The Bank of Canada's success and failure

The Bank of Canada has been very successful in keeping inflation on target. Which is what the Bank of Canada was supposed to do.

But keeping inflation on target has failed to prevent recessions caused by deficient aggregate demand. Which is what keeping inflation on target was supposed to do.

The problem is not the Bank of Canada. The problem is the Bank of Canada's inflation target.

The first graph shows the level of total CPI, compared to a 2% trend line.

The second graph shows the level of core CPI, compared to a 2% trend.

You will notice two things:

1. Over the longer term, while total CPI kept very close to the 2% trend line, core CPI drifted below the 2% trend line. That is exactly what is supposed to happen, if the Bank of Canada was doing its job right. If total CPI is trending higher than core CPI, the Bank of Canada's job is to keep total CPI growing at 2%, and let core CPI grow more slowly than 2%.

2. In the shorter term, in 2008, we notice a sharp rise then fall in total CPI, relative to the trend, while core CPI keeps growing very steadily. That is exactly what is supposed to happen, if the Bank of Canada was doing its job right. It uses core inflation as a short-term "operational guide", rather than the more volatile total inflation.

The Bank of Canada does not have a crystal ball. But over the last few years its lack of a crystal ball didn't seem to make much difference. Even with the benefit of hindsight, we can say that the Bank of Canada made almost no mistakes in doing what it needed to do to keep inflation on target.

The Bank of Canada kept inflation on target, almost exactly as it was supposed to.

But keeping inflation on target wasn't good enough to prevent the 2008 recession.

Price level path targeting wouldn't have made any difference either. Because what the Bank of Canada actually did under inflation targeting was almost exactly the same as if it had been successfully targeting the price level path. Inflation targeting is only different from price level path targeting if the Bank makes repeated mistakes in the same direction, so that those mistakes cumulate under inflation targeting but are corrected under price level path targeting. But the Bank did not make repeated mistakes in the same direction.

You can't see any signature of the 2008 recession in the above two graphs. You can easily see the signature of the 2008 recession in the next graph.

The third graph shows Nominal GDP, compared to a 5% trend. In a counterfactual world, where the Bank of Canada was supposed to be targeting the level path of NGDP to follow that 5% trend line, what would we say? We would say that monetary policy was a little too loose in the years leading up to 2008, and then suddenly became much too tight in 2008, and stayed too tight thereafter.

In that counterfactual world, where the Bank was supposed to be targeting NGDP, but actually allowed NGDP first to rise a little above target, then suddenly fall well below target, we would all be looking at that third graph, and we would all be blaming the Bank of Canada for the 2008 recession.

It is as easy for the Bank of Canada to target NGDP as it is to target CPI inflation. There is no theoretical reason to believe that, if we had told the Bank of Canada to target NGDP at 5%, rather than CPI inflation at 2%, the Bank of Canada could not have kept NGDP as close to the trend line as it actually kept CPI close to the trend line. Because:

1. Monetary policy can ultimately target nominal variables but not real variables. NGDP is a nominal variable, just like CPI.

2. NGDP responds more quickly to monetary policy than does the CPI. We know this because the very reason the Bank uses a 2 year horizon to bring inflation back to target is precisely because it believes that overly aggressive monetary policy to bring CPI inflation back to target more quickly than 2 years would cause excessive short-term volatility in Real GDP. And NGDP is simply the product of Real GDP and the price level.

3. If people knew that the Bank was targeting NGDP, and expected NGDP to return to trend line following a shock, those expectations would act as an automatic stabiliser for NGDP. For example, if NGDP fell below trend, people would expect NGDP to grow faster than 5% for the next few years, and that combination of higher expected inflation and/or higher expected real growth would cause aggregate demand to increase today and NGDP to increase today, even if the Bank did nothing today. Or even if the Bank were unable to do anything today, because nominal interest rates were at the Zero Lower Bound.

The decision 20 years ago to have the Bank of Canada target inflation was a mistake. Inflation targeting was a better policy than what went before, but not as good as the path not taken. We should have adopted NGDP targeting instead. We thought that if the Bank succeeded in keeping inflation on target there would be no recessions due to deficient aggregate demand. We thought that recessions due to deficient aggregate demand would only happen if the Bank made a mistake, and let inflation fall below target, because it lacked a crystal ball. We were wrong. We know that now.

The graphs for CPI, either total or core, show no signature of the 2008 recession. The graph for NGDP shows a very clear signature of the 2008 recession. Targeting NGDP is no harder, and probably easier, than targeting inflation.

"It ain't broke; don't fix it"? The above graphs show that inflation is the dog that didn't bark to warn us of the 2008 recession. Inflation targeting is broke; we need to fix it. NGDP targeting is a better policy.

(Thanks to Stephen Gordon for the graphs.)

(BTW, I'm not able to post or respond to comments as frequently as I used to. That's because I'm temporarily back in administrative harness as associate dean, which is keeping me very busy doing lots and lots of all the little things that associate deans do. Sorry.)

Comments

[Sina Motamedi]

I think the graphs speak for themselves. Show them to every grad student out there.

