Draghi gives a Monetary Economics 101 class

A James Alexander post

ECB President Draghi was on far better form in his press conference after the April ECB Council meeting  than the one in March.

It was great to hear the German journalists having the special pleading of their insurance companies, pension funds and savers slapped down time and time again by Draghi. They are only one country in the Eurozone, like it or lump it. The ECB sets policy for the whole monetary area.

German leaders and economists also do those special interests a massive disservice by not helping them to understand the direction of causality when it comes to monetary policy. Low rates are a sign of tight money, not loose, or ultra-loose as so many supposedly clever commentators like to mistakenly opine. High rates are a sign of loose policy.

In a splendidly clear answer to one journalist, about 38 minutes in, Draghi stated:

Low interest rates are a symptom of low growth and low inflation. It’s not the monetary policy consequence … as I’ve said before, if we want to return to higher interest rates we have to return to higher growth and higher inflation to do so we need the current monetary policy, that’s the necessary condition [for a recovery].

Hear, hear!

Sounds good, but it´s not!

Draghi Warns on Risks of Low Inflation:

European Central Bank President Mario Draghi hit back at a warning from Germany’s Bundesbank that the ECB shouldn’t overreact to a sharp drop in oil prices, underlining his readiness to launch additional stimulus to shore up ultralow inflation.

In a speech at the Bundesbank’s home in Frankfurt, Mr. Draghi warned that central banks “cannot be relaxed” in the face of a series of shocks to commodity prices.

“The longer inflation stays too low, the greater the risk that inflation does not return automatically to target,” Mr. Draghi said.

Cheaper oil and other “forces in the global economy” that are holding down consumer prices “should not lead to a permanently lower inflation rate,” he said. “They do not justify inaction.”

The comments come a week after Bundesbank President Jens Weidmann urged central bankers to look through an oil-price driven drop in inflation, arguing that they shouldn’t fixate on current price levels like a “rabbit staring at a snake.”

The back-and-forth between two of Europe’s most influential central bankers underlines the debate within the ECB about how urgently the bank should respond to sharply lower oil prices.

It´s a mirror image of what happened in 2007-08, when oil prices were rising and central bankers felt “compelled” to tighten lest inflation permanently rose!

This is one more evidence against “Inflation Targeting”. It also shows how, in practice, central banks have an “asymmetric view” of the target!



“Close to, but below, 2%”: the ECB inflation ceiling. Its epitaph?

A James Alexander post

Of course we welcomed Mr Draghi’s willingness to ease monetary policy announced with at the January ECB meeting last week. And we recognised the positve impact on markets and therefore on NGDP expectations. But was this just a stopgap response to a poorer negative trend?

The fight over the direction of US monetary policy between the Fed and the markets will continue to dominate the news. The fight within the ECB will also continue, weakening the credibility of Mr Draghi’s easing bias and the current QE efforts. We think he should open a new front against the hawks by starting a discussion of the inflation target itself, the biggest barrier to optimal monetary policy in the Euro Area.

Wolfgang Munchau is right to despair after reading the minutes of the December 2015 ECB meeting.

The ECB has got itself into an extraordinarily difficult position. It has missed its policy target — a headline rate of inflation at “close to but below” two per cent — for four years. The target has lost credibility. Once people have lost confidence in an inflation target, it becomes very hard for the central bank to persuade them to trust the target again.

It was touching to hear Mr Draghi last Thursday talk about failing to reach a goal, then to try again and to fail again. I do not doubt his determination but the minutes of the December 3 meeting of the governing council tell us that not everybody supports the target in the same way. The minutes are anonymous. We know what has been said but not by whom.

What struck me in particular were two specific arguments used by some of the governors against a further increase in the size of asset purchases — part of the programme of quantitative easing aimed at revitalising the eurozone economy.

One said that he would not accept a further increase in QE unless the eurozone was once again in deflation. The implicit message of that statement is that this particular governor’s policy target must be zero per cent, not two per cent. He will only act once prices actually fall.

Another argument was that the positive effects of QE were diminishing over time while the negative side effects, like potential financial instability, were not. This argument is clever but also inconsistent with the policy goal. It is clever in the sense that it is self-fulfilling: if you choose not to increase the level of QE, then its effects diminish over time. And, of course, when the policy is not working, the adverse side effects may dominate.

