Archive for January 2015


Reply to Tyler Cowen

Tyler has a new post where he makes this claim:

More concretely, I am not persuaded by the view that a kind of sheer internal commitment to good outcomes, however sincere, can sustain a peg or nominal target.  The outside world always impinges on the logic of commitment, and thus capital is required.  This is also why I do not agree with Scott Sumner’s claim that a truly credible Swiss target, eliminating the need to expand the SNB balance sheet to make it stick, is possible circa January 2015 or for that matter anytime soon.

Just to be clear, the post Tyler links to does not claim that a currency peg eliminates the need for a central bank to buy assets, and indeed the SNB had to buy assets to maintain its recent peg (which was “truly credible.”)  My claim is different, that the switch to tighter money in Switzerland will require an even bigger balance sheet; it will require the SNB to buy even more assets than the previous policy.

In this case, Tyler may be showing too much respect for the decision-making of central banks.  He should show the SNB exactly the same respect that the market showed their recent decision.  Yes, there are scenarios where you could imagine a central bank having capital problems.  That scenario does not fit Switzerland circa 2015, and even if it did the recent policy switch is not an effective solution. Indeed it makes the problem worse.

Update:  Over at Econlog I reply to a comment by Bill Woolsey.

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.)

Playing with toy models

Back in 2002, Bennett McCallum did a really nice survey piece on contemporary monetary economics.  The best parts are his insights into some of the controversial issues, but I’d like to focus on something else (in the equations I changed the style a bit—I can’t do subscripts and deltas).  Here’s McCallum, with adjustments:

A striking feature of the typical models in the NBER and Riksbank conferences is that they include no money demand equations or sectors. That none is necessary can be understood by reference to the following simple three-equation system.

yt = α0 + α1Et(yt+1) + α2(Rt − Et(dpt+1)) + α3(gt − Et(gt+1)) + vt (1)
dpt = Et(dpt+1) + α4(yt − ynt) + ut                                           (2)
Rt = µ0 + µ1(dpt − dp∗) + µ2(yt − ynt) + et                               (3)

Here equations (1)-(3) represent an expectational IS equation, a price adjustment relationship, and a Taylor-style monetary policy rule, respectively. The basic variables are yt = log of output, pt = log of price level, and Rt = nominal one-period interest rate, so dpt represents inflation, Rt − Et(dpt+1) is the real interest rate, and yt − ynt ≡ Ëœyt is the fractional output gap (output relative to its capacity or natural rate value, whose log is ynt). Also, gt represents the log of government purchases, which for present purposes we take to be exogenous. In this system, Et denotes the expectations operator conditional on information available at time t, so Et(pt+1) is the rational expectation formed at t of pt+1, the inflation rate one period in the future.

(In the original dpt was “delta” pt.  I also corrected a typo in equation 2.)

Now let’s do something similar in the MM model.  In equation 3 we will replace R in the previous model with NGDP futures prices (NGDPF), which is the instrument of monetary policy.  (It’s not really the instrument, the base is.  But then the fed funds rate is also not really the instrument, the base is. Both NGDPF and R are financial market variables that are observable and controllable in real time.)  The NGDP futures price equals the target value, plus a systematic error (SE).  The systematic error is the predictable part of the central bank’s policy failure.

In equation 2, actual NGDP reflects both the predicted value (previous NGDPF), and an unforecastable error term (et.)  The employment gap in equation 1, more specifically the gap between actual hours worked and the natural rate of hours worked, is alpha times the NGDP gap. Alpha is probably roughly one.  The hours worked gap is thus roughly equal to the difference between actual and target NGDP growth.  Between mid-2008 and mid-2009, NGDP fell about 8% below trend, and hours worked also fell about 8% below trend

(Ht – Hnt) = Î±(NGDPt – NGDPTt)      (1)

NGDPt = NGDPFt-1 + et                      (2)

NGDPFt-1 = NGDPTt + SEt-1            (3)

And all this boils down to:

(Ht – Hnt) = Î±(SEt-1 + et)                    (1)

Where the monetary policymaker determines SEt-1.

If they do NGDP futures targeting, then SE = 0.  Let’s use an inflation targeting analogy.  The ECB is targeting inflation at 1.9%, and last time I checked the 5-year inflation forecast in the German TIPS market was about -0.1%.  So in the eurozone SEt-1 is roughly negative 2%.  If the ECB pegged CPI futures prices at 1.9% inflation, then the SE would rise from negative 2% to zero.  Actual eurozone inflation would be 1.9% plus et.  Under NGDP futures targeting, SE is equal to zero and the hours worked gap is a random walk.

Of course this oversimplifies everything (but then so does the 3 equation model described by McCallum.)  Hours worked would actually depend on Wage/NGDP, or even better Wage/(NGDP/person). Further refinement would include shocks to labor’s share of national income.  Nominal wages depend on expected future NGDP, but are also very sticky, adjusting slowly when pushed away from the desired Wage/NGDP ratio.  That would all have to be modeled.

The NGDPF market could be modeled as follows.  Define the ratio of next period’s NGDP and the current monetary base as “quasi-velocity” (QV.):

Mt*QVt = NGDPt+1

Then create a futures market in QV, and tell traders that the base will be set at such a level that the base times equilibrium QV (in the futures market) is equal to target NGDP (NGDPT.) That replaces the Taylor rule. And by using a velocity futures market, you avoid the circularity problem discussed by Bernanke and Woodford (1997). QV is obviously a function of the nominal interest rate. (This is based on a 2006 Economic Inquiry paper I did with Aaron Jackson.)

There is nothing at all like the IS relationship, as equation 2 is simply an application of the EMH (plus the assumption that the NGDP futures price is an unbiased forecast of future NGDP.) The hours worked gap is the closest thing to a Phillips Curve.  If you want output gaps, you can derive them from the hours gap equation using a variant of Okun’s Law.  Once you have real output, you can also derive the price level, as NGDP is already determined.  But why would you want those things?  The hours gap equation measures the business cycle, and NGDP is superior to the price level as a proxy for the welfare costs of inflation.  And if it’s long run economic growth you are interested in, then why mess around with monetary models?

I see several differences between the standard approach and my toy model:

1.  I use NGDP futures prices, which is not subject to the ambiguity associated with nominal interest rates.  NeoFisherites will not misinterpret my policy equation.  And it’s more efficient, as it cuts out the middleman and uses open market operations to directly target NGDP futures, which is what you care about.

2.  My “Phillips Curve” uses NGDP and not inflation (the switch from unemployment to hours is not so important.)  Inflation is problematic, because it might reflect either demand or supply shocks. So the standard model needs to account for supply shocks.  NGDP is better, as it only reflects demand shocks, which are what drive any Phillips Curve relationship.  It simplifies things.

This is just a toy model; perhaps someone else can create a real model along market monetarist lines.  As a blogger this is the approach I like best.  As director of the Mercatus Monetary Policy Program, I want the model that the rest of the profession finds most convincing.  I imagine that would be something more along the lines of a Nick Rowe model.

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 . . . . ?????