Monetary Policy

I wrote a week ago about an old paper by Bernanke, Gertler, and Watson (BGW) that attributed much of the impact of past oil price shocks to the response of monetary policy. Jim Hamilton followed up this weekend: “Michael Levi (hat tip:Marginal Revolution) and Jeremy Kahn are among those who recently rediscovered some earlier research by Ben Bernanke and others that concluded that the economic downturns that followed historical oil price shocks could have been avoided if the Fed had followed a more expansionary monetary policy at the time. Here I call attention to some subsequent research that took another look at their evidence and reached a different conclusion.” Hamilton goes on to describe a followup paper that he published with Ana Herrera in 2004. They criticize BGW on two fronts. First, they argue that the monetary policy alternative proposed by BGW isn’t credible, since it’s a huge departure from the historical pattern. I thought that that was precisely the issue I’d discussed in my original post. Indeed, as I argued, one can put this matter to an empirical test. During the 2008 oil price spike, headline inflation rose to over 5 percent, but core inflation maxed out at about 2.5 percent. Had this been 1973, policymakers would have responded to headline inflation and jacked up rates, in turn slowing the economy; as it happened, they focused on core inflation, and didn’t. As I noted in my original post, however, there are limits to this dynamic, since energy price rises eventually pass through to core inflation, forcing a response; thus, I suggested, good monetary policy has limits in what it can accomplish. (As a side note, Hamilton claims that, in 1973, policymakers would have had to hold constant a federal funds rate that actually rose by 900 basis points in order to implement the BGW policy. That’s not true: only part of that 900 point rise was a response to the oil price shock; it’s only that part that would have had to be curtailed to match the BGW policy.) The trickier critique offered by Hamilton and Herrera (HH) focuses on the fact that BGW estimate the relationship between oil prices and macroeconomic variables using a model that includes seven monthly lags. What this basically means is that if oil price shocks have big consequences for the economy more than seven months after they happen, BGW won’t notice that. Indeed HH point out that most studies of the oil-economy relationship show that the biggest impacts come after twelve months. HH redo the BGW analysis, but with a twelve month horizon rather than a seven month one. They find a bigger impact for oil price shocks – and a much smaller role for monetary policy. What Hamilton doesn’t mention in his post is that Bernanke, Gertler, and Watson responded to the HH critiques. To address the question of whether their counterfactual monetary policy is credible, they simulate another counterfactual where rates are held flat for a year before responding to inflation. In response to the criticism that using seven monthly lags misses much of the picture, they make two points. First, they argue, shifting to twelve monthly lags has its own problems, namely that it introduces 245 new parameters to the model, increasing uncertainty. Thus, they note, “it is possible that the weaker effects of systematic monetary policy found by HH in models with more lags are the result of additional sampling uncertainty rather than a structural feature”. Instead, they offer a compromise, simulating a model that uses four quarterly lags; this allows them to looks at effects that take as much as a year to materialize without introducing too much uncertainty (since it keeps the number of parameters down). They report the results for a model with four quarterly lags and only temporary monetary policy restraint. The result is that monetary policy still explains about half of the GDP impact – less than in their original paper, but more than in HH. The same result holds for a model with six quarterly lags. I should probably close by noting that I don’t want to suggest that this is the final word, just like I didn’t mean to suggest in my last post that BGW was the last word either. (The point of that post was to use some comments from a new Nobel laureate to highlight how hard it is to figure out whether and how oil prices affect the economy.) There are plenty of other authors who disagree with both of the papers I’ve discussed here. This only reinforces the point I made in the previous post: policymakers are inevitably going to need to operate in the presence of limited knowledge. That, I suspect, is something that no academic paper will change.  

