Category: Monetary Economics

Whatever Happened to “Targeting the Forecast”?

The Bank of Japan’s Outlook for Economic Activity and Prices published today contains this amazing chart showing the Policy Board members’ forecasts of inflation:

Screenshot 2020-04-27 at 21.45.18

Each Policy Board member made his/her forecast as a range and submitted two figures (i.e., the highest and lowest figures). The forecasts of the majority of the Policy Board members are shown as a range excluding four figures (namely the two highest figures and the two lowest figures among the forecasts submitted by the nine members).

Not a single BOJ Policy Board member expects inflation to exceed 1.5 percent for the next three years – even in the best case scenario!

Given that the BoJ has an inflation target of  2 percent, this is just amazing. Each BOJ Policy Board expects the BoJ will fail to do its job.

Given that they themselves don’t expect to hit the inflation target, how are markets supposed to expect the BoJ will achieve its target. Has nobody told them that monetary policy is almost all about expectations?

So how can the BoJ get inflation expectations up to 2 percent? Here’s an absolutely surefire way to do that:

  1. Announce the BoJ will start buying the average investor’s portfolio and not stop asset purchases until markets expect prices to rise at 2 percent.
  2. Start buying.

Even if this didn’t work and failed to reach the 2 percent inflation target, it would at least solve all of Japan’s other problems: the BoJ would end up owning the entire global stock of financial assets and the Japanese, having become the capitalist overlords of the rest of humanity, would never have to work again.

But rest assured that Japanese inflation expectations would be back on target long before that happened.

At least the Fed won’t Undershoot its Inflation Target now

Before today I had been worried that the Fed would (again) undershoot its 2% inflation target. After the Fed’s announcement of unlimited QE today, those worries are gone:

The Federal Reserve on Monday announced aggressive new emergency measures to support the economy and ensure that credit flows to households and businesses as the country faces the prospect of a deep downturn from the coronavirus pandemic.

The central bank is committing to buying as many U.S. government bonds and mortgage-backed securities as needed “to support smooth market functioning.”

 

Meanwhile, inflation expectations in the Euro area have collapsed. I wish the ECB would announce to do “whatever it takes” to bring those inflation expectations back on track. But I’m doubtful.

Explaining the Absence of Stagflation Expectations

As I wrote before, the corona shock constitutes a supply shock. Normally, a supply shock reduces the long-term productive capacity of the economy resulting both in reduced output and inflationary pressure. Hence Bryan Caplan was wondering on Twitter why nobody is talking about stagflation:

I replied on Twitter already but want to provide a more thorough discussion of the topic here.

The corona shock is different from other supply shocks because, in principle, it does not need to result in reduced long-term productive capacity. Basically, the corona shock constitutes a deliberate temporary shutdown of large parts of the economy. The goal should be to enable businesses which had to shut down temporarily to start right up again once health experts have given the green light for that to happen. The long-term productive capacity of the economy will only be hurt, if businesses that needed to shut down go bust before the economy is turned on again.

Since the corona shock does not permanently reduce the productive capacity of the economy, there is no need for real wages to adjust and hence no need for rising prices. That’s one part of the answer.

For the rest of the answer consider the economy as a whole. Let’s say 20% of the economy is shutdown by public-health mandate, voluntarily or because of a break-down of supply chains.

If NGDP in the economy (under normal circumstances) is roughly 20 trillion USD, this means that the NGDP produced by the part of the economy that is still running would, under normal conditions, amount to roughly 16 trillion USD (= 80% x 20 trillion USD). Let’s call the NGDP produced by the running part of the economy NGDP_r and the NGDP produced by the other part of the economy NGDP_h (whereby “h” stands for “hibernation”).

Under normal conditions we would have NGDP_r = 16 trillion USD, NGDP_h = 4 trillion USD and therefore NGDP = NGDP_r + NGDP_h = 20 trillion USD.

Under shutdown, NGDP_h obviously equals 0 USD. But what will happen to NGDP_r? The development of NGDP_r (= nominal spending on products and services produced by the part of the economy that is still running) determines how prices will develop. If NGDP_r increases, there will be inflationary pressures. If NGDP_r shrinks, there will deflationary pressures. If it stays at roughly 16 trillion USD,  neither inflationary nor deflationary pressures will arise.

