The BoE’s new monetary policy tool: toleration of above target projected inflation

A James Alexander post

Watching Bank of England Governor Mark Carney joust again with Jacob Rees-Mogg MP at the UK’s Treasury Select Committee yesterday got me looking back to the May press conference when Carney launched his warnings about the riskiness of voting Leave, that were then repeated at the May Treasury Select Committee hearings.

There was a lot going on at the time but Carney had a secret weapon, a new monetary policy tool whose importance is still being overlooked.

Carney took sides, but …

The intensity of the debate over Brexit was terrific during May and June. The Bank of England was clear that there could be financial chaos and a technical recession. There was only downside risk from the voting Leave. In that view the BoE was amplifying, but with authority, the typical consensus expert view. It took sides with the Cameron/Osborne government, clearly and simply, loyally.

Remain supporters amongst journalists and politicians were very pleased. Leave supporters were not. Rees-Mogg was entirely right to question the independence of the bank. If Carney had talked in any remotely balanced way about the potential benefits of Leave then he would have been fair but as Rees-Mogg noted, he didn’t take up that opportunity. All serious people agreed Brexit would be a disaster, and Carney is a very serious person indeed.

However, the sub-text was also crystal clear. And FX markets, a prime window onto, and channel of, monetary policy very much got the message. If the UK voted Leave then all the monetary policy power of the Bank of England would be brought to bear immediately to offset any shock to demand, due to fears about the supply side.

Once it was clear that the UK had voted Leave then the markets immediately knew what to expect from UK monetary policy. Potential rate cuts, QE and other liquidity schemes – plus the bonus of a dramatic and statesmanlike broadcast from Carney himself. Sterling fell 10% in response to the u-turn in monetary policy, UK domestic equities fell in response to demand shock fears caused by long-run supply side fears. Political turmoil didn’t help much either. But, it wasn’t a disaster. Financial institutions sailed through unscathed, many even profitably. There was no repeat of Lehman.

With one step he was free

In the hearing yesterday Carney was not exactly smug, but he did say he was “serene” about the new stance. He also elaborated about just how profound the 180-degree u turn on monetary policy had been. He said monetary policy was on a tightening bias as late as May/June, and the next moves in rates were due to be up. That had all changed now and he clearly was a much happier man as a result. His incorrect monetary policy stance of the previous year and a  half was now just a distant memory, “ancient history” as he called it.

No monetary shock here, so no demand shock either

While the vote to leave was a shock a bigger shock, a monetary shock, would have been if the Bank of England hadn’t intervened to offset the uncertainty shock.

If it had decided to defend the currency with a monetary tightening, that would have been truly disastrous. Some central bankers have made that mistake in the past and it never ends well.

If it had appeared to stand pat and just keep its tightening bias, that would still have been a shock. Some central bankers have done that too, and it didn’t end well.

The BoE had primed markets that it would respond appropriately and it did. GBP immediately fell 10%, and then rates were cut and QE was expanded. Osborne’s replacement, Philip Hammond, also made it very clear that the response to the Brexit shock was monetary, not fiscal.

The BoE even said it would also tolerate an above target inflation rate – all in order to ensure financial stability and a return of inflation to 2% in the longer term. That “even ” is subtle, but very powerful.

Overshoot of projected inflation now tolerated

Why did Carney never say during 2015 that it would tolerate a period of above target inflation in order to bring current inflation up to target. Well, the obvious answer is because the BoE took its own projections seriously, and they showed inflation returning to 2%.

Those projections always showing this happening kept monetary policy tight, with promises of more tightening to come if those projections showed an overshoot. The fact that this stance meant constant under-shooting was lost on the BoE.

Is this a new tool?

After the Brexit vote the UK central bank seems to have added this new weapon to its toolbox: Toleration of projected overshoots to its inflation target at a time when actual inflation is stubbornly below target.

