The year-on-year change in CPI-IW,
with target zone superposed.
The best price index in India is the CPI-IW. `Headline inflation’ in India corresponds to the widely watched year-on-year change in the CPI-IW. The above graph shows us the experience of inflation in India from 1999 onwards. The informal target of policy makers is for inflation to lie between four and five per cent. These are the two blue lines on the graph.
In February 2006, inflation breached the upper bound of five per cent. It has never come back in range. Things are so bad that even the overall average inflation of this period (the red line) is now above the upper bound of five per cent. We don’t just occasionally fail to stay within the target range of inflation; we persistently fail to get there. This inflation crisis is a major failure in Indian macroeconomic policy, and is holding back India’s growth.
Many explanations like supply side factors or droughts are offered. They fail to persuade when we see this time-series experience. Did we have fewer droughts before 2006? Or that supply side factors were not a problem before 2006? Sustained failures on inflation are always rooted in monetary policy. In the long run, inflation is always and everywhere a monetary phenomenon.
There is some tiny progress in the latest months in this graph, but we cannot claim that the inflationary spiral has been broken. Policy rates are 7 and 8 per cent, and inflation is almost surely above 8 per cent, so the policy rate is likely to be negative when expressed in real terms.
|Smoothed month-on-month inflation
(annualised, based on seasonally adjusted CPI-IW)
The year-on-year change is a moving average of the latest 12 month-on-month changes. We obtain information about current conditions by looking at more recent month-on-month changes. This requires seasonal adjustment. The graph above shows the 3-month moving average (3mma) [source]. Just as the y-o-y change shows average inflation over the latest 12 months, this graph shows average inflation over the latest 3 months.
There is some progress in recent months. But at the same time, in the entire period, we see many such short periods of decline in inflation. Eyeballing the graph does not give us confidence that there has been a qualitative change in inflationary conditions. As an example, consider the previous dip in inflation. We could have become quite excited by the drop in this 3mma CPI-IW inflation down to 2%. But this was a temporary gain which was quickly reversed.
We should hence be cautious about reading too much in the recent decline in month-on-month CPI-IW inflation. While it is great news if inflationary pressures in the economy are declining, and it will be great news when the cycle of high inflationary expectations will be broken, there isn’t enough evidence as yet to announce that the mission — of achieving low and stable inflation — has been achieved.
So minting the [$1 trillion] coin would be undignified, but so what? At the same time, it would be economically harmless — and would both avoid catastrophic economic developments and help head off government by blackmail.
What we all hope, of course, is that the prospect of the coin or some equivalent strategy will simply take the debt ceiling off the table. But if not, mint the darn coin. [Emphasis added.]
Here’s how you can tell that Krugman is peddling nonsense: he doesn’t take his argument to its logical conclusion. If minting a $1 trillion coin is so harmless, why not mint a $16.4 trillion coin and pay off the entire federal debt in fell swoop? Why not mint $84 trillion coin and cover unfunded liabilities? Why not mint one platinum coin annually to cover each year’s budgetary deficit instead of going into debt? I mean, if $1 trillion dollar coins are so harmless, why not mint enough of them to completely solve the problem instead of minting one or two and just sort of half-assing it?
In many ways, Krugman’s argument is similar to the arguments made by proponents of the minimum wage. If minimum wage is so good and has no drawbacks, only benefits, why not mandate that minimum wage is $50 per hour? Or $100? Of course, that proponents of minimum wage don’t take their arguments this far suggests one of two things: either most proponents of minimum wage are unthinking idiots who simply parrot the talking points spouted off by people they deem intelligent, or proponents of minimum wage recognize the flaws inherent to their argument and are simply lying misrepresenting the reasons why they desire minimum wage.
The same, of course, is true for Krugman in his defense of minting the $1 trillion coin. If it is indeed so harmless, why not go ahead and mint all the money we need? To ask the question is to answer it. The reason why it’s so bad to mint $1 trillion coins is because they are inflationary, and would jack up ordinary citizens’ cost of living while enabling the wealthy and politically connected to profit at the middle class’s expense. Of course, this effect happens whether inflation occurs monetarily or by credit expansion, but if you admit that one type of inflation has negative consequences—and Krugman is implicitly admitting that monetary inflation is a bad thing, else he would pursue it to its logical end—then you must admit that any other form of inflation has the exact same type of negative consequences, even though the timing of their appearance may differ.
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Thus, it is apparent that Krugman is either a fool or a liar. Given that he constantly reverses himself about every major belief he’s ever had or any opinion he’s ever voiced, one might reasonably conclude that he’s a liar. Unfortunately, though, this would be a foolish conclusion, as the above-referenced post indicates that Krugman has no imagination, which would generally preclude him from being a liar. However, this does make him an idiot and, judging by the scope of his influence, a rather useful idiot at that. And since his devotees and followers are apparently not smart enough to see through him, it would appear that Krugman is nothing more than a blind leader of the blind. Too bad his leadership will drag blind and sighted alike down into a pit.