The eurozone leadership is finally coming around to accepting that a major continent-wide bank recapitalization program is necessary.  Germany wants each country to take care of its own banks.  This approach could buy time, but it won’t work for long.  National bank backstops are untenable in a common currency area, as each sovereign has its own credit risk profile.  Depositors will simply flee toward the better backstops.  This can already be seen in the correlation between bank deposits in Germany and the PIGS (Portugal, Ireland, Greece, and Spain).  Before the financial crisis, those deposits were tightly correlated, as shown in the graphic above, but over the past two years the correlation has flipped - deposits are fleeing the PIGS and flying into Germany.  A stable eurozone banking system will require a unified regulatory, resolution, and rescue regime. Steil: Europe's Failings Illuminate Marshall Plan Analysis Brief: Waiting on the Eurozone Video: World Economic Update Analysis Brief: Managing a Greek Default

[Dear new readers: Please click here if you’d like to see the rest of this blog, which focuses on energy, security, and climate.] Do you think that it’s straightforward to figure out whether high oil prices cause recessions? Many people apparently do. The 2011 Nobel Prize in Economics, awarded today to Thomas Sargent and Christopher Sims for “empirical research on cause and effect in the macroeconomy”, should make them reconsider. The basic reason is simple: if it was easy to separate cause from effect and thus measure the relationship between stimulus and response, they wouldn’t be awarding Nobel Prizes for related progress. Indeed the difficulty of distinguishing economic cause from effect is a big reason for economists’ longstanding interest in oil price shocks, particularly those of the 1970s. Those price hikes were clearly spurred by events outside the economic system, in 1973 by the Arab oil embargo, and in 1979 by the Iranian revolution (though even on these points there is some dissent). Identification should thus be simple: the oil shock is the cause, and any macroeconomic change is a consequence. This provides an unusually clean laboratory in which to study economics. Alas, there is a problem. The oil price shocks of the 1970s prompted big interest rate hikes in consuming countries, as policymakers tried to stem inflation. One now must ask: were the economic slowdowns that followed the oil price shocks the result of the shocks themselves, or consequences of the monetary policy reaction? The difference matters, because one leads to an energy policy solution, while the other points to better monetary policy as the right response. In a seminal 1997 paper, Bernanke, Gertler, and Watson (BGW) came down strongly on the latter side. They drew on methodology developed by Sims (one of the new Nobel laureates) and Tao Zha to fit a model that incorporates both the direct response of the economy to oil price rises and a monetary policy component. Then they simulated the model with one change: instead of having interest rates rise in immediate response to increased inflation, those rates remained constant. The result? Most of the economic slowdown triggered by the oil price rises disappeared. The conclusion is clear: it is the monetary policy response, not the oil price shocks themselves, which slowed growth and triggered recessions. This has clear policy implications: it may be more effective to fight oil price shocks with good monetary policy than with energy policy itself. I hadn’t noticed before this morning that the original BGW paper was accompanied by an illuminating critique by one Christopher Sims. Sims offers two related criticisms. The first is that the alternative policy modeled by Bernanke et al is implausible. Superficially, the alternative policy (where interest rates remain unchanged) permits high inflation, which Sims sees as unsustainable. More fundamentally, Sims has trouble seeing a way to get from the pre-shock monetary policy to the post-shock one.  He argues in essence that if your starting point is a monetary policy that responds strongly to oil price shocks (or, more generally, inflationary pressures), it’s basically impossible to credibly switch to one that ignores them. If your new policy isn’t credible, though, the response to it won’t be the one that’s predicted by the model. Sims is basically arguing that, at best, policymakers will eventually be forced to return to their old (tighter) monetary policy rule, that markets will anticipate that, and that the benefits of looser money in the near-term will thus be blunted. Sims’s second criticism, based on the so-called Lucas critique, is closely related. He essentially argues that a fundamentally new policy rule, even if it is successfully implemented, might not have the modeled effects. That’s because some of the parameters identified in specifying the original model might implicitly reflect the old policy rule.  