It's 2012, Not 2002

Back in the early 2000s, the world economy was buffeted with a series of positive aggregate supply shocks: the opening up of Asia, rapid technological gains, and the ongoing liberalization of the real economy in many countries.  These shocks expanded global economic capacity and implied higher future economic growth.  In turn, there should have been a higher global natural real rate of interest given the higher expected economic growth. These shocks also should have resulted in more benign deflationary pressures that would have kept real wages up in advanced economies.

The Fed, however, did not allow this to happen because it feared the deflationary pressures. It loosened U.S. monetary policy and through the many countries that link their currency to the dollar, it also loosened global monetary policy. Even the ECB and Bank of Japan followed suit to some degree since they were mindful of letting their currencies become too expensive relative to dollar and the all the currencies pegged to it. In short, the Fed's monetary superpower status allowed it to lower global real interest rates below the global natural real interest rate level during this time.¹  This was an important part of the global housing boom story and the Bank for International Settlements (BIS) was all over it. It repeatedly told the Fed that its misguided fears of deflation were causing it to create a global liquidity glut.  The BIS was spot on during this time.

But that was then and this is now.  The global economy is now being hit with negative aggregate demand shocks in Europe, Asia, and the United States.  The economic outlook is dim and consequently the global natural real interest rate is depressed and is most likely negative.  This time around the Fed, with help from the ECB, is keeping global real interest rates above the natural real interest rate level.  In other words, global monetary policy is too tight now. This is evident in the figure below which shows that total current dollar spending for the OECD region is depressed.

The only way for such a drop in aggregate nominal spending to occur is for either the stock of money asset to decline or the velocity of money to decline.  Central banks can meaningfully reverse both through better expectation management (e.g.. by raising the expected path of aggregate nominal income and spending).  The fact that this has not happened and that OECD nominal GDP remains depressed is thus prima facie evidence that global monetary policy has been too tight.  

The BIS, however, seems to be operating from the same manual it used in the early 2000s.  It tries to argue   that global monetary policy is actually accommodative.  From its 2012 annual report:

In the major advanced economies, policy rates remain very low and central bank balance sheets continue to expand in the wake of new rounds of balance sheet policy measures. These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies in the form of undesirable exchange rate and capital flow volatility. As a consequence, the stance of monetary policy is accommodative globally.  

How could central bank policy be "extraordinarily accommodative" if measures of the money supply in both the Eurozone and the United States are declining?  The BIS is falling for the interest rate fallacy here that Milton Friedman warned us about. Low interest rates only indicate loose monetary policy when they are low relative to the natural interest rate, as in the early 2000s. As noted above, this is note the case now.  

Put it this way: does the BIS really think that fall in yields on 10-year treasuries from about 5.25% before the crisis to a low of 1.50% recently has been due to the Fed?  It is more likely that global slump can explain most of the drop in yields.  The fact that yields have remained so low is, if anything, an indication that monetary policy has been too tight.  For were the Fed and ECB to raise expected nominal growth, yields would start rising again.

The BIS calls for monetary restraint are therefore way off.  It needs to quit thinking like this is 2002 when global monetary policy was too loose and realize that it is 2012, the fourth year of tight monetary policy.  The global economy is a far different beast today and policy makers need to respond appropriately. 

P.S. Paul Krugman, Scott Sumner, [update: Ryan Avent,] and Isabella Kaminsky also raise questions about the BIS report.  Kaminsky notes that what is really needed are more safe assets, something that U.S. Treasury could provide.  I agree with her, but would note that if the Fed were to return nominal GDP to trend then it is likely that there would be far more privately-produced safe assets and thus less need for government securities. See here for more on this point.

¹ The "global saving glut" can be understood in part as the global economy simply recycling the Fed's loose monetary policy back to the United States.  For all those dollar-pegging countries that were forced to buy more dollars when the Fed eased monetary policy used those dollars to buy up U.S. debt.  And they did not want just any U.S. debt, but safe U.S. debt.  This increased the demand for safe assets.  Since there was a limited amount of  public safe debt, the private sector responded by converting risky assets into safe assets (e.g. AAA-rated CDOs).  Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.  

The Evolution of Monetary Policy

Jeffrey Frankel makes the case that monetary policy is moving away from inflation targeting:

It is with regret that we announce the death of Inflation Targeting. The monetary regime, known affectionately as “IT” to its friends, evidently passed away in September 2009. That the demise of IT has not been officially announced until now testifies to the esteem in which it was widely held, its usefulness as a figurehead for central banks, and fears that there might be no good candidates to assume its position as preferred anchor for monetary policy.

