Archive for the Category Monetary Theory


Asking too much of a central bank

Here’s an article discussing Bill Gross’s views on monetary policy:

Bond guru Bill Gross, who has long called for the Federal Reserve to raise interest rates, urged the U.S. central bank on Wednesday to “get off zero and get off quick” as zero-bound levels are harming the real economy and destroying insurance company balance sheets and pension funds.

In his October Investment Outlook report, Gross wrote that the Fed, which did not raise its benchmark interest rates at last week’s high-profile policy meeting, should acknowledge the destructive nature of zero percent interest rates over the intermediate and longer term.

“Zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society,” Gross said. “These assumed liabilities were based on the assumption that a balanced portfolio of stocks and bonds would return 7-8 percent over the long term.”

But with corporate bonds now at 2-3 percent, Gross said it was obvious that to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10 percent a year to meet the targeted assumption. “That, of course, is a stretch of some accountant’s or actuary’s imagination,” he said.

Not only are Bill Gross’s views wrong, they aren’t even defensible.  Let’s look at several perspectives:

1.  Money is neutral.  In that case the Fed can only impact nominal returns.  If it wants higher nominal returns then it needs to adopt a more expansionary monetary policy. That’s the opposite of what Gross is proposing.

2.  Money is non-neutral.  In that case the Fed can raise nominal returns on debt with a tight money policy, but only in the short run.  And Gross says the problem is that long-term returns are too low.  However to raise them you need to raise NGDP growth, which means easier money.  Even worse, a contractionary monetary policy that raises the return on T-bills will reduce the return on stocks.

Why is there so much confusion on this point?  Perhaps because people forget that most central bank decisions are endogenous, on any given day or week the Fed usually follows the market.  Here’s a perfect example of why people get confused, look at the first paragraph of a recent Reuters article:

Euro zone government bond yields dropped by more than 10 basis points on Friday after the U.S. Federal Reserve prolonged the era of nearly-free money amid concerns about a weak world economy.

Most readers probably think there is a connection between these two events.  And there may be one.  But it’s not the connection you might assume at first glance. It’s obviously not that case that the Fed deciding to keep rates steady on Wednesday caused eurozone bond yields to fall on Friday.  That makes no sense. Instead both the Fed and the bond market are reacting to the same facts—a weakening global economy.  People see short and long-term rates rise and fall at about the same time, and draw the erroneous conclusion that Fed policy is causing those changes.

The Fed can’t magically produce strong long run real returns on investment for insurance companies, especially with tight money.  That’s far beyond their powers, according to all models I’m aware of (monetarist, Keynesian, Austrian, etc.)  If Bill Gross has a new model, I’d love to see it.  In the 21st century, insurance companies will have to learn to live with lower returns.  They may have to raise the price of insurance. If they lose business, then . . . well, tough luck!

Off topic, Tyler Cowen recently noted that China’s September PMI fell to 47, and then asked:

How quickly do services have to be expanding for the entire Chinese economy to be growing at anything close to six percent?

Since I’m on record predicting 6% RGDP growth, I’ll address this question.  First we need to determine how fast industrial production is growing.  Here’s a graph of the growth rate of IP since 1990:

Screen Shot 2015-09-23 at 11.12.40 AMOther than the post-Tiananmen crash, China’s industrial production has maintained a strong upward trend.  However there are three notable slowdowns.  The slowdown in the late 1990s was caused by China’s currency being overvalued due to its peg to an appreciating dollar, at the same time the emerging markets were struggling and devaluing, and at the same time the US and Europe were growing. Sound familiar? And notice that the gradually slowdown since 2012 looks a lot like the late 1990s.  And then there was a sharp but brief slowdown during the global recession of 2008-09.

The most recent figures show 6.1% growth (YOY) in August, and September may show further deterioration.  After than I expect Chinese IP growth to begin recovering, although the YOY figures may worsen for some time.