If that’s true, and a policy change thus effects deeper changes in the economy, the model projections of the new policy can’t be trusted; in turn, that makes it impossible to say that it was monetary policy, not high oil prices, that did the real economic damage. How have these two competing views stood the test of time? One can argue, at least superficially, that U.S. policymakers have succeeded in credibly and sustainably changing the policy rule. Back in the 1970s, monetary policy responded to headline inflation; today, it responds only to core inflation, which excludes energy and food prices. To be sure, this only gets you part way to the hypothetical strategy described by BGW and dismissed as not credible by Sims, since changes in oil prices ultimately pass through in part to core inflation, to which the Fed still responds. Moreover, European policymakers have been far less swayed by the case for ignoring headline inflation. Still, the historical track record suggests that on this particular matter, Bernanke et al were, at least in principle, on largely defensible ground. The other critique offered by Sims is tougher to rebut, since it cuts at the heart of the modeling enterprise. Back in the 1970s, market participants pretty much knew that rising oil prices would prompt monetary tightening. That presumably affected their behavior more broadly. Today, they can be similarly (though not entirely) confident that the Fed won’t react to increasing oil prices by cranking up interest rates; once again, that might change their broader behavior. Extracting lessons for today’s economy from patterns displayed in the 1970s may thus be a fraught exercise. And that, to return to where we started, is the real bottom line. Anyone who claims to have looked at the historical data and established a strong, immutable relationship between oil prices and macroeconomics is being overconfident. Cause and effect are tough to disentangle in the macroeconomy. Changes in monetary policy since the 1970s make extracting lessons from the first two big oil shocks exceedingly difficult. Policymakers are stuck with the inevitable uncertainty that remains.

A resident rides a tricycle past the head of a bullet train outside an exhibition for the Seventh World Congress on High Speed Rail in Beijing (Jason Lee/Courtesy Reuters). China’s recurring 10 percent annual average growth rate has won it predominantly accolades (and not a little envy); making it the global economic powerhouse it is today. But as Brazil nears these numbers – growing 7.5 percent in 2010 -- it is the naysayers and doubters that have come to the fore. Even the government has labored to reassure investors and the public that it is working hard to “slow down” growth: Finance Minister Guido Mantega assured last week that “[Brazil] will grow moderately” due to proactive measures to raise interests rates and cut public spending. Why the stark contrast? One reason is the source of economic growth. China’s has been primarily investment led. From 2000-2008 China invested an average of 41 percent of GDP, a ratio more than double that of Brazil (and other countries such as the United States). In 2009, in the depths of the worldwide global downturn, investment soared to almost 50 percent of GDP, much dedicated to infrastructure. Thousands of factories, millions of miles of road, new ports, high speed railway lines, and airports have sprung up over the past decade. The country is now populated by entirely new cities and manufacturing centers that then drive growth. Brazil, by comparison, invests less than 19 percent of GDP a year. Infrastructure is notoriously bad – which some economists estimate will curtail future growth by nearly 1 percent a year. Instead, consumption fuels Brazil’s recent rise. In 2009 a whopping 84 percent of GDP was consumption - compared to just 48 percent in China. Brazil now ranks at the top of the list of the world’s best shoppers led by booming credit, the expansion of foreign and domestic retailers, and the now 100 million strong middle class. The current over reliance on consumption leads economists and policymakers alike to worry about overheating. Furthermore, China’s transformative growth has been mostly self-funded. It leads the world in internal domestic savings, which has risen steadily since the turn of the 21st century and in 2007 topped 54 percent of GDP, dwarfing the 23 percent average rate of OECD countries. Brazil’s internal savings rate, meanwhile, is only 15 percent, making it more reliant on foreign investment (both long term FDI and more worryingly shorter term portfolio or “hot money” flows) to fund needed investment. Even with these inflows, the savings available don’t approximate those China wields, limiting the potential pace of growth. But another real and important reason for the discrepancy is that Brazil is already a much more developed economy. Brazil’s per capita income is more than double China’s - $8,230 vs. $3,650 in 2009. Its mortality rates, education rates and urban development rates all top China’s. The basic health improvements, spread of education, and urbanization behind much of China’s growth occurred in Brazil from 1967-1979, when it too grew at rates of almost 9 percent a year. This current growth differential between China and Brazil isn’t a permanent status quo.  China’s per capita income has now already risen, and much of the “easy” productivity gains are behind it. Some China observers point to the growing speculative real estate bubble, the rapid aging of its population, and a less than open government as further obstacles to sustainable high growth. Brazil, in turn, has many advantages - a sizable and diversified economy, low government debt and healthy banks. But going forward, for Brazil to grow quickly (and sustainably) it must increase its productivity (and not rely on just high commodity prices and consumption). This will depend on more investment, better education, and other structural reforms. If these changes happen, then the skeptics should fade, and a true second “Brazilian miracle” will be possible.