Frankel goes on to argue that nominal GDP targeting is likely to be the candidate to replace IT. It might be a bit premature to say IT is dead, but I do think the flaws of IT--even the flexible version of it--have been made apparent over the past few years. It is time to retarget the Fed.

P.S. Josh Hendrickson provides a thoughtful reply to David Andolfatto on nominal GDP targeting.

The FOMC Press Release I Would Like to See

Release Date: June 20, 2012

For immediate release

Information received since the Federal Open Market Committee met in April suggests that economic growth remains anemic. Labor market conditions are weakening and the unemployment rate continues to remain elevated.  Household spending and business fixed investment appears to be slowing down. Inflation has moderated in recent months. Long-term inflation expectations remain well anchored.

  

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a sluggish pace of economic growth over coming quarters as the crisis in Europe, the slowdown in Asia, and the uncertainty over year-end fiscal austerity plans are creating significant headwinds for the economy.  These developments along with the economy  operating below its full-employment level indicates that further action is warranted by the Committee.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to begin a new conditional asset purchasing program tied to an explicit growth path for nominal GDP.  The Committee believes that nominal GDP should expand to $16 trillion dollars and grow at a 5% annual pace thereafter.  To this end, the Committee intends to purchase Treasury and Agency securities every week until this target is hit.  

This program should raise expectations of future nominal GDP growth and cause a rebalancing of portfolios that will facilitate a rise in current aggregate nominal spending.  The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Sarah Bloom Raskin; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen. Voting against the action was Jeffrey M. Lacker, who does not anticipate that economic conditions are likely to warrant a new conditional asset purchase program.

Update: Well, this press release did not happen. Instead we got an extension of Operation Twist.  Yawn.  

Michael Darda on Bloomberg

Michael Darda does a great job explaining why the Eurozone crisis is really a monetary crisis in this Bloomberg interview.  This figure from the interview says it all: 

Ramesh Ponnuru Responds

Ramesh Ponurru provides an elegant response to John Tamny's rant.

The ECB is Passively Tightening

Something that many observers miss about the Eurozone crisis is that by doing nothing the ECB is doing something: it is passively tightening monetary policy.  Total current Euro spending is falling, either through a endogenous fall in the money supply or through a decrease in velocity, and the ECB is failing to respond to it.  The impact of passive tightening is no different than that of an overt tightening of monetary policy. Currently it is tearing the Eurozone apart.

Michael Darda sees this passive tightening by the ECB and is not impressed:

European markets quickly ran out of steam today on news of a Spanish bank recapitalization over the weekend. Part of this may be due to the fact that  equity markets already discounted the news last week. Moreover, the ECB took a pass on a relatively costless (in our view)  opportunity to surprise to the upside with  even symbolic  monetary stimulus (rate cut,  anyone?). Given the ongoing pressure on Spanish and Italian sovereign debt markets—and the correspondingly level of regional inflation expectations—the Spanish bank recapitalization is highly  unlikely to be enough to set the eurozone on  a more robust growth trajectory. Indeed, we do not believe additional EFSF/ESM measures will be effective unless they are coupled with a much more  accommodative ECB monetary policy (i.e., one that provides for faster euro-area nominal GDP growth). The key here is for the ECB to manage expectations properly. Closed-ended, ad hoc actions that are limited in scope are not likely to bear fruit, as increases in base money get  absorbed by  falling base velocity. A more open-ended and aggressive commitment to reflationary policies, however, would likely require the ECB to do less with its balance sheet, as market forces would help the ECB ease. Although we believe ECB President Mario Draghi got off to a good start, we are not  encouraged by recent statements  and the lack  of  follow-through at a critical juncture for the eurozone.

Passive tightening is fashionable these days.  It is being done of both sides of the Atlantic.

Update: Jim Pethokoukis agrees with Michael Darda.

Niall Ferguson is On a Roll

Niall Ferguson has jut published some great articles on the Eurozone crisis. They are a great place to  get up to speed on this important issue.  His first one with Nouriel Roubini starts as follows:

We fear that the German government’s policy of doing “too little too late” risks a repeat of precisely the crisis of the mid-20th century that European integration was designed to avoid. 

We find it extraordinary that it should be Germany, of all countries, that is failing to learn from history. Fixated on the non-threat of inflation, today’s Germans appear to attach more importance to 1923 (the year of hyperinflation) than to 1933 (the year democracy died). They would do well to remember how a European banking crisis two years before 1933 contributed directly to the breakdown of democracy not just in their own country but right across the European continent.

Ferguson and Roubini go on to list both macropolicies and structural policies that would help the Eurozone.  Structural reforms are important since the Eurozone is a flawed currency union.  However, in order to make those structural changes the ECB needs to restore aggregate nominal spending to a more robust levels so that there can be enough time for such reforms.