QVMS - Is There A Sea Change Coming To Global Monetary Policy?

Summary

• Has the BOJ opened a can of worms for global monetary policy?
• Are central banks amid their huge target misses getting ready to shift their policy targets or monetary approaches?
• Inflation targeting is a black-box world - when central banks miss their targets, do those targets still have credibility?

Is There a Sea Change Coming to Global Monetary Policy?

The recent change in monetary policy announced by the Bank of Japan to widen the band on its 10 year note yield and its yield curve control program may be a sign of the global monetary policy is about to shift. To be sure the change in Japan is only about Japan and BoJ governor Kuroda has described it as not even a change in monetary policy. However, this is contrary to what he had previously said, that any widening of the band would constitute a change in monetary policy. This observations puts central bank speak in the same category as Lewis Carroll's famous Humpty Dumpty who said "when I use a word it means exactly what I choose it to mean, nothing more and nothing less." And if that is true, how does communication take place? Language cannot be idiosyncratic.

Lurking in the background of this move by the Bank of Japan is the coming end of Mr Kuroda's term, the pending appointment of a new BOJ head, and discussion of the policy of the government, potentially, to allow the Bank of Japan to pursue a 2% inflation target with more flexibility.

It's true that we don't usually look to the Bank of Japan as the place to set new trends in global monetary policy- at least not any more than we look to the Caribbean for a place to find icebergs. But, you find things where they occur and when they occur- not always where and when you expect them. Not only is this change by the Bank of Japan somewhat stunning it also fits into a pattern of issues that we see at other central banks that are also missing their targets and missing them without a great deal of discussion as to what that means.

Central bankers and their view of policy credibility

If we look back to the past several years among the major G4 central banks only the Bank of Japan has been issuing complaints about what its persistent target misses meant for its credibility. The Bank of Japan has worried for some time that it had a 2% inflation target that at first it was undershooting persistently and now, of course, it's overshooting, and it is concerned that not being able to hit its target is going to harm its credibility.

Compare this to the United States where the Federal Reserve never seems to doubt that it has credibility. In my opinion, no matter how badly it misses its targets or how badly it runs policy, it continues to assume that it has credibility. From 2016 to 2018 the Federal Reserve missed its inflation targets, undershooting persistently hitting or exceeding its target of 2% less than 20% of the time. Still, it never complained about its credibility. In fact, during that entire period, the Federal Reserve was raising rates just about every other meeting. Some people look back at that Fed episode and argue that the Fed was unable to hit its target. However, a central bank that's raising rates every other meeting and continues to miss its inflation target on the downside clearly was not trying very hard to hit that target. The problem the Federal Reserve had was that it had a different agenda and it never told us that. Instead, the Fed ran what it called a 'bygones policy' which allowed it to ignore past policy errors and to pursue each meeting with a clean slate as though the past errors didn't matter. But that didn't mean the past errors didn't matter, nor did it mean that nobody was watching. Even though that occurred during the Trump presidency, the progressives were watching; they were greatly critical of the Federal Reserve during this period. Raising interest rates preemptively when there was no reason for it, progressives argued, the Fed prevented the unemployment rate from falling even further.

The Federal Reserve's Reaction to its policy miss

The Federal Reserve has made a switch in its policy framework in August of 2020 to emphasize the achievement of full employment and we can see where that has gotten us. However, the Federal Reserve continues to conduct policy the same way it used to. It continues to show us forward guidance in terms of its dots indicating where it thinks policy is going to go. Fed Chair Powell continues to talk about the Fed's conviction and determination to reach its inflation target. However, when we look at what the Fed plans to do, the Fed plans to raise interest rates less than what it would have historically, and it plans for inflation to fall while attacking it with lesser interest rate levels than it would have in the past. If this doesn't make anyone wonder about what the Fed really is up to, and what inflation rate it is really seeking, then you are simply not paying attention.

The ECB

And the ECB has similarly gone off track running a post Great Recession policy, at first using negative interest rates and continuing to run a policy of low interest rates with a rising and high inflation level. The ECB clearly has a split between hawks and doves among its members. But its policy congeniality has been damaged by the too hawkish approach when monetary conservatives had full control and because of their endorsement of austerity programs under EU rules to punish deficit countries when recession pushed them into bigger deficit positions in their budgets. As a result, the ECB policy directive itself has been changed, like the Feds, to target average inflation. That's like saying that the central bank now has a mythological inflation target. After all, averages can be just about anything depending on how central banks wish to define them and to define the period over which they're going to measure them.

