The Loflation Pandemic

The IMF reports in the latest WEO that the world has a low inflation problem:

By 2015, inflation rates in more than 85 percent of a broad sample of more than 120 economies were below long-term expectations, and about 20 percent were in deflation—that is, facing a fall in the aggregate price level for goods and services (Figure 3.2). While the recent decline in inflation coincided with a sharp drop in oil and other commodity prices, core inflation—which excludes the more volatile categories of food and energy prices—has remained below central bank targets for several consecutive years in most of the major advanced economies.

Here is the IMF's figure that nicely summarizes this development:

This figure shows this trend toward low inflation started around the time of the Great Recession and has only grown. Given its global nature, I am going to call this development the loflation pandemic. So what is behind it? Here is the IMF's explanation:

Economic slack and changes in commodity prices are the main drivers of lower inflation since the Great Recession.

The commodity story, in my view, is limited in how much it can explain since commodity prices have gone up and down since 2008. Moreover, as Jim Hamilton and Ben Bernanke argue, just under half of the commodity price decline since mid-2014 can be attributed to weak global demand. Weak commodity prices, in other words, are themselves partly the result of anemic demand.

That leaves economic slack, or insufficient nominal demand growth, as the main reason for the decline in global inflation. As I said before, nominal demand ain't what it used to be. This, though, begs the question as to why nominal demand growth been so weak? And why have advanced economies been so willing to tolerate it? 

The IMF does not answer these questions. All it recommends is that governments do more with fiscal and monetary policy, complemented with structural policy. This is futile. One cannot expect to change government's behavior without first knowing why they are acting as they do. 

Since the IMF seems unwilling to go there, I will. Governments in advanced economies have avoided robust aggregate demand growth--and therefore have created the loflation pandemic--because of the constraints created by their past successes with inflation targeting. Inflation targeting has become the poisoned chalice of macroeconomic policy:

Central banks have been so good at creating low inflation since the early 1990s that it is now the expected norm by the body politic. Any deviation from low inflation is simply intolerable. In the US, everyone from the media to politicians to the average person start to freak out if inflation heads north of 2%. This mentality seems even worse in Europe. Inflation-targeting central banks, in other words, have worked themselves into an inflation-targeting straitjacket that has removed the few degrees of freedom they had. It is hard to imagine Yellen and Draghi being able to raise inflation temporarily above 2% in this environment. All they can do is operate in the 1-2% inflation window. Inflation targeting's success has become it own worst enemy.  

Another way of saying this is that the space for doing macro policy has shrunk to the small window of 1-2% inflation. Not only is monetary policy constrained by this, but so is fiscal policy...  

For these reasons inflation targeting has become the poisoned chalice of macroeconomic policy. It was a much needed nominal anchor in the 1990s that helped restore monetary stability. Its limitations, however, have become very clear over the past decade and now is preventing the world from having the recovery it needs...

Put differently, no matter what the central banks try--QE, forward guidance, negative rates--they will never push beyond the public's expectation of low inflation. Fiscal policy, including helicopter drops, will also run up against this constraint. 

This constraint also means that policymakers may not have the flexibility they need to stave off recessions:

If a trucker gets stuck in traffic jam, he will have to temporarily speed up afterwards to make up for lost time. On average, his speed for the trip will be the legal speed limit but only if he temporarily speeds up after the traffic jam. Likewise, an economy may need temporarily higher-than-normal inflation after a sharp recession to return to full employment. This also implies temporarily higher-than-normal nominal demand growth. On average, this temporary pickup will keep inflation and nominal demand growth on target. Running a little hot, therefore, is necessary sometimes. Currently, however, this policy flexibility is not possible.

This, in my view, is a key reason why the recovery from 2008-2009 was so weak. It is also why QE was set up to disappoint.

Inflation targeting was a much needed nominal anchor across the globe when it was first introduced in the early 1990s. But now it has put advanced economies into a low inflation straitjacket that is becoming a drag on economic growth. Until we recognize and act upon this observation, we can expect the loflation pandemic to spread.  

