New Economist

'Lone dove Danny' quits the MPC

Controversial Monetary Policy Commitee member and Dartmouth professor Danny Blanchflower is leaving the Bank of England, according to The Times: Man who wanted early rate cuts David Blanchflower steps down from MPC

Professor Blanchflower, who has voted to cut interest rates every month since October last year, said that he would not seek reappointment when his three-year term ends on May 31.

Once can hardly blame him. Despite being one of the first to call the economic slowdown, global recession, downside risks to inflation and upside risks to unempoyment, he has routinely been derided by City economists and market commentators - and ignored by his fellow MPC members.

His doveish voting record often put him at loggerheads with members of the committee, who refused to cut rates earlier over fears about rising inflation. Professor Blanchflower, who travelled to rate meetings from his home in the United States, maintained that the sharp economic downturn in America could be replicated here and advocated taking evasive action by cutting rates.

'Lone dove' Danny has been proven right. The rest of the MPC stubbornly refused to acknowledge the growing downside risks to UK inflation from the global credit crunch and economic downturn.

A key lesson from this is the importance to bring a global (or US0 perspective to monetary policy. In a globalised world, what happens in the United States economy and financial markets clearly has major implicatiosn for the UK. While in theory British-based MPc members ought to be aware of these developments and factor them into their thinking, danny's example shows that they don't.

It is clearly time to globalise the Monetary Policy Commitee and move away from a parochial 'little England' approach. Let's see if Treasury have learned the lesson, and appoint another US-based member as Danny's replacement.

'The continuing muddles of monetary theory'

One of the more lively papers delivered at this week's 75th Anniversary Lionel Robbins Conference in London was by the LSE's Charles Goodhart: The Continuing Muddles of Monetary Theory: A Steadfast Refusal to Face Facts (PDF). Goodhart believes monetary economics has "a long way yet to go", and few economists "have bothered much to relate theory to reality." Here's the abstract to his short paper:

Lionel Robbins was much concerned about the methodology of economic science.
When he discussed the desirable relationship between theory and ‘reality’, two of the
three examples that he presented where the theoretical analysis was not sufficiently
based on a knowledge of historical fact were taken from monetary economics.
Indeed, monetary theory has remained prone to such shortcomings ever since.

Amongst the worst are:-
(1) IS/LM: the monetary authorities set the monetary base, and the interest rate is
determined in the market;
(2) The monetary base multiplier of bank deposits, and the role of reserve ratios;
(3) The current three equation neo-classical consensus, which not only assumes
perfect creditworthiness for all agents, but also an essentially non-monetary
system, e.g. no need for banks;
(4) The standard theory of the evolution of money.

Monetary economics can only get better, but it has a long way yet to go.

Do central banks react to house prices?

Some do and some don't, according to a new working paper by Swedish Riksbank economists Daria Finocchiaro and Virginia Queijo von Heideken:

The substantial fluctuations in house prices recently experienced by many industrialized economies have stimulated a vivid debate on the possible implications for monetary policy. In this paper, we ask whether the U.S. Fed, the Bank of Japan and the Bank of England have reacted to house prices. We study the responses of these central banks by estimating a structural model for each country where credit constrained agents borrow against real estate. The main result is that house price movements did play a separate role in the U.K. and Japanese central bank reaction functions, while they did not in the U.S.

Rate cuts due next year as UK growth slows

Today's Bank of England Inflation Report contains a whiff of stagflation in its latest economic projections. Inflation is heading higher, at least in the short-run, while growth risks are to the downside:

In the central projection, higher energy and import prices push inflation above the target in the near term. Inflation then falls back to settle around the target in the medium term. The risks to growth are on the downside, while those to inflation are balanced.

The Bank expects tighter credit conditions and a slowing in domestic demand will slow UK growth to around 2% in 2008. While this is in line with private sector forecasts, I would not be surprised to see sub-trend growth dip towards 1.5% next year. Governor Mervyn King was ceretainly rather gloomy at today's press conference (webcast here). According to a Bloomberg report he warned that:

The central projection is for growth to slow sharply in the next year. ...There has been some tightening of credit. Residential and commercial property investment are likely to moderate, possibly quite sharply.

