Sliding Back To The Gold Standard?

| About: ProShares Inflation (RINF)

When the Bank of International Settlements was created in 1930, it was hoped that it would provide a progressive voice on monetary policy, pushing back against the passivity of the Fed and the Bank of France. Commenter Emerich directed me to a new report out by the BIS. I don't know what sort of term to apply, but it certainly is not "progressive":

For monetary policy, the key is to rebalance the evaluation of risks in the current global stance. The exceptionally accommodative policies in place are reaching their limits. The balance between benefits and costs has been deteriorating (Chapter IV). In some cases, market participants have begun to question whether further easing can be effective, not least as its impact on confidence is increasingly uncertain. Individual incremental steps become less compelling once the growing distance from normality comes into focus. Hence, accumulated risks and the need to regain monetary space could be assigned greater weight in policy decisions. In practice, and with due regard to country specific circumstances, this means seizing available opportunities by paying greater attention to the costs of extreme policy settings and to the risks of normalising too late and too gradually. This is especially important for large jurisdictions with international currencies, as they set the tone for monetary policy in the rest of the world.

Translation: The Fed needs to raise interest rates so that it will have more "monetary space" to cut them in the future, when monetary stimulus is once again needed. Of course, this is a very basic error. Monetary space results from the gap between the Wicksellian equilibrium nominal rate and the effective lower bound (zero or slightly below). If central banks tighten monetary policy, then the Wicksellian equilibrium rate will decline, even if actual market rates increase, thus reducing monetary space. Indeed, back in 2011, the ECB did exactly what the BIS wants the Fed to do, and ended up with far less "monetary space".

Let's look at the next paragraph in detail:

Such a policy shift relies on a number of prerequisites. First: a more critical evaluation of what monetary policy can credibly do.

Translation: The BIS wrongly thinks monetary policy might be unable to boost demand.

Second: full use of the flexibility in current frameworks to allow temporary but possibly persistent deviations of inflation from targets, depending on the factors behind the shortfall.

The BIS understands that its recommendation might cause the Fed to fall short of its policy targets, but is OK with that.

Third: recognising the risk of overestimating both the costs of mildly falling prices and the likelihood of destabilising downward spirals.

The BIS doesn't see it as a major problem if the central bank falls short of its target, as long as we don't face a deflationary spiral. What the BIS doesn't understand is that falling short will lead to precisely the ultra-low rates and bloated balance sheets that it abhors. Furthermore, not hitting your target reduces policy credibility, making monetary policy more difficult to implement in the future.

Fourth: a firm and steady hand - after so many years of exceptional accommodation and growing financial market dependence on central banks, the road ahead is bound to be bumpy.

The BIS understands that the markets will scream bloody murder if the Fed adopts the BIS's advice, but it wants the Fed to ignore those screams and keep a steady hand on the tiller as they steer toward higher and higher interest rates. In fact, the market screams would be rational forecasts of economic disaster ahead, and should not be ignored by the Fed.

Last: a communication strategy that is consistent with the above and thus avoids the risk of talking down the economy. Given the road already travelled, the challenges involved are great, but they are not insurmountable.

The BIS thinks the "road already travelled" has been ultra-easy money, whereas it's actually been tight money. The BIS thinks an upbeat communication strategy by the Fed, i.e., communicating that raising rates is desirable because the economy would otherwise overheat, will reassure the markets. In fact, the markets will assume the Fed is delusional, and asset prices will decline sharply as a result. Fortunately, the Fed is very unlikely to accept the BIS's advice.

Later in the report, the BIS suggests we are approaching something like the old gold standard:

More generally, there are natural limits to the process - to how far interest rates can be pushed into negative territory, central bank balance sheets expanded, spreads compressed and asset prices boosted. And there are limits to how far spending can be brought forward from the future. As these limits are approached, the marginal effect of policy tends to decline, and any side effects - whether strictly economic or of a political economy nature - tend to rise. This is why central banks have been closely monitoring these side effects, such as the impact on risk-taking, market functioning and financial institutions' profitability.

I don't see those limits, but let's say I'm wrong. In that case, the solution is to adopt a higher inflation target, or NGDPLT, so that monetary policy does not become impotent. But the BIS also appears to oppose those ideas. Rather, it seems to want to return to the world of the gold standard. Not literally, of course, but in the sense that it is willing to live with a policy regime where the effectiveness of monetary policy is greatly reduced.

The BIS of 2016 holds views that are striking similar to the conservative central bankers of 1930, which the BIS was created to push back against. Its primary focus seems to be using monetary policy to push back against financial bubbles.

If the Fed were to follow this approach right now, the entire world would be in a deep depression within 6 months. Instead, the Fed should do the opposite. I'd like to see them cut rates by 50 basis points today by eliminating IOR. The global economy (NGDP expectations) needs a shot in the arm.

For instance, Brian Donohue recently pointed out that the dividend yield on the S&P500 (2.20%) is now almost has high as the 30-year T-bond yield (2.28%).

And the Fed is still worried about inflation.

PS: The last few days would have been a wonderful time to have a highly liquid and subsidized NGDP futures market. And yet, I don't even see other economists calling for it. Another failure of the economics profession.

Off topic, Gideon Rachman has a very good post on Brexit.