The ECB moved more aggressively than expected to cut IOR and increase QE. Today I will explore the effects, beginning with the banks.  Recall how negative IOR was supposed to be so bad for bank profits.  It seems those theories were wrong:

Banks have warned that negative interest rates are eroding their profitability. The rates cut into banks’ net interest margins as lenders have been reluctant to pass on the cost of negative rates to all but the biggest retail customers.

To offset some of the pain to banks, the ECB will provide cheap loans through targeted longer-term refinancing operations, each with a maturity of four years, starting in June 2016. These loans could potentially be provided at rates as low as minus 0.4 per cent, in effect paying banks to borrow money. Banks will also benefit from a refinancing rate of 0 per cent.

Shares in eurozone banks rallied sharply after the ECB announcement with Deutsche Bank up 6.5 per cent, Commerzbank up 4.9 per cent, Société Générale up 5.4 per cent and UniCredit up 8.2 per cent.

Over the years I’ve pointed out that there are things that central banks could do to offset the hit to bank profits. For instance, they could raise IOR on infra-marginal reserve holdings, while they lowered IOR at the margin. I did not propose the exact offset discussed above, but it seems that the general concept is workable. Negative IOR need not be a problem for banks, if done correctly.

European stocks rose sharply on the more aggressive than expected announcement and the euro fell in the forex markets. Oddly, however, for the 347th consecutive time the “beggar-thy-neighbor” theory was falsified by the market reaction.  Not only did Europe’s actions not hurt the US, our stocks soared higher on the news:

Dow futures added more than 150 points after the ECB cut the deposit rate to negative 0.4 percent from minus 0.3 percent, charging banks more to keep their money with the central bank. The refinancing rate was also cut, down 5 basis points to 0.00 percent.

I warned people to be careful after the Japan announcement; the EMH is not a theory to be trifled with.  As you recall, Japanese stocks soared and the yen fall sharply when negative IOR was announced in Japan.  But then a few days later both markets went into reverse (probably for unrelated reasons).  Many people assumed it was a delayed reaction to the negative IOR.  That’s possible, but markets generally respond immediately to news.  With the European moves today we see yet another confirmation of market monetarism:

1.  Policy is not ineffective at the zero bound.  So do more!!

2.  Reducing the demand for the medium of account (negative IOR) is expansionary.

3.  Increasing in the supply of the medium of account (QE) is expansionary.  I.e. the supply and demand theory is true.

4.  There is no beggar-thy-neighbor effect from monetary stimulus.

Market monetarists were the first to propose negative IOR.  It’s our idea.  When your ideas are correct, they help to explain how the world evolves over time. Things make sense.  In contrast, people with a more “finance view” of monetary policy have been consistently caught flat-footed.  Note that these people are represented on both the right and the left, and they have been consistently wrong in their views of monetary policy at the zero bound.

BTW, James Alexander has a post showing that eurozone growth has nearly caught up with the US:

Notice that at the beginning of 2012, NGDP growth in Europe had been running at less than 1% over the previous 12 months.  That’s the horrific situation that Draghi inherited from Trichet.  Draghi did move much too slowly at first, but at least things are beginning to look a bit better for the eurozone.  Still, Draghi needs to do more, as the eurozone is likely to fall short of its 1.9% inflation target.

Even better, the ECB needs to change its target, and set a new one high enough so that the markets are not expecting near-zero interest rates for the rest of the 21st century:

Take overnight interest rate swaps. They imply European Central Bank policy rates won’t get back above 0.5 percent for around 13 years and aren’t even expected to be much above 1 percent for at least 60 years.

Update:  The euro later reversed its fall.  But note that US stocks soared even after the initial plunge in the euro.  It’s interesting to think about why the euro reversed its losses–perhaps a view that the ECB action will make the Fed less likely to raise rates?  Or because it was expected that the action would lead to stronger eurozone growth?  What do you think?

Update#2:  Commenters HL and GF pointed out that the euro rose in value after Draghi indicated (in a press conference) that the ECB would probably not push rates any lower.

Vaidas Urba sent me a very nice speech by Mario Draghi.  Here he points out that monetary policy remains effective at the zero bound:

“Some argue that today the situation is different; that whereas Volcker could raise rates to 20% to tame inflation, central banks fighting disinflation are inhibited by the lower bound on interest rates. The Japanese experience after the bursting of the housing bubble in early 1990s is often presented as evidence.

