Matt Nolan

Export prices, import prices, terms of trade, and inflation

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As a small little open economy, international variables are incredibly important to us.  The international rate of return, world prices for tradable goods, and the availability of external people, goods, and services, all have a disproportionate impact on us.

When discussing external prices, people constantly hear economists talk about the terms of trade (note, the wiki article is crap).  During 2007 the Bank was (appropriately) lifting the official cash rate on the back of New Zealand’s climbing terms of trade.  However, what all this meant, and what was going on didn’t really seem clear to everyone at the time.

The terms of trade tells us about the price of what we sell overseas relative to what we buy in.  This is all very nice, but when people see this they might wonder why the Bank would want to react.  To understand what was (and is) going on with our terms of trade we do need to differentiate between both sides of the ratio – export prices and import prices.

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Matt Nolan

The exchange rate and the RBNZ

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I see that we are back to discussing this sort of stuff, fair enough.  There is a Herald article with Cunliffe expressly mentioning that the RBNZ should reduce volatility in the exchange rate, and Brian Fallow discussing currency intervention following the Fed.

There are a few key points I would like us to keep in mind here:

  1. RBNZ policy depends on inflationary pressures.  A higher dollar (all other things equal) lowers tradable prices, which may have a downward impact on inflation expectations, which in turn will lead the Bank to lower the interest rate.  As a result, if people overseas start stimulating policy – then unless this leads to a significant pick up in external demand and commodity prices the Bank could well cut rates on its current mandate.
  2. For all the talk of volatility it is important to note that the NZ$ has actually been less volatile than the Australian dollar over the crisis years – surprising fact.
  3. Is it volatility in the exchange rate we care about, or volatility in the prices people actually face – remember that the “world price” of the things we sell overseas have been moving around violently, and the floating dollar has actually helped to reduce variability in the prices many exporters faced.
  4. Exporters and importers can hedge … combined with the fact that movements are smoothing external prices, this makes me feel that the volatility argument is often overplayed.
  5. Given that the exchange rate is seen as a random walk – and we have no idea what (short run) fair value really is a lot of the time – isn’t it just as likely intervention will increase volatility!
  6. If we are worried about the “relative price” argument (our dollar is too high because we are running a CA deficit that is “too large”) we should try to figure out what internal/external imbalances are causing that and deal with them directly.  This is not a volatility argument – and it should be well thought through and communicated before anything happens.
  7. If we believe the “exchange rate is too high for manufacturers” we need to ask why – is it the relative price impact above (which we have discussed), or is it “Dutch disease” – something that I don’t really believe is a disease, but merely the diagnosis of a side-effect stemming from a POSITIVE shock.

We all know I’m a sucker for the status quo, but I have no problem discussing these issues.  We should recognise that there are two perceived issues:  (1) volatility, (2) the relative price.  And then we should investigate why these things are happening, if there are associated welfare costs that we can reduce at a lower cost, and if so then clearly communicate why and what is going on.

Given my lack of faith in central government to achieve these things, as they enjoy using monetary policy as a political football, I am a strong proponent of the status quo.

Matt Nolan

What is this …

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This article on Bloomberg is something I largely disagree with – however, there is statement that needs more discussion.

Quantitative easing is “terrorizing” the world economy and will lead to depreciation of the U.S. dollar, pushing down prices in Europe and exacerbating the continent’s sovereign debt crisis, Mundell said.

The European Central Bank’s mandate to control inflation would likely hamper it from stemming the euro’s rise, while the currency’s gains would “likely lead to deflation,” said Mundell, who received the prize in 1999 and is known as the intellectual father of the euro. Falling prices would increase “the real value of indebtedness.”

Mundell is a genius, and one of the intellectual fathers of open economy macro, but what is this.

He is saying the the ECB won’t loosen policy because it fears inflation, but a rising euro will lead to deflation.  By the same logic, shouldn’t the ECB loosen policy to prevent deflation.  The same logic.  What the …

On the Chinese side, I disagree with the majority of what they are saying.  But:

The U.S. “has not fully taken into consideration the shock of excessive capital flows to the financial stability of emerging markets.”

Is a fair point.  Places where credit institutions are weak could be at risk in the case where global monetary policy is softened.  IMO, this implies that there should be more pressure on these places to make risks transparent and to work on institutional setting – not that countries facing deflationary pressures should just ignore them.

If the institutional setting is appropriate, then loosening global monetary policy in the face of higher than “natural unemployment” rates is a good thing both in terms of:

  1. Meeting inflation targets and ensuring that the deviations from the “natural rate” are as small as is efficient.
  2. Pushing countries who have an inflation mandate but have been fiddling the currency to either revalue OR force them to take on greater capital controls – which will also lead to larger asset losses for them.

I’m unsurprised China is not impressed – if the US is devaluing they face a loss on the capital value of their reserves.  This does not mean that it isn’t good policy – and if they are going to fiddle exchange rates this is a risk they had to face!

Matt Nolan

Monetary policy and the sun

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If you can follow the idea that price setting is a co-ordination game, you can see one of the reasons why monetary policy has real effects.  When economists discuss “menu costs” as a major reason for prices not changing, they are primarily thinking of this strategic element (where there are multiple, pareto ranked, stable and state dependent eqm) – even though it isn’t really a traditional menu cost at all, and how it interacts with menu costs is of more interest.

Sure, when we think about the labour market we enjoy talking about the “relative price of labour” and using monetary policy to make “labour relatively cheaper” – in fact a co-ordination game argument can be used here.  But the existence of a co-ordination game where the “relative price of goods” is held up too high is also important.  As long as prices are “state dependent” monetary policy has traction (even if physically prices are completely flexible!).

I had never heard the daylight savings analogy before, but I like it.

Update:  Economist’s View points to Romer’s graduate macro text where this is discussed.  It is a useful rundown but:

If there were literally no cost to changing nominal schedules and communicating this information to others, daylight saving time would just cause everyone to do this and would have no effect on real schedules

This statement is true, but it is worth fleshing out.  The “communicating” issue here is important methinks – as there are multiple Nash Equilibrium, and there may be uncertainty regarding the value other firms place on different ones.  If firms could communicate, or had knowledge about each others payoffs, and if there was a single Pareto superior eqm – firms would turn around and set prices in this way.

There can be zero cost to changing prices – but the fact that we have a co-ordination game with uncertainty implies that we can slip into an inferior equilibrium.  Furthermore, even with full information – if the equilibrium aren’t pareto ranked, but can be ranked on the basis of welfare, there can still be a justification for intervention.

I always felt that the fact that monetary policy has scope even in the face of fully flexible prices is something worth recognising.

Matt Nolan

November 10 Fed meeting

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The November 10 Fed meeting is more important for New Zealand then I think we currently recognise.  The decisions they make over the next two days are going to have a profound impact on the general monetary policy environment around the world – and New Zealand will not be immune.

Once they finally announce what they are doing I’ll be sure to stab down some thoughts.

Matt Nolan

Scott Sumner wins

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That is my impression of what is going on here (see Fed minutes too):

The Fed also said for the first time that it was considering targeting a path for the level of nominal gross domestic product as a way to increase price expectations.

And in case you aren’t sure who I’m talking about – Scott Sumner is the author of this excellent blog here, and has been pushing the NGDP target line for the entire crisis.  See the start of the blog in February 2009 – in the depths of the crisis.

While such a target doesn’t help in the face of a “supply side” shock, it does deal with “demand side” issues eg here.

Update:  His semi ‘celebration’ here.