Showing posts with label Money. Show all posts
Showing posts with label Money. Show all posts
Saturday, April 5, 2008
Candy Money.....
What happens when an economy runs out of fiat money? Just such an outcome has occured in Argentina. With coins in short supply, stores have taken to using candy in place of small change. If candy can in turn be used to make small payments in other stores, then candy has become a form of commodity money. But if it cannot be used as payment, then the only beneficiaries of this practice will be the dentists! See this Freakonomics link for more.
Tuesday, February 5, 2008
Zimbabwe inflation... again
Another in a continuing saga.... inflation in Zimbabwe officially hits 24,000%, although it may actually be far higher....
For the previous installment, see here.
For the previous installment, see here.
Tuesday, January 22, 2008
Real vs. Nominal
"What is the real price (for example of oil)? What is the difference between the real and nominal price? Do real prices change over time?" - Phillip
A nominal price is measured in terms of units of money- for example, oil is currently $88USD per barrel. A real price is adjusted for changes in the value of a unit of money- for example, if prices had risen by 20% since 2000, we'd say that the real price of a barrel of oil is (88 x 0.8) USD per barrel in year 2000 USD. Real prices changes over time, but generally by smaller magnitudes than nominal prices.
A nominal price is measured in terms of units of money- for example, oil is currently $88USD per barrel. A real price is adjusted for changes in the value of a unit of money- for example, if prices had risen by 20% since 2000, we'd say that the real price of a barrel of oil is (88 x 0.8) USD per barrel in year 2000 USD. Real prices changes over time, but generally by smaller magnitudes than nominal prices.
Thursday, January 17, 2008
Chinese Price Controls...
Prices are going up in Mainland China, so the Government has enacted price controls. From today's SCMP editorial...
"The tough measures introduced yesterday to cap soaring food prices on the mainland clearly signal that Beijing is seriously concerned about inflation - and determined to combat the problem. These are the most stringent controls on the prices of basic necessities for 15 years. Their introduction shows that even as the mainland continues to move ahead with free-market reforms, the government is not afraid to use tough administrative measures when it believes they are necessary."
The tone of the editorial suggests that price controls represent a difficult, but ultimately effective, policy to combat increasing inflation. I'm far more sanguine. Price controls never have been, and in my view never will be, an effective policy to try to lower inflation- see my earlier posts here and here for more.
"The tough measures introduced yesterday to cap soaring food prices on the mainland clearly signal that Beijing is seriously concerned about inflation - and determined to combat the problem. These are the most stringent controls on the prices of basic necessities for 15 years. Their introduction shows that even as the mainland continues to move ahead with free-market reforms, the government is not afraid to use tough administrative measures when it believes they are necessary."
The tone of the editorial suggests that price controls represent a difficult, but ultimately effective, policy to combat increasing inflation. I'm far more sanguine. Price controls never have been, and in my view never will be, an effective policy to try to lower inflation- see my earlier posts here and here for more.
Wednesday, November 28, 2007
The Zimbabwe CPI is now Undefined....
According to this article, the Zimbabwe state statistical agency is no longer calculating the CPI, as there are too many empty shelves, and not enough goods left to include in the calculation.
Following from my earlier discussions of Zimbabwe's inflation (the latest being here), I think this new development highlights a potential bias in the CPI that I haven't seen discussed elsewhere. What is the price of a good that is no longer available at any price? The only answer to this question is that it is undefined, or infinite. If even one component of the CPI is no longer available at any price, then regardless of how trivial that component is within the CPI, Zimbabwe inflation now equals infinity!
(This is part of the reason why price controls are such a bad idea: they lower the prices for some consumers but inevitably create shortages, and therefore infinite prices, for others).
But life is not actually quite as bad as infinite inflation would imply. Recall that we often use the CPI as a measure of the "cost of living." To an economist, the cost of living is the lowest cost of attaining a given standard of living, or utility. The CPI is an imperfect measure of this because it ignores substitution effects (consumers substitute away from relatively expensive goods towards cheaper ones), new goods (the weights are only updated occasionally, so ignores the rapid price declines usually associated with new goods), and improvements in quality over time. These three biases tend to result in the CPI overstating rises in the true cost of living.
If we ignore goods that are no longer available at any price due to a collapsing, corrupt, crime-ridden economy, then that introduces a bias that works the other way. It will not in fact result in infinite inflation (since a rational consumer would substitute away from the unavailable goods to those that are still available), but in the case of Zimbabwe is likely to result in measured inflation significantly understating the true rise in the cost of living. True infinite inflation can only arise when there is nothing left available for sale at any price.
So the poor people of Zimbabwe who have been arguing that the prices they pay are rising faster than official CPI figures indicate have a point.
And what is the source of this hyper-inflation? The money supply is growing at 18000% per year! as Friedman said, "Inflation is always and everywhere a monetary phenomena."
Following from my earlier discussions of Zimbabwe's inflation (the latest being here), I think this new development highlights a potential bias in the CPI that I haven't seen discussed elsewhere. What is the price of a good that is no longer available at any price? The only answer to this question is that it is undefined, or infinite. If even one component of the CPI is no longer available at any price, then regardless of how trivial that component is within the CPI, Zimbabwe inflation now equals infinity!
(This is part of the reason why price controls are such a bad idea: they lower the prices for some consumers but inevitably create shortages, and therefore infinite prices, for others).
But life is not actually quite as bad as infinite inflation would imply. Recall that we often use the CPI as a measure of the "cost of living." To an economist, the cost of living is the lowest cost of attaining a given standard of living, or utility. The CPI is an imperfect measure of this because it ignores substitution effects (consumers substitute away from relatively expensive goods towards cheaper ones), new goods (the weights are only updated occasionally, so ignores the rapid price declines usually associated with new goods), and improvements in quality over time. These three biases tend to result in the CPI overstating rises in the true cost of living.
