Contra Nick Xenophon´s idea

The Conversation is critical, but for the wrong reasons:

In the revolving door of economic ideas, the old can be suddenly new again. Independent Senator Nick Xenophon resurrected one such idea this week. He said the Reserve Bank of Australia should replace its inflation target of 2-3% per annum with a target of nominal GDP growth of around 5.5% per annum.

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One big problem with Xenophon’s idea is that the theory does not fit the times. It is not the right policy for today.

Energy prices are not going up; they have been falling and are now flat. Yes, electricity prices have been going through the roof in South Australia and to a lesser extent elsewhere. But oil prices have been falling or flat over recent years, and this has a more pervasive effect than government bungling of the electricity market.

So output growth and inflation are not moving in opposite directions – both have fallen in recent years. Inflation is now below the bottom of the RBA’s target zone of 2-3% on any of the alternative measures.

The RBA, along with most central banks of advanced countries, would actually like to see more inflation, not less. Annual output growth is struggling to reach 3%, which is below the long run average of 3.5%. Hence nominal GDP growth is below the 5.5% long-run average that Xenophon would target. So whether the RBA targets inflation or nominal GDP growth doesn’t matter – the policy would be the same – that is, stimulate spending by lowering interest rates, which is exactly what it has been doing.

Why does The Conversation think NGDP targeting is only useful when (real) growth and inflation are moving in opposite directions? That is, when the economy is buffeted by a supply shock. Inflation targeting entices the wrong policy from the central bank, “instructing” it to tighten. NGDP targeting “instructs” the central bank to “ignore it” – good move.

But, more generally, NGDP targeting (in fact NGDP LEVEL Targeting) is the appropriate framework for “all seasons”. In addition to keeping the central bank from mishandling supply shocks, it keeps the central bank from generating demand shocks, which throws both inflation and real growth in the same direction, up as during the “Great Inflation” and down as in the “Great Recession”.

The last highlighted sentence from The Conversation is just confirmation that what is required is a LEVEL target. For example, if the central bank adopted a Price Level Target it would not be in the “low inflation-low real growth” it is in today. The downside of PLT is that just as in the case of IT, the central bank would be tricked into taking the wrong action when the economy is hit by supply shocks.

Another wrong take (among others) of The Conversation is this:

Another downside is that although nominal GDP growth would be more stable, inflation would tend to be more volatile. Inflation could jump up and down, but as long as output growth moved in the opposite direction the RBA would do nothing to dampen the volatility in inflation. Volatile inflation increases the uncertainty about future prices, which inhibits investment spending by firms and households.

As the “experience” of many countries (US,UK, Australia, for example) with implicit NGDP Level Targeting showed, what NGDP-LT provides is Nominal Stability. As Nick Xenophon puts in his “comments on critics” (see comment here):

How does someone who starts a business – taking out a loan and hiring staff – in expectation of 7 per cent a year growth in nominal spending deal with a sudden drop in spending to 2 per cent? Not well, I reckon.

Someone has been listening

And that someone is in far-away Australia, a country that has avoided recession for a quarter century. Things started going wrong for the past few years, when it ignored its NGDP level target and started worrying about home prices.

Read this: The new RBA governor should target [nominal] growth, not inflation:

If you had told Australians 10 years ago that official interest rates would fall to 1.5 per cent, many would have jumped for joy.

Aside from homeowners, Australians are not feeling much joy these days. This is despite the lowest interest rates in 70 years, low inflation, economic growth close to normal and the unemployment rate – though not ideal – still lower than it was during the Sydney Olympics.

So why are we feeling so miserable? The reason is that most Australians’ incomes are going nowhere.

Wages are growing at recessionary levels, profits for small and medium-sized businesses are flat and the budget deficit constrains government spending.

Overall, Australia’s “nominal” growth rate –  the growth in actual money in our pockets – has fallen from 7 per cent per annum in the decade before the GFC to only 2 per cent today.

A large part of it is also due to the out-of-date inflation target that the Reserve Bank of Australia has been tasked with hitting.

A better option would be for the RBA to target a reasonable rate of growth in Australia’s nominal GDP.

In other words, we should replace the RBA’s existing inflation target with a nominal GDP target.

Stronger growth in nominal GDP would provide workers and businesses with greater means to pay their debts, hire more staff and invest in new plant and equipment.

Amen

HT Virgílio

The Reserve Bank of Australia is becoming ‘conventional’

Today:

The Reserve Bank of Australia has lowered the cash rate to 1.5% in an effort to stimulate growth, boost inflation and encourage a fall in the Australian dollar.

The cut of 25 basis points from 1.75% is the last decision from outgoing RBA Governor Glenn Stevens. In a statement on the rate decision he says:

“Low interest rates have been supporting domestic demand and the lower exchange rate since 2013 is helping the traded sector. Financial institutions are in a position to lend for worthwhile purposes.”

In addition:

In his statement, Glenn Stevens also addressed the concerns around Australia’s property market. He noted Australia’s banks have been cautious in lending to certain sectors like the property market and despite the possibility of a considerable supply of apartments emerging over the next few years, lending for housing has slowed this year.