The BoE tolerated current inflation above target when it was above target, but what else could it do? It was a fact, but was it a choice too? We don’t really know. We do know that it wouldn’t tolerate inflation projections going above its target until we had the vote to leave, now we do.

Perhaps this new tool could also be used by other central banks. Temporary overshoots of projected inflation in order to get current inflation up to target. Are you listening at the Fed, ECB and BoJ?

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Switzerland escapes deflation … by printing money

A James Alexander post

Back in Autumn last year I was concerned  by the negative trend in Swiss NGDP during 3Q 2015. In January 2015 the new head of the Swiss National Bank broke the fixed ceiling on the currency vs the Euro that had prevented appreciation and a consequent monetary tightening. The ceiling had been so credible that after early attacks the SNB had not had to defend it by selling currency and thus expanding its balance sheet – a major cause of concern inside Switzerland.

On breaking the ceiling the currency duly rose dramatically and the SNB was forced to sell currency in order to stop what it saw as “excessive” appreciation. Effectively, the SNB was now running an unofficial peg vs the Euro. It was forced to begin expanding its balance sheet all over again. The initial currency appreciation was monetary tightening and did see NGDP slow and then turn negative, dragging down RGDP too, but not quite sending Switzerland into a recession.

ja-swiss16_1

Over the last three quarters the recession was narrowly avoided so there has been no poor ending yet. Why not?

• The unofficial peg vs the Euro means that monetary policy has stopped tightening.

• The cost of maintaining the new unofficial peg means Switzerland is actually engaged in monetary easing as Base Money has grown steadily thanks to the continual sale of currency in return for foreign assets. If a major country did this it would be termed “currency manipulation”, but the US Treasury has only named China, Japan, Korea, Taiwan and Germany on its infamous May 2016 “Monitoring List”.

• It won’t have helped that Switzerland is running with very negative policy rates, but it doesn’t appear to have hurt either.

ja-swiss16_2

In just the 2nd quarter of 2016 alone he SNB has bought more USD (11.5bn) and more EUR (16bn) than they owned before the financial crisis.

ja-swiss16_3

By tying itself again to Euro monetary policy Switzerland has effectively outsourced its monetary policy direction to the ECB, which itself is trying hard to ease monetary policy via its QE programme, despite the massive handicap of its absurdly low inflation ceiling. Euro Area NGDP and RGDP growth has avoided disaster as a result, and has had a similar impact on Switzerland.

Independent Fiat-Money Central Banks and ITs: A Toxic Combination

A Benjamin Cole post

The woeful record of independent fiat-money central banks and inflation targets is one of nearly universal economic asphyxiation. Everywhere on the globe where a central bank has an IT, one sees inflation below targets, deflation and anemic growth.

Right to it:

  • The Reserve Bank of Australia has an inflation target of 2% to 3%, but with inflation at 1% the RBA is below target. Growth is subpar—and this is the best of the lot.
  • Thailand has a1.5% inflation band around 2.5% IT, and has no inflation and subpar growth.
  • The People’s Bank of China has a 4% IT, and a 1.8% inflation rate. The nation is about at half of real growth rates when inflation was close to target.
  • The ECB has a 2% IT, and is in deflation perma-gloom
  • Japan has a 2% IT, and is in deflation perma-gloom.
  • The Bank of England has a 2% IT, and a 0.3% inflation rate. Growth is subpar.
  • Singapore has exchange-rate target on currencies that are ruled by ITs. The city-state nation most recently posted 0.3% QoQ growth and is in deflation.

Calling Inspector Clouseau

I see a pattern!

For that matter the Fed has a 2% IT on the PCE, often misperceived as a 2% ceiling on the CPI (perhaps even by FOMC officials). The Fed is below target and real growth in the U.S. microscopic. What a surprise!

Should not the macroeconomic topic of the day be,  “Why are global central banks nearly universally falling below their ITs while mired in slow growth?”

At this late date, why does anyone think an IT is a good idea? Where has an IT worked (with the possible exception of the RBA’s IT-band, a slightly less worse idea than an strict IT).