What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.—Adam Smith, The Wealth of Nations
Here’s some nonsense on stilts:
Richard Feynman was once asked what he would pass on if the whole edifice of modern scientific knowledge had been lost, and all he could give to posterity was a single sentence. What axiom would convey the maximum amount of scientific information in the fewest possible words? His candidate was ‘all things are made of atoms.’ In a similar spirit, if the whole ramshackle structure of contemporary macroeconomics vanished into thin air and the field had to be reconstructed from scratch, the sentence which packs as much of the discipline into the fewest possible words might be ‘governments are not households.’ The principles of running an economy are in many crucial respects different from those of keeping your own finances in order. The example of the hypothetical tenner is part of the reason why: governments need to keep money moving around. For a household, to deposit the money in a savings account might well be the most sensible course. Governments, on the other hand, need that velocity – they need GDP. In order to get it, they sometimes have to borrow that first tenner, which they can do in a range of ways not available to ordinary citizens (who can’t, for example, just print the money). Once that first tenner is spent, the government’s hope is that it will continue to be spent many more times. [Emphasis added.]
The fundamental fallacy of Keynesian economic analysis is that it is predicated on the notion that the rules of fiscal common sense do not apply to the government. Contra Smith, the Keynesians assume that the government need not live within its means, and that it focus on attaining certain target numbers for highly abstract, generally unrealistic abstract notions of economic productivity.
The shallowness of the Keynesian worldview is apparent in many ways:
First, the Keynesian emphasis on monetary velocity is extraordinarily shallow. It is assumed that government spending increases monetary velocity by spreading money throughout the economy. Even if this assertion is true, what is often neglected is how, at least in regards to taxation and borrowing, the only way the government spreads money throughout the economy is by first taking money from the economy (of course, this is not technically the case with inflation, but since governments do not fund their budgetary expenditures solely by inflation, one must necessarily conclude that governments at least partially fund their expenses by either debt, taxes, or some combination of the two, which requires the further conclusion that, at some point, money must first be taken from the economy to later be put in to the economy). Another observation that is often neglected is that money that is not spent by the government (i.e. privately-spent money) also has some degree of velocity as well. Money does not generally sit stagnant, except among those who wish to store currency under their mattress or such-like, and so money that is spent my non-government market actors has the same velocity as money spent by government market actors, assuming that in both cases, no currency is ever removed from circulation. Thus, the assertion that government policy must needs be different from household economic policy is fallacious because the justification for the assertion that government policy is special is itself specious.
Second, Keynesians neglect to understand that money is not itself production. As was noted in the excerpted piece, households cannot print money whereas the government can. Unfortunately, the mere printing of money does not itself magically cause more products to appear in the economy. Now, inflation can draw demand forward, but only to a limited extent, because ultimately shifting production forward runs into the very serious problem of running out of demand, production materials, or both. One of the reasons why the housing market collapsed in 2008 was due in part to demand exhausting itself. To put it simply, people stopped wanting houses at the prices provided. Sure, the housing supply is at its highest, but now the demand for houses has declined, which is why housing prices remain relatively depressed. Quite simply, demand is not infinite—neither is production—which is why inflation will always fail to permanently increase production. There are limits to everything, and inflating the currency does not change that very simple fact.
Third, Keynesians fail to realize the scalability of hierarchy. The reason why the government is often compared to a household is because the household is a useful metaphor for understanding hierarchy. Every household has a head, every household has expenses, every household has members, and so on. A functioning household is one where everyone contributes to its upkeep, and one that lives within its means, and so on. Of course, the metaphor is not exactly perfect, but it is generally useful, and so it serves as a useful point of comparison, and provides people with simple heuristics for evaluating, say, the long-term reliability and stability of any hierarchical organization, such as a business, charity, church, or government. If a functioning family is one that minimizes deadweight and free riders through the proper division of labor, and manages to avoid fiscal problems by living within its means, then it is generally reasonable to expect that a state or business that minimizes deadweight and free riders, and also lives within its means, well do reasonably well and be expected to have a lot of stability.
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And so, while governments are not households, the difference is more along the lines of scale than quality. Governments are similar enough in form to households that the microeconomic analysis used to evaluate the fiscal health and stability of a household should be a useful heuristic for evaluating the fiscal health and stability of a government. Furthermore, the form of government is not so radically different from the form of households that it justifies a radically different set of analysis and evaluation.
In terms of forward guidance I think the Fed Chairman’s speech provided little direction, but Friday’s precious metal price action into the close and the various sell side notes that I have seen suggest that this, at least initially, is too bearish a conclusion. The following excerpt from the speech, in particular, was taken as clear evidence of more and aggressive easing in the pipeline.
As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.
Great emphasis has been attached to the chairman’s use of the word “grave” as a clear tell-tell sign of more easing to come. I find this quite interesting since it is one of the first instances of such “new speak” interpretation of the Fed’s statements akin to the good old days of Trichet and the utterance of (strong) vigilance. Needless to say, next week’s jobs market report has suddenly been propelled to a key market event and every single US data point will now be watched with caution. On that note, the next ISM reading as well as consumption figures will be equally important to watch.