But the Japanese case in fact only reinforces the importance of full commitment from policymakers. As long as the commitment of the Bank of Japan to a low positive inflation number was not clear, actual inflation and inflation expectations stayed in deflationary zone. Since the Bank of Japan has signaled its commitment to reach 2% inflation, however, core inflation has risen from less than -0.5% in 2012 to close to 1% today. This is still short of the 2% objective, to be sure, but downward price shocks are also hitting Japan like all other advanced economies.”

And here he discusses the mistakes made by “some central banks”:

In fact, when central banks have pursued the alternative course – i.e. an unduly tight monetary policy in a nascent recovery – the track record has not been encouraging. Famously, the Fed began raising reserve requirements in 1936-37, partially due to fear of a renewed stock bubble, but had to reverse course the next year as the economy fell back into recession. That has also been the experience of some central banks in recent years: raising rates to offset financial stability risks has undermined the primary mandate, and ultimately required rates to stay lower for longer.

It’s gratifying to read Draghi’s speech because it contains lots of talking points emphasized by market monetarists (and also by more enlightened Keynesians.) Notice how he realizes that raising rates actually causes them to be lower in the long run, something Milton Friedman recognized back in 1997.  Of course the ECB in 2011 was one of the central banks that tightened prematurely, and triggered a double dip recession.  Will the Fed’s 2015 tightening be added to the list?  It was certainly a mistake, but it’s too soon to suggest the next move will be down.  (The market predicts flat.)

Unfortunately, the outlook for the eurozone is increasingly bleak.  Wolfgang Münchau has a very good post:

Four signs another eurozone financial crisis is looming

The rout in European financial markets last week was a wat­ershed event. What we witnessed was not necessarily the beginnings of a bear market in equities or an uncertain harbinger of a future recession. What we saw — at least here in Europe — is the return of the financial crisis.

Version 2.0 of the eurozone crisis may look less frightening than the original in some respects but it is worse in others. The bond yields are not quite as high as they were then. The eurozone now has a rescue umbrella in place. The banks have lower levels of leverage.

But the banking system has not been cleaned up, there are plenty of zombie lenders around and in contrast to 2010 we are in a deflationary environment. The European Central Bank has missed its inflation target for four years and is very likely to miss it for years to come.

The markets are sending us four specific messages. The first and most imp­ortant is the return of the toxic twins: the interaction between banks and their sovereigns. Last week’s crash in bank share prices coincided with an increase in bond yields in the eurozone’s periphery. The pattern is similar to what happened during 2010-12. The sovereign bond yields have not quite reached the same dizzy heights, though Portugal’s 10-year yields are almost 4 per cent.

You might wonder why the eurozone debt situation is worsening even as the labor market gradually improves.  Perhaps the problem is that debt contracts are often quite long, whereas wage contracts tend to be much shorter.  Thus wage growth is now adjusting to slower NGDP growth, but long-term debt contracts have not fully adjusted.

The FT also has a piece that criticizes QE:

For years, central bankers have been reluctant to suggest that unconventional monetary policies even had costs. But while developed markets plunge ever deeper into uncharted financial territory as a result of central bank actions, the drawbacks and the limitations of such policies are finally becoming apparent.

The negative effects will become even more obvious over time. This will occur as asset price inflation — the main consequence of central bank policies — goes into reverse, robbing financial engineering of its efficacy and flattening the yield curve.

Suddenly, the success of central bankers in lifting financial asset prices through unconventional monetary policies seems to be coming to an end.

In other words, don’t do beneficial policies that help the economy and also raise asset prices as a side effect, because if at some point in the future you foolishly stop doing beneficial policies and NGDP growth plunges then asset prices may fall. Or something like that.

And this:

The Bank of Japan’s use of negative rates, dovish coos from New York Fed Chairman William Dudley, and carefully worded statements from Mr Bernanke’s successor, Janet Yellen, last week spooked markets rather than soothed them.

I suppose if you ignore the fact that the Japanese negative rate announcement triggered a big rise in global equity markets then this article might make some sense.  But I prefer not to ignore reality.

It’s hard not to see the current global situation in Manichaean terms.  On one side you have people like Draghi and Kuroda, desperately trying to nudge their institutions towards higher inflation.  On the other you have people who see up as down and left as right, and who offer no constructive suggestions as to how central banks can hit their targets.  In the middle is the Fed, just twiddling its thumbs.

PS. Discussion of market monetarism is now appearing in academic journals.  Here’s a new paper by Ryan Murphy and Jiawen Chen.  (Ungated preliminary version here.)

I also recommend the new post by Marcus Nunes, which discusses a post by Gavyn Davies in the FT.

