Tag: Central Banks

Inflation (re)targeting

Central banks by and large try to pin inflation to 2%. When prices rise above that, central banks lift rates, people lose jobs, the economy slows and prices slink back down. The higher inflation, the harder it is to muscle back down. Going from 8% to 4% will be tough and take time. Going from 4% to 2% will be even tougher, especially because by then, many will have lost jobs and the economy will be stalling. Why not make it a little easier and raise the target slightly?

Two great pieces in the FT over the past week on the issue.


Ethan Wu in the FT lays out the temptation for central banks succinctly:


It’s no large leap to imagine a scenario where inflation is falling but still above target, while unemployment is rising but not yet recessionary. The political pressure to loosen policy would be immense. The Fed might conclude raising its inflation target, or at least acting chill about enforcing it, is the best of a bad set of options.

Well, people might not believe the new target, goes the counter argument. If people suspect the central bank will goes easy on inflation today, they’ll expect the same again tomorrow. The result is inflation tends to stick around.

Still, the idea of lifting the inflation target slightly to 3% or 4% is gaining traction. In an opinion piece last November Olivier Blanchard, an economist who has banged this drum since at least 2010, dusted off the idea. He spoke to the FT again about whether changing the target will make people distrust central banks:

I think, in the right environment, a one-time goalpost move would be credible. There is no slippery slope here. It is clear that the earlier conclusions and computations that 2 per cent was the right target, and the probability of hitting the ZLB was small, were wrong. I think any reasonable economist, including [Harvard’s Kenneth Rogoff and Gramercy’s Mohamed El-Erian], agree about that. I think there is zero risk of moving the target further and further. I heard the same argument about credibility when central banks started QE.

I share Blanchard’s skepticism about slippery slope arguments. Trust does not grow in a vacuum. I treat differently the friend who repeatedly borrows and fails to repay money, to the one who faithfully repays me, but one day comes in tears, to say they lost their job, and need more time. Context matters, history matters.

Andy Haldane, former Bank of England chief economist argues for a third way. Central banks should fudge the issue and promise to get back to 2% eventually. He sees the 2% target as a relic of an era where inflation was kept low by globalization (cheap transport / cheap labour, predominantly in China). That’s over he says, and we’re now in an era where inflation will be buoyed up (trade wars make transport expensive and Chinese workers want higher wages). The 2% target should be shelved until this passes.

But the line is thin between a permanent change and a pause for an undefined amount of time. If they’re both likely to undermine credibility, better to make the change and be done with it.

Central banks, climate change, and firing an AK-47 underwater (wonkish)

Barry Eichengreen has written a piece for Project Syndicate on how central banks can help tackle climate change and inequality.

The standard argument is that central banks do not possess the tools to combat these issues, and even if they did, doing so would call their independence into question, undermining their ability to fight inflation. Barry disagrees. He argues central banks have a swathe of regulatory tools that could be deployed, and this fact creates a moral responsibility to act given the existential nature of these issues.

As I read it, Eichengreen’s climate change proposal does not go beyond what most central banks have already expressed willingness to do: create a strict and consistent framework for disclosing climate risk, and then use that information when assessing risk in the financial sector. For example, banks who hold lots of assets with climate risk might have higher capital requirements, the same as if they hold lots of junk bonds or dodgy mortgages. There is no mention of using the balance sheet, or differentiating between the collateral a central bank accepts (as I discussed the other day).

His deeper point, that there is no shortage of tools for central banks to tackle important policy issues, is an important one.

Central banks often claim they do no possess the appropriate tools for tackling inequality or climate change. Look, they’ll say, interest rate changes take years to filter through the economy, and besides, the effects are too broad; it’s like trying to hit a target 500 meters away, with a shotgun, underwater.

An AK-47 – close enough

This is a bit disingenuous. The experience of the GFC and COVID-19 has shown that tools can be invented to fit our needs; swap lines, the paycheck protection program, the Main Street lending program, the multiple variations of quantitative easing. Central bankers may well be the only innovators in the world who do not post about their new creations on LinkedIn.

Even the boring old interest rate can be incredibly flexible, as Eric Lonergan’s proposal for dual (and discerning) interest rates shows.