The Bank's latest forecasts are based on market assumptions that they will cut base rates by 25bp in the first quarter of next year. Indeed, financial markets are now expecting not just one 25bp cut around February 2008, but have also priced in a second cut around May 2008, which would bring official cash rates back to 5.25%.

New Chancellor Alistair Darling will certainly have his work cut out keeping budget and revenue projections on track. But at least British home owners can look forward to lower mortgage rates next year.

Explaining the T-bond 'conundrum'

In February 2005, then Fed Chairman Alan Greenspan referred to the decline in long-term rates in the wake of the Fed increasing the target for the federal funds rate by 150 basis points as a "conundrum" St Louis Fed's Daniel L. Thornton has investigated Greenspan's remarks and provides an answer, in a new working paper: The unusual behavior of the federal funds and 10-year Treasury rates: a conundrum or Goodhart's Law?

I show that the relationship between the 10 year Treasury yield and the federal funds rate changed dramatically in the late 1980s, well in advance of Greenspan's observation. I argue that the marked change in the relationship between the federal funds rate and long-term yields is a natural consequence of Goodhart's Law.

Here is what happened:

Once the Fed began targeting the funds rate for policy purposes and the funds rate remained close to the target, the behavior of the funds rate is necessarily different from what it would have been had it been free to respond to market fundamentals. This implies that the relationship between the funds rate and rates that are less closely linked to the funds rate would necessarily change. Since long-term yields are much less affected by the funds rate than other shorter-term rates, it is reasonable that the relationship between the funds rate and long-term rates would be most affected.

This hypothesis is supported by the fact that there was a marked change in the relationship between changes in the 10-year Treasury bond yield and changes in the federal funds rate that occurred in the late 1980s. The change in the relationship is statistically significant at monthly and quarterly frequencies. Moreover, an analysis of the levels of these rates indicates that the change persists at lower frequencies as well.

Some of you may not have heard of Goodhart's Law. It was coined by British economist Charles Goodhart in the mid-1970s, when he was was Chief Adviser to the Bank of England. The basic idea is that when a government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends. This proved prophetic when Margaret Thatcher was elected Prime Minister in 1979, and sought - disastrously - to conduct monetary policy on the broad and narrow money supply targets.

UPDATE:
Almost as soon as this post went up, another paper on the same subject appeared. Cracking the Conundrum, by the Stern School's David Backus and Federal Reserve economist Jonathan H. Wright, has just been published as Finance and Economics Discussion Series No. 2007-46. The authors hedge their best a little more than Thornton, citing several possible contributing factors:

From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25 percentage points, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic uncertainty and financial market volatility, more predictable monetary policy, and the state of the business cycle.

I accept there was a decline in the term premium (the expected return on long-term bonds). But surely this begs the obvious question: 'why?'. A post by James Hamilton of Econbrowser fame provides some discussion: The term premium and reduced volatility

Who took the money out of monetary policy?

In a recent economic discussion paper, Will Monetary Policy Become More of a Science?, Federal Reserve Governor Frederic Mishkin reviewed the progress economists have made in monetary theory and policy in recent decades. He had some good news for central bankers:

Monetary policy will however never become as boring as dentistry. Monetary policy will always have elements of art as well as science. (That is good news because it will keep life interesting for monetary economists like me.)

Not so boring - but there's a caveat:

However, the advances in the science of monetary policy that I have described here suggest that monetary policy will become more of a science over time. Furthermore, even though art will always be a key element in the conduct of monetary policy, the more it is informed by good science, the more successful monetary policy will be.

Mishkin's paper is worth reading for anyone interested in monetary policy (see also the comments at Mark Thoma's post). The paper was given in Frankfurt on 21 September at a conference to mark the 50th anniversary of the Deutsche Bundesbank: Monetary policy over fifty years (PDF). One of the other speaks was David Laidler, professor Emeretus at the University of Western Ontario, who spoke on: Successes and Failures of Monetary Policy since the 1950s (PDF). While quite upbeat, he is not uncritical:

Successes and failures in monetary policy stem mainly from coherence or lack thereof in the monetary order, rather than the tactical skills of policy makers. Crucial here are questions of consistency among the economic ideas that the policy regime embodies, the way in which the economy actually functions, and the beliefs of private agents and policy makers about these matters.