All countries with central banks exercise monetary sovereignty, right?  Nobel economist Paul Krugman certainly thinks so.  “Wow,” he wrote, after reading Benn Steil and Manuel Hinds say otherwise in the Financial Times on May 24, “Have these guys ever talked to anyone in Sweden, which doesn’t need euros to create more kronor?” Fortunately, we have the data, which is better than talk.  Since Mr. Krugman throws Australia into the mix, we will too.  As the figures above illustrate, when the Swedish and Australian central banks expanded credit dramatically during the recent financial crisis their net foreign assets plummeted.  And this is not merely a crisis effect, as the three decades of Australian data show. So it turns out that you do indeed need euros and (American) dollars to create kronor and Australian dollars.  A country that plows on creating credit without them eventually becomes a ward of the IMF. Steil and Hinds: Keynesians are complacent about the dollar Steil: Hayek and the Dangers of Monetary Nationalism Steil and Hinds: Money, Markets, and Sovereignty Hinds: Playing Monopoly with the Devil

Monetary policy is one of the basic mechanisms through which rising oil prices are believed to hurt the economy: oil prices rise, inflation results, central bankers raise rates, and the economy slows. Over the last decade or two, though, most economists – at least in the United States – have come to believe that policymakers should focus on core inflation, which ignores energy and food prices, rather than headline inflation, which includes them. To the extent that Fed officials focus on core inflation, oil prices rises don’t necessarily spur inflation; consequently, officials don’t raise rates, and the economy doesn’t suffer. That view is less popular in Europe. Lorenzo Bini Smaghi, a member of the executive board of the European Central Bank, presents the counterargument well in a Financial Times op-ed today: “The rationale for excluding food and energy, however, is that they tend to fluctuate sharply, as we have seen with recent rises and falls in the price of oil. This volatility is then passed on into the general price index, in turn making it difficult to interpret the overall trend…. However, for core inflation to be a good basis for forecasting headline inflation, the variations in the prices of agricultural and energy products have to be temporary, and should on average not differ from other prices. If that is not the case, core inflation is neither a good estimate of underlying inflation, nor a good forecast of future inflation…. Since 1999, the global index of energy and raw materials prices has more than doubled, as has that of food prices. These increases have not been short-lived at all, but have had a lasting effect.” This argument makes sense as far as it goes. The original rationale for focusing on core inflation – that it allowed policymakers to filter out volatility, and hence avoid rash rate rises – is pretty difficult to defend at this point. Structural changes in world energy (and food) markets mean that price rises in those areas are much more likely to be permanent than they once were; hence, to the extent that they ignore them, policymakers are being willfully blind to real stresses being faced by consumers and firms. But Bini Smaghi and his intellectual bedfellows take things a step too far. Here’s how he concludes: “For central banks around the world, this means that core inflation is no longer a very useful indicator for monetary policy, and should probably be abandoned.” What this means, in practical terms, is that he thinks policymakers should focus on headline inflation instead. That, in turn, means that high headline inflation should prompt central banks to raise interest rates. This strikes me as missing the big picture. Why? Central bankers should respond to inflation because (a) they believe that inflation will be highly damaging, and (b) they believe that their policy can blunt the damages. Inflation is particularly dangerous when it drives demands for higher wages, which in turn fuels more inflation, and so on. But this is not a significant risk in Europe or the United States right now: with unemployment still through the roof, workers