Scott Sumner  

Monetary Policy: The more ambitious your goals the less hard you have to work

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In most areas of life, lofty goals require hard work. Monetary policy is the exact opposite. The more modest the objective the harder a central bank must struggle to achieve those objectives.

For instance, the Reserve Bank of Australia has had pretty ambitious goals, including 2% to 3% inflation. Because Australia also has a high rate of immigration and fast RGDP growth, this translates into roughly 6% NGDP growth in recent decades, well above other developed countries. In that sort of economy, nominal returns on investment are well above zero, and people (and banks) don't want to hold much zero interest base money. Australia's base is about 4% of GDP, lower than the US base demand even during normal times.

At the other extreme are countries like Japan and Switzerland, which have had near zero inflation in recent years. Japan also suffers from a falling population, while Switzerland "suffers" from the facts that its currency is so respected that it has become a safe haven in times of turmoil. Thus both countries have low interest rates and a very high demand for base money as a share of GDP. As a result their central banks have the arduous task of having to "spend" lots of yen and Swiss francs (SF) buying assets to prevent a steep deflation like the early 1930s. Neither bank would face that "problem" if they targeted NGDP growth at 5%, level targeting. (Notice that central banks are the world's only counterfeiters who complain about the task of having to print up money at near zero cost and buying valuable assets with that free money.)

It's possible that the Swiss National Bank thinks the less lofty the goal, the less hard it will have to work. That might be one reason why they decided to stop pegging the SF against the euro. But they will find out that the reverse is true. People want to hold hard currencies. The harder the currency the greater the demand. The SNB just made the Swiss franc considerably harder than it was a few days ago. Look for lots of QE from the SNB in the future. They'll be working fanatically trying to hold down the value of their currency while the RBA officials have plenty of time to go surfing on Bondi Beach.


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CATEGORIES: Monetary Policy




COMMENTS (14 to date)
foosion writes:

The WSJ is reporting the the SNB may start intervening again.

"Switzerland Could Act on Currency Again, Central Banker Says
Swiss Franc Is ‘Greatly Overvalued,’ Central Bank President Thomas Jordan Says"
http://www.wsj.com/articles/switzerland-could-act-on-currency-again-central-banker-says-1421501547?mod=WSJ_hp_LEFTWhatsNewsCollection

ThomasH writes:

Why is doing whatever the RBA does to maintain inflation at 3% any "harder" than buying a unit of foreign currency at a pre-announced price. Seems like something an intern could do.

Andrew_FL writes:

The key is managing expectations to get the market to do the heavy lifting, right?

Nick Rowe writes:

Yep. This is the point the concrete steppes people find so hard to get. Yet it is very standard economic theory. For a central bank that issues 0% nominal interest currency, the higher the NGDP growth rate target, or the higher the inflation target, the smaller the real stock of currency demanded, and the smaller the balance sheet of the central bank, in real terms.

ThomasH writes:

I guess Andrew-Fl takes it that larger transactions are harder so if market expectations align, the CB does not have to do large transactions . I don't see that transactions are "hard." I know exactly what to do to keep the SF at 1.25 Euro. I do not know how to keep Australian inflation at 3%. That seems "harder" to me, unless they have an inflation expectations market so the RBA intern just buys and sell to keep the price of the 3% contract at parity.

I think the really "hard" part is going against those Krugman calls VSP who want tight money yesterday, tight money today, tight money forever.

Scott Sumner writes:

Everyone, Just to clarify, I used scare quotes because I don't actually think open market purchases are "hard" or a "problem."

CMA writes:

"For instance, the Reserve Bank of Australia has had pretty ambitious goals, including 2% to 3% inflation."


Is it possible to prove this idea wrong though? If Aus goes into recesion you will say the CB lowered its target. What would it take to prove this theory wrong? Is it possible that the CB isnt always omnipotent and may not be capable of reaching targets especially if it depends on bank intermediaries/counterparties for policy to operate?

Matt writes:

It would be good to see more discussion in the media of other central banks that have done the same things as the Swiss National Bank without any difficulty. For example, the Czech National Bank and Monetary Authority of Singapore both target inflation with adjustable exchange rate pegs and have zero interest rates, but neither have had to substantially expand their balance sheets
http://www.tradingeconomics.com/singapore/central-bank-balance-sheet
http://www.tradingeconomics.com/czech-republic/central-bank-balance-sheet

While the CHF's safe have status no doubt has a lot to do with it, I also suspect credibility also plays a big role. The Swiss National Bank was very slow to peg between 2009-2011, even giving up one earlier peg (at 1.5CHF/EUR). Investors sensed weakness (correctly as we now know) and loaded up on Swiss francs.

Commentators and calling this 'the end to the power of central banks' and reaching other absurd conclusions, but the lesson is really as old as the hills. A peg backed by the full commitment of the central bank is cheap and easy to maintain. A peg lacking credibility is expensive.