I find that when things go bad with the economy, the level of discourse seems to suffer.  Here are a few items I keep bumping up against:

1.  Why not do a helicopter drop?  Because there are no free lunches in economics, and any fiscal stimulus will have to be paid for with future distortionary taxes.  What if they promise to never remove the money injected in the helicopter drop? Then we either get hyperinflation or perma-deflation, neither of which is appealing.  Won’t it help to achieve the Fed’s inflation target?  The Fed already thinks it’s achieved its target, in the sense that expected future inflation is 2%, in the Fed’s view.  That’s why they raised rates in December.  You and I may not agree, but helicopter drops are a solution for a problem that the Fed doesn’t think exists.  If we can convince the Fed that market forecasts are superior to Philips curve forecasts, then the solution is not helicopter drops, it’s a more expansionary monetary policy.

2.  Are negative interest rates good for the economy?  That’s not even a question.  I don’t even know what that means.  For any given monetary base, lower levels of IOR are expansionary (for NGDP), and lower levels of long term bond yields are contractionary. So there is no point in even talking about whether negative rates are good or bad, unless you are clear as to what sort of interest rate you are discussing.

People often debate whether the problem is that interest rates are too high, or whether the problem is that interest rates are too low.  Neither.  The problem is that we are discussing interest rates, which means we are talking nonsense.  We need to talk about whether NGDP growth expectations are too high or too low.  We need to create a NGDP futures market (which I’m trying to do, but not getting much support) and focus on getting that variable right.

Tyler Cowen’s recent post on negative rates is not helpful, because it fails to distinguish between the fact that negative bond yields are bad and negative IOR is mildly helpful.  The eurozone has negative bond yields because it raised IOR in 2011.  That was a really bad move.

3.  If market monetarism is so smart, how come you guys can’t predict recessions?  The point of economics is not to predict recessions (which is impossible, at least for demand-side recessions) the point is to prevent recessions.

4.  What’s the optimal rate of NGDP growth, or the optimal rate of inflation?  It depends.  If the central bank plans to hit the target you can get by with a lower growth rate than if they plan to miss the target.  If they use level targeting then the optimal growth rate is lower than if they target the growth rate.  If capital income taxes are abolished then the optimal rate of inflation/NGDP growth is higher than otherwise. So I can’t give you a specific number, except to say “it depends.”

5.  What do we make of the fact that the yen depreciated when negative IOR was announced, and later appreciated?  The depreciation that occurred immediately after the announcement was caused by the negative IOR.  The later appreciation was caused by other factors.  The EMH says the market responds immediately to new information.  BTW, talk about a new headline not matching the accompanying article, check out this bizarre story from Bloomberg.

6.  Thomas Piketty recently claimed:

Whatever the case, however, the failures to make such [structural] reforms are not enough to explain the sudden plunge in GDP in the eurozone from 2011 to 2013, even as the US economy was in recovery. There can be no question now that the recovery in Europe was throttled by the attempt to cut deficits too quickly between 2011 and 2013—and particularly by tax hikes that were far too sharp in France. Such application of tight budgetary rules ensured that the eurozone’s GDP still, in 2015, hasn’t recovered to its 2007 levels.

No question?  Anyone making that claim has clearly paid no attention to the recent debate over fiscal and monetary policy. His claim is not just wrong, it’s patently absurd.  I question the claim.  Hence there is a question.  QED.

Seriously, Piketty himself points out that the US kept growing during 2011-13.  And the US did even more austerity than Europe.  And the only significant policy difference was that the US monetary policy was much more expansionary than the eurozone monetary policy.  The logical inference is that the eurozone recession was caused by tighter money in Europe. I’m tempted to say that there is “no question” that tight money in Europe caused the double-dip recession, as eurozone fiscal policy was more expansionary than in the US.  But I won’t, because Piketty clearly questions this claim.

Are there any Keynesians out there who are willing to debate me on this point?  I’d love to see the argument as to how fiscal austerity clearly caused a double dip recession in Europe, even though the US did even more austerity and kept growing. It seems to me as if Keynesians live in some sort of intellectual bubble, where they aren’t even aware of the arguments made by people on the other side.  That’s not helpful if you have to debate the other side.

