Tag Archives: monetary policy

Housing Prices and Monetary Policy: The Long View

A long 140 year history on housing prices and interest rates provides evidence that lower short term interest rates have significant positive effects on mortgage borrowing and housing prices. These findings by Oscar Jorda, Moritz Schularick, and Alan Taylor pose a dilemma for monetary policymakers: should they prioritize restoring nominal GDP or trying to prevent housing bubbles? This is well illustrated by the front page of the digital WSJ at the time of writing: while the Fed considers how long it should continue keeping rates low, there are signs that subprime lending is expanding again.

Should Monetary Policy Respond to Financial Stability?

I have written before on what I think about the role of monetary policy authorities and financial stability. I am skeptical of the direct role of monetary policy for three reasons:

First, there’s no reason to believe that the Fed can accurately identify bubbles in advance. Second, even if a bubble appears, it’s not clear that raising short term interest rates could pop it. Third, even if monetary policy ends up bringing asset prices down, it is likely to do so only through hurting the livelihoods of average Americans.

In the article, I walk through a variety of historical examples including the Great Recession, the recession of 1937, and the Great Depression.

I still stand by the arguments I made in the article and want to offer several extensions. Note that I mean to criticize the idea that monetary policy should lean against financial bubbles — not the more general idea that central banks can play a role through macroprudential policies.

  1. The Swedish experience with raising rates in order to bring down debt levels has been a disaster. Instead of lowering debt to gdp ratios, tighter monetary policy instead reduced nominal incomes and caused debt to rise as a percentage of GDP.
  2. Lower rates are usually not a sign that monetary policy has been easy, but rather that it has been too tight. Low rates are typically a sign that demand is low, and as such central banks should try to lower rates even further in order to stimulate demand. If instead you try to raise rates too soon, by cutting off demand you just extend the period of low rates.
  3. There may be structural reasons to believe that housing prices tend to be higher when aggregate demand is low. Capital equipment, which is much more sensitive to the business cycle, become less attractive at every interest rate relative to houses. As such if central banks want to head off a housing bubble they may be better off ensuring rates are low enough to stimulate demand.

It’s also not clear that Jorda et. al. can get much traction on the types of monetary policy decisions facing much of the developed world right now. In their statistical approach, they identify exogenous variations in interest rates with falling interest rates from abroad that get passed through as a result of a fixed exchange rate and free capital flows. In other words, their monetary policy does not come from a domestic central banker deciding to ease instead of tighten, instead it comes from a decision from a foreign central bank.

This opens up the possibility that what they’re really identifying is unwanted expansionary monetary shocks when the economy is already booming, or the potentially destabilizing effects of rapid foreign inflows of capital. Neither of these are quite appropriate for central banks right now:

  1. The United States, for example, is sluggishly chugging along — hardly a boom time in which bubbles are started. The authors tell a Eurozone parable and explain how easy ECB monetary policy for Spain caused a property bubble. But even here we see this timing issue in effect — even if low rates in a boom cause asset prices to rise while doing little for output, the same may not be true in a slump.
  2. If the negative rate shock comes from a domestic source, that would mean that capital flows out to chase yields elsewhere . This is the exact opposite of what would be going on to the countries in the Jorda et. al. dataset.

The Problem with Musical Chairs

Scott Sumner has a recent paper with the Adam Smith institute outlining the basic tenets of Market Monetarism. In this paper he discusses why the central banks should abandon inflation targeting and instead target the expected value of future nominal GDP (NGDP).

I have no disagreement on the policy advice. But I do have an issue with the way that Scott justifies his “musical chairs” model of employment. In particular, the key stylized fact — the countercyclicality ratio of wages divided by nominal GDP — is not unique to his model. As such, it does not provide any smoking gun for the market monetarist claim that fluctuations in nominal GDP are key to understanding the business cycle.

In the “musical chairs” model, we have a bunch of workers working for certain nominal wages. Along comes a nominal GDP shock. Then because wages and hours worked per person are sticky in the short run, there are fewer employment opportunities. “Musical chairs” refers to how everybody can be in a job (and dance around) so long as nominal GDP growth is humming along. But when the music stops, some are left without a chair and we are left with unemployment.