If we ignore goods that are no longer available at any price due to a collapsing, corrupt, crime-ridden economy, then that introduces a bias that works the other way. It will not in fact result in infinite inflation (since a rational consumer would substitute away from the unavailable goods to those that are still available), but in the case of Zimbabwe is likely to result in measured inflation significantly understating the true rise in the cost of living. True infinite inflation can only arise when there is nothing left available for sale at any price.
So the poor people of Zimbabwe who have been arguing that the prices they pay are rising faster than official CPI figures indicate have a point.
And what is the source of this hyper-inflation? The money supply is growing at 18000% per year! as Friedman said, "Inflation is always and everywhere a monetary phenomena."
Thursday, November 8, 2007
The Economics of Remittances....
Every year, domestic helpers in Hong Kong send money home to support their families. In this post, I want to briefly examine the economics of these remittances. (This post is motivated by this story about the remittances of polish truck drivers from the UK).
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
Wednesday, November 7, 2007
Has the Fed lost the plot?
"I am afraid that the Fed Reserve, which regards its loose monetary policy can overcome potential recession, has missed the point. The underlying problem with US' economy is the unbelievable deficit! With high deficit and high oil price, I am reminded of the stagflation of 1970s. What do you think?" - Wallace
The Federal Reserve is in a tight spot. Their objective is to try to ensure that the US economy grows as fast as possible without generating excessive inflation. If the economy starts to slow, they cut interest rates, while if the economy grows too fast, they raise rates.
That's the theory, in the simplest possible terms. But the reality is much more complicated. We can think of the economy as consisting of many different key indicators, that all suggest different monetary policy responses. For example, if we were to focus on the latest employment numbers, GDP release, or inflation data, they were relatively strong, suggesting that a reduction in interest rates is definitely not required at the current point in time, and runs the risk of fueling further increases in the inflation rate. In sharp contrast, if we focus on one key aspect of the economy, the stock of wealth tied up in housing, this is dropping in value very quickly, and will most likely lead to a significant drop in consumption and a recession in the coming months. (I know I've been making this argument for some time now, but I still believe it to be true!).
Add to the mixture the fact the monetary policy acts on the real economy (e.g. GDP) with a lag of 6-12 months, and on the nominal economy (i.e. inflation) with a lag of 12-18 months, and you end up with a central bank that has to worry about what is going to happen in the future, rather than the present.
And just to make things even more confusing, the current subprime mortgage meltdown has effectively tightened monetary policy, as banks require higher interest rates to offset their increased risk aversion as a large part of their portfolio has gone up in smoke. To some extent, the cuts in interest rates have simply offset this recent phenomena. To illustrate this, consider the following graph, containing the prime rate, the effective federal funds rate, and the yield on BBA-rated bonds (all data taken from FRED). While the first two series have seen falls in interest rates since May of 50 basis points, the BBA yields are actually higher!
So coming back to the question, I think there is a risk of stagflation (when the economy's growth rate slows and inflation increases) if the central bank cuts rates too much, but there's also a risk of a serious recession (if house prices continue to fall dramatically, and consumers cut back on their consumption). On balance, we could argue about whether the central bank has done too little or too much, but we will never know for sure until after the fact, and by then it is too late to do anything about it!
On the real issue being the budget deficit, this is indeed a problem going forward for the United States, but not directly related to the monetary policy dilemma that the Federal Reserve faces. (In the margin, an expansionary fiscal policy requires a relatively contractionary monetary policy to offset its inflationary effects). And of course, moving to a contractionary fiscal policy would only make matters worse if the US economy does enter a recession.
The Federal Reserve is in a tight spot. Their objective is to try to ensure that the US economy grows as fast as possible without generating excessive inflation. If the economy starts to slow, they cut interest rates, while if the economy grows too fast, they raise rates.
That's the theory, in the simplest possible terms. But the reality is much more complicated. We can think of the economy as consisting of many different key indicators, that all suggest different monetary policy responses. For example, if we were to focus on the latest employment numbers, GDP release, or inflation data, they were relatively strong, suggesting that a reduction in interest rates is definitely not required at the current point in time, and runs the risk of fueling further increases in the inflation rate. In sharp contrast, if we focus on one key aspect of the economy, the stock of wealth tied up in housing, this is dropping in value very quickly, and will most likely lead to a significant drop in consumption and a recession in the coming months. (I know I've been making this argument for some time now, but I still believe it to be true!).
Add to the mixture the fact the monetary policy acts on the real economy (e.g. GDP) with a lag of 6-12 months, and on the nominal economy (i.e. inflation) with a lag of 12-18 months, and you end up with a central bank that has to worry about what is going to happen in the future, rather than the present.
And just to make things even more confusing, the current subprime mortgage meltdown has effectively tightened monetary policy, as banks require higher interest rates to offset their increased risk aversion as a large part of their portfolio has gone up in smoke. To some extent, the cuts in interest rates have simply offset this recent phenomena. To illustrate this, consider the following graph, containing the prime rate, the effective federal funds rate, and the yield on BBA-rated bonds (all data taken from FRED). While the first two series have seen falls in interest rates since May of 50 basis points, the BBA yields are actually higher!
So coming back to the question, I think there is a risk of stagflation (when the economy's growth rate slows and inflation increases) if the central bank cuts rates too much, but there's also a risk of a serious recession (if house prices continue to fall dramatically, and consumers cut back on their consumption). On balance, we could argue about whether the central bank has done too little or too much, but we will never know for sure until after the fact, and by then it is too late to do anything about it!
On the real issue being the budget deficit, this is indeed a problem going forward for the United States, but not directly related to the monetary policy dilemma that the Federal Reserve faces. (In the margin, an expansionary fiscal policy requires a relatively contractionary monetary policy to offset its inflationary effects). And of course, moving to a contractionary fiscal policy would only make matters worse if the US economy does enter a recession.
Monday, November 5, 2007
Pressure on the HKD peg...
