According to Peter Tulip, Chief Economist at Centre for Independent Studies. Ex-RBA, ex-Fed:
“Any organisation that persistently fails to achieve its main performance benchmark should be reviewed. So today’s editorials in the SMH and Age are great.”
Last December, Ignazio Angeloni of the Harvard Kennedy wrote in VoxEu: “The ECB strategy review: Walking a narrow path”:
Expectations are mounting for the outcome of the ECB’s monetary policy strategy review. An academic panel hosted by the ECB online on 11 November focused on the real crux of the matter: the poor understanding of inflation – a variable the ECB mandate hinges on, but one which has become more and more difficult to explain and control. For several years now, inflation has remained below the central bank’s target of “close to but below 2%”.
And in August 2020, the Fed unveiled its new Monetary Strategy Framework (AIT):
Overall, our new Statement on Longer-Run Goals and Monetary Policy Strategy conveys our continued strong commitment to achieving our goals, given the difficult challenges presented by the proximity of interest rates to the effective lower bound. In conducting monetary policy, we will remain highly focused on fostering as strong a labor market as possible for the benefit of all Americans. And we will steadfastly seek to achieve a 2 percent inflation rate over time.
If you read Angeloni´s piece, you´ll better understand why Scott Sumner more than 10 years ago wrote:
I don’t propose to abolish the phenomenon of inflation, but rather the concept of inflation. And to be more precise, price inflation, which is what almost everyone means by the term. I want it stripped from our macroeconomic theories, removed from our textbooks, banished into the dustbin of discarded mental constructs.
So it´s all about inflation. In fact, too low inflation! In the US, the unemployment rate figures prominently, more so than in either Australia or the EZ, but that´s because in addition to the “inflation mental construct, the US is only now distancing itself from the “Phillips Curve mental construct”.
The chart below shows that, while in the US & EZ inflation has fallen short of the respective Central Banks targets for more than 10 years (at least), in Australia the “shortfall” only began five years ago, in 2016.
In addition to keeping inflation well within the target band during the Great Recession (GR) while most countries experienced significant disinflation, Australia was also notable for being one of the very few countries (Israel & Poland are “brothers in arms”) not to have experienced a recession, but only a growth slowdown. The next chart illustrates.
Being the quintessential example of a Small Open Economy (SOE), Australia is sensitive to global demand conditions. Nevertheless it escaped virtually unscathed. I posit that good monetary policy by the RBA was the determining factor.
In the next charts, which depict for each of the countries under scrutiny the behavior of Aggregate Nominal Spending (NGDP) relative to trend and the associated behavior of inflation, Australia is shown last, after we see how the effects of the Euro Zone and US getting monetary policy wrong.
The charts also indicate that very bad global monetary policy, not financial troubles, was the main factor behind the recession receiving the moniker “Great”. The fact that it is popularly called the “Great Financial Crisis” (GFC) tells us much about the power of central banks to deflect blame!
The pattern that comes out of the charts is clear. When NGDP falls well below the trend path, i.e., NGDP growth tanks, inflation, which was close to the target rate (2% for the US and “below, but close to 2% in the EZ), falls significantly. Furthermore, given that NGDP never recovered to the trend path it was on previously, but grows at a lower rate along a lower trend path, inflation remains well below the designated targets.
In Australia, things happen differently, but confirm the view that monetary policy, by closely controlling the behavior of NGDP, is the determining factor.
Note that inflation begins to trend down, and breaches the lower bound of the target band, only when NGDP slips below the trend level path in 2014. Inflation only stops falling when NGDP picks up, even if by less than necessary to bring it back to the original path. Inflation, like in the cases of the US and Euro Zone, remains well below target.
One implication of the analysis is that, if the RBA should review its framework, a good candidate for target is what is known as NGDP-LT (level target NGDP). Even if implicit, this worked well for Australia before 2014 (and for the EZ and US before their “Big Mistake” of 2008).
Moving to the present, we observe from all the charts above that the Covid19 pandemic generated the same pattern of NGDP, inflation and real output for all the countries. I call that pattern the “Big Drop”, where the “drop” refers to the big and sudden fall in the velocity of money (equivalently, a large and sudden rise in the demand for money).
From the equation of exchange in growth form, you have:
M+V=P+Y
Where M=money supply growth, V=velocity growth, P=inflation and Y=real GDP growth. P+Y, therefore, is the growth of Nominal GDP, or NGDP.
To give the equation of exchange some structure and call it the Quantity Theory of Money, it was usually assumed that velocity is constant (V=0), so that it could be said that inflation was the result of money supply growing at a rate higher than the growth of real output (popularly known as “too much money chasing too few goods”) from writing the above as M-Y=P.
However, as Milton Friedman put it 50 years ago (see here):
For monetary theory, the key question is the process of adjustment to the discrepancy between the nominal quantity of money demanded and the nominal quantity of money supplied…The key insight of the quantity-theory approach is that a discrepancy will be manifested primarily in attempted spending, thence in the rate of change in nominal income.
Put differently, money holders cannot determine the nominal quantity of money, but they can make velocity anything they wish.
What, on this view, will cause the rate of change in nominal income to depart from its permanent value? Anything that produces a discrepancy between the nominal quantity of money demanded and the quantity supplied, or between the two rates of change of money demanded and money supplied.
Looking at Australia just before the pandemic shock hit, the chart below indicates that monetary policy was already in “tightening mode”, with money supply growth not offsetting the slight fall in velocity since mid 2019. With that, NGDP growth dipped, but tanked when the “Big Drop” hit in early 2020.
In “Region 1”, monetary policy is tightening (despite the RBA cash rate falling), which is consistent with Friedman´s take that:
…On still another level, the approach is consistent with much of the work that Fisher did on interest rates…In particular the approach provides an interpretation of the empirical generalization that high interest rates mean that money has been easy, in the sense of increasing rapidly, and low interest rates that money has been tight, in the sense of increasing slowly, rather than the reverse.
In other words, interest rates are not a good indicator of the stance of monetary policy!
In “Region 2”, monetary policy is expansionary. Initially, velocity stabilizes while money supply growth rises. Then, money supply growth stabilizes and velocity rises.
The next chart illustrates the “decision problem” facing the RBA. First it has to decide the level aggregate nominal spending (NGDP) it feels is “best” for the Australian economy. Will it be content with putting it back on the low trend level from 2016, or will it strive to get closer to the trend level path that prevailed since 1992?
Thereafter, it should conduct monetary policy by offsetting changes in velocity so as to keep NGDP growing at a stable rate, in other words, practice NGDP-LT, which served it so well until 2014.
As Stephen Kirchner, commenting on the SMH and Age articles linked to at the beginning of this post put it:
My suggestion would be to convene a panel chaired by a noted international authority on monetary policy. The terms of reference should be wide-ranging. There are a lot of incentives for the government of the day to just sign-off on whatever the Bank gives them, as the current government did in 2016, but it’s a short-sighted approach. As the current government has found, when the Bank is not pulling its weight, the government’s job gets harder. An astute government would do something about it.
Note: The corresponding charts for the US economy are qualitatively the same (as it will be for most of the major economies). In other words, most central banks face the same “decision problem”.