[rp1]

I think NGDP targeting would be substantially more unfair than CPI targeting. You seem to think that recessions are a problem, and that you can prevent business cycles. I do not believe that is the case. I think recessions are caused by excessively optimistic investments leading to losses. If you mess with the business cycle, I believe it will just show up somewhere else. That is why CPI targeting is good. It is relatively neutral towards the credit cycle, and inflation expectations factor into everyones' decision making.

What if targeting NGDP at 5% reinforces inflation at 7%? I wouldn't want that policy long term. What if NGDP at 5% increases CPI by 1% per year? And there would never be a recession - no change, no restructuring, etc.

I think NGDP targeting is a return to the 1970's. If that policy is ever adopted, at least I know what to do.

[Determinant]

Vote for Pierre, er, Justin Trudeau?

[JP Koning]

Nice charts, good explanation. There's something about mixing words and images that makes a message so much clearer.

[Declan]

Agree with JP on nice charts and a good explanation.

What I wonder is, you say, "The graphs for CPI, either total or core, show no signature of the 2008 recession. The graph for NGDP shows a very clear signature of the 2008 recession. ... Inflation targeting is broke; we need to fix it. NGDP targeting is a better policy."

But maybe the type of recession you get is the one that isn't picked up by the approach you are using?

If you only guard the front door, inevitably somebody will sneak in the back door, and you'll say, if only we had devoted our efforts to watching the back door instead of the front door, they never could have snuck past us.

Just speculating, I can't explain with any confidence what the relevant mechanisms might be.

[Ralph Musgrave]

I quite agree with Sina Motamedi above. To repeat Sina’s point, the crisis was caused by excessively optimistic investment. In that scenario, to boost the economy by cutting rates so as to encourage investment is the definition of madness.

Even if the crisis had NOT BEEN caused by over-optimistic investment, I fail to see the point in boosting an economy just via entities that are reliant on variable rate loans, which is what happens when stimulus is implemented via interest rate cuts. You might as well stimulate an economy just via those with black hair, while blondes, red heads, etc wait for a trickle down effect.

In other words if stimulus is needed, why not implement fiscal AND MONETARY measures? As to whether those measures target inflation or NGDP, that’s a separate issue.

[Max]

"In that counterfactual world, where the Bank was supposed to be targeting NGDP, but actually allowed NGDP first to rise a little above target, then suddenly fall well below target, we would all be looking at that third graph, and we would all be blaming the Bank of Canada for the 2008 recession."

This is absolutely correct, but I'm not sure about the implication that if the bank had been targeting GDP, and GDP stayed on target, then there would be no severe recessions. Maybe we would be talking about how GDP targeting failed us, and we need to switch to this other thing which unlike GDP path clearly shows the recession.

Maybe rather than trying to find the best policy rule, it would be more ideal if central banks used a variety of rules. Policy diversification, if you will, so a bad rule doesn't take down the entire global economy.

[J.V. Dubois]

Yes, graphs and text is the way to go.

rp1&declan: We if you see the word recession, it most likely means "demand driven recession". It was mentioned many times over all over Market Monetarist blogs. Monetary policy have no power to guard us from supply-side recession (other then preventing simultaneous demand recession from forming). But as we see in 2008 example, even preventing demand recession is very important

And as for price level/inflation targeting being "neutral" towards credit cycle, that is plain wrong. It was proven for instance here: http://marketmonetarist.com/2012/01/20/guest-blog-the-two-fundamental-welfare-principles-of-monetary-economics-by-david-eagle/ that IT or PLT favors creditors by guarding and guaranteeing real purchasing power of money. This shifts all risks of negative shocks in real GDP on debtors. It is NGDP level targeting that distributes these risks evenly between debtors and creditors and thus it is better policy in term of social welfare.

PS: If NGDP growth is 5% and inflation is 7% that means that we would live in a world of minus two percent trend real growth which means minus two percent real interest rates. If we would pursue the same monetary policy of 2% IT or PLT that would mean that nominal interest rate would be zero on average. That means that we would be forever stuck at "zero lower bound" and that central banks would be basically "unable" (or unwilling given how they operate) to offset even minor shocks to aggregate demand. In truth in such a world to pursue current monetary regime would be madness.

[W. Peden]

rp1,

"And there would never be a recession - no change, no restructuring, etc."

Quite apart from everything else that was wrong in that comment, this sentence is mind-boggling: firstly, NGDP targeting wouldn't eliminate supply shocks and therefore wouldn't eliminate supply-side recessions; secondly, it's a fallacy of division to think that an economy-wide recession is needed for restructuring in/of particular industries or firms. Nor are any recessions needed for change since investment allocation is not zero-sum.

There was no recession in the UK from 1992 to 2007, but it was hardly a time without change or restructuring.

[W. Peden]

Ralph Musgrave,

"In other words if stimulus is needed, why not implement fiscal AND MONETARY measures?"

A good question. Here's what I hope is a good answer: there are things that fiscal policy needs to do that monetary policy can't, whereas there's nothing that monetary policy can do that fiscal policy can't do. So the efficient use is to focus fiscal policy on what it can do and monetary policy on what it can do.