So to answer Tyler’s question, if industry is growing at 6%, then services would also need to be growing at roughly 6%, in order to produce 6% GDP growth.  Is it plausible that China’s industrial production could be growing at 6% with such horrible manufacturing PMIs?  See for yourself, here’s the PMI index as far back as I could find:

Screen Shot 2015-09-23 at 11.20.34 AM

The recent numbers are a bit worse than usual, but as you can see the PMI often dipped to 48, with no obvious ill effects on the China boom.  I believe that this time China is slowing a bit more than usual, which explains my bearish forecast of 6% growth in 2016, vs. the consensus of 6.7% by China experts.  So like Tyler I’m currently bearish on the Chinese economy, just not as bearish.  My bearishness comes from the fact that I believe China experts are underestimating the impact of the strong dollar, which is making China’s currency overvalued.

I’m also more bearish than the Fed on the US economy, for much the same reason.

Williamson on NeoFisherism (define “loosening”)

Stephen Williamson has a new post that interprets recent monetary history from a NeoFisherian perspective.  It concludes as follows:

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP produces low inflation. We should also not be surprised that NIRP produces even lower inflation. Further, experience with QE should make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than having a nominal interest rate target well above zero, on average. To get there from here may require “tightening” in the face of low inflation.

I partly agree, but disagree on some pretty important specifics.  I thought it might be instructive to start out by rewriting this paragraph to express my own view, with as few changes as possible (in bold):

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP results from low inflation. We should also not be surprised that NIRP results from even lower inflation. Further, experience with QE and inflation forecasts embedded in TIPS should not make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than eventually having a nominal interest rate target well above zero, on average. To get there from here may require “loosening” in the face of low inflation.

Why do we reach such differing conclusions?  I think it’s because I have a different understanding of recent empirical data.  For instance, Williamson’s skepticism about monetary stimulus in Japan is partly based on his assumption that the recent sales tax increase raised the Japanese price level by 3%. But there’s never a one for one pass through, as it doesn’t cover major parts of the cost of living, such as rents.  So the Japanese price level (net of taxes) has risen by considerably more than Williamson assumes (albeit still less than 2%/year).  Even more importantly, Japan had persistent deflation prior to Abenomics.  And if Williamson is going to point to special factors such as the sales tax rise, it’s also worth mentioning that his recent data for Japan (and the other countries he considers) is distorted by a large one-time fall in oil prices.  Almost all economic forecasters (and the TIPS markets) expect inflation to soon rise from the near zero levels over the past 12 months.  Abenomics drove the yen from 80 to 120 to the dollar—-is that not inflationary?

In the Swiss case Williamson mentions low rates and asset purchases, but completely misses the elephant in the room, the huge upward revaluation of the franc earlier this year, which was widely condemned by economists (and even by many Swiss).  This policy was unexpected, unneeded and undesirable.  It immediately led forecasters to downgrade their forecasts for Swiss inflation, and those bearish forecasts have turned out to be correct.  I hope that’s not the sort of “tightening” of monetary policy that Williamson believes will lead us to higher inflation rates.

Seriously, I’m confident that Williamson would agree with the conventional view that currency appreciation is deflationary. That should send out warning signals that terms like “loosening” are very tricky.  Before we use those terms, we need to be very clear what we mean.  You can achieve higher interest rates through either loosening (a crawling peg devaluation forex regime) or tightening (open market sale of bonds), it all depends how you do it.  More specifically, it depends on the broader policy context, including changes in expectations of the future path of policy.

I think he also gets the Swedish case backwards.  The Swedish Riksbank tried to raise interest rates in 2011.  Instead of producing the expected NeoFisherian result, it led to what conventional Keynesians and New Keynesians and Market Monetarists would have expected—falling inflation. It led to exactly the type of bad outcome that Lars Svensson predicted. So Svensson was right.  And contrary to Williamson, the Riksbank did not turn around and adopt Svensson’s preferred policy, which is actually the “target the forecast” approach; rather they continued to reject that approach.  They continued to set rates at a high enough level so that their own internal forecasts were of failure. Once a tight money policy drives NGDP growth lower, the Wicksellian equilibrium rate falls and policy actually tightens unless the policy rate falls as fast or faster.  That did not occur in Sweden.

