Chart of the Day

From Marcus Nunes we get this figure which helps shed some light on the recent upswing in the stock market.   It shows that as inflationary expectations improve so does the stock market.  

The easiest way to interpret this relationship is that when inflationary expectations rise, the market is effectively saying it expects higher aggregate demand in the future.  Given nominal rigidities, the higher expected aggregate demand in turn means higher expected real growth. Ergo, higher stock prices.  (For a more technical discussion on this relationship see David Glasner who first spotted this relationship.)

Note that Marcus Nunes shows in the figure how the Fed's various monetary easing programs have been tied to trend changes in inflation expectations and the stock market.  Thus, the most recent developments might also be attributed to the Fed's new long-run interest rate forecasts which is not on the figure.

For me the big take away from this picture is that all this time the Fed has been playing with us.  If the Fed's timid, piecemeal programs listed on the figure above can systematically affect the stock market, then just imagine what would happen if the Fed had gone nuclear and adopted a nominal GDP level target.  The stock market would be way up, balance sheets would be stronger, the economic outlook would be vastly improved, and the economy would be back on path to full employment.

Update: Given my claims above, I was curious to see how close the TIPS-created expected inflation series tracked the nominal GDP forecasts provided in the quarterly Survey of Professional Forecasters. To do this, I transformed the 5-year expected inflation series into a quarterly average and plotted them against the forecasted growth of nominal GDP over the next four quarters.  Here is what I got:

This indicates that my interpretation of the expected inflation series as an implicit forecast of expected future aggregate demand is appropriate, at least for now.

This is What Ails Europe

Paul Krugman argues that the primary problem facing Europe is a monetary one (my bold):

So what does ail Europe? The truth is that the story is mostly monetary. By introducing a single currency without the institutions needed to make that currency work, Europe effectively reinvented the defects of the gold standard — defects that played a major role in causing and perpetuating the Great Depression. 

[...] 

If the peripheral nations still had their own currencies, they could and would use devaluation to quickly restore competitiveness. But they don’t, which means that they are in for a long period of mass unemployment and slow, grinding deflation. Their debt crises are mainly a byproduct of this sad prospect, because depressed economies lead to budget deficits and deflation magnifies the burden of debt.

I agree that the Eurozone was a flawed currency union from the start.  So yes, what ails Europe is a structural monetary problem. But the monetary problem goes deeper than that.  There is also a cyclical monetary problem that is alluded to in the bold passage above.  This cyclical dimension can be seen in the figure below:

This figure shows that ECB's failure to stabilize and restore nominal spending to expected levels--as proxied by the  1995-2006 trend--during the crisis as the real culprit behind the Eurozone crisis.  This failure to act has been devastating because it means nominal incomes are far lower than were expected when borrowers took out loans fixed in nominal terms.  European borrowers, both public and private, are therefore not able to pay back their debt and the result is a fiscal crisis.

The reduced ability for Europeans to payback debt also means that risk premiums on countries with lots of debt or ones perceived to have debt problems increases, further raising these country's debt burden with higher financing costs.  The fiscal crisis gets bigger, and being easy to observe, gets wrongly credited as the cause of the Eurozone's problems.  Consequently, the Eurozone crisis is prescribed with the fiscal solution of austerity. The real solution, then, requires the ECB to restore nominal incomes to their originally expected values. This is what ails Europe.

What is Money?

Nick Rowe says we should not think of money as a store of wealth:

Money is what money does. There are two functions of money that define what is and what is not used as money: medium of exchange; and medium of account. That's it... We need to start worrying a lot more about how money works as a medium of exchange. We need to understand a lot better than we do how money works as a coordinating device in a decentralised economy. And we need to understand a lot better than we do how money can sometimes fail as a coordinating device. Because, outside a very simple economy, people can't barter their way back to full employment if the monetary exchange system fails. 

We need to stop thinking of money as a store of wealth, just like all the others. And let's start by changing the textbook definition of money, by deleting that bit about money being a store of wealth. 

I agree, but would add that we also need to start thinking about money at all levels of transactions. Most textbooks and many economists think of money assets at only the retail level (i.e. the M2 money supply).  This crisis has taught us that institutional money assets--those assets like treasuries, commercial paper, and repos that facilitate transactions in the financial system--matter too.  The bank run on the shadow banking system was a bank run using institutional money assets.  If we really want to understand money and its implications for the economy we need to be thinking about these money assets too.  Thanks to Gary Gorton, David Aldonfatto, and Stephen Williamson I have come to better appreciate this point.  And thanks to this perspective I have come to see the demand for safe assets and budget deficits in a different light. 

NGDP Targeting News Roundup

Just when you thought interest in nominal GDP (NGDP) might be waning there is more, including some discussions of it from central bank officials.  

First, Mark Carney, Governor of the Bank of Canada delivered a speech where he discussed what would be a monetary policy for all seasons. He had some nice things to say about NGDP targeting, but ultimately comes out in favor of flexible inflation targeting as the top choice.  The thing is, flexible inflation targeting is effectively like a NGDP target if conducted properly.  Sweden is a good illustration of it.  There are other examples, but the point is this: why not just be explicit about it?  Doing so would not just formalize what is being done implicitly, but it would better anchor nominal expectations--especially if it were an level target--and thus reduce the chances of  large collapses in aggregate nominal spending.  Why not add more clarity?  And why focus on a symptom (i.e. inflation) when one can focus on the cause directly (i.e. changes in aggregate demand)? 