The sooner fiat-money central banks kill off ITs the better. They have not worked. Is that not reason enough?

Yes, NGDPLT’s would be better.

The oddity: For decades, there has been long-winded sermons on the risks of fiat-money central banks, one reason they were made independent. The premise, even in present-day literature, is that central banks have been loose, are loose, and want to be loose, to serve sinister statist-inflationist goals and populist madmen.

The reality? Independent fiat-money central banks have universally asphyxiated commerce through tight money.

How else to explain gathering global deflation and slow growth?

When will macroeconomic orthodoxy accept the reality?

The genius that was Milton Friedman

Going back over old posts, I found one from 6 years ago that covered Milton Friedman. That was in Portuguese, and here I have more.

This is taken from the Q&A following Friedman´s Keynote Address at a Bank of Canada Conference in 2000. Here´s Friedman, on the hot topics of today: The Euro, Inflation Targeting operated primarily through interest rates, and Japan

Michael Bordo: Do you think the recent introduction of the euro will lead to the formation of other common-currency areas?

Milton Friedman: That’s an extremely interesting question. I think that the euro is one of the few really new things we’ve had in the world in recent years. Never in history, to my knowledge, has there been a similar case in which you have a single central bank controlling politically independent countries.

The gold standard was one in which individual countries adhered to a particular commodity—gold—and they were always free to break or to leave it, or to change the rate. Under the euro, that possibility is not there. For a country to break, it really has to break. It has to introduce a brand new currency of its own.

I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them.

Right now, Ireland is a very different state; it needs a very different monetary policy from that of Spain or Italy. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time. On the other hand, new things happen and new developments arise.

The one additional factor that has come out that leads me to raise a question about this is the evidence that a single currency—currency unification— tends to very sharply increase the trade among the various political units. If international trade goes up enough, it may reduce some of the harm that comes from the inability of individual countries to adjust to asynchronous shocks. But that’s just a potential scenario.

You know, the various countries in the euro are not a natural currency trading group. They are not a currency area. There is very little mobility of people among the countries. They have extensive controls and regulations and rules, and so they need some kind of an adjustment mechanism to adjust to asynchronous shocks—and the floating exchange rate gave them one. They have no mechanism now. If we look back at recent history, they’ve tried in the past to have rigid exchange rates, and each time it has broken down. 1992, 1993, you had the crises. Before that, Europe had the snake, and then it broke down into something else. So the verdict isn’t in on the euro. It’s only a year old. Give it time to develop its troubles.

(Note)

Malcolm Knight: Countries with a flexible exchange rate need a nominal target for monetary policy to anchor expectations. Do you feel that inflation targeting provides a useful nominal target?

Milton Friedman: As I mentioned earlier, I think it’s a good thing to have a nominal target, to say that you’re not going to try to fine-tune, and to indicate what you aren’t going to do.

The problem I have is this: the current mechanism for all of the central banks who are inflation targeting is a short-term interest rate—as in the United States—in all of the central banks.

We know from the past that interest rates can be a very deceptive indicator of the state of affairs. A low interest rate may be a sign of an expansive monetary policy or of an earlier restrictive policy. And similarly, a high rate may be a sign of restriction, of trying to hold things down; or it may be a sign of past inflation.

The 1970s offer the classical illustration in which there were high interest rates that were reflecting the Fisher effect of inflation expectations. So I’m a little leery of operating primarily, or almost primarily, via interest rates. But, I think that having a given inflation target is a good objective. The question is, how long will you be able to keep it?

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

Shared misery is more comforting

This could only come from someone like Trichet:

Lackluster growth in the euro area is just as miserable as that seen in the U.S., the former president of the European Central Bank (ECB), told CNBC on Friday, defending the central bank’s policies.

“I would like to underline something that is not something well-perceived. I compared over the last 12 months real growth in the U.S. and real growth in the euro area and, to my great surprise, the euro area had growth of 1.6 percent over 12 months whereas in the U.S. it was 1.2 percent,” Jean-Claude Trichet told CNBC on the sidelines of the Ambrosetti forum.