The BOE

The Bank of England likewise has undershot its inflation targets and in this case there's been a host of difficulties that it has had to deal with beginning with the transition to Brexit, it's wholly unexpected exit from the European Monetary Union. This occurred with the COVID disaster coming on top of it along with the war between Ukraine and Russia creating a series of difficulties that the Bank of England has not been able to cope with.

BOJ move as a Kabuki signal?

What the Bank of Japan's move does and what it means is that the BOJ has taken an existing policy that it had strongly supported and changed it as well as changing its interpretation. The shift is both subtle and stark. It's subtle because it is an evenhanded band-widening that looks innocuous. It is stark because the BOJ previously argued it could not and would not do this. As it does this, we know there's a new governor coming and we know the government is thinking about giving the BOJ more flexibility on its inflation targeting. That must make us wonder what it means for the actual inflation target and why Kuroda is doing this now… In both the US and in the European Monetary Union the central banks have been less obsessed about hitting their inflation targets and have simply missed them and moved on to targeting 'an unspecified average.' They talk the talk about hitting targets in the future, but they do not plan to walk the walk. However, for markets and for market valuations what central banks decide to do is going to be very important. If they decide to step away from what has guided policy over the last decade, that is going to be an important element that must be considered to evaluate markets.

In inconstancy of monetary policy

Monetary policy, in fact, has a history of moving back and forth between different theories and operating methods. Are we due for a change? For a while monetary policy was obsessed with monetarism.

• From the early 1960s the Federal Reserve had monetary targets although it did not pursue those targets relentlessly. It did employ fairly strict monetarism for a short period from 1980 to 1982.
• The Bundesbank was always much more vigilant about inflation and careful to react to it no matter what the other circumstances were or the cause. It became the most successful bank in keeping inflation at bay.
• The Bundesbank charter was supposed to be replicated by the European Central Bank, but a number of things happened that allowed for some modifications in how the ECB operates and now the ECB is operating in a way that would not be recognizable by any past Bundesbank president from the days when the Bundesbank was an independent bank running monetary policy for the German economy.
• Then, of course, in 1971, there was the tectonic shift. Nixon closed the gold window and took the US off the gold standard for international transactions. That took everyone else off the gold standard as well. It paved the way for a much more inflationary period that followed. The monetary policy regime matters.

The Phillips Curve

A belief in the Phillips curve underpins much of monetary policy since it is the link between inflation and how the real economy performs and specifies the leverage that monetary policy has to affect inflation through the real economy. However, it's unclear exactly what the Phillips curve is and if it's still operating. Just a few years ago it was declared dead, now like a creature in a zombie movie it's back, alive and in use.

What inflation targeting is and isn't

In 2012 the Federal Reserve under Ben Bernanke switched to running a policy that would emphasize inflation targeting which was essentially a black-box policy in which the Federal Reserve did not agree to run policy in any particular way but agreed that the outcome of policy would be a 2% inflation rate. This he argued would put markets on the Fed's side and make achieving a 2% target easier to do. Well, what happens now that the Fed has missed this target so badly? How do markets react? The problem with this policy is that since the Federal Reserve has missed its targets miserably, what is left of this pledge and policy? There is no framework. There is no pledge to control money growth or to maintain real interest rates. There are no intermediate targets. The question is what of Fed monetary policy can be believed? Clearly the Fed has not run policy to hit its 2% target- and while it was missing, it was very slow to act. The Fed's reaction to its 'miss' is a worse indictment of it than the policy miss itself. And now that the Fed once again pledges that it's going to get back to 2%, do markets really believe it- do they believe it can; do they believe it will?

Perceived credibility after the fall

It's hard to tell where the Fed stands by looking at markets because markets only generate inferential or implicit interest rate forecasts and in some cases inflation forecasts that require a lot of assumptions to extract the embedded outlook. And, in fact, we can't assume that this mechanism is clean because markets, for example, might be looking for inflation to be low in the future because they assume we're going to have a substantial recession between now and the future when they look for inflation to be lower. We don't know exactly why markets are looking for inflation to stay tame if markets are looking for inflation to remain tame. So, it's hard to use market pricing to test central bank credibility. Markets may think the central bank is all wrong but that a recession will clean things up.