There is no arguing with this set of relations. The events I have described above are nothing more than a consequence of various accounting identities. The problem arises when Scott tries to ascribe a causal interpretation to this story. In his story, a monetary policy maker allows nominal GDP to fall because of a monetary policy error. Causality then flows through the wages and hours relationship, and as a result contractions in nominal GDP result in unemployment. Statistically, this means that we should see the ratio of total wages to nominal GDP ratio rise during recessions. Indeed, we see this relation.

Here is our disagreement. I cannot think of models of the macroeconomy in which we don’t see this relationship! Those who live by accounting identities are also doomed to die by them. I can rewrite the wages/NGDP relationship as:

Employment = NGDP/(nominal wages)

And so of course any increase in the wage/(nominal GDP) ratio is associated with a negative change in employment! This is true even in an RBC world in which recessions are caused by technology shocks. In that world, a negative technology shock pushes marginal workers out of the labor force, employment falls, and as such the ratio of nominal income to wages will increase.

Now, I still believe that a model of nominal GDP + sticky wages is a powerful framework. Wages are indeed sticky, as evidenced by a spike in the wage change distribution at 0. And if wages are sticky, monetary tightness and declining nominal GDP mean that people are paid high real wages and as such there are fewer jobs. Alternatively, you can view it as a liquidity issue as companies just don’t have enough nominal cash flows to pay those persistently elevated wages. So I don’t think there are too many issues with the underlying framework. I would just advise more caution on the way that statistical evidence is used.

If it Isn’t Broken, Don’t Try to Fix It

Last month, Republican senator Rand Paul introduced a bill that would expand Congressional oversight over the Federal Reserve and used it to spearhead a self-proclaimed “Audit the Fed” movement.  In an op-ed on Breitbart written by the senator himself, Rand cites the Fed’s massive balance sheet leverage being composed of faulty loans, long-term dollar dilution, and expanded powers from the Dodd-Frank Act as being the driving forces behind the movement.  Many journalists seem to be missing the underlying implications of the proposed bill.  Neil Irwin of the New York Times delves into a description of how the Fed is actually quite transparent and argues that its financial statements are indeed already audited yearly, then goes on to claim that experts say the bill is really about “unveiling the secrets of the temple, exposing the perfidy that these secretive central bankers are surely engaged in”.  He counters that issue by going into detail about the Fed’s communication with the public, but what his analysis is missing is the fact that Congress having even the slightest input on the Fed’s decisions is a terrible idea.  A writer for the Wall Street Journal glanced over that notion as well, providing an explanation of the Fed’s balance sheet and Paul’s claims, adding a mere sentence about how Fed officials think the bill would limit their independence with no elaboration beyond that.  Journalists are missing the real story here.  While some are acknowledging the fact that the Fed is adamantly against the issue, as this WSJ article does, they are simply quoting statements from Fed officials and leaving the meaty story on the table, opting instead for the side-salad.

Nobody should be surprised that the Fed is against expanding Congressional oversight – it goes against everything they stand for as independent, “private” bankers.  The issue at hand here is not about a lousy financial audit, nor is it about tapping into the minds of the Fed’s Board of Governors.  It is about Congress, a radically political being, wanting to interrupt a monetary system that has a solid track record.  It is about lawmakers diverting their efforts towards a matter of policy where there is little room for improvement.  Since the peak of the global recession, the United States has had the best recovery out of the five countries with the biggest central banks, as demonstrated by this data from the World Bank.




