A plea for a more neutral monetary policy rule: the ‘productivity norm’

In a series of posts on the assessment of the bias of the US Fed prior to the Global Financial Crisis published on Alt-M, the blog of the recently established Center for Money and Financial Alternatives at the Cato Institute, David Beckworth just published a post with a very clear analysis of the inflationary bias of the Fed before 2008, based on an excellent paper written along with George Selgin and Berrak Bahadir in the Journal of Policy Modelling (those interested in monetary policy rules cannot miss it!).

The publication of both these posts and the academic article couldn’t be more timely. Surprisingly enough, monetary economists still disagree on the stance of monetary policy (not just in the US but elsewhere) before the outbreak of the Global Financial Crisis; this proves that we, economists, are not even that good at what we were supposed to do well, that is, the ‘prediction’ of the past. Leaving the academic interest of the subject aside, this is a policy question of major concern for all, should we want to contribute to the running of more sound, and more monetary-stability-oriented, monetary policy rules in the years to come. Now there are very good academics suggesting the way to exit QE and to move forward towards a more ‘normal’ monetary environment, and it is thus the perfect time to make the case for a different type of policy rules, those compatible with the fall of prices in a growing economy.

As I wrote as a comment on a recent George Selgin’s entry to this blog, the productivity rule ‘certainly provides solid theoretical basis to support the running of a different type of monetary policy rules; indeed different to the (CPI) inflation stabilising rules applied by all and sundry before 2008, which contributed to the recent crisis as well as to the instability generated in markets in the last years. It is time to apply less active and less inflationary monetary rules, those that allow the price level to reflect changes in productivity during expansions. Rather than focusing on price stability (actually it is most often ‘inflation stability’) we should be focusing on rules that better preserve monetary and financial stability on longer term basis; and the productivity norm is a good example of the latter. They are not going to be the cure for all problems but at least they will not be adding monetary disturbances on top of other (real-side) disturbances and shocks affecting the economy. And this will help agents form their expectations and make their plans.‘

For those unfamiliar with this literature, David Beckworth’s post provides the explanation for why (market or Fed’s) interest rates should be increased whenever productivity raises, so that the market interest rate runs in parallel with the natural interest rate, as Wicksell put it a century ago. Since then, this has been taken as the condition to keep monetary equilibrium in the economy (or at least, to put it more modestly and accurately, to avoid at least major disequilibria in the markets) and thus to  prevent from the excess of money creation that so often has contributed to monetary and financial crises in the past as well as to the succession of the so-called boom and bust business cycles. Quoting Beckworth’s words from his recent post, ‘Was monetary policy loose during the last housing boom?’:

‘Note that the rise in the labor force and productivity growth rates both raised the expected return to capital. The faster productivity growth also implied higher expected household incomes. These developments, in turn, should have lead to less saving and more borrowing by firms and households and put upward pressure on the natural interest rate. Interest rates, in short, should have been rising given these large positive supply shocks during this time.‘

And guess what the Fed did during those years of increase in productivity? Focused much more on (a falling) CPI rate of inflation in a growing economy (which shouldn’t be surprising at all), its policy rule didn’t recommend a change in the Fed’s nominal interest rates (at the very best) and later on it kept on cutting them down for years to avoid deflation by all means. It is well time to put the debate on policy rules on the agenda so we dot repeat the same mistakes in the future.

Juan Castaneda

PS. To be fair and fully transparent, let me declare myself any possible conflict of interest (if at all): I am a lecturer at the University of Buckingham and yes, I am a visiting research scholar at Cato (during the spring 2015).

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Price stability does not always lead to monetary stability, nor to financial stability

Price stability has been adopted as the best policy goal in our days by most central banks. It is indeed a step forward in light of the inflationary dicretionary policies adopted in previous decades. However, as some Austrian theorist masterly exposed in the 20s and 30s of the 20th century (of course, Hayek did), it is not only a panacea not a sound policy goal in the face of a growing economy. This is because there are “benign deflations” associated with increases in productivity and the expansion of markets that need not be counter-balanced by the central bank. In few words, a benign deflation is compatible with a stable nominal income path and thus with monetary stability. In its place, the current anti-inflationist central banks’ policies are designed to offset any deflationary trend, even mild deflation, whatsoever its origin and nature. Thus, within these policy rules, money supply must grow to offset the declining pattern of prices. In my view, this has been at the core of the excessive money creation problem during the last business expansion; and a key reason that explains the monetary and financial chaos created thereafter.

Prof. Pedro Schwartz (CEU University, Madrid) and myself have studied this question in the last years and here goes the link to the presentation I made on it last January in a roundtable at the École Normale Supérieure (Paris) (http://www.anr-damin.net/spip.php?article31). We studied how the price level remain truly stable from 1868 to 1914 in Spain; when the Bank of Spain did not have to target inflation and led prices evolve according to changes in the supply and demand in the markets. Suprinsingly enough, current price stabilising central banks have not achieved that degree of true price stability.

Juan Castañeda

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The work that serves as the background of my presentation (“Spain’s deflations and monetary stability in the late 19th c.”) will be published in MONETA collection in May 2012. Here you can find the abstract and conclusions of prof. Pedro Schwartz’ s and myself piece.

Abstract

We study and identify a different type of deflation that affected the Spanish economy from the launch of the peseta in 1868 to the start of World War I. In the 20^th century price deflations have been interpreted as monetary phenomena leading to recession and financial instability. However, this is just one type of deflation. Real price falls can originate from productivity gains. They can be the effect of a growing supply of goods and services in an expanding economy. This was the case in the UK and the US during the second half of 19th century and Spain was not an exception. Gold standard central banks did not watch the price level but were constrained by the guarantee of convertibility into gold. Though Spain was on a silver standard and silver depreciated with respect to gold, the Spanish price level remained remarkably stable from 1868 to 1914. Around this trend, mild real deflations were allowed to take place and balanced modest inflations. Productivity-based deflations could take place in the monetary environment of the late mid 19th century. Central banks did not at that time suffer from an inflationary bias. They did not feel they had to offset deflation at all costs by increasing the means of payment in circulation. In our day, central banks react to avoid every fall in the price level or fall in the rate of inflation, even if it is the result of growing output. In the late 19^th century prices could change more freely to reflect gains or losses in productivity. This flexibility contributed to Spanish price stability in the late 

Conclusion

We have focused our attention on those benign or productivity-induced deflations, as they have been widely neglected in post WW II literature, which has had important policy implications in the way monetary policy has been conducted. This type of deflation is to be allowed in a market economy with flexible and open and competitive markets. Rather than an exception, they are the welcome result of real growth. These benign deflations can be observed in the late 19^th century, when price stability was an indirect and long term result of the convertibility but not a goal to be pursued directly by central banks.  Their strategic goal was to keep the connection of their currency with the gold or silver anchor. Such was the case of Spain, where the silver standard resulted in half a century of stable prices, though the Bank did not even measure them continuously. Paradoxically, today’s central banks are made to pursue of price stability directly but in the long term have presided over a secular loss of purchasing power of their fiat moneys. In our days, inflation targets are the norm but continuous price inflation is the reality. Modern central banks fear all types of deflation but by ignoring the beneficial effects of productivity led deflations they are led to a secular over-expansion of the money supply.

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