“The euro area is, of course, posting growth which is totally insufficient but we share that insufficiency with the U.S…so we shouldn’t present growth in the euro areas as totally miserable. We share this misery with the other advanced economies in the current period,” he added.

Further arguing that:

Trichet defended the central bank’s track record, however, saying that it had done a “fantastic job” over a “very difficult time.”

Which, as the chart indicates, he made much more difficult!

Trichet´s Misery

 

Appearances can be deceiving

To many, the economy is strong enough to sustain a jolt of higher rates. Richmond´s Jeff Lacker is a case in point:

The U.S. economy appears strong enough to warrant significantly higher interest rates, Richmond Federal Reserve Bank President Jeffrey Lacker said on Friday.

Lacker, who is not a voting member of the U.S. central bank’s rate-setting committee this year, said he still favors raising rates sooner than later and that the Fed’s last policy meeting in July would have been a “good time” to tighten policy.

Speaking to a group of economists in Richmond, Lacker argued that a range of economic analysis suggests the Fed’s benchmark overnight interest rate – the federal funds rate – is currently too low.

“It appears that the funds rate should be significantly higher than it is now,” he said in the speech.

As the chart shows, for the past 23 years, inflation (PCE-Core) has been ‘cornered’.

Appearances Deceiving_1

What we dearly miss is some of the robust growth the economy experienced during the Greenspan years (1987 – 2005)

Appearances Deceiving_2

August payrolls – in line, except for awful AWE

A James Alexander post

The auguries for the August payrolls have not been good judging by industry-side surveys of August activity, and they still disappointed expectations.

Monthly jobs growth was relatively weak. With the participation rate flat there were not enough jobs created to keep pace with entries into the labour force and so the unemployment rate ticked up to 4.9%. No big deal and certainly nothing to move markets or expectations about Fed action.

What should trigger Fed action and more concern generally is the very weak Average Weekly Earnings (AWE) number. It is derived from two more commonly watched numbers, Average Hourly Earnings (AHE) and Average Weekly Hours (AWH). Hourly earnings had made some progress over the past 18 months, rising from a risible 2% YoY growth to a slightly less risible 2.5% or even 2.6%. Hawks had gotten very excited seeing incipient take-off in wage inflation, especially when annualizing a 3-month trend etc. More careful analysis showed that this very modest growth had been accompanied by lower hours worked per week, thus suppressing AWE growth to just 2% or so.

JA Weekly090216

The August data showed both weaker growth in AHE and another drop in AWH (plus a revision down in the July hours) leading to weekly earnings growth dropping from 2.1% YoY to just 1.5%. It has to be remembered that this is nominal growth and so really depressing for wage earners. Other non-wage costs are rising, like medical cover but it remains incredibly dull for employees.

Incredibly, and perhaps tellingly about the market’s view of the FOMC, the chances of a September rate rise stayed put at 24% but the chances of a December hike rose from 54% to 60%. The market is always right, after all. Both equities and the USD initially fell, but then went up, as might have been expected. Even the long bond yield initially rose, before paring back.

Federal Reserve Bankers Victoriously Declare Defeat!

A Benjamin Cole post

Speaking in Beijing a few days ago, Chicago Federal Reserve Bank President Charles Evans said economic stagnation is the new normal and so he sees slow inflation, interest rates and growth for far as the eye can see. Ergo, there is nothing for the Fed to do.

Eric Rosengren, Boston Fed President, reviewed the same outlook, but added that rate hikes will be needed soon, as the U.S. economy, particularly commercial real estate, could “overheat.”

Overheat?

Again, here is a telling graph:

BC Hours

For Q1 2016, the index of hours worked nationally in the United States private sector was 112.3. It was 110.2 in Q2 2007, and 109.2 in Q2 2000. That is 16 years of essentially no employment growth in the United States.

This is overheating?

