Do inflation targets help?

During the 1990s, inflation targeting emerged as the dominant monetary policy framework. With inflation subsequently declining and remaining amazingly stable, the majority of economists heralded this framework as a phenomenal success. Even after the oil price shocks of the mid-2000s, which pushed headline inflation rates higher, there were few signs of any ‘second-round’ effects on wages and core inflation. Proponents of these policies claimed inflation targets had helped anchor inflation expectations and, in doing so, increased the efficacy of demand management through monetary policy.

Still, others doubted the contribution policymakers were really making. In particular, some economists pointed out that even those central banks that didn’t have formal inflation targets – notably the Federal Reserve – had also enjoyed a lengthy period of low and stable inflation. This was because the OECD economies had benefitted from several favourable supply-side shocks – notably globalization – that kept inflation down and compressed overall macroeconomic volatility. Some critics also worried that formal inflation targets might reduce central banks’ ability to react to unfavourable demand shocks. This criticism was most forceful in the early stages of the 2007-09 financial crisis, when the inflation-targeting European central banks seemed to react more slowly to the subsequent downturn than the Federal Reserve. (The ECB even raised rates at first.)

In a paper earlier this week, Kuttner and Posen assess these criticisms by comparing the performance of the Bank of England to the Fed. They find that while there is some evidence inflation expectations are stickier in the UK – suggesting a positive effect from the explicit inflation target - the impact is not especially large. This offers some support then, for those FOMC members who resisted pressure to announce a explicit inflation target. Still, perhaps as significant, Kuttner and Posen also find little evidence that the inflation target reduced the BoE’s policy flexibility relative to the Federal Reserve.

Overall, though, these results are unsurprising – for two reasons. First, though the Fed hasn’t had a formal inflation target over the past two decades, it has had an informal target. Investors and market commentators have known what level of inflation the Fed prefers and even which measure of inflation it likes to base this on (1-2% on the core PCE deflator). Second, the MPC targets a forecast for  inflation, not the current level of inflation. Because current and expected levels of demand have a critical influence on these forecasts, it seems obvious the MPC should be just as responsive to growth developments as is the Federal Reserve. In short, the inflation forecast provides the MPC with significant flexibility.

Finally, it is important to highlight a major political-economy difference between the Fed and the BoE, which this paper largely misses. In the mid-1990s, the Fed had a long history of price stability and had built up considerable credibly in financial markets. In contrast, the UK adopted an inflation target only after the UK had calamitously dropped out of the ERM in 1992. Its monetary policy framework was in tatters. So while the Fed didn’t need an explicit inflation target to establish its credibly, the Bank of England certainly did.

End-zone

How will the euro-area crisis end? Note, Macro Maestro is asking what will happen, not what should happen. Every economist in Europe has a view on the former – expressing those views daily in the financial press – but it’s pretty clear European policymakers aren’t listening.

MM can see several possible outcomes:

1.       No countries default and aid/austerity mix is enough (i.e. the current policy)

2.       One/several countries default and stay within EMU

3.       One/several countries default and leave EMU

4.       Core countries get fed up with Greece etc and leave to start new currency.

5.       No defaults and full fiscal integration (Eurobond)

The answer certainly isn’t easy, but option 2 seems the most likely. 

It is pretty clear austerity alone wont be enough for Greece, particularly with the economy entering a death spiral that will further undermine its public finances. MM has been amazed with Greek efforts so far, but can’t see how these can continue without some kind of social implosion. In this context, eventual default looks certain – indeed markets are already priced for it.

The question then becomes, once default has occurred, will the Greeks stay in the euro area or leave and re-introduce their own currency. From both a Greek perspective and that of the wider euro area, it seems most likely Greece would stick with the euro.

Default would trigger substantial losses for the European banking sector, forcing bank recapitalizations in other euro-area countries. But the destruction could end there – particularly if the Europeans simultaneously announced wider fiscal integration. (Possible because the Germans would be underwriting future not past borrowing, which would come with all kinds of conditions and rules attached.)  