I think Tim Duy’s interpretation is the right one then (hat tip Calculated Risk) with my emphasis.
On net, Bernanke’s speech leads me to believe the odds of additional easing at the next FOMC meeting are somewhat higher (and above 50%) than I had previously believed. His defense of nontraditional action to date and focus on unemployment points in that direction. This is the bandwagon the financial press will jump on. Still, the backward looking nature of the speech and the obvious concern that the Fed has limited ability to offset the factors currently holding back more rapid improvement in labor markets, however, leave me wary that Bernanke remains hesitant to take additional action at this juncture. This suggests to me that additional easing is not a no-brainer, but perhaps that is just my internal bias talking.
On balance the main point for me is that the recent change in economic data clearly merits policy change on the basis of the Fed’s reaction function.
The unemployment rate in the US is sticky and the Fed has been persistently concerned about this which is indeed a strong signal to the policy bias especially as inflation expectations are well behaved. Inflation has come down significantly in the US running at 1.4% YoY and the Taylor Rule rate is now declining (though still in level terms way above 0 but that has more to do with the inputs than anything else). We have had two consecutive months of sub-50 ISM readings and consumption growth appears to be rolling over. My interpretation of the forward looking indicators is that they look better than the consensus suggests, but the Fed lives in the here and now and will act accordingly.
Another interesting point here is that despite the visible and strong recovery in the growth rates of US housing market indicators, Bernanke mentions the level of the housing market and not the change which suggest that the despite a good run of data with respect to the change in housing market indicators the level is still seen as depressed.
The bottom line is that some form of easing is coming but what I find highly uncertain is the timing and aggressiveness of such easing. The August minutes had already stipulated potential moves for the Fed in the form of an extension of the low interest rate commitment, lowering interest rates on excess reserves as well as an extension of Operation Twist or outright asset purchases (probably through MBS securities). But which of these measures will be employed and in what order?
One thing for example which I find very interesting is the glaring gap between Bernanke’s discussion of the effectiveness of unconventional monetary policy and its effect on the real economy (i.e. labour market). In that sense, it seems quite clear to me that quantitative easing can have a strong effect in the context of imminent deflation risks and strong downward pressures in asset prices. In such an environment the portfolio effect and, indeed, outright price effect from aggressive central bank action can be very effective.
However, whether quantitative easing can be effective in countering a structural and sticky unemployment rate (and indeed a structurally declining labour force participation rate) seems much more uncertain to me. Obviously, this goes back to the point that the Fed is the wrong tool for the job at hand, but it also raises the issue of what kind of easing the Fed is planning here.
Of the measures mentioned above one of the only things which would have an effect on the labour market (from a theoretical point of view) is an extension of the low interest rate commitment. This would be a signal to companies that their cost of capital would remain low and incentivise investment and thus, in theory, additional labour input. But such a process is slow and arguably a weak remedy in the context of structural labour market issues.
More generally, we must ask ourselves whether an extension of the low interest rate commitment be enough for the market Clearly not and in any case, an extension much beyond Bernanke’s term would be meaningless as the looming presidential election has created uncertainty as to how strong this commitment is, if for example Bernanke is faced with a Republican president.
What about an extension of Operation Twist then? If this is combined with an expansion of the balance sheet through purchases of MBS I think this could be an effective medicine (although in general I find it hard to see how it could meaningfully affect the labour market). However, the theoretical argument here is fair. By influencing long rates the Fed is likely to stand the greatest chance of supporting the ongoing recovery in the housing market and thus, by derivative, the US economy.
Ultimately, I see two sources of uncertainty here. Firstly, it is not clear to me that the US economy is heading into a hole in the second half of 2012 to an extent that would allow very strong Fed action. Secondly, while the Fed clearly seems committed and perhaps even pre-committed to more easing the nature of such easing and its scope is still very uncertain to me. The upside risk attached to much stronger easing is clearly there (not least because we also have the ECB coming in with policy measures soon), but the spectre of grave disappointment has not been completely extinguished in my view.
Carlos Vegh and Guillermo Vuletin have an article Overcoming the fear of free falling: Monetary policy graduation in emerging markets, in `The role of Central Banks in financial stability: How has it changed?’, Federal Reserve Bank of Chicago, 2012. They have drawn on this to write a column on voxEU titled Graduation from monetary policy procyclicality.
In an ideal world, monetary policy should stabilise business cycle conditions. When times are good, the central bank should raise rates, thus reining in a boom. When times are bad, the central bank should cut rates. As an example of how this might not arise, recall that on 16 Jan 1998, in what was arguably a pretty bad time for the Indian economy, RBI raised rates by 200 basis points. Economists have a delicate and damning phrase for monetary policy that fuels a boom and exacerbates a bust: it is termed “procyclical” monetary policy.