Let me try to end on a positive note.  I have a new post at Econlog that took a position roughly half way between the NeoFisherians and the Keynesians.  Brad DeLong had noted that Friedman often claimed that low rates are a sign that money has been tight. I’d emphasize, “has been.”  Krugman said this was wrong, at least over the time frame contemplated by Friedman.  I disagreed, defending Friedman.  I believe that Keynesians overestimate the importance and durability of the so-called “liquidity effect” and underestimate how quickly the income and Fisher effects kick in.  At the same time, as far as I can see the NeoFisherians either ignore the liquidity effect, or misinterpret what it means.  (My confusion here depends on how literally we are to take the “tightening” claim in the quote above.)

Question for the NeoFisherians:

I often discuss the Fed announcements of January 2001, September 2007 and December 2007.  That’s because all three were big shocks to the market.  In all three cases long-term interest rates immediately reacted exactly as Irving Fisher or Milton Friedman might have expected.  In the first two cases, easier than expected policy made long-term rates (and TIPS spreads) rise.  And in the last case tighter than expected policy made long-term rates (and TIPS spreads) fall.  Please explain.

To me, that’s the Fisher effect.  But here’s the problem, the Fed produced those three results using the conventional manipulation of short-term rates.  Thus in the first two cases the Fed funds rate was cut more than expected, and vice versa in the third case. From a Keynesian perspective this is really confusing—why did long-term rates move in the “wrong way”? From the NeoFisherian perspective this is also really confusing—why did moving short-term rates one way, cause TIPS spreads (and long term rates) to move the other direction?  From a market monetarist perspective this all makes perfect sense.  (It doesn’t always play out this way, but if you look at the really big monetary shocks the liquidity effect is often swamped by the long-term effects.)

HT:  Marcus Nunes

Pop Monetary Economics

Paul Krugman has an excellent post demolishing the following claim by William Cohan, in the NYT:

The case for raising rates is straightforward: Like any commodity, the price of borrowing money — interest rates — should be determined by supply and demand, not by manipulation by a market behemoth. Essentially, the clever Q.E. program caused a widespread mispricing of risk, deluding investors into underestimating the risk of various financial assets they were buying.

BTW, Krugman’s post is the one to read (not mine) if you only look at one post on this topic.  He carefully walks through an explanation of what’s wrong with this paragraph, in a way that would be recognizable to any competent monetary economist. But in some ways it’s even worse than Krugman assumes.  Here’s Krugman:

The Fed sets interest rates, whether it wants to or not — even a supposed hands-off policy has to involve choosing the level of the monetary base somehow, which means that it’s a monetary policy choice.

That’s also my view, but I suppose one could argue that from a different perspective if you set the money supply you are letting markets determine interest rates, whereas if you actually target interest rates, then you are “interfering” in the market.  Not exactly my view, but let’s go with it.  Let’s put the best spin on Mr. Cohan’s essay.

Now here’s the big irony.  For the past seven years the Fed hasn’t been targeting interest rates, they’ve been using base control to influence the economy, increasing the monetary base through QE programs.  They switched from interest rate control before 2008 to monetary base control after.  And now Cohan is calling for the Fed to raise interest rates.  That means he wants the Fed to go back to manipulating interest rates.

So the great irony here is that in the paragraph I quoted from above Cohan says:

Like any commodity, the price of borrowing money — interest rates — should be determined by supply and demand, not by manipulation by a market behemoth.

And yet in the essay he’s actually calling for the exact opposite; he wants the market behemoth (the Fed) to start manipulating interest rates, something it hasn’t been doing for the past 7 years.