If instead Greece left the euro, speculation would grow about other countries abandoning the single currency. This would prompt huge capital flight from other peripheral countries, causing further waves of bank losses. Greek default would turn truly systemic. The same line reasoning also probably excludes option 4 (where the core countries would also face a much stronger currency to further undermine their economic prospects).

It should also be in Greek interests to stay in EMU once it had defaulted. While leaving the euro might seem appealing given the potential depreciation in its new currency, this process would also destroy its banking system. Facing these systemic risks, the Greeks would probably choose to stay in the euro and gradually rebuild the economy’s competitiveness through real adjustment, rather than choose financial suicide.

Markets and indeed most commentators prefer a much simpler solution – the Eurobond (option 5). This is perfectly understandable, but it is clear the European political consensus isn’t there to support it. Indeed, politicians have explicitly excluded this option. That doesn’t mean it’s impossible  - the history of macro policy crises shows denial often turns to acceptance when faced with sufficient market pressure  – but right now there seems to be too many obstacles and not enough time for such an outcome.

Posen the wrong solution

12 months ago, Adam Posen first set out his arguments for more policy stimulus in the UK. As the economy has slowed, evidently Posen's conviction has grown and his demands have become more forceful. In a speech yesterday, he berated UK policymakers for their inertia and claimed they were repeating the errors of the 1930s. A quick glance at Posen's bibliography, which runs to 4 pages, suggests Paul Krugman has heavily influenced his opinions - no bad thing in Macro Maestro's view. Still, MM can imagine the way Posen's boss, Mervyn King, responded to this criticism - "In my office, now!".

Generally, Macro Maestro finds Posen's (Krugman's) diagnosis convincing. He also accepts part of the Posen cure, namely additional gilt purchases designed to support asset prices. But Posen also recommends ‘credit easing’, in which the Bank and the Treasury would set up a new bank to lend directly to small and medium-sized enterprises (SMEs). This, he claims, would boost business investment and support overall demand.

Unfortunately, there is little evidence tight credit conditions are holding back capital spending. Pointing to weak lending growth proves nothing. While business investment has posted a weak improvement compared to previous recoveries, lacklustre expected demand seems the most likely cause of this. Why would the corporate sector start spending more aggressively while households and the government sector are deleveraging? Investment is ‘derived demand’ – companies only invest if they expect future demand to be healthy. Indeed, as the chart below shows – UK business investment usually only grows when consumer spending growth is healthy (e.g. exceeds 2%).

Moreover, in aggregate, the UK corporate sector (excluding financials) is in good health. Profitability has remained strong – despite labour hoarding during the downturn – and the sector has been a net lender (i.e. borrowing less than it lends) for much of the past decade. This suggests firms do have the resources to invest in new capital, but can’t find profitable enough opportunities.  Uncertainty about the future is clearly playing a critical role. There are lots of ways to measure this but perhaps the simplest is to look at the MPC’s fan charts for future GDP growth. As the chart below shows, these are currently the widest they have ever been , based on a standard deviation of almost 2.

MM also reminds his readers (both of you) that the real cost of capital is very low by historical standards. So even taking into account wider spreads, it’s hard to see how funding costs are a constraint on the corporate sector overall. Unless credit easing can make businesses more confident about the future, it seems unlikely to have any meaningful influence on the macro economy. Far better to use QE, which by raising asset prices, has a better chance of raising wider sentiment (for a while at least..)

Uncoordinated

Macro Maestro believes global imbalances played a critical role in the 2008/09 crisis and continue to highlight the problems faced by the global economy today. In short, they suggest the need for a degree of policy co-ordination that will be impossible to achieve. For that reason, it's hard not to take a pessimistic view about growth prospects in 2012 and beyond.

Over the past few years, global policymakers have been quick to blame each other for the imbalances that developed in the run up to the crisis. For a nice summary, see here. Notably, the Chinese contribution blames the US for its irresponsible monetary and financial-sector policies, whereas the consensus among US policymakers has always been to blame the Asians and their saving glut/currency interventions. The reality is that all these things played a role.