Andrew_FL writes:

@ThomasH-I was asking for clarification, actually.

But my point wasn't that anything would be "hard." You could replace "heavy lifting" with "most of the work" and retain my entire meaning.

Ray Lopez writes:

Scott Sumner:

Neither bank would face that "problem" if they targeted NGDP growth at 5%, level targeting.

Can you please provide a model to back up this assertion?

Bill Woolsey writes:

Of course I agree that a more rapid trend growth in nominal GDP results in a lower demand to hold base money. Looking at the asset side of a central banks balance sheet, its task of choosing what assets to buy is simpler. With a higher trend rate of inflation, It may be able to just buy short bonds issued by its own government denominated in its own currency.

However, it is even simpler to follow a k% rule, especially with k = 0. A central bank doesn't have to do anything! Nominal GDP, the price level, and inflation can adjust to keep the real demand for base money equal to the fixed quantity. While there would likely be quite a bit of nominal instability, a central bank could "achieve" the "modest" goal of a a deflationary trend for the price level.

In my view, if the goal is to provide nominal stability, and further, if something approximating a stable trend price level is desirable (no inflation or modest inflation or deflation,) then the task of the central bank is hard.

Choosing a more rapid trend inflation to reduce the demand to hold base money, when stable prices or perhaps modest deflation would be better for other reasons, would be to choose a more modest goal.

We would prefer to have stable prices, but that is too hard to accomplish because the resulting demand for base money would be "too high" and we would have to expand our asset portfolio "too much" including something other than short and safe bonds issued in our own currency by our own government.

OK... I grant that this argument is important in responding to those who say that a central bank has already expanded its balance sheet "lots" and inflation remains low, so obviously, they cannot achieve higher inflation. But don't really think that higher inflation all the time to avoid temporary problems is the answer.

Steve H. writes:

Sitting in the US, you start to wonder: I wonder what the heck the Fed is trying to convince us of: we "fell down in a hole" in 2008 - 09. What to do? Ask someone who knows: Bernanke (I actually think he knew what he was doing but was duped into believing that the "Big Money" would actually do what he suggested.) We got into a quarterly routine of issuing bonds and buying them back from ourselves at no cost. Result? Printing money (in the basement). Inflation? The CPI had been made more reflective of "actual inflation" by eliminating food and fuel from the CPI a number of years ago. (We're so smart.) (Unless you wanted to buy food / fuel. For some reason, those prices just kept increasing. Anyway, there we are with Zero Inflation and no bond interest, and no inflation, but that didn't make any difference 'cause Wall Street invested in equities - to the point of a 17,000 Dow. How did we do this? Threw away our balance sheets. Now we have 20 hour work weeks, Obamacare, increases unemployment, rising number of "job filled" (by keeping wages flat), a huge increase in numbers of citizens on various gov't programs of assistance, college grads unable to find jobs, etc., etc.
Now, the Fed is scrambling to come up with a plan: raise the interest rates WITHOUT costing businesses anything since additional costs will cause a drop in the Dow Hmm.... Well, er, ..., um, .... Fortunately (and/or coincidentally/or due to cause and effect?) there occurred a world wide economic slow down at the same time. Not a problem: makes you feel like you won't stand out in a crowd. Phew! NEXT: M.O.S.? Nah! Ah Ha! We can raise taxes for the "rich" (Could that mean anyone with a job or investments? Kind'a. Oh,well: all the rich have to do is look at their brokerage balances to feel better. After all, it won't be taxed until withdrawn.) Nobody will notice an increase in income taxes. (????) Now, let's get back to the important stuff (i.e., the political distractions: the Keystone Pipeline, Global Warming, Guantanamo, the rise in the need for 'income inequality', immigration along the Southern boarder (forget the other ones), issuing driver's licenses to just about anybody, reducing the size of the military, doubling the minimum wage, etc., etc. PLUS? One more (at least one): a Presdential

Steve H. writes:

Oops! Got cut off. (A little wordy, perhaps?) Here goes again:
Contd. a Presidential election with - at least at this point - every former Republican Candidate (except Gov. Perry?) who tried, ran, appeared on stage, etc. the last (two? We're not finished yet) times and apparently just one Democratic Candidate (OK: a Retread, but that seems to be OK: see the remarks in re Repubs).
We seem to have found the perfect balm for all economic woes:
distraction, flat screen TV's, cheap beer (who price has remained relatively stable), and ... Who cares what else?
This is just like the Roman Empire! I gotta go! On to the Coliseum - I gotta catch the SUPERBOWL! Living here is great!
(Personally, I preferred the early 60's.)

Zachary Bartsch writes:

Ray Lopez should read "Less than Zero" by George Selgin.

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