These postulates are used to frame accounts of the Bretton Woods System and its collapse, the Great Inflation that followed, the subsequent disappointing performance of moneygrowth targeting, the breakdown of the Japanese "bubble economy" the onset of theEMS crisis at the beginning of the 1990s, and since then, the launch of the Euro and the apparent success of inflation targeting. Though monetary policy seems rather successful at present, certain weaknesses in currently prevailing monetary orders are noted.

The implications are interesting. Like fund managers, for central banking it is more about the coherence of the framework and the process of the 'monetary policy regime' than it is the specific people. On this reading, Greenspan is either an outlier (like a star fund manager) - or has simply taken too much of the credit for the 'great moderation'.

And what about the weaknesses Laidler identifes? His main concern is the mistaken "view that the quantity of money is irrelevant for monetary policy":

Over-exclusive emphasis on the role of interest-rates in monetary policy has already done damage, having, in the 1990s, led the Bank of Japan into thinking that, once short interest rates reach zero, it had exhausted its options, and hence into not tackling promptly and vigorously the credit deadlock which followed the collapse of the “bubble economy”.

...the fact that demand for money functions proved insufficiently stable over monthly or even quarterly intervals to provide a basis for regular monetary policy decisions, does not imply that the only variables of any significance for monetary policy under any circumstances are the short interest rates that central banks use as their instruments, but it seems to be widely believed nowadays that this is the case.

Laidler sums up:

In short, though inflation in the world economy is now lower and more stable than anyone would have predicted even as recently as the beginning of the 1990s, and though we may be closer to a coherent international monetary order now than at any time since the late 1960s, the way forward is not yet risk-free.

Why not target unit labour costs?

Perhaps I am missing some fatal flaw, but I have found  econoblogger KNZN's arguments in favour of central banks targeting unit labour costs quite persuasive. It has the advantage over inflation targets of excluding exogenous shocks. It also forces the monetary authorities to take more account of productivity. Here is the nub of KZNZ's arguments:

The main purpose of this approach is to have a simple and easily understood (by the market) answer to the question of how to react to supply shocks. The appropriate response to supply shocks is a matter of great controversy in macroeconomics: should a central bank accommodate supply shocks and let the inflation rate rise temporarily in order to avoid a recession or a slowing of growth (or a boom, in the case of a favorable supply shock), or should it lean heavily against the inflationary impact (or the deflationary impact) of supply shocks in order to pursue an unchanged target inflation rate? The labor cost target settles the question: if the shock is to domestic productivity or to the labor market, then lean against the inflationary impact; if the shock is entirely outside the domestic labor market and production process, then accommodate (except to the extent that you expect the shock to have indirect effects on productivity and the labor market, such as might arise, for example, from sticky real wages).

The main arguments against this approach I can think of are:
1) the objection that this would put undue focus on wage bargaining
2) estimates of unit labour costs are subject to considerable revision - unlike the CPI.

Mark Thoma's post is, as always, worth reading. Your views welcome.

Who’s afraid of a big bad oil shock?

Another Yale professor, William D. Nordhaus, contributed a paper to last weeks BPEA celebration at the Brookings Institution. When the U.S. invaded Iraq in March 2003, many economists feared that the war would lead to a sharp decline in Iraqi oil production, a spike in oil prices, and a woeful economy that would follow the scripts of the oil shocks of 1973, 1978, and 1990. What happened and why is analysed by Nordhaus in a paper entitled: Who’s Afraid of a Big Bad Oil Shock? (PDF). Here are his conclusions:

So what should we conclude? To begin with, the oil shock of 2002-2006 was different from those of earlier period. If we measure the shock as the income effect per year of the price increases, the shock was substantially smaller than the shocks of the 1970s. It occurred more gradually, and the change was much less of a surprise in the context of past experience. Roughly speaking, the shock was about one-third as large as the shocks of the 1970s.