Fiscal policy should be focused on funding government expenditure and providing a long-term environment for employment & growth, while also having a fair tax regime. That's a full time job and fiscal policymakers shouldn't be unnecessarily distracted from it. So, IF a task like stabilising demand can be carried out using monetary policy, why not take it off the hardworking politicians' backs?

[Oupoot]

Economic Policy consists of not just monetary policy, but also fiscal policy, international trade policy, competition policy, etc. Each area of economic policy has its area of speciality/focus. Why is it for economists to think monetary policy will solve the ills of poor economic policy?

The 2007-2009 recession was a failure of overall economic policy,in particular coordination between various elements of economic policy, despite the success of monetary policy. The poor response to the recession since then is mostly a failure of fiscal policy, despite all the efforts of monetary policy.

The major weakness of economics is its everlasting quest for the single indicator that will solve all the ills of economic policy. As someone commented, focussing only on 1 indicator will mean taking our eyes from the other indicators, allowing potential disaster to sneak up on you from somewhere else.

Besides, please find me any economists that said prior to 2007 that the economy was growing too fast (because the NGDP above 5% was due to GDP growing too quickly) - I would say 99% of economists were finding ways of explaining why there was "high" GDP growth that was natural, not cyclical. Good luck to any economists trying to convince future policy makers and politicians that NGDP above trend not caused by inflation is a bad thing and must be reigned in. E.g. a scenario when inflation is 2%, but NGDP is 7% because GDP growth is 5%.

[Lorenzo from Oz]

rp1 & Ralph: My one word answer is Australia. The question is not whether one can entirely abolish the business cycle, the question is whether you can ameliorate its effects. With perhaps a little luck helping, but not explaining, the outcome the RBA's average-over-the-business cycle inflation target has proved able to give Australia no recessions (defined as two consecutive quarters of negative growth) for over two decades. It still has a business cycle (particularly if you look at the per capita GDP data) but it is very, very mild. (Useful discussion here: http://marketmonetarist.com/2012/11/19/the-export-price-norm-saved-australia-from-the-great-recession/).

If the problem was over-optimistic investment, Australia should have had a problem too. We certainly have more than our share of inflated house prices and mortgage leveraging. Our public debt is low but our combined public and private debt is much the same level as everyone else's. And, hey, no recession for over two decades.

It's not the shock, it's how you respond and what sort of credibility your central bank has and its effect on expectations. The problem with simple inflation targeting is that it only has credibility on price expectations. If you are going to stop recessions, you need credibility on income expectations too. ABCT, as theory of the unsustainable boom, can tell you that a asset shock will hit; it explains not at all the depth and length of any subsequent downturn. Nor does any such asset shock imply that income expectations are unmanageable.

[W. Peden]

Oupoot,

"Good luck to any economists trying to convince future policy makers and politicians that NGDP above trend not caused by inflation is a bad thing and must be reigned in. E.g. a scenario when inflation is 2%, but NGDP is 7% because GDP growth is 5%."

So NGDP targeting is a bad policy, because if we didn't follow NGDP targeting, that would be bad? Interesting reasoning.

[Bill Woolsey]

Great post!

Nominal GDP level targeting only solves the problems of excessive or inadquate spending on output.

Various economic policies or events that result in increases or decreases in productive capacity are not solved nominal GDP level targeting.

A recession or slowdown in the ability to produce goods, perhaps generated by unusually poor investments or poor trade or other types of policy will result in modestly higher inflation for a time. While nominal incomes will continue growing as usual, the higher prices will result in the inevitably slower growth in real incomes.

Nominal GDP level targeting is not about stabilizing real GDP when potential real GDP changes.

CPI targeting requires responding to shifts in productivity by changes in monetary policy to keep the CPI on target. This requires changes in other prices--resource prices, particularly wages.

Wages are prices too. If you stablize the CPI and productivity grows more slowly (say due to unusually poor past investments,) then the prices of resources like wages must grow more slowly.

Nominal GDP lt targeting keeps some prices -- wages-- on trend when this happens, and instead has consumer prices grow more rapidly (or more slowly for a productivity speed up.)

When productivity grows more slowly or more rapidly, the impact of nominal GDP targeting is similar to a quantity of money rule or a gold standard. Under those regimes, the result of more rapid or slower growth in productivity is a temporary change in the inflation rate.

It is not the case that a slowdown in productivity growth requires lower interest rates to cause inflation to rise. The slowdown in productivity growth with a given trend in wages results in more rapid growth in unit costs, so firms raise their prices more quickly. Output grows more slowly (and is expected too) which tends to slow growth in credit demand, but inflation is expected to be higher which tends to raise credit demand. While it is likely that there would be some effect on interest rates, it isn't obvious that they must fall.

The notion that inflation stays the same unless interest rates fall is false.

If investment demand falls for some reason (say past investments turned out worse than expected and there is nothing else) then this lowers the interest rate necessary to keep saving and investment equal. In that situation, using monetary policy to keep interest rates from falling is distoritionary.