This was largely due to the Fed’s quick response of buying up toxic assets, a response which may have taken years (and which would have been far too late) if it involved some sort of Congressional vote or approval.  Critics of the Fed claim that purchasing these assets was a mistake, reasoning that there is risk inherent to increasing the size of the Fed’s liabilities.  In reality, the asset purchase program was well-implemented, likely saved Americans years of economic stagnation, and carried less risk than what was perceived.  It is only natural that it will take a while for the Fed’s balance sheet to shrink, just as Fed officials claim, since it must space out the asset sales at a reasonable rate (and its asset sales have been accelerating, as noted in CNBC).  The Fed has been wise in its handling of these assets, opting to hold on mortgage-backed securities that it had previously intended to sell in 2013, waiting for the right time so as to avoid losses, as described by this Bloomberg article.  Those who claim that the Fed has not been transparent enough seem to be overlooking the fact that Ben Bernanke provided plenty of guidance to the market with respect to the Fed’s goals.  The Fed as we know it is working perfectly fine as it is: a board of apolitical experts who are free to make decisions without worrying about public or political input that is often misguided, as Rand Paul’s is.  To insert any sort of Congressional control would jeopardize a system that has worked perfectly fine as is.


Macroeconomic “Excuses”: A Look at Europe

Policy makers are good at coming up with excuses for bad policy. That’s one of my key takeaways from Barry Eichengreen’s recently released “Hall of Mirrors”. In this book, Eichengreen compares the policy responses to the Great Depression and Great Recession and finds that while we may have done better this time around in the initial monetary and fiscal response, we have still managed to unlearn the lessons in the policy responses during the years after the initial crisis. Neil Irwin, summarized this in his NYT review: “Rather than hoist anyone to our shoulders for preventing another Depression, we should be more cleareyed about the ways in which global leaders did not really learn the lessons of the 1930s at all and made many of the same mistakes as their Depression-era counterparts”

An important part of making mistakes is coming up with excuses to justify them. It is here that we see a troubling parallel between the current permissive attitude towards the European collapse in nominal GDP and the passivity of European central bankers in the face of the Great Depression.

Prior to the Great Depression, the global monetary system ran on the gold standard. Since every country’s currency was pegged to gold, each country’s gold stock served as a limit to how much it could expand its money supply. This meant that if you enjoyed the privilege of capital inflows, you could expand your money supply in response to a recession. But if on the other hand you suffered capital outflows, then you were forced to raise interest rates and contract the money supply, even if you were in the depths of a recession.

Prior to the first World War, there were “rules of the game” that helped to mitigate these constraints. In particular, central banks in countries with gold inflows were supposed to expand their money supplies in response to gold inflows. This way, if a country ran a substantial trade surplus and had lots of gold flowing in to buy its goods, the central bank would allow the price level to rise. This would eventually reduce that country’s competitiveness relative to other countries. The trade surplus would turn to deficit, and then gold would flow out as it chased cheaper goods abroad. In doing so, central banks in surplus countries let gold flow back to deficit countries, thereby returning some degree of monetary sovereignty to those deficit countries as they could then expand their money supply

But in the interwar period, France refused to play by these rules. Due to large fiscal battles in the immediate aftermath of the war, the Franc was forced to devalue several times. Eventually it settled at a level that made the Franc very competitive, and gold flowed into France. But instead of following the rules of the game and letting the French price level rise, the Bank of Japan sterilized the gold inflows, stuffing them under the proverbial central banker’s mattress.

From Irwin 2010, “Did France Cause the Great Depression”

This caused severe problems in deficit countries such as the UK and Germany. Since the French price level was not rising, the deficit countries were stuck with their trade deficits. But the French did not see this as a monetary problem. As Eichengreen describes in his new book, “If France enjoyed a balance-of-payments surplus, then this reflected the innate frugality of the French, who preferred saving over spending.” Douglas Irwin, a monetary historian at Dartmouth, notes that French officials attributed the capital inflows to renewed confidence in their economic policies.

This is remarkably similar to the current European situation, except now it is Germany that is the surplus country and peripheral Europe that is running a trade deficit. And again, the surplus country does not see this situation as something about the quasi fixed exchange rate regime of the Euro, but rather as structural superiority relative to the deficit countries. Eichengreen too makes this connection.

The historical lesson for modern Germany would be to recognize that monetary inflation for the Eurozone indeed may be a bad deal for Germany right now. It would open the gate for peripheral Europe to sustainably lower their real wages and thus rob Germany of its competitive advantage relative to peripheral Europe. But that’s the point. Had France consented to expanding their money supply prior to the Great Depression, it would have substantially eased the adjustment process for the UK and Germany. With the benefit of hindsight, Germany should reject moralism about trade surpluses and recognize that monetary expansion is the only true sustainable way to bring South European competitiveness back on track.

