Recent Monetary News

by: Scott Sumner

Vaidas Urba sent me a very nice speech by Mario Draghi. Here he points out that monetary policy remains effective at the zero bound:

"Some argue that today the situation is different; that whereas Volcker could raise rates to 20% to tame inflation, central banks fighting disinflation are inhibited by the lower bound on interest rates. The Japanese experience after the bursting of the housing bubble in early 1990s is often presented as evidence.

But the Japanese case in fact only reinforces the importance of full commitment from policymakers. As long as the commitment of the Bank of Japan to a low positive inflation number was not clear, actual inflation and inflation expectations stayed in deflationary zone. Since the Bank of Japan has signaled its commitment to reach 2% inflation, however, core inflation has risen from less than -0.5% in 2012 to close to 1% today. This is still short of the 2% objective, to be sure, but downward price shocks are also hitting Japan like all other advanced economies."

And here he discusses the mistakes made by "some central banks":

In fact, when central banks have pursued the alternative course - i.e. an unduly tight monetary policy in a nascent recovery - the track record has not been encouraging. Famously, the Fed began raising reserve requirements in 1936-37, partially due to fear of a renewed stock bubble, but had to reverse course the next year as the economy fell back into recession. That has also been the experience of some central banks in recent years: raising rates to offset financial stability risks has undermined the primary mandate, and ultimately required rates to stay lower for longer.

It's gratifying to read Draghi's speech because it contains lots of talking points emphasized by market monetarists (and also by more enlightened Keynesians.) Notice how he realizes that raising rates actually causes them to be lower in the long run, something Milton Friedman recognized back in 1997. Of course, the ECB in 2011 was one of the central banks that tightened prematurely, and triggered a double dip recession. Will the Fed's 2015 tightening be added to the list? It was certainly a mistake, but it's too soon to suggest the next move will be down. (The market predicts flat.)

Unfortunately, the outlook for the eurozone is increasingly bleak. Wolfgang Münchau has a very good post:

Four signs another eurozone financial crisis is looming

The rout in European financial markets last week was a wat­ershed event. What we witnessed was not necessarily the beginnings of a bear market in equities or an uncertain harbinger of a future recession. What we saw - at least here in Europe - is the return of the financial crisis.

Version 2.0 of the eurozone crisis may look less frightening than the original in some respects but it is worse in others. The bond yields are not quite as high as they were then. The eurozone now has a rescue umbrella in place. The banks have lower levels of leverage.

But the banking system has not been cleaned up, there are plenty of zombie lenders around and in contrast to 2010 we are in a deflationary environment. The European Central Bank has missed its inflation target for four years and is very likely to miss it for years to come.

The markets are sending us four specific messages. The first and most imp­ortant is the return of the toxic twins: the interaction between banks and their sovereigns. Last week's crash in bank share prices coincided with an increase in bond yields in the eurozone's periphery. The pattern is similar to what happened during 2010-12. The sovereign bond yields have not quite reached the same dizzy heights, though Portugal's 10-year yields are almost 4 per cent.

You might wonder why the eurozone debt situation is worsening even as the labor market gradually improves. Perhaps the problem is that debt contracts are often quite long, whereas wage contracts tend to be much shorter. Thus, wage growth is now adjusting to slower NGDP growth, but long-term debt contracts have not fully adjusted.

The FT also has a piece that criticizes QE:

For years, central bankers have been reluctant to suggest that unconventional monetary policies even had costs. But while developed markets plunge ever deeper into uncharted financial territory as a result of central bank actions, the drawbacks and the limitations of such policies are finally becoming apparent.

The negative effects will become even more obvious over time. This will occur as asset price inflation - the main consequence of central bank policies - goes into reverse, robbing financial engineering of its efficacy and flattening the yield curve.

Suddenly, the success of central bankers in lifting financial asset prices through unconventional monetary policies seems to be coming to an end.

In other words, don't do beneficial policies that help the economy and also raise asset prices as a side effect, because if at some point in the future you foolishly stop doing beneficial policies and NGDP growth plunges then asset prices may fall. Or something like that.

And this:

The Bank of Japan's use of negative rates, dovish coos from New York Fed Chairman William Dudley, and carefully worded statements from Mr. Bernanke's successor, Janet Yellen, last week spooked markets rather than soothed them.

I suppose if you ignore the fact that the Japanese negative rate announcement triggered a big rise in global equity markets then this article might make some sense. But I prefer not to ignore reality.

It's hard not to see the current global situation in Manichaean terms. On one side, you have people like Draghi and Kuroda, desperately trying to nudge their institutions towards higher inflation. On the other, you have people who see up as down and left as right, and who offer no constructive suggestions as to how central banks can hit their targets. In the middle is the Fed, just twiddling its thumbs.

PS. Discussion of market monetarism is now appearing in academic journals. Here's a new paper by Ryan Murphy and Jiawen Chen. (Ungated preliminary version here.)

I also recommend the new post by Marcus Nunes, which discusses a post by Gavyn Davies in the FT.

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