Monday, 20 January 2014

2014 Top 5 POD Stories to Watch. Number 3: Monetary Policy

Been awhile... Life happens.

Back to the five part post looking at the five story lines that I expect to will be interesting to follow in 2014.

Number 5: New Old Sources of Oil
Number 4: US Tight Oil

Number 3: Monetary Policy

With Ben Bernanke stepping down as FED Chairman, monetary policy will likely keep itself in the headlines this year. Monetary policy is best left for the backpages, and when things are going well it often is. However, the financial crisis and subsequent 'great recession' has illuminated how divergent mainstream economic views on monetary policy have become.

2013 gave us a few great tests of theory, hopefully 2014 will bring constructive debate, flush out constructive policy in the developed world, and facilitate best practices as developing countries develop their own monetary policy regimes.

I did a separate post here to outline the on-going policy debate and give a bit of background on monetary policy (an often counter-intuitive mess of inter-causal multi directional contradiction actions and effects) as I see it.

In the end the most important piece to any macro economic look at the world is the US. Having named Janet Yellen to take over for Ben Bernanke alleviates my biggest concerns on this front. In all likely hood, Yellen should maintain the same course that Bernanke has taken the FED.

The FED has two main goals:
to promote “maximum” sustainable output and employment and to promote “stable” prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act.
Countries around the world seem to emphasize different elements of this, but by and large maintain similar objectives. It is thought that these variables proxy the health of the economy. In the long run, factors besides monetary policy determine both levels. But with the ebb and flow of business cycles the need for short run stabilization is deemed necessary.

Currently, the method by which they achieve this mandate is quite discretionary. The FED may outline their targets but, as evidenced by market reactions to FED announcements, it isn't always clear what they will do.

So lets take a look at how well the FED has been achieving these objectives.

Chart of inflation
Inflation: the stated and widely expected target of 2% personal consumption expenditures (PCE) has for the most part not been hit since the sharp fall off in 2008.

Canada frame the 2% target in terms of a 1-3% bound which dispells the persistent notion that 2% is a cap. 2% is the target and misses should deviate equally. Clearly this is not happening in the US.

Chart of unemployment rate

In terms of unemployment, we can see that the US has maintained levels greater then the expected long run full employment level.

Now, of course, we can always claim that the natural rate of unemployment is actually higher then the typical 4-5% bounds, but with unemployment falling to around 7% in Q3 it's likely still high.

Thus, with a 2% inflation target, and assuming the phillips curve holds at all, we would expect a consistent monetary policy to pursue policy above 2% until unemployment is brought down.

Which all begs the question, why hasn't it?

What's the best course of action?

With Bernanke's 'tapering' announcement he offered forward guidance as to how policy will evolve:
The formal part of the new forward guidance was the pledge that interest rates are unlikely to rise until “well past the time that the unemployment rate declines below 6.5 per cent”, especially if inflation is below target.
Bernanke is simply reiterating the criteria put forth in the Evans Rule which, in theory, reduces the discretion involved in monetary policy. Policy choices are made based on the economy, and economic data. The Fed will judge the economy based on unemployment and inflation rates. Simple. Or at least it should be.

But as explained here, the discretionary nature of the current regime leaves alot to be desired. That the US has run below target inflation and above target unemployment since the onset of the recession speaks to that. If

Will Market Monetarism and/or NGDP level targeting gain steam? 2013 saw some prominent economists express their support for it. I'll be watching in 2014 to see if this trend continues.

How the debate today will impact the world tomorrow

Countries like China and India are still in the formative age of monetary policy. China will be developing their regime essentially from scratch while the RBI works through the usual mess of duties to implement effective monetary policy.

China has seen a recent spate of inter-bank rate spikes (June, October, and Dec.)

Because of the opaque (at best) nature of Chinese monetary policy, and the lack of a historical track record to help decipher their actions, there is alot more left to the imagination then would seem optimal:
Most traders believe the People's Bank of China is sending a message targeting specific players in the murky world of Chinese shadow banking, but the opaque way in which the strategy has been executed has produced bouts of volatility.
Currently, the central bank targets the money supply directly, as outlined here:
The mechanics of China’s monetary policy stimulus are also different from the Fed’s quantitative easing. The Fed has been effectively creating money by buying bonds and other securities. The People’s Bank of China has been creating money to a considerable extent by issuing more renminbi to bankroll its purchase of hundreds of billions of dollars a year in currency markets to minimize the appreciation of the renminbi against the dollar and keep Chinese exports inexpensive in foreign markets.
Moreover, the rapidly expanding money supply reflects a flood of loans from the banking system and the so-called shadow banking system that have kept afloat many inefficient state-owned enterprises and bankrolled the construction of huge overcapacity in the manufacturing sector.
Utilizing M2 is a bit of an archaic method that will lose it's appeal as China liberalizes, and more traditional interest rate methods become more viable.

India recently named Raghuram Rajan to the head of it's central bank. As a University of Chicago grad Raghuram rose to fame via correctly diagnosing the housing market correction in 2005.

All in all, we have two developing countries, containing about 36.5% of the world's population attempting to develop sophisticated monetary policy regimes to handle the growing complexity of their economic and financial systems.

Will 2014 be the year they get sorted out? No of course not. But, in the same way that feasible renewable energy discoveries would be adopted best into developing power grids, so to might optimal monteary policy regimes.

Any clarity provided by the developed world debates could establish the direction for, what we can only hope, become the two largest economies in the world.

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