By the way, the nominal GDP above trend before the recession might have been caused by "too much" investment in Canada, And so, inflation targeting failed to prevent "too much" investment in Canada. If there had been nominal GDP lt, that wouldn't have happened.

[Phil Koop]

Well, you've convinced me.

BTW, what did you think of that Romer & Romer paper arguing that the most important mistake of the Fed has been to systematically underestimate its own powers? Seems to support you monetarists, no?

[Frank Kruger]

Like this article as it puts perspective to what the Bank of Canada is trying to do. It is very true that it has done a good job of maintaining a favorable economic environment over the last two decades or so. Also, I agree that targeting core inflation is probably too narrow a mandate. What do you think of the U.S. Fed's dual mandate (inflation and unemployment)?

Just one point...I do not think you can argue that targeting NGDP could allow the country to avoid recessions. After all, we saw a CPI spike in 2008 to to increased demand for resources from Asia, an entirely external influence. In addition, the recession that followed had much to do with the global financial meltdown which ultimately impacted overall aggregate demand, and interest rates just did not matter. Now, with rates at close to zero, the Bank of Canada is really left with potentially unconventional monetary measures to target a higher NGDP. Would these measures be sufficient? Or should fiscal or other policies play their role? There was an initial fiscal package in 2009-2010, but was that really enough? Somehow, I doubt it.

A side note is how the Canada / U.S. exchange rate has changed the game since 2008; businesses since then have been rationalizing what Canadian labour is utilized to provide products for U.S. or other markets. I know that the bank has been considering this while setting its policies, but I just wonder how much of this impact's weight should be placed on only the bank's shoulders.

[Felipe]

Over at Scott Sumner's blog I have sometimes asked about how would NGDP would apply to emerging economies. I remember he said he favoured NGDP targeting for the US because of pragmatic issues, not really because NGDP was the optimal target. In particular, NGDP only works when the economy is sufficiently large and diversified so that a single sector cannot make a significant impact on overall NGDP. For example, an oil exporter would have to tighten a lot when external demand for oil rises, choking off the rest of the economy.

Canada is larger and more diversified than most commodity exporters, but exports are still a sizeable portion of the economy. Would that be a problem for Canada if it implemented NGDP?

[Andy Harless]

"Price level path targeting wouldn't have made any difference either."

Well, it would have if it were done in a sensible manner. Targeting the path of a headline price index makes little sense, because there are components that are volatile but have permanent shifts. For example, suppose a sudden advance in energy technology is discovered that causes a drop in the price of oil. Headline price level targeting would require you to compensate by producing a subsequent bout of inflation, which would be silly. Normally, if you are doing inflation targeting instead of price level targeting, you will just let bygones be bygone and say, OK, that bout of disinflation is water under the bridge, now let's keep pursuing our inflation target. But if you're doing price level path targeting, you have no way out. So if you're going to do price level path targeting, you ought to use an index that removes components that are particularly subject to such dramatic shifts unrelated to aggregate demand. (Or, one could say, leave out important prices that are much more flexible than typical prices.)

So if the BoC were doing price level targeting in a reasonable way (rather than doing inflation targeting in a semi-reasonable way or doing price level targeting in an unreasonable way), it would be targeting the series in your second graph, and it would, on several occasions, have loosened much more aggressively than it did. Or Chuck Norris would have loosened for it. The Great Recession wouldn't have been avoided, but it would have been milder.

I just wrote a post about this topic with respect to the Fed. Maybe there's something in the air.

[J.V. Dubois]

Felipe: This actually also bothers me. Generally, the answer is that some MMs really preffers different measures - from NGDPL per capita targeting, or even better: wage income targeting (as wages are what causes issues, but it cannot be easily implemented for practical reasons). There were also suggestions to regularly reevaluate target NGDP growth as reevaluated RGDP growth + inflation

Anyways, none of these really capture something that (so far) only Nick talks about. Every other macroeconomists out there defines recession as period with high unemployment and/or insufficient aggregate demand. But Nick himself has broader definition in mind that incorporates not only shock to production and sales of newly produced goods and services, but also shock to sales of old goods. I recently read an interesting article by Matt Yglesias who remarked that it is interesting that while everyone is focused on mystery that an unemployment exits - explaining it with various micro theories, but there are equally mysterious things out there that beg for explanation. Like unemployment of buildings. How is it possible that there may exist empty buildings? Why market for renting of already produced buildings does not clear, why prices refuse to fall? The usual suspects borrowed from labor market, such as government regulation or efficiency wages do not explain this phenomena.

I still think that there is more going on then just adopting NGDPLT and then claim that history just ended. But it could be a start.

[RebelEconomist]

"But keeping inflation on target has failed to prevent recessions caused by deficient aggregate demand. Which is what keeping inflation on target was supposed to do."

This is one of the great canards on which calls to replace inflation targeting are based. What was actually said was something like "price stability WAS THE BEST CONTRIBUTION central banks could make to economic stability". As Nick rightly notes, central banks have limited influence over real activity, and some argued that central banks' attempts to use what influence they had had been destabilising anyway, so it was felt that central banks should focus on price stability. There were a whole lot of other contributions that should have been made and were not.

