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.