The HKMA has been intervening regularly lately to maintain the HKD peg. The currency is nominally fixed at 7.80 HKD per USD, but allowed to fluctuate between 7.75 and 7.85. When it hits the weak side of the band (7.85), the HKMA is obliged to buy HKD in exchange for USD. And when it hits the strong side, the HKMA sells HKD in exchange for USD.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Thursday, November 1, 2007
Price Controls make a Comeback...
Price controls are making a comeback, in Argentina, Russia, and China. as I've argued before this is a bad idea. Let me recount my two main objections briefly.
First, price controls do not generally work. If they succeed in preventing prices from rising, then shortages will inevitably result. I'd rather pay "too much" for a good or service than fail to be able to buy it at all because the supplier has run out! (If a supplier runs out of a product, the effective price is infinity- which can hardly be thought of as successful if your objective was to prevent prices from rising! Normally, however, the black market ensures that one can still purchase price controlled goods- perhaps at an inflated price- even when shortages result).
Second, even if they did "work" by prevening prices from rising, they do so from distorting the price signals that are essential for efficient resource allocation.
In the end, too high inflation results from one and only one cause: too lax monetary policy. As Milton Friedman famously said "Inflation is always and everywhere a monetary phenomenom." Indeed, for high inflation countries there is approximately a 1-for-1 relationship between money supply growth and inflation, although the link is less than proportional for lower inflation economies.
See my earlier post for more.
First, price controls do not generally work. If they succeed in preventing prices from rising, then shortages will inevitably result. I'd rather pay "too much" for a good or service than fail to be able to buy it at all because the supplier has run out! (If a supplier runs out of a product, the effective price is infinity- which can hardly be thought of as successful if your objective was to prevent prices from rising! Normally, however, the black market ensures that one can still purchase price controlled goods- perhaps at an inflated price- even when shortages result).
Second, even if they did "work" by prevening prices from rising, they do so from distorting the price signals that are essential for efficient resource allocation.
In the end, too high inflation results from one and only one cause: too lax monetary policy. As Milton Friedman famously said "Inflation is always and everywhere a monetary phenomenom." Indeed, for high inflation countries there is approximately a 1-for-1 relationship between money supply growth and inflation, although the link is less than proportional for lower inflation economies.
See my earlier post for more.
Monday, October 29, 2007
Froth and Bubbles....
"What should China do to try to reduce excess liquidity and inflation" - Qin
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
Wednesday, October 10, 2007
The HKMA is On Top of Things....
The Hong Kong Monetary Authority, Hong Kong's de facto Central Bank, is on top of things... literally! In fact, being housed in the top 11 floors of IFC2, the world's 7th tallest building (and Hong Kong's tallest.... at least until the new ICC building going up across the harbour adds a few more floors).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Tuesday, September 25, 2007
Hong Kong's Money...
Want to know how monetary policy is really set in Hong Kong, and the intricacies of the Currency Board system? Look no further than "Hong Kong's Money," a new book written by Tony Latter and Published by Hong Kong University Press. Mr Latter is a former Deputy Chief Execuative of the Hong Kong Monetary Authority, and his association with monetary policy stretches back to the formation of the currency board in 1983. But his understanding of Hong Kong's monetary history stretches back a long way before then....
Monday, September 24, 2007
How Does a Central Bank Create Money?
James Hamilton of UC San Diego and prolific blogger at Econbrowser provides an excellent explanation of the process by which the Federal Reserve creates money here. While the labels and details vary, any economy with an independent central bank follows a similar process.
The Maestro
Alan Greenspan is the former Chairman of the Federal Reserve Board, the US Central Bank. He was widely hailed as an excellent Chairman throughout his tenure, but some cracks are starting to appear in his reputation.
For one, he continued with an expansionary monetary policy even when most analysts expected interest rates to rise. At the time, this appeared to be a masterstroke- the economy continued growing at a fast rate without the resulting inflation that economists feared.
But now there is an alternative interpretation given to this expansionary policy, and one that implies that he was less than the maestro many had thought. Maybe Greenspan's expansionary policy fueled increased inflation afterall- just not in the prices of consumer goods and services that we track so carefully.
I'm talking about asset prices, of course. Low interest rates encouraged US households to over-invest in real estate, driving up property prices, and creating a property market bubble that is now in the process of deflating. The bubble, and the consequent bust, would most likely have been less severe without the active help of the Greenspan Fed.
We could go further. Indeed, one insightful journalist - Caroline Baum at Bloomberg- has listed a range of excellent questions that she'd like to pose to Greenspan, that together read like an attempt to bring the Maestro from his pedistall back down to earth. Read her article here.
For one, he continued with an expansionary monetary policy even when most analysts expected interest rates to rise. At the time, this appeared to be a masterstroke- the economy continued growing at a fast rate without the resulting inflation that economists feared.
But now there is an alternative interpretation given to this expansionary policy, and one that implies that he was less than the maestro many had thought. Maybe Greenspan's expansionary policy fueled increased inflation afterall- just not in the prices of consumer goods and services that we track so carefully.
I'm talking about asset prices, of course. Low interest rates encouraged US households to over-invest in real estate, driving up property prices, and creating a property market bubble that is now in the process of deflating. The bubble, and the consequent bust, would most likely have been less severe without the active help of the Greenspan Fed.
We could go further. Indeed, one insightful journalist - Caroline Baum at Bloomberg- has listed a range of excellent questions that she'd like to pose to Greenspan, that together read like an attempt to bring the Maestro from his pedistall back down to earth. Read her article here.
Thursday, September 20, 2007
Controlling China's Inflation
China's inflation rate has increasing, and recently hit 6.5%- the highest level in 10 years. The mainland Government has responded to inflation in the past by gradually increasing interest rates in small increments, with limited success. But now it's bringing out the big guns. From today's South China Morning Post....