The idea was that governments could boost real activity by supply side measures, and foster economic stability to some degree by counter-cyclical fiscal policy and regulation. The trouble was of course that governments failed to do this, because just as they would if they were in charge of monetary policy, governments shy away from anything restrictive and therefore unpopular.

It has not been inflation targeting that has failed; it has been the people that WERE supposed to be responsible for economic stability, including regulators and politicians. We should not be so foolish as to be misled by them to look in the wrong place to fix the system.

[Simon van Norden]

"The Bank of Canada kept inflation on target, almost exactly as it was supposed to."

Lovely graphs....but doesn't the first graph seem to suggest that the Bank has effectively been targeting the price level rather than the inflation rate? It doesn't look like they're letting bygones be bygones...

[Simon van Norden]

Doh! I really need to read to the end of your posts before commenting....

[jesse]

- Setting a target for NGDP risks building up distortions if incorrect. Change the slope on the NGDP trendline by 0.5%. Maybe there was a de facto target already in place.
- Further to that, fiscal policy is more than capable of targeting NGDP. Putting it in the purview of the central bank makes the system less flexible given the limited outputs available to the Bank to affect.

You are describing a framework one could employ if fiscal policy is dysfunctional. Canada's fiscal policies were arguably misguided, hence the runup in NGDP during the last decade. From that point of view a reversion was necessary.

In any case you may be right. Applications to change the system are being accepted.

[David]

Lovely graphs, Nick. But what you fail to show is the time-path of real GDP under your hypothetical NGDP targeting regime.

[Ralph Musgrave]

W. Peden,

I quite agree that IN THEORY we should “focus fiscal policy on what it can do and monetary policy on what it can do”. But I suggest the REALITY is that economists have only the haziest of ideas as to which of the two is good at what. In addition, there is plenty of argument as to how big the crowding out effect of fiscal policy is (by that I mean having government borrow and spend). So my reaction to the above theory is: “forget it”. I.e. why not just create new money and spend it into the economy when stimulus is needed (and do the reverse if inflation looms). That automatically combines monetary and fiscal.

The latter “joint” policy was favoured by Abba Lerner (I think) and quite a number of MMTers. Plus it’s advocated in this work:

http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

Next there is your claim that “IF a task like stabilising demand can be carried out using monetary policy, why not take it off the hardworking politicians' backs?” Nick Rowe actually made a very similar point a year or so ago, but I don’t agree, and for the following reasons.

The proportion of GDP allocated to public spending and the division of that money between education, defence, etc etc must remain with the electorate and politicians. But there’d be nothing to stop some sort of independent committee of economists (like the Bank of England’s Monetary Policy Committee) allocating relatively small additional (or fewer) funds to ALL forms of spending when stimulus is required. Plus they could cut taxes by the same amount so that the proportion of GDP going to public spending remained constant.

The latter policy would thus not be any sort of imposition on what you call “hard working politicians”.

Lorenzo from Oz,

If Australia has been smarter with monetary policy than other countries, then other countries need to learn. But I don’t that is strictly relevant to my above initial point which was that there is something inherently illogical about stimulus effected JUST BY monetary policy, namely that all the stimulus comes (at least initially) via extra lending and investment. I actually listed a number of other silly aspects of “monetary policy alone” here:

http://ralphanomics.blogspot.co.uk/2012/03/sixteen-reasons-why-mmt-is-right-on.html

[Ron Ronson]

This is the best explanation of the advantages of NGDPT that I have seen.

It seems that the disadvantage of inflation targeting is that in the case of an extreme fall in expectations about the future it is possible to hit an inflation target while seeing both NGDP and RGDP falling. The advantage of NGDPT is that in these same circumstances it will both increase expectations about future demand and increase expectations about future inflation both of which should improve expectations about the future and drive higher RGDP than under IT.

However in the case of an extreme fall in expectations that cause a sharp fall in RGDP (that may be partially driven by real supply-side factors) then NGDPT may lead to a view that inflation is going to be high and make economic calculation hard and lead to a fall rather than rise in expectations and lower RGDP compared to IT.

(BTW: It the discussion about NGDPT v IT really the "is monetary policy effective at the lower bound" discussion in disguise ? I have an intuition that the point where the effects of NGDPT and IT deviate from each other is the same point that we-would hit the ZLB )

[Andrew F]

So, if the BoC had successfully targeted NGDP, we would see no signature of the 2008 recession, but it would have shown up as spikes of inflation on the first chart?

What is price stability worth? Is the argument that long run RGDP growth should be slightly positive, and thus long run inflation should be also be just slightly positive? And that short run swings in price level are not much of a problem when compared to reducing/eliminating demand recessions?

[rp1]

Lorenzo: Australia is going to have a financial crisis. Slightly higher rates have helped their banks borrow heavily from rest of the world and they've plowed it into housing. They have insane policies such as negative gearing. Get a tax writeoff for your speculative real estate investments that are bleeding money every month. Sorry mate, you guys are cooked.