Macro Musings Podcast: Morgan Ricks

My latest Macro Musings podcast is with Morgan Ricks. Morgan is a law professor at Vanderbilt University where he specializes in financial regulation. Between 2009 and 2010, he was a senior policy adviser at the U.S. Treasury Department where  he dealt with financial stability initiatives and capital markets policies related to the financial crisis.

Before joining the Treasury Department, Morgan was a risk-arbitrage trader at Citadel Investment Group, a Chicago-based hedge fund. He previously served as a vice president in the investment banking division of Merrill Lynch & Co., where he specialized in strategic and capital-raising transactions for financial services companies.

Morgan is also the author of a new book “The Money Problem: Rethinking Financial Regulation”. He joined me to discuss his new book and its implications for policy. His book is timely and adds some needed perspective to understanding the Great Recession. I happened to review his book for National Review and so it was a nice follow up for me to get him on the show.

A key point he makes in the book, and one that we discuss on the show, is that the standard definition of money is too narrow. Money, properly understood, should include both retail and institutional money assets. This is a point I have repeatedly  made on this blog and in various papers. Morgan, however, does a much better job articulating this point and his chapter two "Taking the Money Market Seriously" by itself make the book a great investment. 

This understanding is important because it helps us better understand the financial crisis of 2007-2008. First, it helps us see that the institutional money assets were susceptible to a bank run just like retail money assets were before FDIC was introduced. The potential for a bank run with the institutional money assets came to fruition in 2007-2008. Second, this understanding also helps us see that the bank run caused a collapse in the broad money supply and that, in turn, helped bring about the sharp collapse in 2008-2009. Money still matters! It also, arguably, played a key role in anemic recovery that followed. 

The collapse in the money supply can be seen in the figure below. It shows several broad measures of the money supply that include both retail and institutional money assets. The measures come from the Center for Financial Stability:

We go on to discuss his proposal for fixing the run-prone nature of the banking system, what it would mean for banking, how policy would operate, and more. Once again, another fascinating conversation throughout. And if you want further details read his book.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming. 

Related Links
Morgan Ricks Homepage
Morgan Ricks Twitter Account
Morgan Ricks Book 

The Bank of Japan: Monetary Mastery or Quantitative Quagmire?

The New Abenomics Program

The Bank of Japan (BoJ) just launched a new phase in its monetary easing program popularly known as Abenomics. It is doing so in the hopes of shoring up economic growth. This monetary program until today had involved a targeted expansion of the monetary base at ¥80 trillion a year matched by ¥80 trillion in government bond acquisitions. There were also targeted purchases of ETFs and REITs on a smaller scale.¹

The new phase unveiled today consist of three key developments. First, the BoJ will target the 10-year government bond interest rate at zero percent. Second, it will aim to overshoot its 2% inflation target so that it is truly symmetric. Third, it will drop its quantity target for the monetary base and simply make its expansion conditional on the inflation overshoot. Everything else in Abenomics remains roughly the same. 

So has the Bank of Japan finally mastered its monetary conditions in a way that will spur economic growth? Or is this just another step into the quantitative quagmire of Abenomics? The short answer: do not get your hopes up. There are two reasons why this probably will not make much difference. 

First, the BoJ is pegging the 10-year yield on government bonds at a level it would be at anyways. Because of slow global economic growth and continued uncertainty, yields on safe assets around the world have been falling since 2008. This race to the bottom for safe asset yields can be seen in the figure below:

Over the past eight years, this downward march of yields has occurred before, during, and after various QE programs. So while it is true that the BoJ has been the marginal buyer of Japanese government bonds over the last year, its actions are only doing what the global bond market was already doing and would have continued to do in the absence of BoJ actions. Put differently, the market-clearing or 'natural' interest rate that is based on fundamentals has been falling for some time and is already very low. The BoJ's new long-term interest rate target simply is a recognition of this fact. So there really is nothing new here.