Intuitively, one will probably expect nominal NGDP_r to shrink. After all,  a sizeable part of the population has just lost their sources of income. But intuition is not what matters. What matters is monetary policy because monetary policy controls nominal spending in the economy.

In normal times, monetary policy can (by reducing the real interest rate) counterbalance or at option outweigh any negative effect on NGDP_r resulting from the shutdown. That is, in normal times NGDP_r may grow or shrink or stay the same – depending on the objectives of the central bank.

However, we do not live in normal times. Nominal interest rates have been close to or at the zero lower bound (ZLB) for a decade. Reducing real interest rates (enough to significantly boost nominal spending) by simply adjusting the nominal rate downwards no longer works. In order to boost NGDP growth at the ZLB, the central bank has to commit to temporarily higher inflation (NGDP growth) in the future.

But since the central bank’s inflation targeting regime cuts off this route to boosting NGDP at the ZLB, NGDP_r is likely to fall during the shutdown.

Hence, the hit to Real GDP caused by the corona shutdown will most likely be accompanied by (moderate) deflationary pressures. Stagflation (reduced RGDP accompanied by higher inflation) is not on the table.

The Corona Shock is Different from other Supply Shocks

The coronavirus pandemic constitutes an economic shock, specifically a supply shock. In contrast to demand shocks, supply shocks cannot be offset by monetary policy. A supply shock will lead to a temporary reduction (or slow-down of growth) of output (Real GDP) and therefore a temporary reduction (or slow-down of growth) of consumption and living standards.

While the central bank is not able to prevent a supply shock from having a negative effect on RGDP, it is usually able to prevent secondary effects such as, for example, an increase in unemployment.

Supply Shocks – the Normal Case

A supply shock reduces the productive capacity of the economy. As a result workers need to accept lower real incomes. If nominal wages were fully flexible, they would adjust downwards. The number of jobs would stay the same. In reality, nominal wages are very sticky, so instead the number of jobs adjusts downwards unless the central bank keeps nominal spending stable.

If the central bank stabilizes aggregate demand (i.e. nominal spending), real wages will (as a result of price rises) fully adjust to the diminished productive capacity of the economy. Unemployment will stay the same. Only the composition of Nominal GDP (NGDP) growth will temporarily change (more inflation, less real growth).

The Corona Shock

The corona shock is also a supply shock but one which does not permanently reduce the productive capacity of the economy. Basically, the corona shock constitutes a temporary shutdown of large parts of the economy. There is, in principle, no need for real wages to adjust to a new reality of a less productive economy.

The goal should be to enable businesses which had to shut down temporarily to start right up again once health experts have given the green light for that to happen. What you don’t want is such businesses running out of cash before the restart of the economy. One way of doing this would be for businesses to put employees on temporary unemployment. The temporarily unemployed could then be supported by checks from the government or from the central bank during the time of the shutdown.

Furthermore, the central bank should make sure that businesses have access to credit to stay afloat during the shutdown. If banks don’t provide (enough of) such access, the central bank may even lend money to businesses directly.

How to make Brexit Really Worthwhile – Example: Financial Regulation

This is the title of a new guest post I wrote for Notes on Liberty, here is an excerpt:

In the UK, there was no government regulation of banking until 1979. Instead, the behavior of banks was subject to tight private regulation. This private regulation of banking was then substituted by government regulation in the 1980s.

I do not want to write a lengthy discussion on the question of which alternative is the least costly in dealing with the incentive problems arising from the implicit subsidy by the taxpayer. There are good reasons to believe an incremental, decentralized and evolutionary system of market-based regulation to be superior to centrally designed government regulation.

But even if this is the case, private regulation arising as a response to the incentive problems resulting from explicit and/or implicit government guarantees is still costly. Indeed, the evolved system of private regulation in the UK banking industry was giving the appearance of a restrictive cartel. If my analysis is correct, this “cartel” served a useful social function, namely to deal with the incentive problems created by the implicit government guarantee. Nevertheless, it also involved costs.

At the root of the problem are the taxpayer guarantees.

There’s much more at the link.