[Peter N]

Lorenzo,

"no recession" yet. Consumer debt is high, and you're dependent on resource exports to China. For consumer debt as for everything else, Stein's law applies.

[Peter N]

W. Peden,

Monetary policy doesn't seem to be all that well defined anymore. Do we mean a regime where central banks can buy whatever securities they want, lend to whoever they please, and place fiscal conditions on lending, or just one where they buy and sell government bonds and control the discount rate?

The enhanced version is certainly more powerful, but you can't very easily put it on automatic pilot with a simple rule. Maybe that goal is illusory.

[W. Peden]

Peter N,

"Monetary policy doesn't seem to be all that well defined anymore."

It never was.

"one where they buy and sell government bonds and control the discount rate?"

Though I doubt it was ever defined this way, since (as far as I know) central banks have never restricted their open-market operations to government debt.

"The enhanced version is certainly more powerful, but you can't very easily put it on automatic pilot with a simple rule. Maybe that goal is illusory."

All "auto-pilot" proposals, as far as I know, involve quite radical changes to the very structure of banking and monetary policy. Milton Friedman, for instance, never argued that you could simply turn the expansion of the monetary base over to a computer without a root-and-branch reform of the structure of banking.

[W. Peden]

Ralph Musgrave,

"But I suggest the REALITY is that economists have only the haziest of ideas as to which of the two is good at what."

Perhaps, but I've never heard such modesty from economists when discussing their OWN proposals, and this most certainly includes Post-Keynesians and MMTheorists.

"why not just create new money and spend it into the economy when stimulus is needed (and do the reverse if inflation looms)."

There are big symmetry problems there, as with all fiscal policy. Handing out cheques to poor households would be very popular in a bust, but sending them bills would be unpopular in a boom.

"But there’d be nothing to stop some sort of independent committee of economists (like the Bank of England’s Monetary Policy Committee) allocating relatively small additional (or fewer) funds to ALL forms of spending when stimulus is required. Plus they could cut taxes by the same amount so that the proportion of GDP going to public spending remained constant."

For the sake of argument, let's assume away symmetry problems and political economy issues. Let's assume that the money "getting into the economy" is a big issue. Indeed, let's assume some hardcore monetary circuit assumptions, though let's not assume Keynes's liquidity trap holds in any real-world economies, i.e. ones that have assets other than money and government bonds. Sticking in real-world economies, let's assume that negative IOR is not an option. So QE is never effective and central banks are powerless when the prevailing short-term interest rate reaches zero.

EVEN THEN, I think your proposals are quite unnecessary. All that would be needed for a stimulatory increase in the broad money supply would be for the governor of the central bank to send a letter to the Chancellor of the Exchequer saying, "Please fund expenditure to extent X over the time period Y from the banks rather than the non-banking public." So with no changes in total taxation, no changes in total expenditure, and no changes in particular taxes or expenditure (no "public works") and no unelected committees interfering with the vital details of fiscal policy, you could have a stimulus even at the ZLB.

Is that monetary or fiscal policy? I'm inclined to say fiscal policy. However, if we relax some political economy assumptions, I think it's clearly a better option than the kind of fiscal stimulus that has been promoted for many years by Keynesians in such a scenario. Short of being convinced that government borrowing from banks doesn't increase the broad money supply or that such an increase has no effect on nominal demand, I can't imagine being persuaded by your proposals or indeed any functional finance/social-credit/MMT proposals.

[Nick Rowe]

Bill and Andy: sorry. Your comments got stuck in spam. I just fished them out.

[Nick Rowe]

Phil: "BTW, what did you think of that Romer & Romer paper arguing that the most important mistake of the Fed has been to systematically underestimate its own powers? Seems to support you monetarists, no?"

I didn't read the whole paper, only a few bits on someone's blog. But it sounds plausible to me. From my memory, that exactly fits the 1970's, when many people argued that inflation was caused by non-monetary forces, and therefore monetary policy couldn't control it (which doesn't follow, as e.g. disease is not usually caused by the absence of medicine), and so many countries did things like price and wage controls. And then finally, eventually monetary policy was used, after everything else had failed, and it worked.

And we are seeing exactly the same argument today: "monetary policy didn't cause the recession, therefore monetary policy can't cure it". Now sure, getting financial markets and banks to stop blowing up would be nice, but even if we fail at doing that, it doesn't mean there *has* to be a recession. And in Canada that argument is even less plausible. Because Canadian banks did not fail. And apart from that relatively minor ABCP problem, which was fixed, Canada did not have a financial crisis. And yet, crazily, everyone seems to think that since every other country is having a recession, Canada has to have one too. Sure, the recession in the rest of the world reduces demand in Canada, but the whole point of good monetary policy is that it should offset demand shocks.

Perhaps I should have made this point explicitly in the post, especially for non-Canadian readers: Canada did not have a financial crisis. But we still had a recession! Which surely make the financial crisis = recession theory look less plausible.

[W. Peden]

Nick Rowe,

Although a financial crisis may still be a sufficient condition for a recession. (I don't think that it is.)

