Real Apprecation In China, One Way or the Other

Just last week I noted that because of QE2 a real appreciation in China will occur one way or the other: either its currency will appreciate faster or its domestic prices will soar.   The former seems unlikely because of China's commitment to its export-driven growth strategy.  Consequently, China will most  likely stay tied to the Fed's QE2 monetary policy via its crawling peg and continue to allow domestic prices to soar.   I also mentioned that this real appreciation should contribute to a rebalancing of the global economy.  As if on cue, the New York Times reports the following yesterday:

HONG KONG — Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific.

Markups of 20 to 50 percent on products like leather shoes and polo shirts have sent Western buyers scrambling for alternate suppliers. But from Vietnam to India, few low-wage developing countries can match China’s manufacturing might — and no country offers refuge from high global commodity prices... The trend, if continued, could ease tensions by beginning to limit America’s huge trade deficit with China.

This is an interesting article throughout, but the one thing it fails to do is connect China's high inflation to the Fed's monetary policy.  It is no coincidence that inflation is accelerating now.

A Picture Is Worth a Thousand Words

Why should the Fed aim to stabilize total current dollar spending?  This figure makes it very clear why: changes in nominal spending get translated largely into changes in real economic activity.  Its impact on the price level is far less. 

Of course, in an environment where inflation expectations get unanchored, like the 1965-1979 period, nominal spending shocks will have a greater impact on the price level and less influence on real economic activity.   And, over the long-run the trend growth rate of the real economy is determined by real factors.  But for business cycle considerations, it is hard to argue with a monetary policy goal of stabilizing nominal spending when looking at this figure.

Update:  Check out Marcus Nunes who makes an even stronger case using the above figure.  He also looks at the 1965-1979 period referenced above.   Finally, Marcus provides a nice Beckworth smackdown regarding my use of nominal spending trends.

Are We There Yet?

No, but today's GDP report indicates we are getting closer.  Total current dollar spending, as measured by final sales of domestic output, grew an annualized rate of 7.3%.  This is fantastic news. We need several more quarters of catch-up growth like this to bring nominal spending back to its trend.  Doing so would go along way in making a more robust recovery. 

Here is a figure showing the updated final sales along with its 1987-1998 trend. (Click on figure to enlarge).)

As I explain here, I pick this period's trend because it is the part of the Greenspan period where there were no wide, unsustainable swings in economic activity.  Moreover, 1998 is when the Greenspan Fed for the first time significantly deviated from past practice by lowering the federal funds rates even though the economy was experiencing robust economic growth.  George Kahn provides Taylor Rule evidence that supports this notion.

Update: Bill Woolsey, who prefers a 1984-2007 trend, also takes notice of the acceleration in final sales.

Will There Be an Explicit Inflation Target in 2011?

Jon Hilsenrath says the Fed is closer to adopting an explicit inflation target. 

Inside the Fed, the idea resurfaced in the fall as the Fed debated the merits of initiating a $600 billion bond-buying program known as quantitative easing. In an Oct. 15 speech in Boston, Mr. Bernanke took another step, saying that Fed officials "generally judge the mandate-consistent inflation rate to be about 2% or a bit below." With inflation running at around 1%, he said there was a case for more Fed easing. An inflation target might be an easier sell when inflation is low; if it were adopted when rates were high, it would be seen as a reason for higher interest rates, which are never popular.

[...]

New challenges this year could put the inflation target back on the agenda. Several Republican lawmakers, concerned that the Fed is stoking inflation, have proposed narrowing the Fed's mandate to price stability, eliminating the employment part.

[...]

The controversial decision to embark on a new round of quantitative easing gave the Fed added reason to adopt a target, Mr. Mishkin says. "In order to make quantitative easing understandable you need to move in this direction of being much clearer about what your long-run inflation objective is and how quantitative easing fits into it," he says. Proponents also say an inflation target goes hand-in-hand with the Fed's employment objective because low inflation supports economic growth and hiring.