And look at the 1990s—strong employment growth, and sustained. Yet inflation was moderate throughout the decade.

Presently, the PCE core is reading 1.6% YOY. As Marcus Nunes has pointed out repeatedly on these pages, nominal GDP growth has been falling in recent years.

Conclusion

There remains a premise in central banker and monetary circles that fiat-money central banks have been “easy” (perhaps for decades) or “accommodative,” and have done all they can do, sometimes wreaking destruction in their path.

So now it is time for central bankers to victoriously declare defeat.

Central bankers contend that by being so easy for so long, they have driven the developed world into deflation, or close to it.

So now, raising rates makes sense.

The blameless crowd

They are masters in shifting responsibility.  See “ECB’s Nowotny: Don’t Blame Central Bankers for Low Rates”:

The low interest rate environment has more to do with economic developments, rather than the autonomous actions of central banks, said European Central Bank Governing Council member Ewald Nowotny in a speech Thursday. He added that in this environment it was difficult for a central bank to set interest rates on its own.

Speaking at a conference in Alpbach, Austria, Mr. Nowotny said that one of the factors keeping inflation down is globalization. Low prices are “an advantage for consumers, but puts pressure on wages,” he noted.

Moreover, growth is also relatively low. “We have a trend of long-term, low growth rates, which is not easy to interpret,” he said.

In his pre-Jackson Hole ‘manifesto’:   John Williams shows this chart

Nincompoops_1

And writes:

The underlying determinants for these declines are related to the global supply and demand for funds, including shifting demographics, slower trend productivity and economic growth, emerging markets seeking large reserves of safe assets, and a more general global savings glut.

Although the main reason was starring him in the face, it is never acknowledged. And that reason is the simultaneous crash in NGDP, resulting from sweeping the monetary policy framework pursued during the great moderation under the rug, first by the Fed, immediately followed by the other nincompoops.

Nincompoops_2

The “Guessing Game” Goes On

Caroline Baum had a nice piece yesterday: “The Fed’s baffling fascination with unreliable information”:

The idea of relying on expectations as a means to an end always seemed more viable in theory than in practice. So I was glad to find some support for my reservations from the economics community: specifically, a blog post by William Dupor, an economist at the Federal Reserve Bank of St. Louis, on the subject of inflation expectations.

Titled “Consumer Surveys, Inflation Expectations and the FOMC,” Dupor notes that “survey-based measures of inflation expectations” are mentioned in each of the statements released at the conclusion of the last 12 meetings of the Federal Open Market Committee. (My search revealed a reference to “survey-based measures of inflation expectations” in both FOMC statements and minutes dating back to January 2014.)

Perhaps it’s a coincidence, but market-based measures of inflation expectations set a near-term peak in January 2014 and have been declining ever since, much to the Fed’s consternation.

I always viewed the inclusion of survey measures as a case of confirmation bias: It gave policy makers the answer they wanted to hear. It allowed them to dismiss the sharp decline in market-based measures of inflation expectations, derived from the spread between nominal and inflation-indexed Treasuries, as a distortion due to liquidity preferences. Based on survey measures, they could take comfort that monetary policy was on the right track.

Now, the Fed clings to the labor market. This Bloomberg piece is telling:

An overlooked line in Federal Reserve Chair Janet Yellen’s speech last week could hold the key to whether Friday’s U.S. jobs report clinches an interest-rate increase this month.

While the focus was on Yellen’s statement that the case for an interest-rate increase “has strengthened in recent months,” she followed with new language that the central bank’s decisions depend on the degree that data “continues to confirm” the outlook. That, and other recent remarks by Fed officials, suggest that job gains need to be merely solid — rather than extraordinary — to warrant raising borrowing costs for the first time in 2016.

If what you want is “comfort”, go lie in the sun, but don´t pin your hopes on irrelevant information.

If ‘push comes to shove’ tomorrow, sell stocks, buy dollars and, maybe with a short delay, buy 10-year bonds