Category Archives: Monetary economics

Monetary policy is not the interest rate

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It’s the rule, writes Christy Romer:

The regime shift we are seeing in Japan is just the kind of bold action that might actually succeed in changing both inflation and growth expectations a substantial amount. As a result, it may be an effective tool for encouraging robust recovery and an end to deflation.

Nick Rowe has been saying that for a while but, before we get too gung-ho, Romer cautions:

I don’t know if the Japanese experiment with monetary regime change will work. But I am confident that we will learn a great deal because they had the nerve to try.

Careful where we lay the blame

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Brian Fallow writing in his normal clear and intelligent manner has come out discussing the government budget.  As he says, a slump is not the time for “austerity” in terms of cutting back the size of government, and we should allow temporary deficits to help ease the blow – the point of automatic stabilisers is that they help out those that are struggling the most during a protracted slowdown.  Furthermore, I agree that the low level of long-term government bond rates does imply that government should be shifting investment forward now – something they seemed willing to do in 2009 but have moved away from since.

But, I have to slightly take issue with this:

Especially so since the Reserve Bank yesterday voiced concern at signs that the improvement in household saving rates may be stalling and that household debt is rising from a level already high relative to incomes.

The Government also argues that by running a tight fiscal policy it allows the bank to keep monetary policy looser than it otherwise could – lowering pressure on interest rates and the dollar.

However, as the bank reminded us yesterday, that silver lining comes with an increasingly ominous cloud in the form of rampant house price inflation, most notably in Auckland.

With the dollar as high as it is, the bank is reluctant to raise interest rates.

With the supply side of the housing market, especially in Auckland, unlikely to relieve the pressure on prices for years, and with gruesome examples in the Northern Hemisphere of what happens to an economy when a housing bubble bursts, at some point the bank is going to have to crush the demand side by raising interest rates.

If that coincides with fiscal contraction from a debt-obsessed Government, the effects could be unpleasant.

I don’t like where this logic is starting to go.  The RBNZ is responsible for “aggregate demand” in the economy.  If this is too low, then the RBNZ has set monetary conditions too tight, it is their fault.  Sure they may say it is not, some may say I am being unfair saying this … but if there is anything history has shown us, whenever we try to say “this time is different” with regards to a demand shortfall we usually end up coming back to blaming the central bank.

Relatively high debt levels and high house prices are not a monetary policy or demand issue.  They are an issue of financial stability, an issue of economic structure.  Yes, they create risks and can have negative welfare consequences.  Yes, competition, fiscal, and financial stability policy needs to account for them.  But monetary policy needs to take fiscal, competition, and financial stability policy AS GIVEN and then focus on “demand” from there.

Not dealing with demand because of concerns about these issues isn’t prudent, it is policy failure.  Blatant policy failure.  If you don’t believe me, ask someone who is both smarter and more articulate than me such as Nick Rowe.

Now, if the government remains on course and the RBNZ tightens monetary conditions to “fight the housing market” while it expects inflation to be low and unemployment high, they are explicitly violating their mandate and best practice of a central bank.  It is as simple as that.  I’m happy saying this out loud because they would not do that, they know these things, and will continue attempting to set monetary policy at the right level to deal with demand issues (as represented by their forecasts for inflation and unemployment over the next two years).  But given that the RBNZ does this appropriately, the government deficit does not matter outside of its impact on the composition of the economy.

If we want to criticise government policy during the recession, do it in terms of investment (it would have been a good time to move a bit more investment forward), and social policy related things.

Note:  If we believe that the response to interest rate changes will be very small, that in some sense investment demand is very “inelastic” then we can make a claim for government investment – we just need to be very clear on that AND we need to ask why in that case we still have a positive cash rate.  Remember, government investment here also works by driving up the “natural” interest rate … so through the same logic it will lead to a higher real exchange rate and higher government borrowing … unless the “cumulative impact” of rising demand pushing activity towards potential outweighs that.  And if we are using that “cumulative impact” argument for government spending then it also holds for a cut in domestic interest rates, just with a lower real exchange rate and compositionally more private sector activity.  So protip:  we can’t complain the exchange rate is too high and that government spending is too low at the same time!

Update:  Also after today’s unemployment and employment numbers I think people should be willing to rethink whether they think there is a “demand” issue in NZ going forward … ;)

Blanchard on expectations

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Matt loves to talk about multiple equilibria and how changing expectations can shift us between Pareto-ranked equilibria. It turns out he’s not the only one who thinks it’s an important matter in the current environment. Here is Olivier Blanchard discussing recent developments in the implementation of monetary policy.