Vegh and Vuletin construct a measure of monetary policy procyclicality : the correlation between the cyclical component of the short-term interest rate and GDP. This is computed for a large number of countries for the 1960-1999 period. Here is the result:
The bars in black are advanced economies and the bars in yellow are developing countries. There is a striking pattern: All the countries with a negative correlations — i.e. interest rates are raised in bad times — are developing countries. This is a striking demonstration of the faulty monetary policy frameworks that are found in developing countries: Every country which suffers from procyclicality in this period is a developing country.
India fares pretty badly in this list: Starting from the bottom, we have Uruguay (Rank 1 from the bottom), Chile, Mexico, Venezuela, Gambia, and then India (Rank 6 from the bottom).
Things got better after 1999. Vegh and Vuletin repeat the analysis for 2000-2009 and find that India did much better. The correlation swung to a positive value. India moved up, to the middle of the distribution. You could find one developed country — Japan — which did worse than India in this period.
In my assessment, there are two elements to this story: (a) Is there room to manoeuvre for monetary policy and (b) Is the monetary policy process properly constructed? The first is largely a question about exchange rate flexibility. If the central bank pursues exchange rate goals, this uses up the instrument of monetary policy. The second is about how monetary policy is conducted.
The figure above shows how India’s exchange rate regime evolved towards flexibility. The structural break dates (23 May 2003 and 23 March 2007) are computed using the methodology of Zeileis, Shah, Patnaik, 2010. For 4.74 years, we had INR/USD volatility of 2.31% per year. On 23 May 2003, the contradictions of this regime became unbearable, and the exchange rate regime changed: volatility jumped up to 3.93% per year: a rough doubling. On 23 March 2007, the contradictions of this regime became unbearable, and the exchange rate regime changed: volatility jumped up to 9.05% per year: another rough doubling.
From 23 March 2007 onwards, we have finished 5.43 years — the longest single period out of the three shown here — in this zone of high exchange rate flexibility. On the subject of the Indian exchange rate regime, you may like to read this post.
I believe these changes have substantially, though not completely, freed monetary policy of the burden of pursuing exchange rate goals. This is one half of the story of Indian monetary policy reform. The second half is that of setting up a sound monetary policy process. Now that you have a lever of setting the short rate in your hands, what would you like to do with it? The first stage is a relatively easy and nihilistic one: it requires getting out of trading in the currency market. By 23 March 2007, this was completed. The second stage is harder: it requires institution building. We have not yet begun on this phase.
This increase in exchange rate flexibility is consistent with the Vegh & Vuletin calculation which shows that the procyclicality of Indian monetary policy was reduced in the 2000-2009 period.
In this second part of my take on liquidity traps and missing collateral in global financial markets I would like to respond to some of the talking points set out by FT Alphaville’s Cardiff Garcia (again in response to the much talked about piece by Credit Suisse). Even though blog posts tend to age quickly, recent central bank action suggests that this topic is relevant as ever. Specifically, negative readings across a wide range of short term interest rates in Europe has raised the question not only what the effect of such abnormal interest rates are, but also whether such market prices are sending a signal to central banks that they ought to act much more aggressively.
Following up on FT Alphaville’s coverage, one question that is intereting to consider is the following.
2) The movement of M1 and M2 in recent years seems not to have told us anything helpful about inflationary prospects. Should the Fed finally ditch them and start concentrating on another measure, perhaps one that incorporates some of the items above? Or bring back M3 (which at least included such shadow banking elements as institutional money market funds and repo)?
Initially, I should point out that I disagree with the premise of this statement. I think that there are still important effects from fluctuations in M1 and M2. Specifically, I believe that while being in structural process of deleveraging may certainly mitigate the inflationary pressures from central banks generating excess reserves (and liquidity) in the system, it is dangerous to assume that expanding base money does not have a real economic effect.
Still, this raises a very important point. The traditional monetary policy transmission mechanism is broken and as a result the size and expansion of base money aggregates have little bearing on credit creation in the real economy. The key question is the whether central banks should extend their control of the money supply further down the credit foodchain (i.e. closer to the end user/beneficiary of the credit)? And if you answer to this is yes, how do central banks do this most effectively.
Firstly, it is important to emphasize that, in many ways, they already have. Initial responses to the crisis in the US (and QE conducted by the BOJ) have been engaged in strategic and direct purchases of several kinds of marketable debt and equity securities, but central banks generally do not like to do that. Historically, the Bank of Japan has been most direct trying to influence market prices through the purchase of corporate bonds and exchange traded funds.
Now however, they are at it again of course. The BOE recently suggested open market operations with strings attached in the form of banks only getting access if they added to their balance sheet and in Europe, the ECB has cut its deposit rate to 0% and may even push it into negative this week.
The problem however is that it is very complicated for the central bank to do this effectively and a central bank will always be adverse to taking direct market risk (even if e.g. the allegedly most conservative central banks of them all, the ECB, has taken substantial market risks through the collateralised LTROs). In addition, targeting M3, M4 etc would mean an even more direct involvement in the credit process by which the central bank potentially acted as direct underwriter for pools of securitised loans of all shapes and sizes. This adds illiquidity to the balance sheet and exposes the central bank to significant mark to market risks which eventually may have to be covered by printing money. Such an implicit backstop to securities that the central bank may agree to buy creates significant moral hazard.