However, what is infinitely more depressing in the minutes, and so sad too Munchau does not mention it, is the constant reference to the “close to, but below, 2%” inflation target. Expectations are almost everything in life, QE is fine but only as a tool to achieve a target. This inflation target undoes a huge part of the QE and general easing bias. Markets and economic actors know the ECB will tighten if inflation really does start to approach even 1.5% let alone 2%. Such tightening would then crush economic activity just as it did in in the Euro Area in 2008 and 2011.

European mainstream economists seem to think the ECB has a flexible target. But do these economists read the minutes of the policy-making body? It seems not.

Although we were encouraged by the near non-mention of the inflation ceiling target in the recent January ECB press conference, it’s dead hand still appeared, if very late in the statement, chilling all it touches.

Third quarter Euro Area economic growth was modestly encouraging. Signs are that 4Q will continue this trend, although monthly consumer inflation looks too weak for comfort. While many fret about headwinds from the China slowdown or US monetary tightening, the biggest headwind to Euro Area growth remains the inflation ceiling. Even if the Germans seem more inflation-phobic than ever, it would be nice to see some on the ECB open up a discussion about changing to a formally flexible inflation target, if not NGDP target like some Europeans have proposed.

The communications “conundrum”

This report dealt with yesterday´s ECB “surprise” – Draghi’s Weeks of Rhetoric Culminate in ECB Stumble on Stimulus. Concluding:

Draghi isn’t alone among central bankers struggling to convey their message. Bank of England Governor Mark Carney was labeled an “unreliable boyfriend” by a U.K. lawmaker last year after he first told investors they were behind the curve, then two weeks later said there was more spare capacity in the labor market than thought.

Yellen has faced criticism this year for holding off on a decision to imposing the Fed’s first rate increases since the financial crisis, contrary to previous signals.

Draghi, who has successfully introduced multiple measures in the face of opposition from politicians and policy makers, may now have to work to repair his reputation among investors who once lauded him as “Super Mario.”

Contrast that with Greenspan´s very “clear” communication “strategy”:

“I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant”

What this implies is that “communication” does not matter very much. What really matters is that there´s a generalized expectation that monetary policy will continue to be “good”, meaning that expectations of continued future Nominal Stability (at an adequate level of spending) is pervasive!

More rays of light in the Euro Area

A James Alexander post

In a few decades, if the European monetary union experiment has failed, the gravestone will be marked with the utterly depressing and anti-stimulative inflation objective of “Below, but close to, two percent”.

You just knew the press conference after the ECB meeting this week was going to go badly when Draghi intoned the dreaded six words in the second paragraph of his opening statement. This was a record for the year in fact. My analysis shows that normally it is in the third paragraph, and at the last two press conferences it was rather excitingly relegated to the sixth and seventh paragraphs. There can be no convincing recovery in the Euro Area while there is an inflation ceiling like this.

Scott Sumner has already opined on the undoubted tightening of monetary policy today as markets reacted negatively: the Euro currency strengthened and stocks fell. He also correctly points out that expectations were running high.

However, the data from the rear view mirror isn’t too bad if you look at base money or NGDP growth. Draghi pointed out the strong growth of M1 at 11% before launching into the newer central bank creed of creditism. Loans were much cheaper, following bond yields down.

Of course, true success for his monetary easing would be bond yields rising. Ironically, on the day yields did rise. But this was more due to the disappointment of no additional QE bond buying rather than any additional hopes for a recovery. A sort of reverse liquidity effect (ie bonds had been overbought and fell back in price) rather than any Fisher effect (where higher nominal growth expectations cut the real return on bonds and their prices fall).

A growing debate on changing the mandate of the ECB

I am still looking for silver linings and was very interested to see this policy report from a pro-European think tank, the Centre for European Reform, with a very heavyweight Advisory Board of VSPs. The author, Christian Odendahl, recommends ending national monetary influences in the ECB Board – a great idea and one we alluded to recently. But even more he recommends investigating targeting a higher inflation rate, a level target and even Aggregate Demand.