"Beijing has issued price-control measures for consumer products, which include a freeze on prices.... the government would not change any of the prices of products and services it controlled for the rest of the year. The government administers a vast array of prices, including those for land, transport, utilities and fuel."
It then goes on, more ominously, to reccommend....
".... price-monitoring systems for food, electricity and medicine, and an emergency response system to address any big price fluctuations..... [L]ocal governments should increase minimum wages as soon as possible to make up for inflation."
Let's boil down the problem of increasing inflation to its elementary economic components. Ultimately, any increase in prices is due to a mis-match between supply and demand. At existing prices, demand exceeds supply across a wide range of goods and services, so producers respond by raising their prices, to maximise their profits. But price increases will likely lead to demands for higher wages, as workers seek to maintain their real wages, which firms will in turn pass on to consumers via higher prices, causing a wage-price spiral.
The government's solution to this problem is to try to limit this process by preventing price rises across the range of goods and services whose prices they control. By definition, they may be able to control these prices, but this is a small front in the overall battle against inflation. And ultimately price controls are futile in this battle.
Price controls are nothing new, but they have never been very successful. Even the United States had price controls over the 1971-1973 period, and while the inflation rate fell from 6% to 3-4% over during the freeze, it shot up to 11% in 1974 when the price controls were removed. That's because the fundamental source of inflation had not been addressed.
So that's one black mark against price controls: they fail to work, except in the short run. But there's another more fundamental reasons to dislike price controls. They cause the price system to break down.
When we as consumers decide what we'd like to consume, the price provides an important input into our decision making process. We tend to skimp on high priced goods, but consume relatively more of low priced goods. Because the prices reflect the resource costs of providing the goods, this is efficient. Our consumption decisions reflect the fundamental cost of providing goods and services, reducing resource wastage in the economy.
Now the Government decides to delink the price from the cost of provision across a range of goods and services. Rational consumers will respond by consuming more of these relatively cheap goods and services. The government will need to respond to this increase in demand by stepping up supply- even though it may be making a loss on each unit of output that it is now providing. Thus valuable resources will need to be diverted from some alternative use to increasing the supply of the price controlled goods.
The alternative is that the goverment fails to increase the supply of price-controlled goods, and instead allows demand to outstrip supply. The end result of this would be shortages, and the likely establishment of black markets where the goods are sold at their true economic value, away from government control.
So if price controls are futile, what can the Government do to try to lower the inflation rate in Mainland China? Ultimately they need to lower the demand for goods in the economy. That requires that the economy cool off, and the break-neck rate of economic growth slow.
The appropriate channels for achieving the required economic slowdown are what we would label a "contractionary monetary policy"- for example, raising interest rates abruptly, by more than the increase in inflation, to ensure that real interest rates rise. Or allowing the currency to appreciate more quickly, so that foreign demand for domestic goods slows, and and domestic demand for foreign goods (which are now cheaper) increases. These steps would deal with the fundamental imblance in the Mainland economy, and ensure that demand moves back into line with supply.
The alternative- a partial price freeze- is like a partial stop bank in the path of a swollen river. Yes it might keep the water out for a while, but ultimately it just won't work.
For my earlier take on price level targeting in China, see here.
See also this column by Thomas Palley in the Guardian.
"Beijing has issued price-control measures for consumer products, which include a freeze on prices.... the government would not change any of the prices of products and services it controlled for the rest of the year. The government administers a vast array of prices, including those for land, transport, utilities and fuel."
It then goes on, more ominously, to reccommend....
".... price-monitoring systems for food, electricity and medicine, and an emergency response system to address any big price fluctuations..... [L]ocal governments should increase minimum wages as soon as possible to make up for inflation."
Let's boil down the problem of increasing inflation to its elementary economic components. Ultimately, any increase in prices is due to a mis-match between supply and demand. At existing prices, demand exceeds supply across a wide range of goods and services, so producers respond by raising their prices, to maximise their profits. But price increases will likely lead to demands for higher wages, as workers seek to maintain their real wages, which firms will in turn pass on to consumers via higher prices, causing a wage-price spiral.
The government's solution to this problem is to try to limit this process by preventing price rises across the range of goods and services whose prices they control. By definition, they may be able to control these prices, but this is a small front in the overall battle against inflation. And ultimately price controls are futile in this battle.
Price controls are nothing new, but they have never been very successful. Even the United States had price controls over the 1971-1973 period, and while the inflation rate fell from 6% to 3-4% over during the freeze, it shot up to 11% in 1974 when the price controls were removed. That's because the fundamental source of inflation had not been addressed.
So that's one black mark against price controls: they fail to work, except in the short run. But there's another more fundamental reasons to dislike price controls. They cause the price system to break down.
When we as consumers decide what we'd like to consume, the price provides an important input into our decision making process. We tend to skimp on high priced goods, but consume relatively more of low priced goods. Because the prices reflect the resource costs of providing the goods, this is efficient. Our consumption decisions reflect the fundamental cost of providing goods and services, reducing resource wastage in the economy.
Now the Government decides to delink the price from the cost of provision across a range of goods and services. Rational consumers will respond by consuming more of these relatively cheap goods and services. The government will need to respond to this increase in demand by stepping up supply- even though it may be making a loss on each unit of output that it is now providing. Thus valuable resources will need to be diverted from some alternative use to increasing the supply of the price controlled goods.
The alternative is that the goverment fails to increase the supply of price-controlled goods, and instead allows demand to outstrip supply. The end result of this would be shortages, and the likely establishment of black markets where the goods are sold at their true economic value, away from government control.
So if price controls are futile, what can the Government do to try to lower the inflation rate in Mainland China? Ultimately they need to lower the demand for goods in the economy. That requires that the economy cool off, and the break-neck rate of economic growth slow.