Originally posted on Medium.

Keep Monetary Policy and Structural Reform Separate

European QE alleviates the need for structural reform. Or so Merkel and Weidmann say. The argument here is that if the ECB eases monetary policy in an effort to improve economic conditions in Southern Europe, that enables Southern European countries to kick the can down the road and delay on enacting structural reforms.

This is hogwash.

Now, I do not mean to say structural reforms are not necessary. Jay Shambaugh, an economics professor at Georgetown, descries the current European malaise was the result of three interconnected crises: a banking crisis, a sovereign debt crisis, and a growth crisis. Given the crisis in growth, structural reforms such as “deregulating product or retail markets, streamlining rules for investment or starting businesses, implementing policies that foster innovation, or removing barriers to entry in various services professions” must play a role.

But central bankers should not try to be “enforcers”. The Bank of Japan tried this in the 1990’s. In his article titled “The Political Economy of Deflationary Monetary Policy“, Adam Posen argued that there was a broadly held belief at the Bank of Japan belief that tight money was necessary to encourage economic dynamism. As an example, Posen draws on remarks by BOJ Governer Hayami in 2000:

“Mr. Hayami also repeated his view that the zero interest rate policy was undermining structural reform in Japan and preventing the rise of promising high-tech industries. “If we retain zero interest rates indefinitely, these places will lose vitality…and it will end up being a minus for Japan’s economic recovery.”

Given the lack of evidence that tight money can encourage structural reforms, Posen concludes “that ‘creative destruction,’ invoked and praised repeatedly in Hayami’s speeches, [was] the motivating ideology”.

The fact that the German leadership is committing the same errors as the Japanese leadership in the 1990’s shows that this obsession with structural reform is deep seated in the minds of “very serious people”.

Syriza’s victory also shows that democracies do not walk willingly into structural reform when growth is moribund. Instead, they are likely to elect radical parties that promise to overthrow these reforms. And so instead of slightly higher inflation which would help Greece more easily accomplish an adjustment in real wages, we instead get a party whose platform includes higher minimum wages and public sector pensions. As Scott Sumner has complained, “conservatives seem so opposed to slightly higher inflation that they’ll often end up tacitly or explicitly supporting much more statist policies instead.” Unfortunately, we see exactly this playing out in Greece today.

Fortunately, Draghi seems to have a clear head on the issue of structural reform.

“What monetary policy can do is create the basis for growth,” he said. “But for growth to pick up, you need investment; for investment, you need confidence; and for confidence, you need structural reform.”

One would hope that German leadership would also adopt this attitude. Insist on structural reform, but recognize that the only way to get there is through a monetary policy that takes the needs of all Euro nations into account.

Will Europe Finally Join the QE Bandwagon? (Revised)

Europe has struggled to rebound from the Great Recession.  A few years ago, it appeared that the EU and the United States were recovering at roughly the same pace, as shown by this graph of World Bank data on GDP growth rates.  In 2012, the EU dropped off of the path to recovery, posting a -0.4% growth rate, while the United States continued to chug on at around 2% growth per year.  This divergence was largely a product of the two different policy approaches taken by the central banks of each economy.  In the US, the Fed engaged in three separate rounds of large monthly bond purchases, or quantitative easing, with the goal of expanding the money supply and lowering interest rates.  In contrast, the European Central Bank responded with the European Financial Stability Facility to provide liquidity to EU members, and several European states undertook austerity policies.  It may be slightly naive to attribute all of the US economy’s recovery to QE, but it certainly appears to have been incredibly effective.