A stable level of demand is crucially important in a monetary union, as excessively low demand can lead to regional depressions and soaring debt, destabilising the whole union in the process. The European Central Bank (ECB) has failed to maintain the necessary level of demand and inflation during the course of the eurozone crisis, and needs a stronger mandate to prevent this from happening in the future. Such a mandate should include a higher and symmetrical inflation target, as well as the explicit responsibility for maintaining an adequate level of demand. National central banks should no longer be involved in eurozone monetary policy, since they tend to politicise decisions along national lines.

Ideally, therefore, the ECB should be given a more robust and activist mandate to manage demand.

This mandate should include:

« A higher inflation target of 3 per cent so that interest rates can be lowered more in the event of a crisis.18

« An explicit commitment that this target be symmetrical, so that undershooting and overshooting the target are of equal concern.

« A provision to take overall demand into account, rather than just inflation. In 2011, for example, inflation rose but demand was weak – and the ECB made the wrong decision to raise interest rates, which weakened demand further. In such a situation, preference should not be given to inflation.

Odendahl also included a great, Marcus Nunes-style chart showing the colossal failure of the ECB to properly manage Aggregate Demand, aka Nominal GDP.

JA Draghi-1

Odendahl referred readers to the recent European Parliament hearing on NGDP Targeting. A draft of just one of the papers had found its way onto various blog sites but the link shows there were in fact three papers presented. I have reproduced all three abstracts of the final papers.

It is both fascinating and hopeful that academics from leading German, French and British economics departments were represented even if only one (can you guess which?) was clearly in favour. The two others were sympathetic but did go off on some strange tangents. One favoured flexible inflation targeting and thought NGDP  targeting wouldn’t help central banks with their central problem of “financial stability”. The third  favoured a complex amendment to the Taylor Rule.

Is nominal GDP targeting a suitable tool for the ECB’s monetary policy? 

We seek to clarify whether or not nominal GDP targeting (NGDP) may be a suitable tool for the ECB’s monetary policy. We argue that this question really consists of three distinct but related questions: (1) Is it better for the ECB to put more weight on output than it does currently, by switching to a NGDP target? (The theoretical evidence suggests, maybe, but this depends on the distortions faced by the economy.) (2) Should a NGDP (or inflation) target be formulated in rates of growth, or in levels? (The theoretical evidence suggests that a levels target may have some appealing properties, by stabilizing expectations.) (3) What technical issues remain to be addressed? (Issues include the selection of an operating instrument, difficulties in estimating trends, data revisions, and communication.) Altogether, we argue that thinking about nominal GDP targeting in this way might help to clarify what is otherwise a confusing debate.

(Wolfgang LECHTHALER, Kiel Institute for the World Economy; Claire A. REICHER, Kiel Institute for the World Economy; Mewael F. TESFASELASSIE, Kiel Institute for the World Economy)

Flexible inflation targeting vs. nominal GDP targeting in the euro area 

We assess the pros and cons of nominal GDP targeting vis-à-vis flexible inflation targeting regime. We show that the benefit of a regime shift towards nominal GDP targeting in the euro area might be small. Moreover, nominal GDP targeting is not concerned with financial stability. Finally, targeting nominal GDP would make ECB communication very difficult. If the aim of a regime shift were to bring the ECB to pay more attention to growth, it would be more straightforward to fix a dual mandate and to set an explicit target for real output growth or the unemployment rate.

(Christophe BLOT, OFCE/Sciences Po; Jérôme CREEL, OFCE/Sciences Po and ESCP Europe; Xavier RAGOT, OFCE/Sciences Po, CNRS and PSE)

Is Nominal GDP targeting a suitable tool for ECB monetary policy? 

The idea of targeting smooth growth for nominal income (GDP), as an alternative to the conventional Taylor or inflation targeting rules for setting monetary policy, has been in discussion for many years. But they have never been used in practice. In this paper we review the pros and cons of adopting such an approach, and find them to be rather finely balanced. To dig deeper, we consider certain particular features of nominal income targeting: the crucial role of supply side responsive- ness (nominal income targeting substitutes for poor responses or a lack of market or structural reform); the need to bring market forces into play; the question of whether income targeting increases discipline; and the extra constraints imposed by having a dual mandate. The upshot is that nominal income targeting emerges as a special case of the more flexible Taylor rule formulation, although it does generalise on pure inflation targeting. In practice the Taylor rule form may be improved by using time varying, state contingent coefficients. De facto, this is what the ECB has done in recent years. The simulation studies available suggest that the more flexible rules of this kind perform better in reducing the fluctuations of output and inflation away from target; and are, crucially, more robust to model uncertainty (important for design) and real-time data/information errors (important in implementation).