The appropriate channels for achieving the required economic slowdown are what we would label a "contractionary monetary policy"- for example, raising interest rates abruptly, by more than the increase in inflation, to ensure that real interest rates rise. Or allowing the currency to appreciate more quickly, so that foreign demand for domestic goods slows, and and domestic demand for foreign goods (which are now cheaper) increases. These steps would deal with the fundamental imblance in the Mainland economy, and ensure that demand moves back into line with supply.
The alternative- a partial price freeze- is like a partial stop bank in the path of a swollen river. Yes it might keep the water out for a while, but ultimately it just won't work.
For my earlier take on price level targeting in China, see here.
See also this column by Thomas Palley in the Guardian.
Tuesday, September 4, 2007
Controlling China's Inflation Rate
"In response to the surging CPI in mainland China, some economists have proposed that the RMB be anchored to the prices of 50-100 goods. The goverment would fix a certain price for the basket (say 100 RMB), and adjust the money supply to try to keep that price fixed, no matter what happens to the economy, so that people can always buy such a basket with 100RMB. Is it feasible? And what are the advantages and shortcomings? Were there any precedence in the history of the world economy?" - Roy
This sounds like a version of price level targeting, which has been tried before- in Sweden, 1931-1937 (see this paper for a discussion). Normally, we would think of price level targeting as focusing on the entire basket of goods and services enjoyed by consumers by targeting the Consumer Price Index, but there's nothing to stop the Government targeting a select basket of goods and/or services.
Provided the central bank is given the automony to focus fully on its target (by adjusting interest rates or, equivalently, the money supply), such a policy target is achievable. If the price level increased above the target, the central bank would need to raise interest rates (decrease the money supply) to slow the economy sufficiently to get the price level to return to its target, and vice versa if the price level was below the target. This may not always be politically popular, but with sufficient autonomy, it can work.
The principle benefit of such a target is that it gives the Central Bank a numerical objective, and individuals can easily see whether or not the objective is being achieved. If indeed the target is achieved, then inflation expectations should remain under control, which should in turn make it easier to maintain stable price levels in future- all in a nice, virtuous circle.
This same benefit can in principle be conferred by any nominal anchor for monetary policy- for example an inflation target (as is common in many countries, starting with New Zealand in 1990), or an exchange rate target (China's official form of monetary policy target until recently), or any other numerical objective for that matter.
There may be some other benefits as well. Some people have argued that one problem with monetary policy is that Central Banks cannot credibly commit to future actions. In modern Macroeconomics models with sticky prices, the policy that the Central Bank should choose today depends on the policy that they will choose in the future. If they cannot commit to the policy that they will follow in the future, then they will be reduced to choosing a sub-optimal policy today.
A price level target can help to reduce the costs imposed by their inability to commit, because of the manner in which it ensures that the policy that the central bank will follow in the future is related to the policy that the central bank follows today.
I've written a couple of papers related to this, published in the Journal of Macroeconomics (see here and here). Personally, I'm sceptical that there are any gains to price level targeting by this mechanism, since the results are very sensitive to assumptions about how believable the central bank is, and how price setters set prices.
This sounds like a version of price level targeting, which has been tried before- in Sweden, 1931-1937 (see this paper for a discussion). Normally, we would think of price level targeting as focusing on the entire basket of goods and services enjoyed by consumers by targeting the Consumer Price Index, but there's nothing to stop the Government targeting a select basket of goods and/or services.
Provided the central bank is given the automony to focus fully on its target (by adjusting interest rates or, equivalently, the money supply), such a policy target is achievable. If the price level increased above the target, the central bank would need to raise interest rates (decrease the money supply) to slow the economy sufficiently to get the price level to return to its target, and vice versa if the price level was below the target. This may not always be politically popular, but with sufficient autonomy, it can work.
The principle benefit of such a target is that it gives the Central Bank a numerical objective, and individuals can easily see whether or not the objective is being achieved. If indeed the target is achieved, then inflation expectations should remain under control, which should in turn make it easier to maintain stable price levels in future- all in a nice, virtuous circle.
This same benefit can in principle be conferred by any nominal anchor for monetary policy- for example an inflation target (as is common in many countries, starting with New Zealand in 1990), or an exchange rate target (China's official form of monetary policy target until recently), or any other numerical objective for that matter.
There may be some other benefits as well. Some people have argued that one problem with monetary policy is that Central Banks cannot credibly commit to future actions. In modern Macroeconomics models with sticky prices, the policy that the Central Bank should choose today depends on the policy that they will choose in the future. If they cannot commit to the policy that they will follow in the future, then they will be reduced to choosing a sub-optimal policy today.
A price level target can help to reduce the costs imposed by their inability to commit, because of the manner in which it ensures that the policy that the central bank will follow in the future is related to the policy that the central bank follows today.
I've written a couple of papers related to this, published in the Journal of Macroeconomics (see here and here). Personally, I'm sceptical that there are any gains to price level targeting by this mechanism, since the results are very sensitive to assumptions about how believable the central bank is, and how price setters set prices.
Monday, August 13, 2007
Liquidity Injections
"Recently central banks have inject liquidity into the banking system. Will this create higher inflation? What is the difference between this and lowering the interest rate?" - Wallace
That's an excellent question! Normally we think of central banks controlling the short-term interest rates that major banks borrow at in order to meet their daily settlement needs. The central bank sets this rate, and then lends or borrows as required to keep the actual interest rate near the target level. In some countries, they may need to consistently inject small amounts of money into the financial system, while in others they may need to consistently remove money (effectively borrowing it) in order to achieve the target interest rate. Most of the time, the amounts of money are small.
However, once in a while there's some sort of crisis. Suddenly some banks are very short of money to meet settlement needs, and other major banks are unwilling to loan them money at the official central-bank set rate. Then interest rates in the overnight market may diverge significantly from the desired rate of the central bank.
This typically happens when there's a credit crunch of some sort. If banks are struggling with a sudden burst of bad loans, they may be reluctant to make loans of any sort, but will instead try to increase their reserves to offset the increased bad loans. Then, if the central bank really wants to maintain it's target, it needs to inject new money into the market.