The real problem is not so much a lack of tools, but the risk of becoming politicized (I’m going to write a whole post on politicization, because it is more nuanced than it first appears). That’s a legitimate concern, and one we should seriously discuss.

Economics is about optimization under conditions of scarcity, so any such discussion should be guided by the trade-offs associated with independence. What policy tools would be available were maintaining independence no longer a concern? What would the costs and benefits of any alternative arrangement be?

Please do read the whole thing.

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Inflation forecasts or irrational exuberance?

If your eyes glaze over at the mention of inflation, take a look at this and feel free to go:

My own calculations using forecast figures from the SMP and inflation data from the ABS

Forecasting inflation

Forecasting is an unforgiving art. There are an infinite number of wrong answers, and one right one. The years since the GFC have been particularly unforgiving for central bank forecasts, and no forecast has struggled so much as inflation. First too high, now too low, inflation has a mind of its own which central banks have yet to fully discern.

No surprise then that central banks have grown more cautious. They have commissioned research into their forecasting track record to better understand the scope of the problem, and what might be done about it (RBA, RBNZ, and BoE). Forecasts are now accompanied by caveats, confidence intervals, and cautious language.

An example of representing uncertainty better (Reserve Bank of Australia Statement on Monetary Policy Feb 2015)

While helpful, there are still two small issues:

The reports I’ve read primarily assess forecasts for accuracy. This involves calculating the difference between the forecast and reality and adjusting it to remove the sign.* This shows the error’s magnitude – the higher the number, the greater the deviation – but not the direction of the forecasts or actual inflation. Some reports do also test for bias – the degree to which results repeatedly skew in one direction – but not all.

Bank of England 2015 forecasting evaluation

Second, most of the reports are from before 2015, around the time when problems with inflation started to appear.

I want to see recent results, so I’ve started building a data set from publicly available forecasts. I will eventually do this for all the major central banks, but started with Australia because it has enjoyed uninterrupted growth for the period when the rest of the world has been in and out of crisis. This should minimise forecasting errors from big shocks like Trump, Brexit, or the Euro-crisis.

Persistent errors in the same direction

Inflation forecasts between 2005 and 2014 missed sudden changes in the inflation rate, like in 2006, 2011 or 2012. Some of these mistakes were over-estimations, others were under-estimations. The errors are not surprising given the global recession, and lots of fiscal and monetary stimulus going around.

My own calculations using the figures provided by the RBA
My own calculations using the figures provided by the RBA

2015 is where it gets interesting. Inflation forecasts have been persistently panglossian over the last five years; forecasts keep reaching for the sky while inflation trundles along below. From 2017 the forecasts sober up a little, but the errors are still all in the same (hopeful) direction.

My own calculations using forecast figures from the SMP and inflation data from the ABS

When the forecast errors trend in the same direction, one of the relationships in the model may be misrepresented.*** This kind of diagram illustrates the issue in a way that accuracy bar charts do not. It also suggests that forecasters may not have updated the model.

Forecasting macroeconomic variables may be the only form of divination that requires a suit, but forecasts can still be useful. We feel more comfortable about an uncertain future if we can attach numbers and neat lines to it. This psychological comfort helps us make decisions about the future, whether to buy a house, or invest in a plant that manufactures fidget spinners. If these beliefs are shared by enough people, they can become self-sustaining, and even ‘true’ by simple fact that everyone now believes them. Forecasts can also give a reliable sense of direction,

If the past has any bearing on the future, forecasts can also calibrate models for economic or social behavior. In practice, these models can often give us a reliable sense of direction, if not complete certainty. Here, mistakes are useful for tuning the machine, but not all mistakes are made equal. One-off shocks, like the GFC, add little to models that, by design, cannot predict the unpredictable. Recurrent forecasting errors are another matter. They may be a signal. Taken in this way, the errors are not so much the inevitable failures that go with any attempt to peer past the veil of the present, but indicators of a more persistent change underway.

Or maybe not. It’s the future after all.

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*Called a root-mean-square-error (RMSE)

** Central banks use a larger battery of statistical tools than the simple RMSE

***The Philips Curve is flattening

Are we crying wolf over inflation?

The FT has just published an op-ed from one Professor Jeremy Siegel of Wharton. In it, he predicts that the US is going to experience “an extremely inflationary economy in 2021,” where “inflation will run well above the Fed’s 2 per cent target, and will do so for several years.”