(Andrew HUGHES HALLETT, School of Economics and Finance, University of St Andrews, Scotland)


Wow! ECB Vice-President reads The Riot Act

A James Alexander post
The ECB has just put out a full transcript of Thursday’s press conference in Malta. No wonder the market responded well, in real time, as it listened to this splendid take-down of a serial inflation hawk questioner:

Question: You talked about the inflation picture being less sanguine. Can you just explain a little bit more to the public why you think you have to fight so hard against low inflation? Especially for lower and middle-income people, spending less at the gas station, spending less at the grocery store is helping their purchasing power. You’ve said before, people buy more stuff when inflation is low. Why spend all this money on government bonds to fight something that a lot of people would say is a good thing for them and for their budgets?My second question is, is there a risk that the ECB will just kind of fall into a trap of QE without end? That you keep doing it, that you keep buying government bonds? We see it from the Federal Reserve’s experience, whether or not they start raising interest rates. Is there a danger that this stimulus keeps going on and on and the markets just come to expect it and that you won’t be able to get out?

Draghi: Let me respond first to your second question. The projections of recovery both in output and inflation are based, are conditional on the full implementation of the QE programme as announced in January and the full implementation of all the credit-easing measures that have been announced in the course of 2014. So we have to continue on that. On the other hand, they were also based on a set of technical assumptions concerning exchange rates, oil prices, external demand, growth in output and so on. And to the extent that these conditions change and possibly worsen, we will have to adjust our QE programme or in general our monetary policy stance. That’s the sense of our discussion about downside risks.

On why to fight low inflation: I’ve discussed this many times. Low inflation on one hand has a supporting power for real disposable income. On the other hand, it increases the real value of debt. As we’ve seen, low interest rates promote consumption and it’s essential for the recovery of growth and economic activity. That’s why we’re fighting. But to fight low inflation doesn’t mean that we want high inflation. We just want to be compliant with our mandate, which is to drive inflation back to below but close to 2% in the medium term. I understand the Vice-President may want to add something on the first question.

Constâncio: Yes, I would like to add something. Because it’s the second or third time that you asked that question, so let me add something. First, let me remind you that some years ago in the US there was a commission headed by an economist called Boskin to examine the measurement of inflation. And the conclusion of the Boskin Commission was that the way inflation is measured, in particular the type of indexes that are used, Laspeyres indexes, tend to exaggerate the measurement of inflation, in the case of the US by 1.5 percentage points. So, if the target would be zero, very likely we would be targeting a negative inflation rate. So there is a measurement problem with inflation which justifies that the target for inflation should be above zero.

Second point is the point that the President just reminded you about debt deflation, and when there is a situation of high indebtedness, when inflation is very low, the burden of servicing the debt increases and that is very detrimental to the economy. The third point is that with very low inflation or negative inflation, the real interest rate increases, and when the nominal rate cannot go below zero it means that the interest rate in real terms may be above the equilibrium real interest rates that would equal savings to investment at the level of full employment. So that’s another reason why negative inflation rates can be detrimental.

Then there are the deflation risks – real deflation, not what you implied in your question, because to have negative inflation for a few months is not a deflation situation. A deflation situation is a situation of prolonged period, meaning more than one year, of negative inflation. And in that case you have two phenomena: you have an increase in real wages, because there is rigidity in nominal wage growth to not go negative, so you will constrain supply, profits of firms, and you hit growth. And second, there is also then in such a situation a problem of consumers postponing their expenditure, if deflation lasts long enough; when we are talking about real deflation, not just a few months of negative inflation.

So there are a host of reasons why central banks fight deflation, why they spend money, as you implied – and by the way, just reminding you, there is not just one way of central banks to spend money to fight low inflation. We and other central banks purchase securities. The Swiss central bank purchases foreign exchange in order to defend the level of the exchange rate that they want, and they have a balance sheet which is higher than ours in relation to the respective GDP.”