Unlike quantum mechanics, monetary economics doesn’t seem too hard.  As a result the media produces a non-stop stream of stories on monetary policy that are utter nonsense.  And by “utter nonsense” I don’t mean stories that disagree with my particular market monetarist views (Cohan might be correct that the Fed should raise rates), but rather stories that are simply incoherent, that are completely detached from the field of monetary economics.

We don’t hire plumbers to teach quantum mechanics at MIT.  We don’t put plumbers on the Supreme Court.  But we do put Hawaiian community bankers on the Board of Governors.  It’s not just that our media and Congress and President don’t understand monetary economics, they don’t understand quantum mechanics either.  The real problem is that they don’t even understand that they don’t understand it.  So they have unqualified people write op eds, and sit on the Board of Governors.  People ask me what Trump or Sanders think about monetary policy.  They don’t even know what it is!  What they think doesn’t matter, even if they were to get elected.  Just as it doesn’t matter what their view is on the best trajectory for NASA’s next Saturn bypass.

BWT, I have no problem with Hawaiian community bankers having important policymaker roles at the Fed, but put them on the committee for banking regulation, not monetary policy.

The title of the NYT piece said the Fed needed to “Show Some Spine”.  Over at the Financial Times they want the Fed to “Show Steel.”  (I guess that makes Paul and me wimps.)  Here’s the argument at the FT:

Yet monetary policy cannot confine itself to reacting to the latest inflation data if it is to promote the wider goals of financial stability and sustainable economic growth. An over-reliance on extremely accommodative monetary policy may be one of the reasons why the world has not escaped from the clutches of a financial crisis that began more than eight years ago.

I suppose that’s why the eurozone economy took off after 2011, while the US failed to grow.  The ECB avoided our foolish QE policies, and “showed steel” by raising interest rates twice in the spring of 2011.  If only we had done the same.

Of course I’m being sarcastic, but that points to another problem with the Cohan piece. Rates are not low because of QE (as Cohan implied), indeed Europe didn’t do QE during 2009-13, and that’s why its rates are now lower than in the US, and will probably remain lower.

If this stuff is published in the NYT and FT, just imagine what money analysis is like in the average media outlet, say USA Today or Fox News.

HT:  Tom Brown, Stephen Kirchner

Endogenous money and the QTM (#4)

In the first three posts of the series I sketched out a simple model of inflation and NGDP growth.  For large persistent changes in the money supply, M dominates everything else.  But inflation reflects both money growth and changes in the real demand for money.  So real GDP growth raises real money demand, and hence is deflationary, while higher nominal interest rates reduce real money demand, and hence are inflationary.  The later point is not just NeoFisherism; higher interest rates actually cause inflation to be higher than what you’d get from money growth alone.  All my claims so far are supported by literally hundreds of money demand studies done in the 1970s and 1980s.  This stuff is not controversial for monetary economists who recall the 1970s.

Here in the final post I’ll consider the money/inflation correlation you’d expect when the money growth rate is endogenous. I’ll start with the case of Bretton Woods, which covers the first part of the period in Barro’s table.  Speaking of which, I erred in saying Barro used the monetary base; he actually used the currency stock.  But I’m quite confident that this distinction was unimportant for the period covered. (Today it would be very important.)  I also discovered that he got the data from the IMF.  Still not sure if he used differences of logs.

Under Bretton Woods, exchange rates were fixed and this tended to equalize inflation, due to Purchasing Power Parity.  But inflation rates were not completely equalized, as the real exchange rates would change over time, due to factors such as the Balassa-Samuelson effect.  There would also be gaps between money and inflation, due to differing patterns of real GDP growth and velocity growth.  And here’s the key point—there’s no logical reason to expect changes in real exchange rates to be strongly correlated with variations in money growth caused by all sorts of other factors.  This means that under Bretton Woods, the variation in inflation rates (which is identical to the variation in real exchange rates) will not be closely correlated with variations in money growth rates.