[Nick Rowe]

In response to a number of people:

Sure, I have not *proved* that if the Bank had kept NGDP growing at 5% there would not have been a recession just as bad as the actual recession. But the only model I can think of in which that counterfactual would be true would be a pure RBC perfectly flexible price model, which would say that the 2008 recession was a pure supply shock. And I just find that model so implausible.

Would the relationship between CPI and NGDP be totally invariant with respect to the monetary policy regime (IT vs NGDPLPT)? Probably not. Can I *prove* that the whole economy wouldn't go to hell if we switched from IT to NGDPLPT? Nope. But I don't know any empirical or theoretical reasons to think it should.

If the Bank had failed to keep inflation on target, and had let inflation fall significantly below target, and that mistake had coincided with the recession, then I would have a harder task. Someone could argue that it would have made an equally big mistake if it had been targeting NGDP. But that is not what happened.

[Nick Rowe]

Andy: if you put a ruler on my core CPI graph from about 2002/3 onwards, it looks awfully straight. My eyeballs cannot reject the hypothesis that the BoC was targeting the level path of core CPI (at about 1.9%, or whatever). But we still had a recession.

Now, in the hypothetical case that core CPI *had* deviated significantly from target, then we would have to ask whether the stabilising expectations under PLPT would have been an improvement over IT. And it is plausible that they would have been an improvement. But that case remains a hypothetical. It didn't happen, so in this sample those possibly stabilising expectations never got to play their part.

[Ritwik]

Nick

So, the short run Philips/AS curve is horizontal??

[Nick Rowe]

W Peden: in the space of all functions F( ), where Recession = F(Financial crisis, Monetary policy), only a small subset of that space would have financial crisis being a sufficient but not necessary condition for a crisis. (Sorry. That's perhaps resorting to weird metaphysics.) But yes.

Ritwik: "So, the short run Philips/AS curve is horizontal??"

That's the question I keep asking myself. I knew we never really understood the SRAS/SRPC, but it now seems we understand it even less than I thought we did.

Maybe:

1. 20 years of IT really did make the SRPC *structurally* flatter, (and it's not just a statistical illusion because everything should look flat under IT if inflation is on the vertical axis).

2. Maybe the SRPC was close to flat, and a smallish supply shock (oil?) caused it to shift up a little.

3. Some sort of Peso problem recession.

4. Something sort of coordination thingy I can't get my head around yet, because I don't like any of those 3.

And I haven't seen any/many bloggers really try to come to grips with that question.

[W. Peden]

Nick Rowe,

Actually, I find weird metaphysics much easier to follow than relatively simple mathematics, so there's no need to apologise.

[Ben J]

"Australia is going to have a financial crisis. Slightly higher rates have helped their banks borrow heavily from rest of the world and they've plowed it into housing. They have insane policies such as negative gearing. Get a tax writeoff for your speculative real estate investments that are bleeding money every month. Sorry mate, you guys are cooked."

Well, rp1, you made your prediction. Sady, I don't think it will come to fruition. Primarily, you are misinformed about Australian banks. The biggest cost driver of Australian domestic banking recently has been an increase in funding costs overseas, which drove competition for domestic savings up. Local institutions, especially the Big 4, were competing vigorously by increasing term-deposit rates and offering incentives to switch cash portfolios. The idea that the banks have borrowed heavily from the rest of the world is actually the exact opposite of what has happened.

Peter N said something similar,

"Consumer debt is high, and you're dependent on resource exports to China."

As the RBA notes:

"Households increased their borrowing through the 1990s and early 2000s, and partly used this to fund consumption. However, as noted above, households have changed their spending behaviour since the mid 2000s, which has seen consumption fall as a share of GDP and the saving ratio rise." In fact the savings rate has increased to over 10% in recent years. The stock of consumer debt and business debt are returning to what the bank calls "decade averages". House prices are flat but stable.

On the topic of China, you're just plain wrong. It's madly overstated. Here is a paper on output co-movement between China and Australia that finds that co-movement exists but is limited, hardly a story of dependence.

http://www.uq.edu.au/economics/eaerg/dp/EAERG_DP20.pdf

[Ralph Musgrave]

W. Peden,

I agree that what you call “symmetry problems” exist. But I don’t think those problems totally invalidate my idea. For example, in Britain the VAT rate was reduced and then increased again during the crisis. As to reducing the incomes of “poor households” one could avoid adjusting the state pension perhaps, and alter just things like payroll taxes (as advocated by Warren Mosler). Also adjusting funds disbursed by central government to local government wouldn’t be difficult. Though it would be important to ensure those funds are actually spent: looks like much the stimulus money disbursed by the Federal government in the U.S. to states during the crisis may not actually have been spent. See:

http://johnbtaylorsblog.blogspot.co.uk/2012/03/in-blog-post-yesterday-paul-krugman.html

Re your idea about having private banks “fund expenditure to the extent X over the time period Y”, I don’t see the point in the government / central bank machine telling private banks to create and lend out money (and take a their cut) when the latter “machine” can do the job itself: i.e. create money and dish it out.