China exported cheap goods to the US and then invested the proceeds in US financial instruments, notably Treasuries. The second part of this process was essential to sustain the first - otherwise the RMB would have appreciated and gradually eroded the Chinese trade surplus. The US, of course, benefited from falling import prices, which lowered inflation and raised real incomes. As a result, both economies enjoyed strong growth - China benefiting from strong export demand and the US from strong consumption.

But these trade patterns also created domestic imbalances in both economies. Strong economic growth and low inflation in the US, together with rapid capital inflows, triggered a series of asset price bubbles, most notably in housing. China became increasingly dependent on exports, manufacturing and investment.

MM believes both deficit and surplus countries must share the responsibility for these problems since both could have pursued policies to address them and chose not to. Instead, both had a short-term vested interest in allowing these imbalances to continue. Western central banks, notably the Fed, could have raised rates earlier and more aggressively to damp house-price growth and discourage risk taking in financial markets. Financial regulation had also become ridiculously lax and should have been tightened. Market surveillance wasn't just poor, it was not-knowing-where-to-look poor. In general, deficit-country policymakers were too focused on relatively short-term and narrow measures of inflation. Meanwhile, the Chinese could have facilitated their own domestic rebalancing by allowing their currency to appreciate.

None of this happened and the imbalances eventually collapsed under their own weight. US sub-prime was epicentre, but also a symptom of a much broader set of problems.

So where does this leave us? The US and other deficit countries now need to delever, implying a period of weak demand in the private sector - especially the household sector. This has left a huge gap in global demand. Ideally, the excess-saving countries (not just China, but notably Germany too) would fill this gap by pursuing policies aimed at boosting domestic demand. Unfortunately, there are no signs this is happening.

Instead, the deficit countries have tried to offset deleveraging in the private sector by increasing public-sector debt. This was necessary, but it was always unlikely to be enough given the scale of the debt problem. Moreover, as deficits have grown, policymakers in these countries have become more anxious about avoiding a negative reaction in financial markets. As a result, many of these countries are now tightening policy, simultaneously. This is undermining global demand and intensifying pressure on the private sector.

The only benign solution to all this seems to involve a degree of global policy co-ordination we are unlikely ever to see. That's why MM is worried.

The limits to irresponsibility

Traditionally, international commentators have been critical of the way the Japanese tried to revive their economy following the stock and property crash in the early 1990s. There are typically two parts to this criticism: (i) the Japanese (notably the BoJ) acted too slowly after the crash, allowing private-sector expectations to gradually turn deflationary, and; (ii) they were not brave enough when it came to thinking about and introducing 'unconventional' policies.The strong consensus in the West, associated with the research of Paul Krugman and Ben Bernanke, was that central banks would always be able to prevent/end deflation if only they were prepared to do radical things. Indeed, for such policies to work, Krugman claimed policymakers had to be 'credibly irresponsible'.

As it turned out, of coure, Ben Bernanke was well placed to implement the lessons he learned from the Japanese experience. As Fed Chairman responding to the US fiancial crisis, he adopted unconvetional quantitative easing within months, rather than waiting years as the BoJ had done. And as the recovery has faltered, the Fed has quickly turned to other unconventional policies - most notably the Fed's apparent commitment to keep the Fed Funds rate on hold into 2013.

But Mr Bernanke has surely also developed a better appreciation of the constraints on 'credibly irresponsible' policy. While as an academic it might be possible to sing the virtues of radical policies, policymaking intitutions are simply not designed to accommodate them. In particular, monetary-policy decisions are taken by committees and it will always be dificult to find a consensus for policies that look irresponsible. Then there is the Chairman's reputation to think about. Taking radical action will make you a hero if it works out, but if it doesn't (and especially if there is a strong consensus it wont) history will remember you as a comedy figure.

It is not surprising then that Bernanke's policies have not been as radical as one might have expected based on the speech he gave in late 2002. Yes, the Fed quickly adopted quantitative easing, but a lack of consensus on the FOMC now seems to be halting this particular policy response. And even the commitment to keep the Fed funds rate unchanged till 2013 wasnt really a commitment or a promise, it was simply a forecast. If the Fed's growth and infltion forecasts change, so will this part of the forecast.