But it is certainly a fair question to ask whether central banks have been using the wrong tools as e.g. Izabella suggests in her coverage of the concept of the negative money multiplier.
Traditionally, a central bank will respond to a liquidity trap by supplying (potentially) unlimited levels of excess reserves to the banking system and thereby expanding the potential credit supply in the economy. The counterbalancing asset side entry here will usually be short term government bonds but also, if need be, longer term government securities. In this sense, expanding the balance sheet at the zero bound is essentially a fiscal expansion. However, as Izabella suggests, this may actually be counterproductive in an economy suffering from a structural lack of liquid and investment grade collateral.
The central bank will then actually exacerbate the lack of such assets by doing textbook QE which involves creating bank reserves in exchange for short term government securities. Demand for government securities (collateral), the story goes, would be more than enough to keep yields down and allow the government to conduct fiscal expansion at the zero bound. Still though, one would have to assume a complete lack of any market response from bond vigilantes ad infinity for this to work. I am not sure that I accept this.
So where does a broader monetary aggregate target come in? Well, from the account above the central bank could do two things.
1. Act on the liability side by aggressively cutting excess reserve requirement and enforcing a penalising rate on excess reserves. This would be a direct way (through the liability side) to attempt to jump start the money multiplier and force up velocity, but it will require the central bank to be indifferent between currency and reserves on its liability side (see below).
2. Avoid crowding out demand for safe collateral by booking anything but government securities on the asset side.
On the second point, I would note that this assumes a complete lack of bond vigilantes of any kind and thus no disciplinary market action in the context of financial repression. In the context of structurally overlevered governments across the developed world, I am not sure that this is a reasonable assumption over time. What would Gilts be trading at if the BOE was not holding 30% of the total stock outstanding and how would this have affected the government’s ability to borrow. In addition, taking direct market risk by e.g. purchasing pre-assigned tranches of securitised loans (to beef up broader monetary aggregates) would certainly not work if the underlying problem was one of a structural lack of solvent credit demand. I have argued for example that this is a major part of the problem both in the context of private and public borrowers.
On the first point, events have caught up with theorizing here with the ECB the first major central bank now imposing zero interest rates on its deposit rate (the Riksbank did this in 2008/09 too) and there is a serious probability that the rate may be moved into negative.
I have been lucky to have the opportunity to discuss this with the financial columnist and investor Sean Corrigan who makes the following crucial point.
People are treating this [negative deposit rates] in a completely erroneous fashion. Even negative rates cannot force the banks to lend out the deposits they hold at the central bank; this is to assume they – as a whole – have choice in the matter: they do not. If the central bank creates what is called ‘outside’ money, by buying securities, etc, the corresponding reserves cannot be voluntarily removed: they have to be held as CB liabs/commercial bank assets on the central bank balance sheet.
What such a move could possibly do is to make it more imperative for banks to leverage up by creating new, extra loans (To whom? On what terms?) and to accept new customer depo’s (given that they hold a huge surfeit of reserves on their balance sheets with which to backstop these) and so compensate for the negative rate drain by the volume effect. I take this as dubious, however, given normal credit concerns and, in some cases, binding capital constraints.
Sean then goes on to make the final point that if the central imposes negative interest rate on reserves while at the same time wanting to maintain the size of its balance sheet, it would have to generate currency as reserves were withdrawn.
I think a couple of points are important to note at the offset.
The situation at the ECB and the Fed/BOE is different. More specifically, reserves created in the Fed/BOE is, as Sean points out, “outside money” and is thus what we could call “push QE”. The central bank has a policy objective to affect government bond yields and the only way it can do this is to generate reserves in the system. At the ECB and while the central bank may certainly have intended to affect government bond yields in the periphery this was “pull QE”; i.e. reserves were pulled from the ECB based on banks’ demand for such liquidity and, presumably, their need to shed themselves for collateral.
One of the main objectives as stated by the ECB was to provide liquidity to banks who could not otherwise refinance themselves in the short term money market. I think it is critical here to note that while the Fed and the BOE have always put forward specific targets for their QE operations, the ECB has not! If the banks had put up 2 trillion worth of collateral in the LTRO and asked for 2 trillion in liquidity they would have gotten it!
Anyway, to the point that banks are forced to hold these reserves (as a counterpart to the size of the balance sheet), in the perfect world it is not certain that this is the case. Let us assume a central bank conducts QE through the expansion of reserves with two objectives in mind.
1) To affect government bond yields (perhaps to allow the sovereign to run higher cyclical deficits for a period to boost aggregate demand).
2) To improve risk sentiment and risk taking in the economy through higher credit creation by commercial banks.
One immediate effect of such a policy in an environment where the monetary policy transmission is broken is that while government bond yields may go to zero it has no effect on lending to the real economy.
What can the central bank do? Not a whole lot as it were.
The central bank created the reserves in the first place and cannot easily induce banks to lend these out without compromising its asset side. In other words, it is difficult to pursue both objectives directly at the same time.