don’t have much leverage to extract wage increases. Indeed in much of the periphery of Europe, real wage declines (through modest inflation) may be just what’s needed. But let’s accept, for now, that current levels of inflation are too high. It’s still not clear that ECB rate-raising can do much about them. Since the ECB doesn’t need to move in order to keep wages in check, it would have to have its impact by reducing inflation directly, i.e. by reducing demand for energy and food (or for other goods and services, in order to compensate). But as Bini Smaghi writes in his column, “a structural change has taken place over the past decade, in which strong growth in emerging countries has increased global demand for raw materials in an unprecedented way.” So higher ECB rates would need choke off demand in a compensating fashion. This seems draconian: the ECB would basically need to blunt growth in an already struggling eurozone – not as an unfortunate side effect of its policy but as its main objective. The cure would be worse than the disease. There is one potential counterargument to this: perhaps loose monetary policy is the root cause of high commodity prices in the first place. If that was the case, then there might be a legitimate argument for blunting inflation through tighter monetary policy. But that line of argument is totally inconsistent with the one that Bini Smaghi and similar inflation hawks offer. They are arguing that core inflation should be ditched because energy and food price rises substantially reflect enduring fundamentals (which I think is a correct assessment of the facts). That’s the opposite of an argument that they’re a consequence of loose monetary policy. This leaves us in a rather confusing place. The critics of core inflation are right to argue that it no longer deserves to occupy the central place that it did in the 1980s and 1990s. But those who thus counsel a return to simply targeting nominal inflation are wrong, not only for the reasons outlined above, but because while there have been (and continue to be) big structural changes in energy and food markets, those markets also remain quite volatile (indeed at least energy markets have become more volatile than before). Core inflation, by filtering out this volatility, can thus provide some useful information. Perhaps some smart economists will come up with a new magic number that can replace both of these and anchor monetary policymaking in this new era. Until then, though, policymakers will need to muddle through, looking holistically at the economy rather than simply fixating on one number. There are, of course, bound to be mistakes that result. This is simply another element of the economic risk involved in a navigating the rapidly changing global economy.

[cetsEmbedGmap src=http://maps.google.com/maps/ms?hl=en&ie=UTF8&msa=0&msid=215110937314986215762.0004a40bce79b697167be&ll=12.382928,30.498047&spn=55.711251,79.013672&z=4 width=570 height=425 marginwidth=0 marginheight=0 frameborder=0 scrolling=no] Click on the map’s placemark for more details. Zoom in and out for a better look. Yesterday, I blogged about the escalating conflict between North and South Sudan. I may have understated how serious the situation has become. The media is now reporting that Khartoum’s invasion of Abyei town has displaced at least twenty thousand people. Meanwhile, the international community has called on Khartoum President Bashir to relinquish control of Abyei. Thus far, he has ignored it, and Khartoum’s forces appear to be digging-in. There are even media reports that Sudanese regulars are looting UN facilities in Abyei. As a result, not only has the United States government put on hold plans to normalize relations with Khartoum in return for its cooperation with South Sudan’s independence, but it may withdraw another important carrot extended earlier: a deal to relieve Sudan’s approximately thirty-eight billion U.S. dollars of debt. This is significant considering that Sudan is one of the most heavily indebted countries in sub-Saharan Africa. As the IMF notes, Khartoum will lose significant oil revenues with the South’s secession, meaning that the debt issue may become even more difficult to tackle.