I had Patrick Horan do separate regressions for the top and bottom half of the data set, the 40 countries with the highest inflation rates and the 39 with the lowest. The top half regression had an R2 of over 98%. But here’s what he found in the bottom half:

Screen Shot 2015-08-13 at 8.29.29 PMA very low adjusted R2, below 10%.  About the best you can say is that the coefficients have the correct sign.

And the problem isn’t just Bretton Woods, the same thing happens under inflation targeting.  If everyone is targeting inflation at 2%, then any variation in inflation will simply represent central bank errors, and will likely not be strongly correlated with variation in money growth rates.

But don’t be fooled by the endogenous money correlations, or lack thereof.  Money growth is still driving inflation and NGDP; it’s just that the need to hit certain inflation/exchange rate targets is driving money growth.  If a country had decided to have 5% faster money growth, on average, then they would have had to leave Bretton Woods, and they would have had roughly 5% higher inflation and NGDP growth, on average.

Thus the entire “endogenous money” issue is often misunderstood.  It doesn’t mean that money growth is unimportant; it just means that if you are targeting something other than money, then money growth is determined by your target.  In other words, don’t say, “money growth didn’t cause X, as it’s endogenous”.  Your interest rate, or exchange rate, or inflation target caused money growth to cause X.  Money growth is still the “real thing”, even if you don’t see it in sophisticated models by Michael Woodford.

Conclusion:   A monetarist model that tries to explain NGDP growth and inflation by looking at money growth, real GDP growth and the opportunity cost of holding money does an excellent job of explaining the stylized facts of the Great Inflation, when there was enormous variation in inflation and NGDP growth.  And it does so in a way consistent with basic economic theory about how people behave, how they react to changes in the costs and benefits of holding real cash balances.  As far as I know, no other model can explain all of these stylized facts.  Indeed no other model comes close.  I’ll gladly convert to New Keynesianism or Austrianism, or Old Keynesianism, or MMTism, or Marxism, or New Classical economics, or RBC, or any other school of thought, if you can provide a coherent theoretical explanation for these stylized facts.  And if not, then please tell my why I shouldn’t keep on being a market monetarist.  I’ve got a model that works; why give it up for one that doesn’t?

The Quantity Theory at the extremes (#3)

Our initial look at the quantity theory was very positive.  Over long periods of time the growth rates of M and P are highly correlated, in a sample that includes high inflation countries.  Even better, some of the discrepancy is explained by growth in real GDP.  And better still, the coefficient on RGDP growth was approximately negative one.  Let’s use an example to think about what that means.

Suppose a country has 40%/year money growth.  Your first guess might be 40% inflation.  But now you find out that RGDP growth was 5%/year.  Now your best guess for inflation is 35%, as RGDP growth seems to reduce inflation roughly one for one.  OK, but then why not simplify the model by using NGDP as our scale variable instead of prices?  Instead of going:

inflation = money growth – RGDP growth + other stuff

We could have:

NGDP growth = money growth + other stuff

I had Patrick Horan do a simple regression of NGDP growth on money growth, and this is what he got:

Screen Shot 2015-08-11 at 10.39.20 PM

The adjusted R2 is better than for a simple regression of inflation on money growth, and almost exactly the same as when we regressed inflation on both money growth and real GDP growth (in the previous two posts.)

Let’s think a bit more about real money demand:

M/P = f(RGDP, other stuff)

The real GDP factor is obvious.  People have more demand for real cash balances as they get richer, and make more purchases.  That addresses the benefit of holding cash.  But what about the cost?  There are several ways of thinking about the opportunity cost of holding cash, such as inflation and nominal interest rates.  Inflation is the loss of purchasing power from holding cash and nominal interest rates are the foregone earnings from putting that wealth into an alternative asset. Fortunately, the Fisher Effect suggests these two variables will be highly correlated when inflation is extremely high.  So the “other stuff” could be proxied by either the inflation rate, or (better yet in my view) the nominal interest rate.