Specifically, if banks started to draw on its excess reserves to lend out to the real economy the central bank would need to one of two things. Maintain the size of its balance sheet constant by creating currency or reducing its holdings of securities on the asset side (government bonds). The latter is difficult to do especially if the central bank has been very aggressive in its sovereing bond purchases. Still, theoretically the central bank will be informed by the notion that the economic multiplier of commercial banks lending out to the real economy is higher than central bank financed government spending. It is not inconceivable that this is what central banks may start trying to do. We are seeing this by the BOE now giving preferential treatment to banks lending out and the ECB with its latest move.
Finally, negative rates could, as noted above, force banks to lever up to make money and it is not inconceivable that this could work in some countries where the banking system sounder or where some banks may have the buffer to do so. The main risk for the central bank is that this reduction in its balance sheet simply forces reserves into government bonds anyway as commercial banks see no other choice. The structural features of financial repression also will point towards this.
Here of course, the practicality becomes an issue. The BOE now holds 30% of all Gilts outstanding and if it started to sell these off as banks started to lend to the real economy interest rates across all maturities and lending products could rise very fast and in complete disconnection with underlying fundamentals. Currently, the position for central banks in this matter is complicated because as we have seen liabilities tend to migrate to the government balance sheet and as such the central bank needs to work very hard to keep borrowing costs in check for the sovereign.
Now, as for creating physical currency it is not clear to me that central banks would want to do this but the notes that I have read so far simply assume that it is given that commercial banks would be able to shift reserves into currency. This then brings up a whole hosts of other issues regarding the existence of cash at the zero lower bound. Citi’s chief economist Wilhelm Buiter for example has suggested that physical currency be retired altogether and that electronic money be used instead. Such electronic money could of course be subject to exactly the level of negative interest rates the central bank deemed fit or perhaps even be subject to a fixed maturity.
Negative deposit rates have another effect in so far as they induce carry trades in with the negative currency yielder as funder and thus pushes the currency (euro) down. Such real effective depreciation could be a powerful tool for the ECB and for once it is a first mover here.
Ultimately, negative deposit rates are no panacea and certainly in the context of central bank creating the excess reserves in the first place, but the effect of FX markets as well as the potential for its effect on the quantity of currency in the system should be keenly watched.
I will now give you more warnings about the economy.
The noose is tightening on your organization, vast amounts of money printing are now required to keep your manipulated economy afloat. It will ultimately result in huge price inflation, or, if you stop printing, another massive economic crash will occur. There is no other way out.
Again, thank you for inviting me. You have prepared food, so I will not be rude, I will stay and eat.
Let’s have one good meal here. Let’s make it a feast. Then I ask you, I plead with you, I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths and four-legged rats.
And let the people say amen.
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The most important measure of inflation in India is the year-on-year change of the CPI-IW index. This time series, for 120 months, is shown above. From 2006 onwards, India slipped into a new phase of macroeconomic instability, where inflation has strayed far outside the informal target zone of inflation at four-to-five per cent.
Has inflation subsided?
In recent months, there has been a surge of optimism that the inflation crisis is coming to an end. However, a careful look at the seasonally adjusted data reveals that there is cause for concern.
In September 2011, point-on-point seasonally adjusted (annualised) inflation was at 17.49 per cent. The year-on-year inflation was running at 10.06%.
We then had three good months: October, November and December, where the point-on-point seasonally adjusted (annualised) inflation dropped to 2.01, 3.11 and -2.14 per cent. This yielded a sharp decline in the year-on-year inflation to 6.49 per cent in December 2011 and further to 5.32 per cent in January 2012.
But after that, things haven’t gone well. Point-on-point seasonally adjusted inflation, which is the thing to watch for in understanding what is happening every month, is back up to 8.22 per cent in January 2012 and 12.01 per cent in February 2012. Year-on-year inflation is back up to 7.57 per cent in February 2012.
A casual examination of the key graph (shown above) shows that the worst of double digit inflation seems to have ended. But we are not inside the target zone of 4 to 5 per cent, and neither are we likely to achieve this in the rest of this year. It would be unwise to declare victory over the inflation crisis, with this information set in hand.
Looking forward, there are two main problems worth worrying about. The first is the expectations of households. At the heart of India’s inflation spiral is the problem that the man in the street has lost confidence that inflation will stay in the four-to-five per cent target zone. Survey evidence about household expectations has shown double digit values. This generates persistence of inflation; idiosyncratic shocks tend to not quickly die away. The mistrust of households is rooted in the lack of commitment to low and stable inflation at RBI, and this problem is not going to go away quickly. Despite all the problems faced in fighting inflation, RBI continues to communicate, through speeches and official documents, its lack of focus upon inflation.
The second problem is that of the exchange rate. Exchange rate depreciation feeds into tradeables inflation. With a large current account deficit, with policy impediments putting a cloud on capital inflows, rupee depreciation has taken place and may continue to take place. This would be inflationary. Indeed, if RBI chooses to cut rates on the 17th, there will be further weakening of the rupee (since the interest rate differential will go down thus deterring debt flows), which will further exacerbate tradeables inflation.