QE3 now seems imminent. This will most likely involve selling short term paper and using the proceeds to buy longer-term bonds, with the aim of pushing down long-term interest rates. The Fed prefers this option because it wont increase the overall size of its balance sheet and so minimizes inflation risks. The very mention of inflation risk shows the FMOC is a long way from adopting 'credibly irresponsible' policies.
Yet, the Japanese experience suggests these might be the only policies that work. So while Macro Maestro accepts there is no theoretical reason why the Fed can't prevent deflation (create inflation), practically it might not be willing to do what is necessary. (Which makes him wonder, are independent central banks ultimately doomed?)

12 months on

Macro Maestro stopped blogging 12 months ago, when the his day job began to expose him to market sensitive data and information. But now he has resigned from policymaking and will rejoin the private sector in October. So, for the time being, he can resume posting his views here on the internet.

So, how has the the world evolved over the past 12 months? Unfortunately, things have turned out largely as MM anticipated. (Good to see his buy-side learned skills of self-promotion are still intact.) The acceleration in US economic activity that begun in autumn 2010, shortly after the Fed announced QE2, turned out to be temporary. Growth soon reverted to a sub-trend path. Employment has again stalled. This shouldnt have been a surprise - a long period of weakish growth was always likely following a financial crisis of the magnititude we experienced in 2008-09. The deleveraging process is continuing and still has significantly furher to run. Additional rounds of policy stimulus can push growth above that level for a while, but such periods are unlikely to persist for long. In turn, financial markets naturally become more volatile, as investors repeatedly switch between expectations of recovery and depression. Macro maestro continues to expect sluggish, but uneven, growth in 2013.

But, of course, the risks are to the downside. For deleveraging to take place in a relatively benign way (MM still calls his forecast 'benign' - though others wouldnt agree), incomes must continue to grow. If growth falls too low, the adjustment process can become disordely. Falling incomes intensifie the pressure to delever, which in turn damages income. (Sustainable levels of debt are only meaingful relevative to income as a reference value.) Such negative feedback loops will start in the financial sector - notably in the banking sector - but could quickly spread to households. For this reason, the concept of a 'stall speed' in the US (or indeed any indebted economy) seems more likely to bite now than it was in the past.

Then, of course, there is the euro area. MM has always believed there are only two possible outcomes to this crisis: full fiscal union or total collapse. Given their reltive costs, fiscal union - notably common bond issuance - always seemed the most probable outcome. But he assumed rational policymaking and that is increasingly looking like an error. Angela Merkel's recent comments - notably her objection to the eurobond - have made MM increasingly concerned. MM still thinks we'll get to the eurobond in the end, but it will take a further intensification in the crisis to get us there. MM is bracing himself for a deeply uncomfortable autumn.

Trading places

Though the signal from central banks was relatively subtle, expectations for another round of QE in the US and UK took a decisive shift yesterday.

Here's the words that triggered this move:

- 'The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed' (FOMC policy statement.)

- ‘For some members, the probability that further action would become necessary to stimulate the economy and keep inflation on track to hit the target in the medium term had increased’ (MPC September minutes)

While this doesn't make QE2 inevitable, it’s exactly the kind of shift in tone City analysts have been waiting for. Some are now forecasting QE in both economies as early as November. (e.g. Goldmans for the US, RBS for the UK.)

The resultant rally in bonds isn't surprising - further asset purchases should directly depress yields. Perhaps the limited/slightly negative reaction in stocks is more disturbing. Either equities already had further stimulus priced in (which is possible given their recent resilience) or investors are becoming more sceptical about the effectiveness of such policies.

Macro Maestro has expressed his concerns about the effectiveness of QE2 before. For now he'd just like to point to this. According to the FT, the Fed is going to try BoE-style QE (buying bonds). But last week, the BoE suggested further stimulus would come from Fed-type credit easing. So both central banks are ditching the QE they tried before and switching to the other's previous favourite. Does anyone else find this slightly disturbing (and ironic)?