But real money demand assumes that the price level is the right scale variable.  If we shift over to NGDP, we get the following:

M/NGDP = f(i) = Cambridge K


NGDP/M = V(i) = Velocity

In the data set of 79 countries (in this post) there were 12 cases where inflation was higher than the money supply growth. In each case, real GDP growth was positive.  This meant that in those 12 cases the velocity of circulation grew faster than RGDP over a period of 30 or 40 years.  That’s actually pretty impressive, as most countries see considerable RGDP growth over 40 years.  If velocity grew even faster, then those 12 cases exhibit a pretty large total increase in V, which is a violation of the simple QTM assumption that velocity is stable.

Let’s suppose our models of money demand are correct.  What would it take for velocity to increase sharply?  The demand for money would have to decline sharply.  And that is mostly likely to be caused by a big increase in the opportunity cost of holding money.  So you’d expect to see a big rise in V in countries where the inflation rate/nominal interest rate increased very sharply.  Unfortunately the table doesn’t show the change in the inflation rate, just the average level.  But think about it, if the inflation rate rose very dramatically over that period, isn’t it likely that the average inflation rate would be rather high?  Not certain, but fairly likely.  You normally won’t see the inflation rate increase by 20% or 40% in countries like Switzerland and Germany, where the average rate of inflation was only about 3%.

The preceding view of money demand suggests that there should only be a few countries where inflation exceeded average money growth over 30 or 40 years, and that most of those cases would be countries where the average inflation rate is quite high.  And that’s exactly what we observe.  There are only 12 such countries out of 79, and yet they comprise 8 of the top 14 inflation rates.

So now we have our complete money supply model:

M/P = f(RGDP, i)

and delta M/P = delta Y – V(i)

Or to make the model even simpler:

NGDP/M = V(i)


delta NGDP = delta M + delta V(i)

Nominal GDP growth depends on two factors, money base growth plus the change in velocity.  And velocity is a function of the nominal interest rate.

This means that when the inflation rate rises very sharply, inflation will often be even higher than the money growth rate. But that’s not really a big problem for the quantity theory of money.  No one gets too upset if Argentina has 73% money growth and 76% inflation.  The problems come in the other directions, and for two reasons:

1.  When inflation slows, money growth is often higher than inflation, and sometimes even higher than before inflation slowed, for a brief period when there is a one-time adjustment in real cash balances.  That looks bad for the QTM.  This occurred briefly in the early 1980s, when inflation slowed from 13% to 4%, and the public then chose to hold larger real cash balances (and velocity fell.)  At low rates of inflation these discrepancy stand out more, and tend to discredit the entire QTM approach.

2.  This problem becomes especially severe at near zero interest rates.  Recall that base money is the world’s most liquid asset.  It has some really appealing qualities.  When interest rates fall to zero you are reducing the opportunity cost of holding this desirable asset all the way to zero.  So there can be enormous increases in base money demand.  This problem can also occur if the central bank foolishly chooses to pay market interest rates on bank reserves.

To summarize, at the zero bound the demand for base money can soar, and the money supply growth rate can vastly exceed the inflation and NGDP growth rates.  This is where the QTM looks worst.

But even in this case, money is what drives inflation and NGDP.  If the liquidity trap lasts forever then bonds become money, and the money supply gets redefined to include bonds.  In the far more realistic case where the liquidity trap is expected to be temporary, long term rate stay above zero, and permanent monetary injections still boost the price level and NGDP according to the QTM.

So far I’ve focused on exogenous changes in the money supply, which is the model that works best for the high inflation cases.  The next post will examine monetary regimes like Bretton Woods and the Taylor rule, where the money supply is endogenous.  We will see that the correlation between money and prices greatly weakens, despite the fact that changes in the money supply still cause in one for one changes in P and NGDP.