The media and financial commentators treat it as a given that on 17th, RBI will cut rates. However, the outlook on inflation is worrisome. India’s inflation crisis, which began in 2006, has not ended. Year-on-year CPI-IW inflation has not yet got into the target zone of four-to-five per cent, nor is this likely to happen anytime soon.
Our thinking on this needs to factor in the general elections, which are looming at the horizon in May 2014. Given the salience of inflation in India for the poor, the ruling UPA coalition is likely to be quite concerned about getting inflation back to the informal target zone of four-to-five per cent, well ahead of elections. This also suggests that the time for hawkish monetary policy is now, so as to get inflation under control by mid-2013, well in time for elections in mid-2014.
A historical perspective
Inflation went out of control in 2006/2007 because RBI’s pursuit of the exchange rate peg required very low interest rates at a time when the domestic economy was booming. (The capital controls that were then prevalent failed to deliver monetary policy autonomy; the only way to get towards exchange rate goals was through distortions of monetary policy). Given the lack of anchoring of household expectations, that inflation crisis has not yet gone away. Today, RBI is substantially finished with exchange rate pegging; we are mostly a floating exchange rate. In the future, inflationary expectations will not get unhinged owing to a pursuit of exchange rate policy by RBI. But while a pegged exchange rate pins down monetary policy, a floating exchange rate does not define monetary policy. RBI has yet to articulate what it wants to do with the lever of monetary policy. The first task for the lever of monetary policy should be the conquest of the inflation that is in our midst, owing to the monetary policy stance of 2006/2007.
In the early 1990s, unsterilised intervention in the pursuit of Rs.31.37 a dollar gave an inappropriate stance of monetary policy, which kicked off an inflation. Dr. Rangarajan wrestled it to the ground, even though the monetary policy transmission was weak then. In 2006, we ignited another inflation, once again owing to exceedingly low policy rates in the pursuit of exchange rate policy. Dr. Subbarao’s challenge lies in wrestling this to the ground. His job is easier when compared with what Dr. Rangarajan faced, thanks to the progress which has taken place on financial reforms and capital account decontrol.
University of California (Berkeley) economist Brad DeLong took my late-in-life education on economic issues to a new level. I’ve plenty more to learn, of course, but I enjoyed his discussion.
Here’s a snippet from his article in the Seeking Alpha web site:
In such a setup, the conclusion of Mankiw and Weinzerl that monetary policy has the exclusive role to play is straightforward: One stabilization policy tool–monetary policy–is non-distortionary. The other stabilization policy tool–fiscal policy–is distortionary. If monetary policy can do the job, there is then no need for fiscal policy. And if you do resort to fiscal policy, use the fiscal policy that is most effective at getting people to spend money on the things they were at the tipping point of buying anyway–use the investment tax credit rather than direct government purchases or tax cuts which might well not be spent. End of argument.
Well, actually it wasn’t the end of his argument. He goes on to assert that well-designed fiscal policy is as important and powerful as monetary policy during unusual times like we are experiencing right now.
Prof. DeLong’s discussion is a bit tough going for Principles students. Let me see if I can translate.
In normal times, when short term interest rates are noticeably above zero, monetary policy is often the best tool for government to use to correct the economy. In class we talk about correcting for either a recessionary gap or an inflationary gap. DeLong agrees with Mankiw and Weinzerl that monetary policy is sufficient and does less to distort the marketplace. What does he mean by distortion? In a perfect economic world individuals make decisions on whether to save or spend and if they spend, on what kind of things. When government decides to spend additional money (i.e. uses fiscal policy) then that means it must raise taxes to pay for that spending. Those taxes change, or distort the decisions that rational individuals would make. This moves us away from our theoretically perfect model of allocating resources.
Potential vs. Actual (Real) GDP
As a side note, much government spending is valued by the public and helps correct problems in the market or helps society meet other goals – such as caring for the disadvantaged. So spending and taxes aren’t necessarily bad for those kinds of goals, but spending to stimulate an economy does potentially distort how we would use our funds. In my classes I also point out that fiscal policy is usually a pretty blunt instrument, wielded by not very expert politicians. There are all sorts of time delays, political compromises, and imperfect implementation. So, monetary policy is often the best way to solve short term, mild-to-moderate problems in the economy.
Back to DeLong. He agrees with Mankiw and Weinzerl, but goes on to argue that monetary policy has a hard time working during a liquidity trap – when short term interest rates, and the interest rate target set by the Federal Reserve are so close to zero that pumping more money into the economy just gives it bloat, rather than relief. In these tough times, monetary policy can possibly work if the Fed promises to keep interest rates lower and inflation higher in the future. However, DeLong points out that future Fed committees are not bound by the promises of today’s leaders. If investors think there will be a change of heart, and interest rates will rise in order to force inflation lower, then those investors will delay their spending plans.
