Matt Nolan

Banking panics and deflation

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When looking at the European debt crisis, and even before that the Global Financial Crisis, people constantly described the risks as being shown through deflation – if we experienced deflation monetary policy must do “all it can” to turn things around and help to boost the economy.

The lack of deflation around the world in the face of these “banking panics” was seen as an indicator that we were not facing the same sort of crisis, and that as a result there is no real role for central banks.  Now, in terms of direct monetary policy is may be the case, depending on our view regarding what is going on and how institutional settings are different from the Great Depression.  However, the idea that a banking panic would lead to deflation directly holds no weight.  From Essays on the Great Depression by Bernanke we have this result:

Banking panics had no effect on wholesale prices.  This … result is important, becuase it suggest that the observed effects of panics on output and other real variables are operating largely through nonmonetary channels.

The two large crises we have faced in recent years WERE NOT failures on monetary policy, and monetary policy models were not appropriate for trying to understand them.  They provided an example of a failure of the second function of a central bank – the lender of last resort function.  A lender of last resort is supposed to be sufficient to avoid these banking panics, and it was (and in the case of Europe is) the failure to appropriately take on this role that has led to these crises.

And the fact that deflation didn’t appear, but output fell sharply, is consistent with this explanation of the crisis.  And consistent with the mainstream economist worldview regarding policy.  That is nice.

Matt Nolan

Will current expansionary policy lead to “bubbles”

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An excellent post over at Marginal Revolution on this.  The points raised are:

1. If a more expansionary monetary policy helps an economy recover, yes it may well raise the risk of a later bubble.  We should then be cautious, but that is no reason to turn down the prospect of a recovery.  Anything leading to recovery could have a similar risk.

2. There are already plenty of reserves in the system and there is plenty of room for credit to expand over its current level.  Maybe we don’t know what triggers bubble-inducing investment behavior, but why should raising ngdp expectations and realities raise the risk of a bubble, if not for the factor cited in #1?

3. Arguably a flat yield curve induces a quest for higher returns elsewhere or in more dubious investment areas.  Yet the flattening yield curve did not follow quickly from the massive injection of reserves.  Rather it evolved slowly as prospects for real recovery deteriorated and the long-run outlook for the advanced economies turned down.  Real factors drove the flattening, and if monetary expansion brought a bit of recovery it likely would unflatten that curve a bit.  That could well lower the risk of a bubble.

4. I may consider Austrian theory, with regard to this question, in a separate post.

There are two points I would raise here though.

With regards to bullet three – although I agree that the flat yield cuve is likely the result of weak prosepects for the economy, we can’t really pretend that the long end of the yield curve is currently independent of relatively direct government involvement.  The Fed’s willingness to buy up longer term Treasury bonds in order to stimulate growth could indicate that the low yield curve is partially the result of intervention, rather than true expectations of long term inflation and growth propsects.

Interestingly, I agree with bullet point three – I think that if there were sufficient asset purchases we would actually see the yield curve steepen (through its impact on expectations).  But this is clear, or necessarily the mainstream, view of what is going on.

The second point is that bubbles aren’t necessarily bad – in any sense of the word.  They transfer resources between groups, groups who chose to take risk.  They lead to a change in the timing of investment, often in a way that is suboptimal – but not disasterous.  A “bubble” in of itself doesn’t lead to a failure of monetary policy, and it doesn’t lead to a large scale downturn – there are other significant factors that have lead to these things internationally, factors that were correlated with the bubble (maybe even related to it) but not caused by it!

Matt Nolan

“Sluggish” credit growth, where does NZ fit in?

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Via Tyler Cowen on Twitter was this article, combined with the comment “credit growth sluggish”.  The view here is that the 4% growth in private sector credit is too weak when compared with historic averages – and that the goal of the Fed should be to focus on the “quantity of credit” here, rather than target the price.

Now in New Zealand we have similar data here.  According to this, private sector credit growth was 2.3% year-on-year (or 3.2% if we exclude repurchase agreements – which is preferable IMO).  This compares to a decade-long average of 7.3%pa (8.3%pa), and if we were solely quantity focused this would seem insufficient.  [Note:  I did decade instead of history, as the implicit inflation target moved significantly over the decades – a factor that pushes this figure around.  Would be best to look at “real growth” for a longer-term focus]

I’m not concluding anything from this per se – it is just interesting that NZ analysts are running around getting concerned about inflation and rising credit growth, while analysts in the US, who are observing stronger credit growth than we are, are generally complaining that more needs to be done.  Tbf, their unemployment rate is a lot higher, and their output gap is correspondingly larger (presumably).

But with underlying inflation in the lower end of the RBNZ’s target, credit growth numbers objectively soft, and the unemployment rate undeniably elevated I feel that the inflation calls may be a touch overplayed.  [Note:  A relative price lift in construction due to a rebuild in Canterbury is not inflation – it is a signal of scarcity, as prices are supposed to be].

