“A Monetary Policy Framework for All Seasons”

This commentary is in response to the speech titled A Monetary Policy Framework for All Seasons that Mark Carney presented to the U.S. Monetary Policy Forum in New York, Feb. 24, 2012. In this speech, he discusses monetary policy-targeting frameworks. He briefly examines the major ones and presents the Canadian context. This speech is a rework of the material found in the speech we reviewed in Carney’s Carnage but has some interesting points for discussion.

Setting the Stage

Carney notes (bolding, ours) that policy-makers are battling the possibility of deflation. They are handicapped by transmission mechanisms that are at best impaired and at worst broken. With households and banks in these economies aggressively trying to delever, output gaps remain large and hysteresis threatens. The world, notably households, governments and banks, are over-indebted and are trying to reduce their debt burden by paying it down instead of consuming more and increasing their debt load. This reduces economic growth and is a disinflationary force creating a feedback cycle that causes further economic contraction. In electronics and physics, this cyclical contraction is known as hysteresis.

The current global central bank  policy framework has produced a result that Market expectations that G-3 [US (the Fed), Japan (the BoJ) and the EU (the ECB)] target rates will stay at very low levels for a very long time appear firmly entrenched. G-3 central bank balance sheets have swelled to about 25 per cent of GDP, on average, and can reasonably be expected to expand further.

The result of global fiscal policy to date is that policy rates remain near historic lows and real rates are generally negative. In short, things is broke.

What  or Whom Are Central Banks Shooting At?

In Carney’s Carnage and the speech referenced therein, Carney discusses inflation targeting (IT) versus price level and nominal GDP targeting as the preferred policy response to fix things. He discusses briefly, the BoC’s adoption of inflation targeting as its primary monetary policy and in the current speech, asserts it remains the best response.

In this speech, he lists four objections to IT and counters them, although somewhat incompletely. Carney then argues, based on BoC research, why other policy-targeting regimes such as price stability or nominal GDP are less effective than the flexible IT policy the BoC uses. We choose not to wade into the debate as to which targeting regime is better as we feel all are undesirable and destructive.

In discussing “flexible IT” he is careful to note that flexibility does not mean raising inflation targets. This is especially important as it increases inflationary expectations that cause interest rates to rise. This affects debt negatively by raising the cost of servicing it and creating the hysteresis effect mentioned earlier. As he notes:

However, this is not the kind of flexibility we have in mind when we speak of “flexible IT.” Moving opportunistically to a higher inflation target would risk unmooring inflation expectations and destroying the hard-won gains that have come from the entrenchment of price stability. A higher inflation-risk premium might result, prompting an increase in real rates that would exacerbate unfavourable debt dynamics.

Recognizing the need for debt deleveraging, he makes the interesting observation:

The most palatable strategy to reduce debt is to increase growth. In today’s reality, the hurdles are significant. For example, in Europe, sustained and necessary structural reforms may, for a time, actually depress nominal growth. The repair of U.S. household balance sheets has yet to fully run its course. Japan’s adjustment remains a work in progress. As a consequence, the advanced economies could face a prolonged period of deficient demand and weak nominal growth.

Summarizing to this point, the global economy, and the G-3 in particular, are in a debt-deleveraging cycle that threatens to become deflationary. Deflation (debt reduction per se) is BAD (economic doctrine 101). There are three option (not mentioned in the speech) to deal with debt, default, growth to pay it down, and inflation to reduce its real value to manageable levels.

Elsewhere we discuss an essential characteristic of debt, that of moving future income into the present, reducing future consumption that would otherwise be realized. This creates Carney’s “deficient demand and weak nominal growth”. We suspect that the G-3 economies have passed a critical point at which the cost of debt servicing, a non-discretionary part of government spending in non-default economies, at present rates of deficit financing, is growing faster than the economy can possibly grow creating another one of those deflationary hysteresis cycles.

The other non-conventional policy tool that Carney alludes to, debt monetization or “money printing”, will become the tool of final resort. We also suspect this tool has past a critical point in its usefulness and is now accelerating the economic collapse. Something to examine when we’re bored (unfortunately it doesn’t happen these days).

Why Are They Shooting at Me?

In  Carney’s Carnage we explain the destructive effect of inflation targeting and some of the groups that it destroys. As we said in that post:

The cost of [2%] inflation is this. If your income is rising at 2% a year, you are treading water [we explain why]. But Granny’s income on her money in the bank is earning 1%. And her pension, somehow never reflects the real effect of inflation. Granny is drowning. The working poor whose incomes do not keep pace with the rate of inflation are also drowning.

In the current environment, in many of the OECD economies, the recessionary impact on the business cycle has been so severe that there is a near record-level of spare capacity in the workforce. This means that middle class wages are not rising at the rate of inflation. The destructive effect of central bank inflation-targeting policy has moved up into the central core of the economy.

The central policy objective of our central banks, that a moderate level of inflation is good or even essential, needs to be reexamined – and not exclusively by economists.

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