I know this is pipe dream, but I wish Fed officials would also consider something like a NGDP level target.  Yes, an inflation target would be easier to adopt because it is easier to understand and sell to the public, but it is ladden with problems as I explain here.  Interestingly, the Fed did talk about a NGDP target in its September, 2010 FOMC meeting.  I actually would prefer an aggregate spending target that stabilized final sales of domestic production rather than NGDP, but I would be happy either way.  Should anyone at the Fed care,  here, here, and here are some of my recent thoughts on it. Also, here is how I would set the trend for a nominal spending level target.

Policy Paralysis in Germany

Kantoos responds to my earlier question as to whether Germans dislike inflation or bailouts more. He says that this is a difficult question since Germans passionately detest both. What is known, though, is that because of these strong views there is a sort of  policy paralysis in Germany that leads to a non-optimal policy outcome:

This would be the worst possible deal for the Eurozone that Germany could have made: The bailouts prolong the crisis without putting the burden, where it should be put: on the bondholders. And yes, these are in part German banks and insurances. The contractionary monetary policy on the other hand forces the periphery in an already suboptimal currency union to adjust even more than what would otherwise have been necessary with an adequate monetary policy.

Sigh. On a lighter note, Merle Hazard has penned a new song about Germany's problems:

And here you can find Merle Hazard's song on Ireland's problems.

The ECB is Getting Something Right

The ECB, according to Kantoos and Scott Sumner,  is effectively targeting a stable nominal GDP path for Germany.  Moreover, it is doing a fine job at it.  Kantoos further shows that nominal wage growth is being stabilized around 2% a year.  I take that to mean the ECB is not just effectively targeting nominal GDP, but nominal GDP per capita for Germany.  This comes close to what I think is an ideal goal for monetary policy for reasons discussed here. 

Now while the ECB's monetary policy may be great for Germany it is too tight for the periphery of the Eurozone.  Because this one-size-fits-all monetary policy makes it difficult for the the Eurozone  to solve its current problems, the European countries seemingly face the tough choice of giving up their currency union experiment or giving up their national sovereignties to make the currency union more functional. Ryan Avent notes, though, that there is a third way to solve this problem: have the ECB loosen monetary policy such that there is a real appreciation in Germany and real depreciation in the Eurozone periphery.  I liked his idea and followed up with this:

[H]ere is another option: more monetary easing by the ECB.  As Ryan Avent explains, further easing by the ECB would cause a real depreciation for the Eurozone periphery vis-a-vis the Eurozone core:

[T]he key to a relatively painless internal revaluation is inflation in tighter markets. And it's here that the European Central Bank could play a particularly useful role. Were the ECB to adopt a looser monetary policy, we would expect inflation to pick up first in the markets with the least excess capacity, and that would obviously mean rising prices for Germany.

Prices, therefore, would increase more in Germany than in the troubled periphery.  Good and services from the periphery would then be relatively cheaper.  Thus, even though the exchange rate among them would not change, there would be a relative change in their price levels.  This  would make the Eurozone periphery more externally competitive.  The relative price level change would not be a permanent fix to structural problems facing the Eurozone, but it would provide more time to address the problems. 

Of course, this option seems unlikely. My impression is that the one thing Germans hate more than Eurozone bailouts is Eurozone inflation. Any thoughts Kantoos?

QE2 and Rising Yields, Again

Late last year I was making arguments like this one about how QE2 would work:

[T]he recovery view begins with notion that a successful QE2 will first raise inflation expectations.    The increase in  inflation expectations, however, also implies higher expected nominal spending (i.e. higher future nominal spending means higher future inflation).  Higher expected nominal spending in an economy with sticky prices and excess capacity should in turn lead to increases in expected real economic growth.  Finally, this higher expected real economic growth should increase current real long-term yields.  Given the fisher equation, this understanding implies that the rising long-term nominal yields are occurring because of both higher expected inflation and higher real yields.

Thus, contrary to the sales pitch made by Fed officials that QE2 would lower yields, we should expect to see yields ultimately increase if QE2 is successful.  Below is an updated figure on the 10-year expected inflation and 10-real treasury yield. (Click on figure to enlarge.)

 

[Update: the labels on the graph were original reversed and now have been fixed]

To the extent the sustained rise in real yields is reflecting an improved economic outlook, can we not attribute some of that improvement to QE2?