So why did the EU not even attempt QE while the Fed was rolling out several rounds of it?  One big obstacle that the ECB faces is the fact that it is composed of a multitude of national central banks, making it far more difficult to coordinate asset purchases.  However, it appears that the time may have finally come for the European Central Bank to enlist the help of QE.  As reported in the Wall Street Journal, the ECB’s executive board has proposed a 12-month (at minimum) round of QE, composed of asset purchases of €50 billion per month.  The bank’s governing body will meet Thursday to discuss the proposal.  As noted by MIT professor Athanasios Orphanides in the Journal article, “the potentially open-ended nature of the program—the idea the ECB could continue beyond a year—is a bright spot that could give the program additional power”, since many economists believe one of the core strengths of QE is the effect on the market that expectations of aggressive future monetary policy can have.  More specifically, a central bank indicating that it wishes to keep interest rates low will have far more credibility if it is engaging in QE, since it is exposing itself to the risk of losses on the assets it’s buying up if rates were to rise, as pointed out by an article in The Economist that gives a fantastic overview of the implications of QE.

As news of the potential ECB actions broke, the euro fell against the dollar – good news for the multitude of European states that rely heavily on exports to fuel their economy.  Italian prime minister Matteo Renzi was one of those who welcomed the news, who claimed that he dreams of parity between the Euro and the Dollar in an interview with the Wall Street Journal earlier today, believing that it would grant Europe greater economic flexibility.  However, it is not good news for everybody – German officials oppose the ECB plan, as noted in the first Journal article, since German taxpayers have concerns that they would be responsible for the more risky debt of other European countries.

Since I originally wrote this post, the official ECB press release has been issued, and thus some new pieces of information have emerged.  The official plan is more ambitious than what was originally proposed by the ECB exec board: the monthly purchases will be €60 billion each, and will continue through September 2016 at minimum, far longer than the original 12 months.  This would result in about a €1.1 ($1.24) trillion injection into the eurozone, making it about 75% the size of the Fed’s QE3 program (which was roughly $1.7 trillion), in a very similar format.  The Germans are likely to be pleased with the loss-sharing arrangement: only 20% of asset purchases will be subject to risk-sharing, which, in my opinion, is a necessary arrangement to ensure that every member of the monetary union is convinced.  It’s worth noting that the ECB is strictly targeting inflation with this policy, whereas the Fed’s primary goal with QE was to put downward pressure on interest rates.  It is this disparity in policy goals that leaves me with doubts about how effective QE will be for the eurozone: interest rates are already quite low, so the ECB stands to gain little ground in that respect.

Chinese Central Bank Injected 400 Billion Yuan

Chinese central bank drilled about 400 billion yuan (nearly $65 billion) to the banking system at the beginning of the January 2015. PBOC(The People’s Bank of China), which is led by the State Council, is responsible for introducing policies, setting marketing strategy, monitoring other banking and stock system, controlling exchange rate, issuing currency, and managing the treasury. There are other five state-owned banks: Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China Limited, China Construction Bank, Bank of Communication, are taking charge of implementing the assigned policies for the society. These banks will utilized the 400 billion yuan to compensate their deposits and put more money flood to the market.

The five state-owned banks has suffered the declining profits since the PBOC has introduced a policy of cutting the interest rate down in 2014. They do not have enough deposits to satisfy the demands of the big developing market so this billions of fund will reboot the liquidity. “About 500 billion yuan in loans made in September by China’s central bank to the country’s top five state-owned banks are coming due this month. Uncertainty over whether the central bank would renew those loans has led the banks to grow wary of lending out their funds. Meanwhile, banks in China have been squeezed in recent weeks because many investors shifted their funds out of banks and into the stock market.”(http://www.wsj.com/articles/chinas-central-bank-injects-about-400-billion-yuan-into-interbank-market-1418284627?KEYWORDS=Chinese+central+bank) This time’s injection expressed central bank’s determination of solving the problem.

Moreover, China has experienced the lowest increase of its GDP during the last decade in 2014. The feeble performance of the real-estate market in China, especially in big cities, including Beijing, Shanghai, and Guangzhou, are one of the essential role. The chairman Xi Jingping’s tough attitude towards combating corruption also punched many business. People’s desire of investing and consuming are both debated. This is another pivot contribution of sluggish China’s economy.