In a world of multiple equilibria, announcements can matter a lot. Take for example the case of the Outright Monetary Transaction program announced by the European Central Bank.  …The announcement has succeeded, without the program actually having to be used.

From this viewpoint, the recent announcement by the Bank of Japan that it intends to double the monetary base is even more interesting. What effect it will have on inflation depends very much on how Japanese households and firms change their inflation expectations. If they revise them up, this will affect their wage and price decisions, and lead to higher inflation—which is the desired outcome in the Japanese deflation context.  But if they do not revise them, there is no reason to think that inflation will increase much.

This very much reinforces the message of people like Woodford and Sumner that the expectations channel is by far the most important one for monetary policy.

For next time someone attacks macro based on the “money multiplier”

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Via the Wonkmonk twitter, this paper from the Fed.

The effect of reserve balances in simple macroeconomic models often comes through the money multiplier, affecting the money supply and the amount of bank lending in the economy. Most models currently used for macroeconomic policy analysis, however, either exclude money or model money demand as entirely endogenous, thus precluding any causal role for reserves and money.

This makes more sense if you are willing to think of economic models not as “general models” by as models of individual tendencies – identifying specific causal mechanisms.  In this way, policy making requires “multiple models”, and trying to say something like “you entirely rely on money multipliers” really doesn’t make sense.

Two undervalued points in thinking about monetary stimulus

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Tyler Cowen does his normal thing of making a lot of very good points other people aren’t.  For me these two are key:

  1. The rate of unemployment in Japan, last I checked, was 4.1%.  Yes, they calculate it differently than we do, and yes in their heyday they had an even lower rate of unemployment.  But still, ask yourself: just how labor market slack is there going to be?
  2. An alternative is that money will boost real economic activity through a Lucas supply curve combined with a fair degree of money illusion, which is what you would expect from a longstanding deflationary environment.  Businesses will confuse nominal changes with real changes, raise output, and eventually figure out the confusion and restrict output again.  The economy does get to keep a one-time gain (probably there are positive social externalities to higher output in this setting), but it doesn’t drive an enduring recovery.

The unemployment rate issue is one I have had in the back of my mind.  My presumption has been that Japan has, in recent quarters, been facing a sharp drop in demand – and as a result they are responding to a recent shock.  The stimulus isn’t about their long-run failure to me, it is a monetary policy response to a recent shock.  I am also happy that they appear to be setting up a framework that will deal with similar shocks in the future.

There seems to be this accidental view appearing when may of us, including myself, write about monetary policy – a view where we start to undermine the medium-long term neutrality of money.

Either we need to explicitly state how there is a “multiple equilibrium argument for how the neutrality of money breaks down in this circumstance” (this would certainly take us down the rabbit hole …), or we need to assume that there has been a number of shocks that have built up upon each other.

If we assume the first we are on pretty intense and shaky ground, and need to make sure our arguments are crisp and transparent.  If we assume the second (which is the camp I am closer to when looking at NZ) then we can’t say that the central bank ex-ante failed UNLESS they could have foreseen the shocks.  If the shocks are things such as policy incompetence in Europe, and sudden large shifts in commodity prices and the exchange rate, then they are indeed unforeseeable!

The new Bank of Japan

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Look at that, the Bank of Japan has joined other central banks in announcing an explicit inflation target, and doing all they can to show their credibility for achieving it.

Good.

Some will call this a currency war, or “monetization” – but again, this is the Bank targeting a specific inflation target in a forward looking manner.  This is what they should have been doing all along – and given it is a rule, it helps set expectations and acts as a “no-monetization” condition.

Some will say this destroys central bank independence.  I would note that the purpose of independence is to sovle “time inconsistency” in central banks – rule based policy does this fine.  It would only be a problem if the Japanese government tried to force them to violate the rule.

New Zealander’s will complain about the dollar.  Remember here that the BOJ has commited to inflation of 2%pa (where previously it was expected to, on average, be lower).  The return on holding a Yen has become more negative per year … and so the asset price of the Yen much fall.  This is what has happened, however the price inflation will ensure that the real exchange rate trends back to its true level.  Remember, the exchange rate is a price, and we need to think about the primitive causes of any issue in order to figure out if there is one.  The BOJ actually doing normal monetary policy isn’t negative for NZ – although it will sting the bottom line of people trying to sell to Japan in the near term (hola Rio Tinto).

Posts:  Money Illusion, Market Monetarist. (Where is the rest of the blogsphere, a credible commitment by the BOJ is actually a massive event … I haven’t seen much in the way of posts yet though.