1.  I’m starting the feel sorry for Harvard.  Once again Bentley’s Fed Challenge team advanced to the National competition, where they will face fearsome competition like Princeton (featuring Evan Soltas.)   The Boston regionals are always tough.  Harvard finished second, and the competition included other top schools like Dartmouth and Boston College.  Congratulations to the team members:

Kathryn Mastromarino ’16

Alice Lin ’17

Michael Liotti ’16

Sal Visali ’16

Dan Reeves ’15

Matt Zeglen ’17

Amanda Pine ’16

Aizhan Uzakova ’15

Michael Acampora ’17

Brian Levine ’16

And congratulations also to the coaches Aaron Jackson and David Gulley, who do an outstanding job every year.  The team has advanced to the finals in 4 of the past 6 years, winning it all in 2012.

2.  In other news, here’s Caroline Baum:

One group of economists, known as market monetarists, has advocated implementing a nominal GDP target, which comports with the Fed’s dual mandate of full employment and stable prices. An NGDP target “” real GDP plus inflation “” incorporates both mandates, with employment serving as a proxy for real GDP.

At times, the balance between growth and inflation would be less than ideal, but advocates believe over time an NGDP target would produce smoother results than the current operating procedure, whatever that is.

Central bankers are always in search of the holy grail: something that would enable them to keep the economy on a glide path. They had high hopes for inflation targeting, which was widely viewed as both an end in itself (stable prices) and a means to an end (full employment), as former Fed Chairman Ben Bernanke liked to say.

Yet inflation targeting has its shortfalls. For example, technological innovation tends to raise real GDP and lower inflation. Under an inflation-targeting regime, the central bank would lower interest rates, which is exactly the wrong prescription. With an NGDP target, policy makers would avoid that mistake.

3.  The wrong kind of Austrian economics:

An Austrian 85-year-old cut up into tiny pieces almost a million euros ($1.1 million) in an apparent attempt to spite her heirs, authorities said Thursday.

Like the US, Europe has some truly bizarre public policies.  For instance, a European billionaire is not allowed to give away his fortune to a worthy cause like fighting poverty in Africa, he must give at least 50% to his spoiled children.  This granny tried to get around the rules by converting her million dollar fortune into currency, and shredding the money. (BTW, when you destroy currency you are effectively donating money to the national government–not sure exactly how that works in the eurozone.) She should have burned the cash and scattered the ashes in the ocean, as the National Bank of Austria has said it will replace the shredded money, and the undeserving brats will get their inheritance.  Pathetic.  No wonder Thomas Piketty is so obsessed with inherited wealth.  What the heck is wrong with Europe?

HT:  James Alexander

A quick comment on the current discussion over the seemingly low natural rate of interest.  Perhaps we should put more weight on the views of those who, in retrospect, have been right about the macroeconomy:

1.  Those who, at the time, thought that Fed policy was too tight in late 2008 (something that Bernanke has now admitted).

2.  Those who correctly predicted that the contractionary effects of the 2013 fiscal cliff would be offset by monetary policy.

3.  Those who correctly predicted that the BOJ could sharply depreciate the yen, if they wanted to.

4.  Those who claimed Bernanke was wrong in claiming monetary policy was highly accommodative in the years after 2008.  A critique that has now been confirmed by Vasco Curdia.)

5.  Those who said the Fed’s predictions for real GDP growth were too high.

6.  Those who said that if we ended the extended unemployment benefits, the unemployment rate would fall back to the natural rate faster than the Fed expected.  (Note this is the opposite of the previous prediction, which makes the success of both predictions especially interesting.)

7.  Those who first suggested that central banks could do negative IOR, and that markets would treat the policy as expansionary.

8.  Those who predicted that Trichet’s contractionary monetary policy of 2010-11, in response to transitory price rises from oil and VAT, was a big mistake.  Ditto for those who made the same prediction about Sweden.

9.  Those who first spotted the fact that the UK’s problem was productivity, not jobs, and hence that fiscal austerity was not the problem.

And yes, especially:

10.  Those who predicted low interest rates as far as the eye can see.

(Sorry, I guess that wasn’t a “quick comment”.)

Yes, correct predictions don’t prove anything (especially a single prediction).  But when they occur over and over again, they are at least slightly supportive of the claim that the person knows what he’s talking about.

And speaking of market monetarists, Lars Christensen recently gave a talk at Columbia, which is the best explanation of the euro-crisis I have ever heard. Please check it out.  At one point he points out that the two most influential macroeconomic schools of thought of the past 100 years are Keynesians and monetarists.  And both agree that the problem in the eurozone is a demand shortfall.  And the policymakers in Europe have rejected that view.

I would add these question to the Eurocrats:  Your rejection of the AD shortfall view is based on what academic theory? Does the eurozone have its own special model? If so, how’s that model working out for you?