Matt Nolan

The attempt to make everything a “generation war”

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Via Blaise Drinkwater (on Google+ of all sites!) was this link from Marginal Revolution.  The generational war component comes through this:

By speeding the flood of less expensive imported products into Japan, the strong yen is contributing to a broader drop in the prices of goods and services, known as deflation, that has helped retirees stretch their pensions and savings. The resulting inaction on the yen, according to a growing number of economists and politicians, reflects a new political reality, with already indecisive leaders loath to upset retirees from the postwar baby boom who make up nearly a third of the population and tend to vote in high numbers.

To me, this comment is relatively nonsensical for two reasons.

Firstly, The Yen has “strengthened” from an incredibly weak level in 2007 – incredibly weak by historic standards!  Yes the Yen is now strong against the US dollar, but if you compared it to a wider basket of currencies this is hardly the case.

When talking about currency, historical context isn’t particularly useful.  Instead we need to ask things such as “what is purchasing power parity like” and “are they running a trade surplus”. It turns out that Japan is still running sizable trade surpluses, suggesting that (if anything) the Yen may still be too weak …

My second complaint is this view of the Yen and inflation – inflation is the growth in the general price level over time, a “high Yen” is a one-off price level shock … it doesn’t change the rate of growth in the general price level it merely knocks down the level as a one-off.  The endemic deflation in Japan isn’t a result of “fiddling with tradable prices”, it is the result of persistent deflation expectations feeding into the wage and price setting behaviour in the country.

Now if there is a generational war in this context, it relies on Japan’s pensions not being inflation adjusted.  Is this the case?  If not, this is much ado about nothing.

 

Matt Nolan

Careful reading statements – the July 12 OCR

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Over at NBR, Rob Hosking suggests that the RBNZ is saying a couple of things following today’s statement – a couple of things I believe they are not saying.  Implicitly these are:

  1. Relative to June, the Bank wants a lower average official cash rate in the coming years (so a lower track, and potentially a cut to the OCR).
  2. The Bank feels that the “neutral” interest rate is lower (as this is how a level of the OCR goes from stimulatory to not stimulatory).

The reason for this view is the change to the last line of the statement between June and July – it has gone from having “stimulatory” in it to not having stimulatory in it.  This is true, but I feel it is being taken out of context – note that in April stimulatory was also missing.  Furthermore, the rest of the statement is banging on about how the Bank’s view is unchanged since June … a pretty clear signal that their view is unchanged.

In order to flesh out the argument Hosking states:

It suggests the OCR is going to remain lower for longer, especially when put alongside economic forecasts in the previous statement which said New Zealand’s capacity for economic growth is now lower than previously because of high debt levels and the need to rebuild from recent shocks, both economic and geological.

It is true that the RBNZ “lowered potential”.  However, lowering potential implies that the Bank needs to do less to stimulate the economy – not more.  All other things equal, lowering potential growth output, or shrinking the output gap, suggests that rate will be HIGHER going forward – not lower.

Although I appreciate that it is difficult to read these statements, and that Hosking is right to try to read into slight changes in wording by the Bank – I feel that the interpretation he has given to today’s statement goes a little too far.  In truth, the Bank has reiterated what they said in June – rates are staying at current levels for a while, unless Europe goes bang.

Matt Nolan

Has inflation fallen below the Bank’s target?

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I’ve heard people suggesting that the RBNZ has failed its mandate on the downside, eg this tweet by Vernon Small.

If inflation is 0.6 excluding excise on fags and the RBNZ looks thru Govt charges then hasn’t it just breached 1-3% band on the downside?

Now, I don’t mean to come out to defend the Bank as they can do it fine on their own – but there are a couple of clear issues with this claim I can comment on.

Firstly, as Eric Crampton suggests, the Bank is supposed to aim for inflation outcomes that settle in this range “in the medium term” – moving outside of this range for a single quarter doesn’t imply that they’ve failed anything.

The logic here is that the relative price of goods and services may change, and “unexpected” things may happen that the Bank did not foresee.  If these things happen, then the RBNZ does not want to look backwards – it wants to tell firms and households clearly that they can expect average price growth in this range in the future.

Now, there are a number of indicators of what is expected for inflation – my favourite is the adjusted Labour Cost Index, as it comes from actual behaviour rather than arbitrary reporting by individual firms and households … so what has that been doing?

So in this sense, things look pretty good – in least in so far as the inflation mandate is being met given the current credibility and policy of the RBNZ.

But even in terms of our measures of what “has happened” with inflation, did inflation actually slip temporarily out of the Banks target band?  As I have mentioned before annual growth in the CPI is a poor measure of what “inflation” really is – we want something like the RBNZ’s dynamic factor model (here).  So what is the sectoral factor model telling us?

Now, there is some end-point bias in this (the nearer periods will change as we get more data), but it doesn’t seem to suggest that inflation feel out the bottom of the band – even with the domestic economy, labour market, and global growth all disappointing heavily.

As a result, this type of criticism of the RBNZ doesn’t seem to be warranted.