This is a contrarian position. The Federal Open Market Committee – the body at the Fed which sets monetary policy – does not project inflation reaching 2% until 2022. Professor Siegel joins the vocal minority warning about inflation.

December 2020 FOMC projections

Professor Siegel bases his argument on an old proposition: the Quantity Theory of Money (QTM). Simplified, it argues that the price level is a function of the quantity of money in an economy. If the quantity of money increases faster than output, all other things being equal, prices will rise.

The QTM has motivated previous inflation warnings. After the Global Financial Crisis, some warned that Quantitative Easing (QE), with its massive expansion of the money supply, would cause runaway inflation. The opposite happened, and the major macroeconomic puzzle of the last decade has been falling, not rising, prices.

Professor Siegel argues this time is different (always a red flag). QE created trillions in reserves, but it turned out banks were happy to sit on them, and not make loans, in part because the Fed began paying interest on excess reserves. Today, thanks to the stimulus checks, grants to local government, and the Paycheck Protection Program, money is “going directly into the bank accounts of individuals and firms.” Where before money wound up in bank vaults, this time it will get into the hands of private sector individuals and be spent.

As part of QE, banks exchanged their bond holdings for reserves, and then sat on them

Is that really the case though?

Siegel’s argument rests upon a distinction between the money held by banks as excess reserves, and the money now in consumer bank accounts; growth of the former had little or no effect on inflation, but growth in the latter will.

This raises the question of why money in a consumer bank account is more likely to be spent than bank reserves? Siegel suggests that liquidity requirements, and the interest the Fed pays on excess reserves, explains the tendency of reserves to accumulate. But if so, why should it be any different with consumers, who, as we all know, also receive interest.

The Fed started paying interest on reserves, and regulators imposed liquidity requirements that could be satisfied with these reserves. The banks easily absorbed the extra reserves created by the Fed and quantitative easing led to only a modest increase in lending.

But, why is money sometimes stashed under the proverbial mattress, and other times not? It seems unlikely the answer is directly related to how many notes are under the pillow. It is not enough to simply increase the money supply, you need people to want to spend it.

In fairness, the QTM does acknowledge this. In addition to the price level, the quantity of money, and a measure of real output, it includes a variable called the “velocity of money,” a measure of how often it changes hands.

M = quantity of money, V = velocity, P = price level, T = a measure of real output

High velocity looks like this. I pay you $100 for a bicycle, you use it to (under)pay your neighbor’s son to paint your house, and he spends it taking his girlfriend to a gauche mini-golf bar. In a low velocity world, I buy your bicycle, and you stash the money between the pages of your untouched copy of War and Peace. A healthy economy looks more like the former than the latter.

The problem is, if velocity is subject to unpredictable changes, then there can be no fixed relationship between quantity and the price level. Instead we must look to a third (or fourth or fifth) variable to explain why velocity changes. But, if one wants to posit a stable relationship between quantity and price level, as Professor Siegel does, then velocity must be relatively static in the short to medium term. Otherwise, price is conditional on the quantity of money, which is conditional on velocity, which is conditional on some other unknown. At best we could say the quantity of money is a necessary condition of inflation.

The point is to be skeptical of mechanistic explanations, especially ones first developed in the 18th century. The money supply is broadly correlated with inflation, but that does not mean they are causally related. Even if they were, it would not necessarily tell us the direction or magnitude of the effect.

Correlation or causation?

Let us also look skeptically on theories which avoid falsification tests and rely on verification. QTM theorists can always find historical episodes to verify their arguments. In fact, the allure of the “more money = more inflation” argument is that it is right eventually; at some point there will be inflation, and it is more than likely it will follow an increase in the money supply, if only because the money supply is usually increasing.

To paraphrase Paul Samuelson, inflation hawks have predicted 9 of the last 5 inflationary episodes. Despite this, the opinion pages of major newspapers always seem to find room for them.

It is unclear what would constitute a falsification of their hypothesis. Inflation failed to rise after the GFC, and a series of ad hoc explanations were provided. If inflation fails to increase in 2021, is that a definitive rejection of the QTM, or will more ad hoc explanations be appended to explain it away?

