Month: February 2014

Long-Run Price Level Growth Vs Inflation Targeting

Recent debate seems to have briefly picked up again between the Market Monetarists and their Classical counterparts in an important topic. Namely, should central bankers be targeting long-run price levels or annual inflation rates? Much of the blogosphere in the realm of monetary policy seems to be dominated by economists aiming their fight towards other economists. The pleasure thus falls to me to explain some of the basics behind this important fight that divides two streams of modern monetary thought.

The difference between long-run price-level targeting (LRPT) and inflation rate targeting is a simple one. Inflation rate targeting, championed by Ben Bernanke (and implicitly by Scott Sumner), is the simple notion that a central bank should aim for a constant rate of inflation. For example, if the inflation target is 2%, and in year 1 inflation hits 2.3%, in year 2 policy makers should aim for 2% inflation again. LRPT on the other hand draws from the policy prescriptions of Alan Greenspan and targets a long-term rate of inflation. So to use the same target, if in year 1 inflation hits 2.3%, in year 2 the central bank should aim for 1.7% inflation.

Whilst this debate seems overly theoretical, it brings us to one of the cornerstones of macroeconomic thinking- the problem with inflation.

An annual inflation rate target represents a desire for minimal short-term inflation rate volatility. It is for this reason that those advocating inflation rate targets implicitly perceive inflations rate shocks to be the main problem with inflation. Here, if inflation comes under the market’s forecasts, interest rates determined in that year will be too high, and investment will be misallocated. In the case of a major shock, this temporary wrong-footedness can put the whole financial sector at risk. Hence, policy makers should focus primarily on embedding market expectations for annual inflation rates, and if inflation is off target, expectations should be that normality will return next year. And since short-term inflation volatility is reduced, the shocks to the system should be smaller.

According to the LRPT advocates however, this concern for short-term shocks, and the subsequent obsession with minimising short-run volatility leads to a more variable long-term rate of inflation. LRPT is the way to solve this. If one year inflation comes over the mark, the next year it should come under. Over a period of two years in this scenario the price-level will be closer to the target price level of the previous year. But whilst long-run contracts and loans on fixed rates may be more accurate, the nominal income shocks will be exaggerated. The LRPT supporters in this case implicitly believe that the problem with inflation, is not the nominal shock, but rather the role inflation plays in the distortion of relative prices. To their mind, as long as the market understands the short-term variability problem then the shocks will not materialise at all, and the real income transfers that result from inflation volatility will be corrected.

In this light, one can see that the contemporary debate over inflation rate, versus long-run price growth stems from the very nature of the ‘inflation evil’. To my mind LRPT is by far the inferior monetary policy strategy for 1 simple reason- It is incompatible with the nature of monetary policy.

It is common knowledge that there is a substantial time lag between the implementation of monetary policy and the realisation of their effects. When unplanned for inflation rates are posted, it is normally the case that the monetary base (or interest rates?) has already been set for the following 18 or so months. The new level of reserves in the system aim for whatever nominal targets the central bank has set; but if last year’s results are lacklustre, the ability to compensate by changing the following target rate becomes substantially impeded. The constant contradictions and attempts to routinely adjust the nominal anchor under an inexperienced institution could easily develop into a mini-business cycle that operates in a sort of “see-saw” fashion, and exacerbates the dreaded shocks that inflation target supporters endeavour to avoid.

In Defence of OMT

The German Constitutional Court’s recent ruling to rein in the ECB operations known as “Outright Monetary Transactions” (OMT) as unconstitutional, has elated many German politicians and Euro-sceptic economists. But this is a pyrrhic victory for Germany, and a sad week for the European periphery.

Princeton University economist Ashoka Mody for example has labelled the OMT as economically “ill-conceived” in his recent Project Syndicate article. The argument goes that ECB claims that risk premiums reflect unfounded fear were based on “Cherry-picked evidence” and that the OMT program by definition conceded that “assessments of creditworthiness reflected a real default risk”. Thus, one should let the market price this risk adequately to create an optimal solution. In other words, the ECB has given periphery Europe a free lunch, and distorted the sovereign bond pricing system in the Eurozone.

An implicit notion in this argument however is that causality between finance and fundamentals is a one-way street. Financial feed-back loops, either do not affect the real economy, or they are completely rational and optimise results. This is clearly fallacious. The risk of Sovereign default is almost purely a function of the interest rates that must be paid on their debt. In addition, risky markets do not operate anything like their safer financial and real counterparts in reducing volatility and allocating capital.

In financial markets optimal results requires a balance of speculators and fundamentals traders (value investors). The speculators, supply liquidity to the market and trade in line with trends. The value investors however, absorb this liquidity and tend to trade against trends. The result is a stable asset pricing system, where small shocks do not get blown out of proportion and liquidity is sufficient.

So who are the value traders in Sovereign debt markets? When it’s high grade, there are sovereign wealth funds, superannuation funds, etc. that all use these low-risk assets to hedge against adverse economic shocks. The problem is though, that periphery European debt markets nowadays are no longer high-grade. Indeed, risk premiums have consumed a major part of debt repayments from peripheral Eurozone countries and many of the historical value investors have moved away. Thus the speculative component of these markets is probably too high.

And so the periphery of Europe is faced with a double dilemma. Two positive feedback loops that can cause the downfall of the Eurozone. If individual country risk premiums reach a point where they begin to threaten national solvency, then speculative component of the asset holders will do the rest. They will begin shorting the debt and creating higher interest rates whilst pulling back liquidity lines. Any sizeable shift in fundamentals therefore (such as an elimination of OMT) will cause carnage.

For example, Spain’s public debt still only hovers at around 90% of annualised GDP, and risk premiums are far higher than in the US where debt as a percentage of GDP is around 130%. Risk premiums cause default risk, and more risk premiums. This is an equilibrium reached under artificial circumstances, and it should not be tolerated. It is clearly a market flaw. If Sovereigns are able to repay their debt reasonably, that should be strived for. OMT facilitates this by a reduction in national stress, and reduces actual risk in a very real sense. It breaks the speculative loop and changes the fundamental solvency of the beneficiaries.

Attempts at destroying OMT are thus almost wholly political, and are not astute economic policies. Attempts at diluting it are even worse. To date, OMT has managed to avoid speculative attacks on the ECB’s commitment to do “whatever it takes”, and premia have been meaningfully reduced. If the German High Court, and the European Court of Justice however, choose to dilute the OMT program then a very different scenario could emerge, and the ECB could lose the credibility it’s fought so hard for these past few years.