As to having the Chancellor rather than BoE Monetary Policy type committees decide on the size of stimulus, I don’t like that because it involves a politician deciding how much money to print and spend. As I said, I’m happy with the electorate and politicians deciding the proportion of GDP to be allocated to public spending and how that spending is split between education, defence, etc. But stimulus decisions are ALREADY to significant extent in the hands of the above sort of committee, and I think those decisions should stay there.

Re your claim that the above sort of committee would “interfere with the vital details of fiscal policy”, there is no need for that to happen. When the BoE Monetary Policy Committee adjusts interest rates, that does not mean they “interfere with the vital details” of investment or other borrowing decisions. Interest cuts, for example, just give a bit of encouragement to borrowing and lending. The DETAILS are left to borrowers and lenders.

Likewise, extra money disbursed to local government under fiscal stimulus to local government would just encourage the spending of a bit more on road repairs, education or whatever. The DETAILS remain with those who normally attend to the details.

[Peter N]

W. Peden

I like your proposal "All that would be needed for a stimulatory increase in the broad money supply would be for the governor of the central bank to send a letter to the Chancellor of the Exchequer saying, "Please fund expenditure to extent X over the time period Y from the banks rather than the non-banking public.""

It may or may not be practical or the best alternative, but it's a perfect benchmark against which to compare other policy in economic models, because it's free of side effects. You could say things like "plan Z is demonstrably better than the benchmark according to measure M.

Also narrow monetary policy doesn't really characterize past policy of many central banks, but I believe it is what is meant by monetary policy by some blogging economists. If it isn't, then they should state what the boundaries are for them.

[Peter N]

Ben J,

China trade as percent of GDP has doubled since that paper was published. I'm not forecasting a crash, but I'd be surprised to see the no recession record hold for another 10 years.

[W. Peden]

Ralph Musgrave,

"For example, in Britain the VAT rate was reduced and then increased again during the crisis. As to reducing the incomes of “poor households” one could avoid adjusting the state pension perhaps, and alter just things like payroll taxes (as advocated by Warren Mosler)."

Then one is straight into the problem I mentioned: fiscal policymakers are being distracted from what they can only do.

"Re your idea about having private banks “fund expenditure to the extent X over the time period Y”, I don’t see the point in the government / central bank machine telling private banks to create and lend out money (and take a their cut) when the latter “machine” can do the job itself: i.e. create money and dish it out.

As to having the Chancellor rather than BoE Monetary Policy type committees decide on the size of stimulus, I don’t like that because it involves a politician deciding how much money to print and spend. As I said, I’m happy with the electorate and politicians deciding the proportion of GDP to be allocated to public spending and how that spending is split between education, defence, etc. But stimulus decisions are ALREADY to significant extent in the hands of the above sort of committee, and I think those decisions should stay there."

I disagree with you on your first paragraph for the same reason I agree with you on the second paragraph, namely political economy concerns. Borrowing from banks instead of the non-bank public preserves a cost on credit expansion by the government, while still being stimulating. So "printing money" and borrowing from banks are not quite the same job. However, "underfunding" as it was once called, is also an option in theory, were monetary policy ineffective for some reason.

Peter N,

"Also narrow monetary policy doesn't really characterize past policy of many central banks, but I believe it is what is meant by monetary policy by some blogging economists. If it isn't, then they should state what the boundaries are for them."

A reasonable desire, though a Quixotic one!

Probably the simplest and least (LEAST) misleading approach would be to say that what's in the hands of the suppliers of government base money is monetary policy, and what's in the hands of those who produce national budgets is fiscal policy. Is that a good definition? No, but it's both close to widespread usage across a variety of fields and has at least some theoretical bite e.g. it highlights how fiscal policy can affect monetary policy, since the identity-

Change in broad money = change in lending to the private sector + the balance of payments + (the PSBR - lending to the non-bank public, where PSBR = the Public Sector Borrowing Requirement)

So the PSBR, which is under the control of the fiscal authorities, is a partial determinant of changes in broad money.

(I know that Post-Keynesians like a nice wee accounting identity!)

[Peter N]

I thought it would be interesting to compare Canada to some other developed countries. The figure to be compared is total debt - financial assets as a percentage of GDP. This should be a factor in a central banks freedom of action.

US -5%
Australia -83%
Italy -88%
Germany -90%
France -158%
Canada -189%
Spain -199%
Japan -200%
UK -219%

The question is why is Canada up there among the -200% crowd, and how much of a problem is it?

This is who owes the money

Total Debt as a percentage of GDP: 277%

Household: 105%

Nonfinancial Corporations: 59%

Financial Institutions: 91 %

Government: 21%

The household debt is the largest of any of the countries above. Next is the UK at 98%. The US is 87%. Spain is 82%.

[Bubbles and Busts: Will NGDP Targeting Increase Consumer Price Volatility?]

Nick Rowe recently discussed the Bank of Canada’s success and failure in inflation...

Gordon and Rowe’s focus is strictly on Canada, but given the hype surrounding NGDP targeting in the US, it might prove interesting to compare similar data.