With this 400 billion yuan, China’s state council announced to introduce the deposit-insurance system. “In disclosing plans for a deposit-insurance system, policy makers appeared to nod to rising concerns about financial risks. Deposit insurance will help maintain ‘public confidence’ in China’s banking system, said the People’s Bank of China in a statement accompanying the draft plan. The central bank, which is spearheading the effort, also said the insurance program will ensure that “risks will be discovered early and risks will arise less frequently.”(http://www.wsj.com/articles/china-releases-draft-plan-for-bank-deposit-insurance-1417340960) If the deposit-insurance system is successfully implemented, people’s credibility of saving will be dramatically increased while the competition of banking system as well as. Then, banks will attain more deposit for investments. With the 400 billion yuan, China wish its development will keep mighty in 2015.

The Waiting Game

“The Federal Reserve signaled this past week that it is unlikely to raise short-term interest rates until at least June” (http://blogs.wsj.com/moneybeat/2015/01/30/fed-up-do-rising-rates-matter-after-all/).

This came as a surprise to most people, it seems, but I am not completely surprised based on the underlying motivation of the Fed.

“…The Fed will raise interest rates only when it is confident that the economic recovery is robust and companies have regained the ability to raise prices” (http://blogs.wsj.com/moneybeat/2015/01/30/fed-up-do-rising-rates-matter-after-all/).

Although it seems that the Fed is not in touch with everyday citizens, like you and I, I believe their decision to delay the rise of interest rates is in tune with the best interests of everyday citizens. Although we have been told for a while that the recession is over, it seems that from the perspective of everyday people that is not necessarily the case. It seems like the wealth of the upper class has been rising since post recession, but the middle class and below has not had the same fortune.

The Federal Reserve clearly believes that the economy is not in full rebound yet, hence the delay of raising rates until mid summer. I am happy with the decision the Federal Reserve made, their focus seems to be more on the well being of everyday Americans, rather than worrying about creating high returns for investors. This is not really the common perception of the Federal Reserve; most people seem to think they do not have to best interest of the people in mind. There seems to be this notion or belief that the Federal Reserve is just a group of wealthy bankers in an ivory tower playing with everyone’s money, acting according to the best interest of a few. Their recent decision, however, points to the opposite.

“…Investors seemed mildly disappointed when the Fed reiterated on Wednesday that it would remain “patient”” (http://blogs.wsj.com/moneybeat/2015/01/30/fed-up-do-rising-rates-matter-after-all/).

Although investors seem to be upset with the Federal Reserve’s decision. Most people are not investors so this decision by the Fed to not act does not affect them in the same way as those who speculate based on the Fed’s actions.

“More than three-quarters of Americans say the five-year bull market in U.S. stocks has had little or no effect on their financial well-being, according to a Bloomberg National Poll” (http://www.bloomberg.com/news/articles/2014-03-12/stock-market-surge-bypasses-most-americans-poll-shows).

Bull market is a term used to signal positive beliefs about the market, while bear market is used to signal the exact opposite, pessimism towards the market. Although the stock market, like explained above has been labeled a bull market for the past five years, this has not improved the financial well being of everyday Americans, most who do not own stocks, or at least not a significant amount anyways. With the lower and middle class of America still struggling, it seems that the fed made the appropriate decision to delay raising interest rates.

“Don’t worry about the Fed; be happy” (http://blogs.wsj.com/moneybeat/2015/01/30/fed-up-do-rising-rates-matter-after-all/).

You can be happy; the Fed seems to be thinking about you and I, not just the wealthy elite.