It seems the RBA has ‘unlearned’ the lessons of 2008. Then it did not suffer a recession because, contrary to what most major central banks, it did not allow NGDP to tank.

What supported domestic demand was an adequate monetary policy that kept spending growing close to a stable trend path. Maybe because of worries about house prices, monetary policy has been overly tight for the past two years, despite the drop in the policy interest rate.

Australia´s monetary policy statement says:

In determining monetary policy, the Bank has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term.

The chart shows that since 1992, when the target was set, inflation has averaged 2.5%. The RBA couldn´t have done better! Soon we´ll hear Steven Williamson say “Told you so; interest rates are falling and so is inflation. If rates continue to fall and remain low, you´ll get deflation”!

If only the RBA had continued to pay attention to NGDP!

The chart shows that the house price boom ended, without tears, more than 10 years ago.

What happens when you let NGDP Drop below the trend level target?

You go the “(un)conventional” way:

The Reserve Bank of Australia has drafted an emergency playbook to follow the world’s major central banks in embracing extreme monetary policy as global interest rates stumble to historic lows and the Australian dollar stays stubbornly high.

Until mid-2014, Australia was doing nicely. In the past two years, however, it began worrying about asset bubbles:

Addressing members of the Committee for Economic Development of Australia (CEDA) lunch in Adelaide, he said monetary policy aimed at encouraging business investment and generating employment amid global economic weakness was in danger of creating a housing bubble in Australia.

And continued to do so one year on:

The Reserve Bank of Australia’s surprise decision to defer its widely anticipated April rate cut for at least another month might have been influenced by the increasingly pricey housing market, which it regards as posing a real “dilemma”.

According to UBS, in March the ratio of Australian dwelling prices-to-disposable household incomes equalled – and is presently surpassing – the previous record of 5.3 times set back in September 2003. And they predict it will climb further.

The policy interest rate has been lowered significantly. So what? That only means that monetary policy has been tight, something easily gleaned from the behavior of NGDP growth and inflation.

 

What Australia should do is try to get NGDP back on trend, which has served it well.

Australia falling prey to bad (interest rate oriented) monetary policy

In recent news we read:

Australians must urgently confront the danger that the Reserve Bank of Australia is nearing the very limits of its powers and risks stumbling into the same zero-interest rate trap that has neutered European and Japanese central banks, say two high-profile economists.

Saul Eslake, one of the nation’s most experienced economists, and the ANZ Bank’s top analyst, Richard Yetsenga, say the examples of major central banks around the world don’t provide much hope that ever-more intensive monetary policy stimulus can resurrect inflation.

“The evidence is that even aggressive monetary policy action doesn’t seem to be driving up inflation, so far,” Mr Yetsenga told AFR Weekend.

Calls for a national debate on the eve of the Federal election about how the central bank operates come after the Reserve Bank issued the weakest inflation outlook since introducing its 2-3 per cent target range in the early 1990s. It also comes a day after Phillip Lowe was announced as the replacement for RBA Governor Glenn Stevens.

“Aggressive monetary policy action”? Quite the opposite. Australia weathered the international crisis of 2008-09 because, differently from most other central banks, it managed to avoid letting NGDP to fall below trend, quickly reversing the initial fall in spending, as the two charts indicate.

By identifying the stance of monetary policy with the level of its policy rate, it has allowed NGDP growth to fall continuously, and that has taken the level of spending below the long-term trend.

Meanwhile, inflation has fallen somewhat below the 2%-3% target range, something that is not novel. Since the start of the “IT” regime in 1992 Australia´s inflation, both headline and core measures of the CPI, have averaged 2.5%, and that´s certainly a most satisfactory outcome.

The RBA´s goal should be clear. Work to put NGDP back on the level trend it was at!

Australia tries to find “balance”

Being one of the very few countries (two others are Poland and Israel) whose monetary policy managed to avoid a recession on the heels of the 2008-09 crisis, Australia is a natural object of Schadenfreude!

Two recent articles “wish harm” on Australia

1 Is Australia Sliding Into Recession?

Recent data prompt economists to warn Australia may be ripe for first recession in 24 years

2 Goodbye to the lucky country

What if our economic growth stalls altogether? Worse still, what if we slip into recession?

These are not farcical questions. Figures released this week recording just 0.2 per cent growth in Gross Domestic Product for the June quarter, and just 2 per cent for the year to June, were extremely weak. Indeed, without a one-off increase in government defence spending, the quarter would have recorded zero growth.

There´s as usual some luck involved. In the case of Australia, it did no harm that immediately before the crisis hit, it was effecting an “excessively” expansionary monetary policy, as indicated by NGDP growth and it´s level relative to the trend path. The two charts illustrate.