To put this another way, we think of interest rates as being inversely related to the money supply. In older economic textbooks, the money supply determines demand, and therefore ultimately inflation in the economy. But the largest part of the money supply is not provided by the central bank- it is "created" by commercial banks, via the credit creation process. For each unit of money that is deposited in the banks, only a small portion is kept by banks in their reserves, with the rest being loaned out to borrowers. Thus the total amount of money in circulation is a multiple of the amount of "money" provided by the central bank.
In a credit crunch, this money creation process slows down. Banks decide that they need to keep a higher level of reserves, effectively shrinking the multiplier. The injection of reserves by the central bank is intended to offset this effect, so that the smaller multiplier times by a larger level of base money maintains the total money supply at the level that the central bank desires.
In the current case, I do not think that this will be sufficient to maintain stable inflation in the US. The credit crunch is a direct result of a dropping property market and sub-prime mortgages going bad. But there are other problems beside this. The same housing market correction will see households feeling poorer, reducing consumption demand, and therefore ultimately GDP and inflation. I expect the US to be in recession very shortly, and the Federal Reserve to start cutting interest rates significantly within a few months.
(For more information, see James Hamilton's blog here).
That's an excellent question! Normally we think of central banks controlling the short-term interest rates that major banks borrow at in order to meet their daily settlement needs. The central bank sets this rate, and then lends or borrows as required to keep the actual interest rate near the target level. In some countries, they may need to consistently inject small amounts of money into the financial system, while in others they may need to consistently remove money (effectively borrowing it) in order to achieve the target interest rate. Most of the time, the amounts of money are small.
However, once in a while there's some sort of crisis. Suddenly some banks are very short of money to meet settlement needs, and other major banks are unwilling to loan them money at the official central-bank set rate. Then interest rates in the overnight market may diverge significantly from the desired rate of the central bank.
This typically happens when there's a credit crunch of some sort. If banks are struggling with a sudden burst of bad loans, they may be reluctant to make loans of any sort, but will instead try to increase their reserves to offset the increased bad loans. Then, if the central bank really wants to maintain it's target, it needs to inject new money into the market.
To put this another way, we think of interest rates as being inversely related to the money supply. In older economic textbooks, the money supply determines demand, and therefore ultimately inflation in the economy. But the largest part of the money supply is not provided by the central bank- it is "created" by commercial banks, via the credit creation process. For each unit of money that is deposited in the banks, only a small portion is kept by banks in their reserves, with the rest being loaned out to borrowers. Thus the total amount of money in circulation is a multiple of the amount of "money" provided by the central bank.
In a credit crunch, this money creation process slows down. Banks decide that they need to keep a higher level of reserves, effectively shrinking the multiplier. The injection of reserves by the central bank is intended to offset this effect, so that the smaller multiplier times by a larger level of base money maintains the total money supply at the level that the central bank desires.
In the current case, I do not think that this will be sufficient to maintain stable inflation in the US. The credit crunch is a direct result of a dropping property market and sub-prime mortgages going bad. But there are other problems beside this. The same housing market correction will see households feeling poorer, reducing consumption demand, and therefore ultimately GDP and inflation. I expect the US to be in recession very shortly, and the Federal Reserve to start cutting interest rates significantly within a few months.
(For more information, see James Hamilton's blog here).
Thursday, June 21, 2007
Bond Prices
"What is the relationship between bond prices, interest rates, and other macroeconomic variables?"
The behaviour of bond prices can seem a little mysterious at the best of times. Let me try to demystify them a little in this post.
Let's start with the relationship between bond prices and interest rates. A bond is an instrument that guarantees to pay a fixed sum of money at some point in the future, perhaps with regular interest payments along the way. Once the bond is issued, the amount that the bond will pay and the interest are both fixed. However, the value of the bond can vary with market conditions.
Bond prices and interest rates move in inverse to each other. To see why, consider a bond that will pay out $1 at maturity (principle plus interest), with no additional interest payments along the way. If that bond has a price today of $P, the return (or interest rate) on that bond is given by r = (1-P)/P. Clearly an increase in P corresponds to a decrease in r, and vice versa.
That's the easy part. Now what about the relationship between bond prices and the macroeconomy? The simplest way to understand this is to think about the relationship between the return (or interest rate) on bonds, which tend to be relatively long term, and short term interest rates.
Consider an investor deciding whether to invest in long-term bonds or leave their wealth in a savings account. In the margin, they should be indifferent between the two. That means that the return on a bond must be related to the expected return from leaving your money in your savings account over the same period of time, adjusting for factors such as liquidity (savings accounts are more liquid- easier to spend- than bonds, and therefore offer lower returns on average). This idea lies begind the "expectations hypothesis" (see here
for a concise explanation). It allows us to reduce a long-term interest rate to a sequence of short-term interest rates.
So bond prices depend on expected future short-term interest rates. Then where do short-term interest rates come from? In the case of Hong Kong, our short-term interest rates depend heavily on US short term-interest rates, since any large deviation between the two would open up an arbitrage opportunity that investors could capitilise on (see here and here for more on this).
Then where do US short-term interest rates come from? The shortest term rate is the Federal Funds rate that is set by the Federal Reserve Board. It's the interest rates that major financial corporations pay/receive when receiving/making loans to meet their daily settlement needs. It also tends to be a trend-setting rate that influences other short-term interest rates, such as those you receive on a savings account.
Putting these pieces of the puzzle together, long-term interest rates depend on the expected future behaviour of the Federal Reserve. So what determines the interest rate setting behaviour of the Federal Reserve? To answer that, we'd need to look at what the Federal Reserve is trying to achieve when it adjusts interest rates.
The Federal Reserve has the job of trying to ensure that the US economy grows as fast as possible without triggering too much inflation (for a more precise definition, click here). If they think the economy is going to grow too fast, they'll raise short term interest rates. And if they think the economy is going to grow to slow, they'll lower interest rates.