Scientists' views depart from science

These issues are made more complicated by the fact that what economists think about inflation and what they will stand for seems to be importantly related to their political point of view. Nobel laureates Joe Stiglitz and Peter Diamond, for example, are Democrats and have no problem with higher inflation rate objectives. Peter Diamond has recently said that a 3% to 4% inflation target would be fine with him. However, a 2% inflation target has the US price level doubling every 35 years. A 4% inflation rate target would have the price level doubling every 17 ½ years. Could we really call an inflation rate that allows the price level to double over 17 ½ years price stability? These are, of course, subjective questions with subjective answers. But I think there's also some objectivity that we can insert here, since a strict definition of price stability would be that the price level doesn't change. Goldbugs' prefer a measure of price stability that would anchor the price level to the price of gold, but we have been there and done that and economists know the pitfalls of pursuing such a policy. In addition, there's some recognition that price indices may be imperfect and that allowing for some inflation in the price indices may be a more precise policy of price level stability than what the price index performance would suggest. But allowing prices to double every 17 ½ years simply cannot be construed as price stability. Of course, this brush is not meant to tar all Democrats (or Republicans). Larry Summers has been outspoken about how much the Fed needs to raise rates and he is a Democrat. The politics just complicate the score-keeping.

Is there a new central bank plan in the offing?

The question moving forward is whether central banks are really getting ready to back away from the 2% inflation standard that has been on the books since the Bank of New Zealand adopted it as a target in 1990. For all the central banks the question remains how they are able to restore their credibility in an environment in which they all have missed their inflation targets so badly and from a situation in which inflation is still so high. It seems only the Bank of Japan has wrestled with this question at all. In the US this question has been addressed by Fed Chair Powell simply by asserting that no one can doubt the Fed's resolve to get back to 2%. However, is that statement sufficient since we would have thought that was true in 2019 before any of this happened but yet all of this happened… and the Fed is not taking unequivocal strides to put inflation back in the bottle; it is planning a 'measured response.' Where is the determination? No G4 central bank policy exhibits determination- not one of them.

Covid, debt complications, and market pricing

Covid has caused governments to spend more money than they expected and to pile on more debt. To some extent this was masked by central banks running policies known as quantitative easing and piling government securities onto the central bank balance sheet so they did not have to be sold into the private market and therefore they did not drive-up interest rates the way they might have. Extremely low interest rates in Japan and in Europe have aided the United States since US interest rates have emerged much higher than interest rates in the rest of the world. That has helped money flows to come into the US and to keep US long term interest rates lower than they might otherwise have been. That is in addition to the Fed's purchases of U.S. Treasury securities that it has held on its balance sheet as well. In the wake of these developments, it's quite reasonable to ask whether we can trust the yield curve and the various market pricing mechanisms that pyramid off that to forecast future inflation and future interest rates? It's not clear that we can; and it's not clear that we can't.

Project vigilance!

I urge investors to watch very closely what central bankers are doing. When central bankers begin to do things that are unprecedented we have to be concerned about what happens next. In the US and in Europe central banks are attacking inflation with increases in short-term interest rates that may seem somewhat aggressive but that still leave rate levels short of what we would have demanded historically to attack the inflation rates that exist. It would be foolish not to admit that central banks are attacking inflation with rate hikes as well as with a wish and a prayer. In the US and in Europe both the Fed and ECB have shifted to inflation average targets while giving no information or update on what that means or how that is progressing. Central banking policies have become increasingly mystical. Part of that is the black-box of outcome promising (inflation targeting).

Once but twice shy…or, just back in the saddle?

My old-fashioned self would prefer that a central bank, once having made a mistake, would go the extra distance to make sure it didn't make that mistake again. Instead, what we see are central banks, having made a mistake, taking half-way measures to cure it. We see this most clearly looking at the Federal Reserve and this series of dot-forecasts that it continues to give us. It has taken the Fed a long time to move up its dot-based rate profile to where it is now after finally concluding that the increase in inflation was real. And in its subsequent quarterly meetings when the Federal Reserve made changes to its outlook these changes represented various states of denial until the Fed finally got to its current projections made in December of this year. But the outlook still does not bring the interest rate outlook up to what have what would have been demanded historically. And yet the Fed sees these halfway policies as still consistent with dropping the inflation rate to its target by the end of 2025. In the US, school prayer may be illegal, but prayer at the central bank appears to be still allowable.

I think the questions we need to ask about monetary policy are (1) Is monetary policy simply less willing to assert itself than it used to be? (2) Is the full employment objective carrying a greater weight than it used to in the US? (3) Are we truly headed for a change in the way monetary policy is conducted? (4) Will there be at least a change in the benchmarks that we use to judge monetary policy or is the Fed willing to play repeated games of 'miss and re-promise?' (5) Will the backing off from global free trade lead to a less consistent global monetary scheme with higher geopolitical tensions? For now, we have no way to know these things. But there are straws in the wind. I gauge the wind's direction and speed from what central banks are doing, not from what they are saying. Good luck. Keep your eyes open; plug your ears.

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