Inflation Should Be Feared?

Tight monetary policy is not the source of our problems. Monetary policy is loose by any measure. - John Cochrane 

Loose by any measure?  Label me skeptical.

Since the unemployment rate reached 6.5% in October 2008, the CPI and the PCE (Bernanke's preferred target) have averaged 1.3% annualized.  This number is well below even the Federal Reserve's official target (a better name would be ceiling).   Meanwhile, inflation expectations are also well below 2% over the next 30 years! Quite clearly by this measure, monetary policy is not loose.

The next measure of policy, the monetary base does show an incredible amount of expansion.

But by charging interest on reserves, the large expansion of the base money supply is being treated as an interest earning asset and parked at the Federal Reserve. It would be difficult for Cochrane to call the modest boost in currency over the past 5 years as easy monetary policy.

The last measure he could possibly mean is interest rates, which have been at the zero lower bound since 2009 and according to the recent FOMC meetings, will remain at zero until at least 2014.  Yet interest rates alone say little about the stance of monetary policy.  As a University of Chicago Professor, Cochrane should know better.  Here is Milton Friedman on Japan in 2000, bold portions from David Beckworth: 

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue? 

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

So, loose monetary policy by any measure?  Inflation has been persistently below target, expectations of inflation are below target, broad monetary expansion has been neutralized by paying interest on reserves, and low interest rate environment is a symptom of tight monetary policy much like Japan since the early 90's.  Cochrane must have a different definition of loose.

Poland Revisited

Paul Krugman, Matthew Yglesias, and Matthew O'Brien have recently seized upon presidential candidate Mitt Romney's comments to correctly note the Polish economy's relative strength over the past 5 years is largely attributable to a currency depreciation.  It is a topic that I have discussed briefly here and would like to point out a few things.

Matthew O'Brien claims Poland's comparative success was largely driven by rising exports as the zloty devalued.  He then links to a report with the below chart, which does show a initial growth in net exports as the zloty depreciated, helping Poland weather the worst of the late 2008-09 global nadir.  But a second look at the data shows that exports as a percentage of GDP actually decreased sharply in late 2008-09 and have still yet to recovery to pre-crisis levels, even with a significantly devalued zloty.

Instead of increasing exports, the devaluation initially helped improve the health of the Polish economy by limiting the amount of imports thus improving the terms of the current account.  But since 2009 this effect has largely fluctuated without much of an underlying trend.  This is not to say that the Polish boosting net exports was an unimportant part of the devaluation.  But it does suggest that the traditional devaluation as a means to boost exports channel only explains a small portion of Poland's continued growth.  A larger and more sustainable portion of the growth in Poland has increasingly attributable to domestic consumption and investment, which particularly strengthened moving into 2010.

The next question is how has Poland managed to maintain strong growth as the world around them has largely stagnated?  Marcus Nunes suggests that the devaluation in zloty helped to maintain NGDP growth on trend, thus laying the foundation for a stable macro economic environment, even in the midst of worst global crisis since the great depression.

It is a view I largely subscribe to as well but would also like to point out the importance of market forces in determining monetary policy.  The National Bank of Poland denounced the depreciation and at later stages actively tried to strengthen the Zloty.  Suggesting that if the Poland had reserve currency status, a la the United States, their fate would have been much different, as the large capital inflows would have put forcible appreciation pressure on the Zloty, requiring internal devaluation instead of currency depreciation as a means to combat the slump.  Instead, the swift, market forced devaluation helped to keep nominal income growing largely on trend.  This example is a reminder to all central banks, which are often too slow to quickly respond to rapidly changing market conditions, that if you want to take forcible action, it is best to announce the proper target and allow the markets to do the heavy lifting for you.

If Only Bernanke Had Volcker's FOMC

Former FOMC president Volcker, like Bernanke, is overly reliant on  the creditism view of monetary policy.  Take this past week's comments at the Atlantic magazine news conference.