Investors try to guess which way the Federal Reserve is leaning when deciding whether to buy bonds or not. If they think that the Federal Reserve is thinking that the economy is going to grow too fast, they expect future short term interest rates to rise. As a result, they're less willing to hold bonds, so the price of bonds falls today.
In the last few weeks, the price of bonds has been dropping dramatically, and as a result their interest rates have been rising. That's because investors believe that the likelihood of the Fed raising rates in the future is increasing.
Of course they might be wrong. In that case, bond prices can increase or decrease without really signalling anything about the future behaviour of the Federal Reserve, or for that matter, the macroeconomy more broadly.
So coming back to the original question, what macroeconomic variables influence bond prices? Anything that would help to indicate whether interest rates are likely to rise or drop in future. That includes anything that the Federal Reserve is likely to look at when trying to determine the future path of the economy. And that covers virtually all macroeconomic variables!
The behaviour of bond prices can seem a little mysterious at the best of times. Let me try to demystify them a little in this post.
Let's start with the relationship between bond prices and interest rates. A bond is an instrument that guarantees to pay a fixed sum of money at some point in the future, perhaps with regular interest payments along the way. Once the bond is issued, the amount that the bond will pay and the interest are both fixed. However, the value of the bond can vary with market conditions.
Bond prices and interest rates move in inverse to each other. To see why, consider a bond that will pay out $1 at maturity (principle plus interest), with no additional interest payments along the way. If that bond has a price today of $P, the return (or interest rate) on that bond is given by r = (1-P)/P. Clearly an increase in P corresponds to a decrease in r, and vice versa.
That's the easy part. Now what about the relationship between bond prices and the macroeconomy? The simplest way to understand this is to think about the relationship between the return (or interest rate) on bonds, which tend to be relatively long term, and short term interest rates.
Consider an investor deciding whether to invest in long-term bonds or leave their wealth in a savings account. In the margin, they should be indifferent between the two. That means that the return on a bond must be related to the expected return from leaving your money in your savings account over the same period of time, adjusting for factors such as liquidity (savings accounts are more liquid- easier to spend- than bonds, and therefore offer lower returns on average). This idea lies begind the "expectations hypothesis" (see here
for a concise explanation). It allows us to reduce a long-term interest rate to a sequence of short-term interest rates.
So bond prices depend on expected future short-term interest rates. Then where do short-term interest rates come from? In the case of Hong Kong, our short-term interest rates depend heavily on US short term-interest rates, since any large deviation between the two would open up an arbitrage opportunity that investors could capitilise on (see here and here for more on this).
Then where do US short-term interest rates come from? The shortest term rate is the Federal Funds rate that is set by the Federal Reserve Board. It's the interest rates that major financial corporations pay/receive when receiving/making loans to meet their daily settlement needs. It also tends to be a trend-setting rate that influences other short-term interest rates, such as those you receive on a savings account.
Putting these pieces of the puzzle together, long-term interest rates depend on the expected future behaviour of the Federal Reserve. So what determines the interest rate setting behaviour of the Federal Reserve? To answer that, we'd need to look at what the Federal Reserve is trying to achieve when it adjusts interest rates.
The Federal Reserve has the job of trying to ensure that the US economy grows as fast as possible without triggering too much inflation (for a more precise definition, click here). If they think the economy is going to grow too fast, they'll raise short term interest rates. And if they think the economy is going to grow to slow, they'll lower interest rates.
Investors try to guess which way the Federal Reserve is leaning when deciding whether to buy bonds or not. If they think that the Federal Reserve is thinking that the economy is going to grow too fast, they expect future short term interest rates to rise. As a result, they're less willing to hold bonds, so the price of bonds falls today.
In the last few weeks, the price of bonds has been dropping dramatically, and as a result their interest rates have been rising. That's because investors believe that the likelihood of the Fed raising rates in the future is increasing.
Of course they might be wrong. In that case, bond prices can increase or decrease without really signalling anything about the future behaviour of the Federal Reserve, or for that matter, the macroeconomy more broadly.
So coming back to the original question, what macroeconomic variables influence bond prices? Anything that would help to indicate whether interest rates are likely to rise or drop in future. That includes anything that the Federal Reserve is likely to look at when trying to determine the future path of the economy. And that covers virtually all macroeconomic variables!
Wednesday, June 20, 2007
Inflation in Hell?
A common custom in this part of the world is to burn "money" as a way of transferring wealth to the dead, so that they can enjoy a higher standard of living in the afterlife (BigWhiteMale gives a thorough discussion of the background).
But if there's money, there must be inflation! Chewxy provides a careful economic analysis of the issues. The conclusion? It must be hell to live in Hell- due to the rampant hyperinflation! I'm sure the residents of Zimbabwe would agree (with inflation now running at 4530%)!
Thanks to Marginal Revolution for the pointer- check their original post for a related joke.
But if there's money, there must be inflation! Chewxy provides a careful economic analysis of the issues. The conclusion? It must be hell to live in Hell- due to the rampant hyperinflation! I'm sure the residents of Zimbabwe would agree (with inflation now running at 4530%)!
Thanks to Marginal Revolution for the pointer- check their original post for a related joke.
Tuesday, May 22, 2007
Monetary Policy and Dragon Slaying
The objectives of monetary policy are very different in different economies. For example, Singapore seeks to stabilise the exchange rate against a basket of other currencies. Many central banks seek to maintain the inflation rate on consumer goods in the low single-digits (referred to as "inflation targeting"). The Federal Reserve in the United States seeks to "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," although in recent years its behaviour has looked much like an inflation targeter.
Stepping back, each of these objectives is chosen based on an over-arching concern that monetary policy should increase stability in the economy. Because economies have different structures, different objectives may be appropriate for different economies, and at different times.