On the other hand DeLong argues that an aggressive fiscal policy – i.e. more spending now, backed by printing more money, can have a strong impact, and the government will be less likely to back down from its policies in the future.
DeLong also argues that monetary policy can introduce distortion – by changing the relative amount we invest in projects with short term benefits versus those with long term benefits.
Here’s the last summation:
It is important to get the overall level of production right–to match total spending to potential output. It is also presumably important to direct spending toward high-value commodities. It is important to get the balance between private and public purchases right. And it is important to get the balance between short-duration and long-duration assets right.
Thus fiscal and monetary policy are likely to both have proper stabilization policy roles to play.
Chinese Yuan and U.S. Dollars
The Wall Street Journal reports that China is decreasing its holdings of U.S. dollars
Fresh data suggest China is moderating its appetite for investing in U.S. securities, a trend that could mean lower flows of cheap capital from Beijing and a possible rise in borrowing costs across the American economy. An analysis of U.S. Treasury data suggests China, with $3.2 trillion in foreign-exchange reserves, has begun to rapidly diversify its currencies portfolio. “It clearly indicates China’s intention not to put all its eggs in one basket,” said Lu Feng, director of Peking University’s China Macroeconomic Research Center. China still remains a strong buyer of U.S. debt. China’s holdings of U.S. securities rose 7% to $1.73 trillion as of June 30, an increase of $115 billion from 12 months earlier, Treasury data show.
This is a good time, then, to review how our balance of payments work here in the U.S. and to explore China’s role in our economy.
Balance of Payments
With some detailed records and some good guessing our government estimates how much money is flowing in and out of the country each quarter. You can read these reports, from the Bureau of Economic Analysis here. The most widely publicized of these is the trade deficit which measures the inflow of funds (when we sell/export goods and services to overseas customers) versus the outflow of funds (when we pay to import goods and services.) Most everyone knows that the U.S. chronically runs a trade deficit. A somewhat broader definition is the current account balance, which includes the trade deficit but also adds in unilateral transfers (think of grants and foreign aid) and interest income on investments. The current account balance (inflows minus outflows) is also negative.
If we keep running these deficits, shouldn’t we be running out of money? That’s a good question but fortunately there is another flow of funds into the U.S. that largely offsets our current account deficit. These are capital funds (think of loans or purchases of real assets) that outside investors, including foreign countries make. When an investor in Switzerland, or an insurance company in Singapore, or the government of China buys a U.S. treasury bond, that represents a flow of funds into the United States. These bond purchases also put some upward pressure on the value of the U.S. dollar, since those purchases require dollars to be completed.
To put it simply and approximately, our appetite for imported goods and services is paid for by foreign investments in our country. In theory this can continue on for a long time.
Instead of a trade deficit, China has a trade surplus – exporting more goods and services than it imports. Though this surplus has been shrinking in recent years, the accumulated surpluses generated added to the stock of funds held by China. It is prudent for China to hold those excess funds in different currencies – kind of like a stock portfolio. It has also been prudent for China to invest their funds in US bonds, which are still considered the safest investments in the global economy.
China also purchases assets denominated in dollars in order to influence the relative exchange value of their currency, the yuan (AKA renminbi) against the dollar. They have manipulated the value of their currency in order to keep the value of the yuan relatively low against the dollar. This preserves the low cost competitiveness of Chinese goods in the American market. When China buys dollar assets, like US bonds, that puts upward pressure on the dollar and downward pressure on the yuan. They have been criticized for this currency manipulation, which is relatively rare in a global climate of floating exchange rates.
When Things Begin to Change
This takes us back to the WSJ article. Though China’s holdings of US bonds continue to grow, some analysts see a new trend that will diversify China’s holdings away from the dollar. What might that mean for us?
If China and other foreign investors slowly begin to shift their investments away from the U.S. and towards other attractive economies, the capital inflow that pays for our trade deficit shrinks. The value of the U.S. dollar on currency exchanges might slide more than it is doing now. The impact of a weaker U.S. dollar is that our exports seem cheaper to foreign buyers and they will go up, while foreign goods will appear more expensive to American buyers and imports will go down. Those two forces will shrink our trade deficit. In addition, if capital flows into the U.S. slow down we will see upward pressure on interest rates – particularly on long term loans such as mortgages.
In many ways a slow, purposeful shift in capital funds might be healthy in the long run for the U.S. They can reduce the trade deficit and restore a sort of balance to our position in the global economy. If that shift happens suddenly, however, it would wreak havoc with our economy and almost certainly drive us into a deep recession.
Could China trigger a huge shift in capital flows? In theory. yes. A pragmatic policy on their part would argue against that kind of radical action. They, after all, have a lot of their “savings” in U.S. bonds and it is not in their interest to drive down the value of those bonds. And radical action would cause swift changes in the value of their own currency against the dollar, which in turn would decimate their sales of goods to the U.S. Still, a politically motivated action, similar to declaring war, could prompt them to harm the U.S. economy, even at a significant cost to their own domestic economy. I don’t pretend to have a good crystal ball in this arena, but it is tough to imagine the current leadership would take those radical actions.