Now the above assume the flexible inflation target is executed flawlessly and ends up stabilizing aggregate demand. In practice, the discretion afforded a central bank under flexible inflation targeting makes it vulnerable to poor leadership and bad decisions.  And it is likely bad decisions will arise under flexible inflation targeting because of supply shocks.  In principle, such shocks should not be a problem for flexible inflation targeting, but in practice with political pressure and with real time data limitations they do create problems.  Imagine, for example, there is a great productivity boom.  All else equal, the natural interest rate would rise and disinflationary pressures would emerge.  The central bank should ignore the disinflationary pressures and let the policy rate rise to the level of the natural interest rate to keep the economy at full employment.  However, it might be tempting to leave the policy rate below the natural interest rate since the economy is humming from the productivity gains and inflation is low.  It certainly would not be a popular move to raise interest rates.  With a NGDP target such problems are ignored altogether. Simply focus on stabilizing the path of aggregate demand.  Keep it simple.  

Second, Renee Holtom of the Richmond Fed has a nice article examining the implications of the Fed tolerating higher inflation as a way to kick start a robust recovery.  She discusses all the reasons for doing so, including a NGDP target..  The one thing missing is that she fails to mentions that the proper response to folks like Raghuram Rajan, who argues the Fed would do more harm to savers if it allowed higher inflation, is that the point of the temporarily higher inflation is to spark a recovery that would ultimately lead to higher real returns for savers.  Interest rates are low because the economy is weak. Spark a robust recovery and watch real interest rates take off.  This is a point that is missed by many, especially Bill Gross.  (Also see Scott Sumner's response to Holton.)

Third, in what appears to be the latest convert to Market Monetarism, Jason Rave does a good review of NGDP targeting.  

Where Angels Fear To Tread

The ever so genteel Ramesh Ponnuru makes the mistake of replying to the Walking Rothbardian Dead.  

P.S. Here is my take on the Ponnuru piece that started all of this commotion.

Christina Romer: We Need A Regime Change at the Fed

Christina Romer does the Five Books interview and one of her recommended reads is a famous article by Peter Temin and Barry Wigmore titled "The End of One Big Deflation."  This is a great choice since it shows that even in a "balance sheet recession" facing a binding zero percent lower bound, monetary policy can still be very effective by managing expectations.  The key is to radically shift expectations.  Here is Romer discussing the implications of this article for today:

What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.

In other words, the Fed has failed to appropriately manage expectations and so we are stuck in a slump.  And I am not convinced that it is now doing any better with its new long-run forecasts of the federal funds rate.  So what in the current environment would rise to the level of a "regime shift"?  What would change expectations enough to catalyze a broad-based recovery in aggregate demand?  Here is Romer's answer: 

I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.

Such a regime shift would require Bernanke to man up and have his own Volker moment, as previously noted by Romer.  It would be a huge change and that is the point.  A big shock to public expectations, one that would meaningfully change the expected path of future aggregate nominal spending, could be created by a public commitment to a nominal GDP level target.  This is just the medicine the U.S. economy needs right now.  

P.S. No, a nominal GDP level target would not unmoor long-run inflation expectations and it would not depend on a bank lending to work.

P.P.S. Yes, there is evidence for nominal GDP expectations mattering for subsequent NGDP growth.  Here is how I think it would actually unfold. 

The New York Fed Acknowledges the Fed's Superpower Status

I have made the case many times that the Fed is a monetary superpower.  It controls the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Consequently, its monetary policy gets exported across much of the globe. The other two monetary powers, the ECB and the Bank of Japan, are therefore mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well.  This understanding implies the Fed helped fuel excessive global liquidity in the early-to-mid 2000s, but now it is doing the opposite with its passive tightening of monetary policy.

This understanding also weaves nicely into the shortage of safe assets story.  Back in the early-to-mid 2000s the Fed's loose monetary policy meant dollar-peggers had to buy up  more dollars to maintain their pegs.  These economies then used the dollars to buy up U.S. debt. This increased the demand for safe assets and further drove down yields.  Fast forward to late 2008. The Fed fails to prevent the collapse of NGDP and never attempts to fully restore it to some reasonable pre-crisis path.  This causes the destruction of many safe assets and thus further exacerbates the safe-asset problem.   Now these developments are only the cyclical part of the safe asset problem--there was also a structural shift in demand for safe assets coming the emerging world--but it is an important part of the story.

I bring this up because Andrea Ferrero of the New York Fed has a new paper that makes a similar argument.  He, however, uses more formal modeling than me and notes the implications for the current account deficits.  He is careful not to say the Fed's monetary superpower status was the only factor, yet finds that it was quantitatively important.  Here is an Ferrero:

[T]hese [pegging] countries import U.S. monetary policy so that low U.S. interest rates lead to low global interest rates. The quantitative analysis shows that foreign pegs, coupled with over-expansionary U.S. monetary policy, exert additional downward pressure on the real interest rate and impair a real depreciation of the dollar that would help rebalance the U.S. current account de cit.  Taken together, the relaxation of borrowing constraints and low interest rates in the U.S. coupled with foreign pegs account for about two-thirds of the increase in real house prices and almost one-half of the deterioration of the current account during the first half of the 2000s. These quantitative findings complement the role of other factors in accounting for the correlation between the house price boom and the deterioration of the current account in the U.S. during the early 2000s.

As noted above, the flip side of this argument is that Fed is now being too tight for the global economy, at least passively.