To understand why "inflation targeting" is so popular today, a little history is helpful. The 1970's were a disastrous period of monetary policy. Inflation rates increased into the high teen's in many developed economies, reducing economic stability. Inflation targeting was an appropriate and timely foil to this problem. It was pioneered by one of the worst performing central banks in the developed world over this period, the Reserve Bank of New Zealand, but was quickly adopted by other countries as a transparent way to maintain stable inflation at minimal cost to the real economy.
So the inflation dragon has been slayed; does that mean that central banks can relax, knowing that they are achieving their objectives? Unfortunately, the answer is "no." While price stability is important, it is just one element in achieving a stable economy. Further, there is increasing evidence that slaying the inflation dragon has allowed another, potentially more ominous dragon, to grow in its absence.
What I am talking about here is asset price bubbles. Low and stable inflation over a decade or more has ensured that consumers and investors at large have come to expect low inflation in the future. They know that if the inflation rate jumps, the central bank will quickly respond by increasing interest rates, stabilising inflation. Thus, not worried about surprise inflation, they are content with moderate wage increases, sustaining low inflation as an equilibrium.
With little inflationary pressure, central banks have been able to increase the money supply (or equivalently lower real interest rates) below historical levels. The resulting cheap credit and excess liquidity has led to increased demand for assets, pushing up equities and real estate prices in many countries. To some extent, this is an appropriate outcome: lower real interest rates imply that the opportunity cost of owning equities or real estate is lowered, encouraging higher real prices. My concern is that this process has gone too far, and the prices of many assets now exceed fundamental levels. And when asset price bubbles develop, they must eventually burst.
Examples of possible asset price bubbles vary by country. In the US, UK, Australia, New Zealand, Spain, etc, I would point to real estate as a probable bubble, and one that is starting to burst in the US at least (see my earlier posts here, here, and here). For China, the bubble appears to be equities (see my earlier posts here and here).
Suppose that the arguments I'm making here are correct. Because boom-bust cycles are disruptive for the real economy, monetary policy is not achieving its ultimate objective of economic stability, regardless of its effectiveness at stabilising prices or exchange rates.
What should we do about it? That's the million dollar question! In principle, existing monetary policy tools could be used to try to prevent asset price bubbles developed, but that may require extreme changes in interest rates, which themselves would be destabilising. I'd also be very skeptical of the ability of any central bank to correctly detect bubbles in the long run. That is because it is not always clear whether a rapid increase in asset prices represents a bubble.
But there are some simple first steps that a central bank could take. For example, if inflation is benign but asset prices are roaring ahead, the central bank should be hesitant at cutting rates, and maybe should raise rates at the margin.
These are just my preliminary thoughts on this important topic. I think that this is one of the potential big new areas where central bank behaviour is likely to change in the coming decade, although I have no idea at this point what form such changes are likely to take. I'll blog more on this topic in the near future.....
Stepping back, each of these objectives is chosen based on an over-arching concern that monetary policy should increase stability in the economy. Because economies have different structures, different objectives may be appropriate for different economies, and at different times.
To understand why "inflation targeting" is so popular today, a little history is helpful. The 1970's were a disastrous period of monetary policy. Inflation rates increased into the high teen's in many developed economies, reducing economic stability. Inflation targeting was an appropriate and timely foil to this problem. It was pioneered by one of the worst performing central banks in the developed world over this period, the Reserve Bank of New Zealand, but was quickly adopted by other countries as a transparent way to maintain stable inflation at minimal cost to the real economy.
So the inflation dragon has been slayed; does that mean that central banks can relax, knowing that they are achieving their objectives? Unfortunately, the answer is "no." While price stability is important, it is just one element in achieving a stable economy. Further, there is increasing evidence that slaying the inflation dragon has allowed another, potentially more ominous dragon, to grow in its absence.
What I am talking about here is asset price bubbles. Low and stable inflation over a decade or more has ensured that consumers and investors at large have come to expect low inflation in the future. They know that if the inflation rate jumps, the central bank will quickly respond by increasing interest rates, stabilising inflation. Thus, not worried about surprise inflation, they are content with moderate wage increases, sustaining low inflation as an equilibrium.
With little inflationary pressure, central banks have been able to increase the money supply (or equivalently lower real interest rates) below historical levels. The resulting cheap credit and excess liquidity has led to increased demand for assets, pushing up equities and real estate prices in many countries. To some extent, this is an appropriate outcome: lower real interest rates imply that the opportunity cost of owning equities or real estate is lowered, encouraging higher real prices. My concern is that this process has gone too far, and the prices of many assets now exceed fundamental levels. And when asset price bubbles develop, they must eventually burst.
Examples of possible asset price bubbles vary by country. In the US, UK, Australia, New Zealand, Spain, etc, I would point to real estate as a probable bubble, and one that is starting to burst in the US at least (see my earlier posts here, here, and here). For China, the bubble appears to be equities (see my earlier posts here and here).
Suppose that the arguments I'm making here are correct. Because boom-bust cycles are disruptive for the real economy, monetary policy is not achieving its ultimate objective of economic stability, regardless of its effectiveness at stabilising prices or exchange rates.
What should we do about it? That's the million dollar question! In principle, existing monetary policy tools could be used to try to prevent asset price bubbles developed, but that may require extreme changes in interest rates, which themselves would be destabilising. I'd also be very skeptical of the ability of any central bank to correctly detect bubbles in the long run. That is because it is not always clear whether a rapid increase in asset prices represents a bubble.
But there are some simple first steps that a central bank could take. For example, if inflation is benign but asset prices are roaring ahead, the central bank should be hesitant at cutting rates, and maybe should raise rates at the margin.
These are just my preliminary thoughts on this important topic. I think that this is one of the potential big new areas where central bank behaviour is likely to change in the coming decade, although I have no idea at this point what form such changes are likely to take. I'll blog more on this topic in the near future.....
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