Australia is the prototype commodity exporting country. In such cases, the exchange rate should move to offset commodity price or terms of trade changes. That´s what´s reflected in the next chart, with two notable exceptions. In 2004-07, the exchange rate doesn´t move, while commodity prices are rising. That boils down to an expansionary monetary policy. In the first set of charts that is reflected in the upward trend taken by NGP growth and the rise in NGDP above trend.

In 2001-13, the RBA tightened policy. That is implied by the fact that falling commodity prices were not accompanied by a depreciation (fall) in the A$ relative to the dollar. In the first set of charts, we observe a strong fall in NGDP growth.

We note that NGDP growth has done a lot of “swinging” after the crisis hit. Scott Sumner thinks that the RBA has “chosen” a lower growth rate for NGDP. That may be right, and I put that new trend growth at 4%. If that´s correct, we may soon find Australian NGDP growth settling around that level, implying that NGDP will evolve close to a level path that will be below the previous one.

There´s, however, always the risk that the RBA, if it starts worrying about debt levels and house prices, will make the mistake the Riksbank made in 2010. Let´s hope that doesn´t occur!

Update: In Australia, the post crisis “NGDP growth swings” are reminiscent of the “Volcker NGDP growth swings”. What Volcker was trying to do was find a stable path for NGDP. That was “bequeathed” to Greenspan, and the “Great Moderation” ensued, until Bernanke lost it!

Revisionist Thoughts: Was Australia just luckier than most?

This post was motivated by Scott Sumner´s musings about Australia: Australia´s Great Stagnation:

It looks like the Great Stagnation has hit even Australia.  In an earlier post I pointed out that Australian NGDP rose at a 6.5% rate from 1996:2 to 2006:2.  Then we had the Global Financial Crisis, and Australian NGDP growth slowed to . . . er . . . it stayed at 6.5% from 2006:2 to 2012:2.  No tight money and no recession in Australia.

Some important facts about Australia:

1 NGDP and Trend

2 RGDP & Trend

Notice that when NGDP climbs above trend, RGDP falls below trend!

Zooming in (circles explained later)

What explains the counterintuitive fact that RGDP falls below trend at the same time commodity prices take off?

The rise in NGDP translates into a rise above target in core inflation.

The 200 basis points increase in the cash rate (equivalent to the Fed´s FF rate) just goes to show that interest rates are bad definers of the stance of monetary policy. Despite the increase in the cash rate, inflation and NGDP were moving up, indicating monetary policy was “too easy”!

With Australia being a commodity exporter, another way to gauge the stance of monetary policy is by comparing the move in the exchange rate to the dollar and commodity prices. Monetary policy is “just right” if a rise in commodity prices is accompanied by an appreciation of the Aussie Dollar (USD/A$) and a fall in commodity prices goes hand in hand with a depreciation of the exchange rate.

The chart below shows that in 2004-07 monetary policy was too loose, consistent with NGDP climbing above trend (and inflation increasing). Monetary policy was tightened in 2011-13, consistent with NGDP converging to trend and inflation decreasing (see circles in NGDP & Trend chart above).

At present, NGDP is back on trend (actually just a “whisker” below it). What happens next? Will Australia go the way of Sweden, Israel and Poland, or will it get “smart”?

In the case of Sweden things started unraveling when the Riksbank decided to “prick” a housing “bubble”. According to the FT:

Sweden’s central bank has been lambasted by critics for trying to use interest rates to combat signs of a housing bubble. It lifted rates in 2010 and 2011 as it publicly worried about what it saw as high household debt levels.

In the case of Israel, it may not be coincidence that NGDP began a systematic deviation from trend when Ms Flug took over at the Bank of Israel. Maybe she prefers the role of Finance Minister:

Speaking at a Calcalist conference, Governor of the Bank of Israel said today, “Exceeding the 3% fiscal deficit target will expose the Israeli economy to significant risk and will be liable to harm us citizens. We must show responsibility and take into account the consequences of our decisions over time. Israel’s structural deficit, the deficit not subject to one-time shocks, is already one of the highest in the western world.”

This is what happened:

In the case of Poland, it took three years, but in late 2011 Poland finally botched up and went the way of the majority of countries, letting NGDP fall way below trend. They didn´t (correctly) react to the 2007-08 oil price rise, like the US, UK, EZ, etc. and fared well, but didn´t resist when oil prices picked up again in 2010-11, when, among the initial group, only the ECB was dumb enough to react.

By talking about house prices, the RBA is tempting the “fate” that hit Sweden and Israel. Scott links to an article in a subsequent post:

The Reserve Bank of Australia’s surprise decision to defer its widely anticipated April rate cut for at least another month might have been influenced by the increasingly pricey housing market, which it regards as posing a real “dilemma”.

This, unfortunately, has been going on for some time. Last September, RBA Governor Glenn Stevens was warning of bubble risk in the current low interest rate environment:

Addressing members of the Committee for Economic Development of Australia (CEDA) lunch in Adelaide, he said monetary policy aimed at encouraging business investment and generating employment amid global economic weakness was in danger of creating a housing bubble in Australia.

And the next chart compares two “bubbles”.

Please, Governor Stevens, start thinking smart!