In terms of effects, the impact of the shock on inflation was qualitatively similar although quantitatively different from the earlier shocks. The rise in PCE inflation in the recent shock was consistent with less than full pass-through of the energy-price increase. Unlike the shocks of the 1970s, there appears to have been no substantial pass-through of the energy-price increases into wages or other prices.

The impact of the shock on output was completely different from earlier episodes – indeed the sign was opposite. Output continued to grow relative to potential output after the shock, and unemployment continued to fall. The reason for the anomalous output impact is unclear. One possible reason is that the shock was too small to affect the overall pace of economic growth.

Additionally, there is modest evidence that the transmission mechanism from energy prices to output has changed from negative to neutral over the last three decades. The reasons for the declining sensitivity are not completely understood, but two underlying causes seem plausible. First, there is evidence that the Federal Reserve reacted more sensibly to energy prices in the 2000s.. ...A second and more speculative reason for the muted macroeconomic reaction is that consumers, businesses, and workers may see oil-price increases as volatile and temporary movements rather than the earth-shaking changes of the 1970s. ...All of these factors would tend to reduce the impact of energy-price shocks on the macroeconomy.

In the end, this suggests that much of what we should fear from oil-price shocks is the fearful overreactions of the monetary authority, consumers, businesses, and workers. A cautious reading today suggests that policymakers should not be afraid of a Big Bad Oil Shock. The most recent evidence suggests that the economy is robust in the face of major energy shocks. The economy weathered an increase in real oil prices of 125 percent from 2002 to 2006 without any major strain. This suggests that policymakers should focus on fundamentals such as employment, real output, and containment of inflation as well as the instabilities caused by financial innovations and risk-taking. Oil-price shocks are neither so big nor as bad as in the 1970s.

See also the background documentation: Notes on Data and Methods (PDF)

Was it really due to easy money?

Yale's Robert J. Shiller has a forthcoming article in the Brooking Papers on Economic Activity which questions the popular interpretation that asset booms since the mid 1990s were a direct consequence of falling long-term interest rates. The paper, Low Long-Term Interest Rates and High Asset Prices (PDF), was prepared for a "Celebration of BPEA” Conference being held at the Brookings Institution last week. Here are Shiller's conclusions:

We have seen here that the big movements in stock prices and real estate prices in the last decade or so do not line up with movements in long-term interest rates over the same time period. This appears to confirm the 1988 results of Campbell and Shiller that stock prices relative to dividends or earnings are not well explainable in terms of present value models with time-varying interest rates.

Yet if we are doing very broad comparisons of the present time with another time, comparing the early 1980s when interest rates were very high with today, we might say that lower nominal interest rates are indeed a factor in the relatively higher asset prices we see today. ...Presumably, as I discussed in Irrational Exuberance, there are many factors, including speculative feedback, that have contributed to high asset prices today.

This paper began by considering a certain common belief about the way the world works which was motivation for this paper. We see that the idea that we should think of the level of long-term real interest rates as the dominant force in driving long-term asset prices up or down is not supported by the evidence.

Why the New Monetary Consensus sucks

We've had old-Keynesians, so I guess it's time for post-Keynesians. The Levy Institute's L. Randall Wray has written an intriguing little paper which argues that the foundations of mainstream, modern central banking is bunkum.

I'm a little more orthodox than Wray, but it's often good to consider different opinions. So here's the abstract for A Post-Keynesian View of Central Bank Independence, Policy Targets, and the Rules-versus-Discretion Debate

This paper addresses three issues surrounding monetary policy formation: policy independence, choice of operating targets, and rules versus discretion. According to the New Monetary Consensus, the central bank needs policy independence to build credibility; the operating target is the overnight interbank lending rate, and the ultimate goal is price stability.

This paper provides an alternative view, arguing that an effective central bank cannot be independent as conventionally defined, where effectiveness is indicated by ability to hit an overnight nominal interest rate target. Discretionary policy is rejected, as are conventional views of the central bank’s ability to achieve traditional goals such as robust growth, low inflation, and high employment. Thus, the paper returns to Keynes’s call for low interest rates and euthanasia of the rentier.