Higher inflation would backfire by causing interest rates to rise. "You are not going to get any stimulus and you are going to make it much harder to restore price stability,"

Volcker is implying that the higher interest rates that would accompany a higher inflation target would be contractionary.   At first glance, his analysis appears correct, a higher interest rate would seem to suppress already weak aggregate demand.  Yet with today's current low levels of inflation and interest rates at their lower bound, a higher interest rate stemming from a higher inflation target would be a by product of an improved economic outlook.  To understand why this counter intuitive conclusion is correct, we need to look at David Glasner's recent research on deflationary expectations at the zero lower bound, my bold:

Debt for Lunch

Links from my lunch break:

The debt-disinflation of the great moderation:

The 1980s, in particular, were a kind of slow-motion debt-deflation, or debt-disinflation; the entire growth in debt relative to earlier periods (17 percent of household income, compared with just 3 percent in the 1970s) is due to the slower growth in nominal income as a result of falling inflation. In other words, there is no reason to think that aggregate household borrowing behavior changed after 1980; indeed households rescued their borrowing in the face of higher interest rates just as one would expect rational agents to. The problem is that they didn’t, or couldn’t, reduce borrowing fast enough to make up for the fact that after the Volcker disinflation, leverage was no longer being eroded by rising prices. In this respect, the rise in debt-income ratios in the 1980s is parallel to that of 1929-1931.

Figure 2:

Think of it this way: If you borrow money and your income in dollars rises by 10 percent a year (3 percent real growth, say, and 7 percent inflation) then you will find it much easier to pay off the debt when it comes due. But if you borrow the same amount and your dollar income turns out to rise at only 4 percent a year (the same real growth but only 1 percent inflation) then the payment, when it comes due, will be a larger fraction of your income. That, not increased household spending, is why debt ratios rose in the 1980s.

Neither the 1980s nor the 1990s saw an increase in new household borrowing — on the contrary, the household sector in the aggregate showed a primary surplus in these decades, in contrast with the primary deficits of the postwar decades. So both the conservative theory explaining increased household borrowing in terms of shorter time horizons and a general lack of self-control, and the liberal theory explaining it in terms of efforts by those further down the income ladder to maintain consumption standards in the face of a falling share of income, need some rethinking.

Krugman Again

I'm starting to think my co-worker (and loyal reader) Alexander just likes to link me Krugman articles for the sake of an argument when work is slow. The article in question today was Krugman's Sunday headliner comparing government spending during the "Morning in America" Reagan recovery and today's current recession. Krugman rightly points out that Reagan's government actually increased spending more than Obama's if state and local spending are included.  What Krugman neglects to mention is that the majority of difference comes only AFTER the federal reserve turned on the monetary spigot, increasing NGDP growth to above 12% over the course of a single year.  For comparison sake, here is the government spending graph that Krugman links to followed by NGDP and RGDP growth following both recessions.

The NGDP Effect of Devaluation or Why Exports Don't Matter

Lars Christensen effectively argues that during a currency devaluation, the primary transmission mechanism for monetary policy has little to do with restoring competitiveness, but instead works through the money supply on one hand and velocity on the other.  In equation form, MV=PY=NGDP.   The purpose therefore of the currency devaluation in a depressed economy is not to increase competitiveness in order to boost exports (although he concedes that it is one effect of the devaluation) but to increase nominal spending through the expansion of the money supply and increased velocity.   Lars provides the concise example of Argentina, who abandoned its dollar peg in 2002, resulting in a rapid increase in the money supply, velocity, therefore boosting NGDP and consequently real GDP.

While Argentina provides an informative example of the benefits of devaluation on an economy in stagnation, I thought it would be important to look at a country that used monetary policy to avoid crisis all together.   Poland, as shown by Marcus Nunes last February, provides a unique example of the use of monetary policy to stabilize the broad economy in a time of international economic malaise.  Under normal circumstances, Poland’s continued economic expansion would be of little note, but the world economies since 2007 have been anything but normal.  What makes Poland remarkable is that outside of a minor decrease in RGDP growth in late Q4 2008 (-0.4%), the economy has continued to expand at the same level as it did prior to Lehman’s demise.   A close examination of Poland reveals that competitiveness plays little importance in the transmission mechanism for monetary policy in maintaining Poland's impressive rise....

The Real Story Behind the 1983 Recovery

I was underwhelmed by Krugman’s recent interpretation of the V-shaped recovery from the 1981-2 recession.  I have written about briefly about the 1983-4 recovery before but this post will be a bit longer.  First is NGDP, GDP, inflation, and 10 year inflation expectations from 1982-1987.

Pretty simple, NGDP is at 4% in 1982, the result is a Fed induced recession to fight inflation.  1983 to 1984, NGDP raises to 12 percent a year, the result is a robust recovery.  Let's compare that with the current recession.