For the second time this week, I am reminded of the Marxists, who, when confronted by the failure of history to match their deterministic predictions (when is the revolution?), could always respond “not yet.”

We remain waiting.

James Tobin on Business Cycles

In 1994 the Federal Reserve Bank of Boston hosted a conference on monetary policy. Today it is mostly remembered for Debelle and Fischer’s paper on goal vs. instrument independence, but it has proved full of gems.

This was a time when the modern central bank was still emerging and so lacked today’s (somewhat diminished) aura of certainty and inevitability. New Zealand had made history five years earlier by giving their central bank independence, and it would not be for another three years that the UK would follow suit. Throughout the proceedings, traces of uncertainty at the incipient consensus are visible; these comments from Nobel Laureate James Tobin in particular.

The ECB’s December meeting – climate change and fiscal policy

The ECB’s Governing Council met yesterday for their monetary policy meeting. Its a similar story to what we have seen from other central banks in recent months: expansion of monetary stimulus and a verbal commitment that stimulus will stay in place for at least another two years.


Some technical decisions to take note of (skip to the next section if your eyes are going to glaze over at the mention of the PEPP, APP, and TLTRO III)

  • They are increasing the potential size of their Covid-19 quantitative easing program – The Pandemic Emergency Purchase Programme (PEPP) – by 500 billion, to 1.85 trillion. Importantly, they will continue to reinvest the principals from maturing securities until the end of 2023 – no attempt to reduce balance sheets until then. Put simply, as the bonds they hold mature, and the principal is returned, they will reinvest it in new bonds.

    The ECB’s other QE program – the Asset Purchase Programme (APP) – will continue at its 20 billion/month rhythm, with the principals also reinvested.

    On the question of winding down QE, Lagarde has said that interest rates will be raised (they are currently negative) before the balance sheet starts to be wound down.
APP refers to the ECB’s main QE programme – the Asset Purchase Programme
  • The ECB will improve the terms and conditions of its Targeted Long-Term Refinancing Operations (TLTRO III). The TLTRO programs have been around in various iterations since 2014. Their aim is to preserve the flow of credit by allowing bank to borrow from the ECB very cheaply – at negative rates in fact. Imagine the bank paying you for taking out a mortgage with them.

    To qualify for the special low interest rate, banks must meet two conditions. First they have to reach a certain lending threshold (quantity). Second, they must lend the money to non-financial corporations and households, although loans cannot be used for house purchases (quality). This is a very subtle form of credit direction policy

Some broader points from Lagarde’s press conference:

Fiscal policy and central banks

Lagarde reiterates her call for expansionary fiscal policy. Take note of the phrase “medium term.” That could be anywhere from 2-10 years. Its a big shift for a bank that was a driving force for austerity 8 years ago.

Climate policy and central banks

Lagarde has called out how important it is for fiscal stimulus and structural reform to focus on the green transition. Its only words, but it reflects how much the ECB under Lagarde has shifted on this topic. It’s hard to imagine the Fed or the RBA openly encouraging green spending.

More interesting is the question of the ECB’s QE program and the green transition. Central bank bond buying has never applied any ‘green’ criteria, they have bought trillions in corporate bonds/notes from polluters and non-polluters alike. Since polluters are often a larger part of the market, central bank asset purchases have often benefited polluting industries. There have been calls for some time now for central banks to incorporate green criteria into their bond purchase programmes, or even penalise the use of “brown assets” as collateral.

To date these proposals have been fiercely resisted, on the grounds it would make central banks too political. However, cracks are emerging within the normally monolithic central banking community. Lagarde has come out and said she thinks climate change has price stability implications. If accepted, this would allow central banks to justify action within their existing mandates. She also hinted that the ECB’s asset portfolio needs to be examined from a green perspective:

In addition, from Jan the ECB will be making slight changes to its bond buying criteria to allow certain ESG (Environmental, Social, Governance) bonds to qualify:

While the arguments of those who favor keeping monetary policy narrowly focused do have some merit, it is time we began to openly debate them. They rely on the pre-crisis hope that monetary policy could be a neutral force and conveniently ignore all the political decisions made since the crisis.

If governance arrangements developed in the 1970s mean central banks can no longer deliver what is required of them by society, let’s re-examine the former, not under-deliver on the latter.