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Friday, November 10, 2006

Monetary Aggregate Cage Match

Central bank heads Bernanke and Trichet are battling over the use of monetary aggregates to guide monetary policy decisions. I posted Trichet's argument for the use of monetary aggregates here along with links to many previous posts on this topic (including a discussion of an academic paper by Bernanke that helped to do away with aggregates - it's first on the list at the end of the post). Here's a discussion of Bernanke's response to Trichet from the Financial Times:

Trichet and Bernanke differ on strategy, by Ralph Atkins, Financial Times: Transatlantic differences over monetary strategy erupted into the open on Friday as the European Central Bank sought to modernise its policy of relying on money supply measures as an inflation early-warning system. Jean-Claude Trichet, ECB president, used a Frankfurt conference to stress the importance of indicators such as M3, the broad money supply measure.

But in contrast, Ben Bernanke, US Federal Reserve chairman, said a heavy reliance on money supply measures “would seem to be unwise in the US context,” although money growth data might still offer important signals about future economic developments. ...

Mr Bernanke pointed to larger methodological problems in the US. “The rapid pace of financial innovation in the US has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables.” Changes in payment technologies and individuals’ behaviour had meant usage of different kinds of accounts “have at times shifted rapidly and unpredictably”.

The problems Bernanke discusses, rapid financial innovation and rapid movement of funds between asset classes, led to a breakdown of the relationship between monetary aggregates and macroeconomic variables in the early 1990s. Since then, researchers have not been able to find a collection of financial assets (e.g. M1, M2, and many, many variations including weighted averages of various asset collections) that exhibits the stable relationship needed to make the variable useful for predicting the future evolution of macroeconomic variables and hence useful for policy. Because of that, the Fed has embraced interest rate targeting - the federal funds rate in particular - a move also supported by theoretical work since that time (though as Trichet notes, when substantial financial frictions are present in these models, money retains a role; thus, there are theoretical bases for looking at aggregates as well as interest rates).

Also, from the comments to the first post on this issue, this is Krzysztof Rybiński, deputy governor of the National Bank of Poland:

The role of money in monetary policy is an open issue indeed. Benati (2006) shows that for low frequencies (8-30 years) the correlation between money and inflation is surprisingly strong. But does it offer any guidance, if central banks want assess the future inflation risks in 2-3 year horizon. Many papers show that money affects inflation over the shorter-horizons only on a global scale. I discuss these issues on my blog www.rybinski.eu (probably first ever central banker's blog)

Update: From Cassandra in comments:

I listened to the speeches and subsequent Q&A on taped feed and here are my two cents:

Bernanke (TeamFRB) - He always seems rather nervous and lacking the authority, confidence (and probably arrogance) one should have if one is going to assert that money is really not so important in regards to inflation. HUH??!? So interest rates are low because there's a "savings glut," and money doesn't matter to inflation as long villagers as in Timbuktu are using it for whatever. Oh, yea, [whispering now]  and that the PBoc & BoJ continue to give us back the ones they've accumlated for us to hold temporarily. Huh??!?! He reminds me of the "Alternative School Headmaster" in my hometown when they first set up idea. You know: Kids responsible for themselves. No attendance taken. No grades. Surprise!! Guess what happen?  Hardly anyone came to school, and the kids just sat around and smoked dope all day. OK it was the 60s, but some experiments are best left unrepeated.

Trichet (TeamECB) - Considering the high incidence of intellectual arrogance amongst the typical Grande Ecole French Technocrats (not that it isn't deserved), Mr Trichet was by comparison, profoundly thoughtful, measured, open-minded, yet disciplined, and probably the most able to "wear and consider others' positions" before asserting the superiority of the ECBs approach in theory and practice. Oh yea, in case anyone was wondering, just because Issing retired doesn't mean he's laying down early-morning towels on beach chairs in Grand Canary.

Iwata (TeamBoJ)- Whizzbang!! Wonderful command of the material and thoughtful evaluation of quantitative easing (not that it mattered). Brought some typically nifty Japanese visual aids. Probably the best fun of the lot to go out drinking with. A real shame though that he could not (unsurprisingly) conjure a remotely sensible answer answer the question when posed [paraphrased] "Dude!!...did it ever ever ever cross your mind that ZIRP might.. like.... just have no impact on the demand for money IN Japan, but just might have every Tom Dick & Harry hedge fund manager and Foreign Bank lining OUTSIDE of Japan to up take your magnanimous offer of FREE MONEY? WHAT WERE YOU THINKING ???!??! 

Xiaochuan (TeamPBoC) - Nice, deferential, new kid on the block. So new, that he let no opportunity pass to let everyone know that, before his experience with asset prices is limited since before 1991, there was no stock market!! And before 1995,  there was no difference between fiscal and monetary policy China. That their historical experience monitoring real estate markets is rather patchy too since real estate markets didn't exist before 1998. Everything is a learning experience. "We have a lot to learn." As for inflation, he said something like "Money growth is probably too high, but we keep watching for inflation, but, hey golly no inflation!! [smiles, scratches head like my Zen teacher used to do when quoting Suzuki about What's at the Center of An Onion]. He went on to hypothesize that probably because there was so much capex and new capacity that overcapacity in many industries has not only kept the lid on inflation, but may actually be causing certain prices to fall!! 

One just hopes that Xiaochuan doesn't start talking to Iwata and Bernanke in private and decide that selectively falling prices for certain things (the D-word which must not be named), that in China directly resulted from over-investment that itself resulted from liquidity spillover from ZIRP in Japan + prolonged negative real US rates, now requires some effective rear-guard or preventative action like ZIRP, quantitative easing, more negative real interest rates, or heaven forbid, Ben's Helicopter. I guess what goes around comes around and keeps going and coming around.

    Posted by on Friday, November 10, 2006 at 07:29 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (20)


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