Second, there is a serious credibility issue when it comes to the expansion of the Japan's monetary base. As seen in the figure below, the monetary base has seen a three-fold increase in its size since the beginning of Abenomics. If this expansion were truly permanent, then the price level would also increase threefold over the long-run. There is no way that can happen. The population is aging and depends increasingly on fixed income. Inflation for them is a non-starter. There is no political economy support for such a radical change in the price level.

Here is why this matters: some  portion of the monetary base injection (above that needed for normal money demand growth) needs to be viewed as permanent in order for spending and inflation to rise. If monetary injections are expected to be temporary they would do little to spur spending. If they are viewed as permanent, however, they would raise the expected future price level and thus temporarily push up expected inflation. The higher expected inflation, in turn, would spur robust spending in the present. But this requires some portion of the monetary base growth to be seen as permanent.

The problem, though, is that the expansion of the monetary base has been so large there is no way this growth can be seen a permanent for fear of excessive inflation taking off. The BoJ wants 2% inflation with some overshoot. If the threefold increase of the monetary base were made permanent, the BoJ would get 300% inflation with overshoot! Put differently, the massive expansion of the BoJ's balance sheet undermines its very goal of raising nominal spending and inflation.

So making the growth of monetary base conditional on inflation hitting its target is not credible. The monetary base is simply too large for the BoJ to get any traction this way.

So Does Abenomics Matter?

With all that said, Abenomics has been able to spur some aggregate demand growth and some inflation. Just nowhere near where the government wants it to be.  Below is a figure that shows the level of nominal spending (as measured by nominal GDP) for Japan.  Nominal spending has grown under Abenomics, far more than under the origional QE program of 2001-2006:

I used to think this moderate success was because the monetary base expansion under Abenomics was permanent. But now that the monetary base has gotten so large, I am doubtful for the reasons laid out above. So Abenomics has been moderately successful, but it is not entirely clear to me why this is happening.

It is worth noting one of the goals of Prime Minister Shinzo Abe's government is to raise nominal GDP to ¥600 trillion by 2020. Yes, Japan has a NGDP level target. The Prime Minister first called for this goal in September 2015 and spoke to it again in December 2015.  Since then, it has been in the government's economic and fiscal projections For example, here is the July 2016 executive summary of the projections. The nominal GDP goal stated near the top of the document.  

When the goal was first introduced, it was an ambitious 20% growth  goal for Japan's nominal GDP. It is now closer to 17% given the growth of nominal GDP since then, but this still remains a very ambitious goal as seen in the figure below. This figure shows different paths towards the ¥600 trillion by 2020. 

All of these paths seem ambitious given the recent growth rate of nominal GDP in Japan. It is not clear how to get there without having a major overshoot of inflation.  Maybe the BoJ could reiterate the governments nominal GDP level target and try to communicate that some small portion of the monetary base will be permanent and that it will be injected via purchases of perpetual government bonds. Admittedly, this would be a tough message to communicate. But it is not clear what alternatives there are for Japan. 

So to answer the question in the title to this post, I suspect Japan may be heading further into a quantitative quagmire rather than mastering its monetary conditions. 

P.S. Yes, the markets seem happy about this development so far. But they also seemed happy about the ECB's added stimulus in March 2016. That euphoria did not last and neither will this reaction to the BoJ. 

¹ETFs were and continue be purchased at annual rate of ¥9 trillion while REITs are purchased at a targeted rate of ¥60 billion.

Macro Musings Podcast: Ryan Avent

My latest Macro Musings podcast is with Ryan Avent. Ryan is a columnist at The Economist magazine. He has previously been the news editor, economics correspondent, and online economics editor for The Economist. He is the author of The Gated City. His work has appeared at the Journal of Economic Geography, the New York Times, the Washington Post, the New Republic, Bloomberg, Reuters, and many other places.