FOMC Changes Nothing

The Federal Open Market Committee just finished their two-day meeting on January 28th, 2015, and started off the year with a whole lot of nothing! The Committee did not make any changes or do a whole lot of revisions to their previous guidance’s. This is in grave contrast to the changes that the Swiss National Bank has done as of late. While the FOMC did still make it clear that they are still keeping the door open to the possibility of a June rate hike, Janet Yellen and the entire committee released in their statement, “However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.  Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.” The Committee managed to say a whole 529 words without saying anything new at all. As Sarah Portlock wrote in her Wall Street Journal article, Economists React to the January Fed Statement: ‘The Door is Still Open to a June Hike’, “The FOMC was able to take a pass today, but the rubber will hit the road in March, when the committee will presumably need to tweak the forward guidance language if it wants to keep a June rate move on the table.” Everyone was eagerly awaiting to hear more about their guidance on these rate hikes, but were all utterly disappointed at having to wait until they meet again to learn anything new. This spelt trouble for the stock markets as Alex Veiga reported in his article, Stocks fade late as oil dips, Fed gives investors pause, “The market had been in a wait -and-see mode in advance of the Fed statement, drifting between small gains and losses for much of the day… The market initially perked up after the Fed issued its statement at 2 p.m. Eastern Time. But the gains were short-lived, and by late afternoon three major indexes slumped, extending their losses for the year. The Dow is now 4.8 percent below its all-time high of 18,053.71 on Dec. 26. The S&P 500 index is down 4.2 percent from its high of 2,090.57 on Dec. 29.” This is due to the fact that the Fed kept in a June target to begin their rate hikes, because as interest rates go up they usually make stocks less attractive relative to bonds. Let’s hope that while the US and the FOMC had the most uneventful Central Bank meeting as of late, that Janet Yellen and her committee members truly know what is best to keep our economy humming!


What Price Level Targeting Could do for Europe

There’s more to asset purchases than size. In addition to announcing large bond purchases of €60 bn per month, ECB president Mario Draghi suggested that asset purchases could continue until the ECB hit its inflation target of 2%.

This resembles QE 3, in which the Fed committed to asset purchases until unemployment fell below 6.5% or inflation rose above 2.5%. It also resembles recent events at the Bank of Japan. When Kuroda saw that the Bank of Japan would not be hitting its inflation target, he had the BOJ raise the rate of asset purchases by 30 tr. yen per year — from 50 to 80 tr yen. If the ECB follows up on this open ended commitment, it could be the bold new start of a “Draghi Framework” in which the ECB commits to hitting its inflation target through asset purchases.

This might not be enough. One problem with monetary policy at the zero lower bound is that the only way to lower real interest rates (without introducing negative paper currency interest rates) is to increase expected inflation. If central banks define their own responsibility in terms of hitting an inflation target, then raising inflation expectations is tantamount to “credibly promising to be irresponsible”. To get people to raise their inflation expectations now, the ECB would need to convince people that the central bank will let inflation run too high for a period in the future — something that’s not credible when the inflation target has historically centered around 1.50–1.75%.

One way around this is to commit not to an inflation target but rather a price level target. Instead of targeting a growth path for the price level, the ECB would instead commit to making sure the price level reaches a predetermined path. So if the ECB undershoots one year, its target would have it try to generate more inflation in the next.

Let’s consider what this means given the history of the price level in the Eurozone.

What’s evident from the graph is that the path of the price level was pretty steady up until 2012, and since then it has leveled off. This collapse in the price level growth rate (aka inflation) is even more stark from looking at year over year inflation rates.

Year over year inflation is negative. An inflation target would commit the central bank to raise that up to 2%. A price level target would commit to raising that level inflation above 2% for an extended period of time in order to fill in the gap caused by the persistent lack of inflation over the course of the last year.

(Ignore the 2012 bump — it was the result of VAT tax changes that should have no relevance for monetary policy)

But the key part of a price level target is that it implies larger and larger levels of inflation if the central bank doesn’t hit its target. If the target is a 2% price level path, and inflation is only 1% this year, that implies that the central bank is committing to a 3% inflation target the year after. If inflation stays at 1%, then the inflation target becomes 4%. If the central bank can do this credibly, then expected inflation increases as the experience at zero lower bound gets longer. This lowers real interest rates and allows the central bank to get more traction.

And why might we think this threat is credible? As I discussed before, if a central bank can’t raise the price level then that would imply absurd abilities to change real economic conditions.

Price level targeting gets around Krugman’s “credible irresponsibility” line because the central bank redefines what it means to be responsible. Higher inflation becomes responsible because it’s done in the name of hitting a price level target.

The ECB made an important step towards restoring nominal stability in the Eurozone with QE. But if the ECB finds itself needing to bring out more firepower, a price level target would be one way for the ECB to get more traction at the zero lower bound.

Originally posted on Medium.