Back in 2000, the European Central Bank’s first president, Wim Duisenberg, explained how he knew the Bank’s operational framework for implementing monetary policy was working well.  It was, he said, successfully “steering short-term market interest rates” where the Bank wanted them to go.  Prior to the financial crisis, that was indeed the case: the ECB’s policy rate was tightly connected to important short-term interest rates, such as the 3-month government borrowing rate.  In a growing swath of the eurozone, however, this is no longer the case.  As the figures above show, the correlation between the ECB’s policy rate and actual government borrowing rates in Spain, Greece, Italy, Ireland, and Portugal has plummeted since the ECB began its debt-buying program.  The market’s view of default risk on eurozone government debt has increasingly come to dominate these rates, which themselves strongly influence borrowing rates in the private sector.  By Duisenberg’s criterion, monetary policy in the eurozone is becoming less and less effective.  The only thing that will reverse this trend is a resolution of Europe’s growing bank and government debt crisis.  Yet by continually insisting that debt restructuring is out of the question, the ECB is only delaying such a resolution - and almost surely making it more costly. Geo-Graphics: Sovereign Credibility and Bank Runs Geo-Graphics: Luck of the Irish Hinges on Banks Geo-Graphics: Greek Debt Crisis – Apocalypse Later Geo-Graphics: Beware of Greeks Bearing Debt

In a major speech on April 13th laying out his blueprint for reducing America’s long-term debt burden, President Obama drew a sharp contrast between the outlook today and the much rosier one a decade ago. In 2000, he claimed, “we were prepared for the retirement of the Baby Boomers.” Yet whereas the national debt burden today, at around 65% of GDP and rising fast, is much higher than it was in 2000, the long-term fiscal path the nation was on was as unviable then as it is today. This is illustrated starkly by the figure on the left. The driver of the sharply rising debt curves was, and still is, retirees – and specifically two programs to care for them, Medicare and Social Security, as shown by the bars in the figure on the right. President Obama is surely right to draw attention to the challenge of funding retiree entitlements. He is on less firm ground, however, in suggesting that the last Democratic administration had a handle on this. 2000 was no Golden Age of preparedness for our Golden Years. White House: Remarks by the President on Fiscal Policy Lindsay: Obama's Budget Balancing Act Shlaes: Paul Ryan Plan or Higher Taxes, Take Your Pick Steil, Swartz: Obama Budget Ducks Spending Cuts

Japan’s nuclear industry is in full-blown crisis, raising global concern as to the safety and viability of nuclear energy. In response, China has frozen its nuclear reactor development program, while Germany has shut down seven reactors and initiated a three-month moratorium on a policy program meant to extend the lifespan of existing facilities. Chancellor Merkel said the policy shift was needed to allow the country “to reach the age of renewable energy as quickly as possible.” But the Chairman of the House Energy and Commerce Committee Fred Upton appeared to pour cold water on such a vision: “Wishful thinking about magic-bullet alternatives is not going to heat and cool our homes, get us where we need to go, and power the businesses that provide jobs.’’ Upton is almost certainly right. If the world were to freeze nuclear energy use at current levels, renewable energy output would have to double by 2035 to fill the energy-requirement gap on its own. If it were to abandon nuclear energy entirely, renewable output would have to triple by 2035 to fill the gap. To realize such historically unprecedented renewable growth rates, a wide range of technologies would have to be exploited, many of which will be very expensive for the foreseeable future. Onshore wind energy, which could fill a portion of the gap, is among the cheapest at about $83 per megawatt hour, compared with $70 for coal and only $60 for natural gas. Yet solar energy is 3-4 times more expensive, at $224. Therefore, it is not surprising that governments had to subsidize renewables to the tune of $57 billion in 2009, according to the International Energy Agency. As of November of last year, the IEA expected this to quadruple to $205 billion by 2035. But with rich-country governments in fiscal retrenchment such expenditure looks implausible. The British government recently announced that it actually plans to cut solar subsidies. In short, a move away from nuclear energy is unlikely to fuel the green revolution that many hope for. Note: The original text misattributed Upton’s quote to Steven Chu. We apologize for this error. Bloomberg: Japan Committed to Atomic Power as Renewable Energy Insufficient Levi: The Devil We Know Spiegel: With Moratorium, Merkel 'Driving into a Dead End at Full Speed' CSM: China, Russia stand by nuclear power despite Europe's backtracking