Ryan has a new book that just came out titled “The Wealth of Humans: Work Power, and Status in the 21st Century” He joined me to talk about his new book, his work, and some of the pressing macroeconomic issues of the day.

We begin our conversation by covering what it is like to be a journalist at The Economist. We then move on to his new book, which makes the case that the economy is undergoing a transformative change because of the digital revolution. Ryan notes that while this change is ultimately a plus for the longrun, over the short-to-medium run it present challenges for the way we live and work. Work gives us meaning and income, but Ryan argues it is not clear what work will be like going forward as increased smart technologies displace labor. Will we, on the margin, move into new jobs or into more leisure?  We discuss possible solutions to smooth the transition to this new long-run state.

Ryan just returned from the UK so we also spend some time discussing Brexit and the economic and social forces behind it. We also discuss the Eurozone crisis and why it has persisted for so long. 

Finally, we cover the challenges with inflation targeting, the safe asset problem, and the futility of central banks trying to raise rates when global bond markets are pushing yields down. Once again, a fascinating conversation throughout.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming. 

Related Links

The Wealth of Humans: Work Power, and Status in the 21st Century
Ryan Avent -- A World Without Work is Coming

Macro Musings Podcast: Michael Bordo

  

My latest Macro Musings podcast is with Michael Bordo. Michael is a Professor of Economics at Rutgers University and a distinguished visiting fellow at the Hoover Institution at Stanford University. He has been a visiting scholar at numerous central banks and is a research associate of the National Bureau of Economic Research. Michael has published widely in the field of monetary economics and monetary history. Michael  joined me to talk about both recent and historical cases in monetary economics. 

We began by reviewing the Great Recession and what contributed to it. Among other things, we address whether growing inequality contributed to the recession. We also considered the evidence for the claim that recessions caused by financial crises necessarily lead to slow recoveries. The discussion then turned to Canada and why it did not have a banking crisis during the Great Recession and why its contraction was far milder than the one in the United States.

Michael has also studied the history of fiscal unions. Specifically, he has looked at the history of fiscal union in Argentina, Brazil, Canada, Germany, and the United States and what that means for the future of the Eurozone. The prognosis is not good. 

We closed out the show by talking about the historical record of deflation, rules-based monetary policy, and the use of inflation as a solution to excessive public debt. It was great conversation throughout. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming. 

Related Links
Michael Bordo's Homepage

Macro Musings Podcast: Peter Ireland

My latest Macro Musings podcast is with Peter Ireland. Peter is a professor of economics at Boston college, a research associate at the National Bureau of Economic Research, and a member of the shadow open market committee. Peter has also been a visiting scholar at numerous Federal Reserve banks. Peter has published widely in monetary economics and has been on the editorial board of a number of top journals. Peter joins me to talk about monetary policy.

We begin our conversation by talking about his journey into macroeconomics. Peter did his graduate work at the University of Chicago where he studied under Bob Lucas, John Cochrane, and Michael Woodford. He shares how the spirit of Milton Friedman was very much alive during his time there and what that meant for learning macroeconomics. 

We then discuss the operational side of central banking by reviewing the meaning and role of the instruments, intermediate targets, and ultimate goals of monetary policy. Among other things, we discuss why central banks use short-term interest rates as the instrument of monetary policy rather than the monetary base and draw upon the classic Poole (1970) paper for insight. 

We next discuss the Taylor Rule as a tool to connect the instrument of monetary policy to its goals and then consider whether money supply aggregates could be a substitute for the Taylor Rule. We go on to discuss whether money has additional information not found in interest rates that could inform policy making. The answer seems to be yes if the Divisia monetary aggregates are used rather than the simple sum measures of the money supply. Peter notes that if one uses Divisia measures the empirical results showing a breakdown in the money supply - nominal income relationship are overturned. There is more and the conversation was fascinating throughout. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming!

Related Links

Peter Ireland's homepage

Peter Ireland's twitter account

Divisia Monetary Aggregate Data