he has not heard the MM arguments, by using the metaphor of employing both a regular brake and an emergency brake in a car careening down a hill.  This metaphor is supposed to provide justification for using fiscal stimulus “just in case” to back up monetary stimulus.

But that won’t work if you have monetary offset.

In any case, monetary policy is a brake that never fails, and if it does fail you don’t end up crashing, you end up with the Bank of England owning the entire world.  A level of global domination that makes Victorian-era Britain seem like a 98 pound weakling by comparison.  Global GDP is around $100 trillion.  So Piketty would say that global wealth must be around $500 trillion.  Could the Brits live on 5% of that?  I think so.  But wait until the Scots secede, those ingrates don’t deserve any of it.

As Dylan said on his greatest album:

.  .  . there’s no success like failure . . .