Exactly what are central banks targeting these days?

The last 24 hours have exposed several contradictions at the heart of what are the modern theories of central banking. These especially matter because central banks currently bestride the economic stage like Transformers with the debate being whether they are more like the good Autobots or the evil Decepticons. These days the loose monetary policy and enlarged balance sheets of the world’s major central banks mean that what was once analysis of financial markets has often become simply front-running the next central banking move. For example the early part of 2015 saw surges in Euro area bond markets and indeed negative yields at the shorter end of the maturity spectrum as investors and hedge funds front ran the expected QE (Quantitative Easing) purchases of the European Central Bank.

Central Banks target economic growth

This is a familiar theory and we see many examples of this being put forwards for policy for example in Europe, the UK and United States. But let me take you to Sweden where some good news this morning poses some real questions for the Riksbank.

Sweden’s GDP increased by 1.0 percent in the second quarter of 2015, seasonally adjusted and compared with the first quarter. GDP increased 3.0 percent, working-day adjusted and compared with the second quarter of 2014.

These are economic growth figures which would have been regarded as good even before the credit crunch made them look even better. The Riksbank expects this version of “Happy Days” to continue.

GDP is expected to grow more rapidly than normal in the years ahead and the labour market continues to improve.

So with us regularly being told that economic output is the driver for central banks these days we would expect some tightening of policy or at least a slowing of the easing. Er no.

All the board members considered it appropriate to increase purchases of government bonds by a further SEK 45 billion. Five members also advocated a cut in the repo rate by 0.1 percentage points to -0.35 per cent, ( 1st of July).

I note that Martin Enlund of Nordea has put it thus today.

: strong GDP doesn’t matter much for the Riksbank. Riksbank seeks higher inflation & higher wages, and isn’t getting it.

I think that it is too easy to say those crazy Swedes! So let us mark that strategy for a moment and progress.

What about inflation then?

This is one of the proclaimed objectives of the Riksbank right now and it is far from alone as the ECB and the Bank of Japan are also using it as major policy objectives right now. However no doubt more than a few of you are thinking to yourselves that this is convenient when inflation around the world is mostly below target, also should the current phase of commodity disinflation persist may hang around a little longer than previously expected. However in itself commodity price disinflation is likely to be temporary and therefore should be “looked through” in the manner described below. After all central banks are supposed to target consumer inflation around 2 years hence.

Back in October 2011 the Bank of England told us this.

The Committee’s view remained that inflation was likely to rise above 5% in the near term, boosted by already announced increases in utility prices.

So if it was applying the new philosophy of responding to current inflation it would have been tightening policy. Er no.

Overall, the case for an expansion of the Committee’s programme of asset purchases financed by the issuance of central bank reserves was compelling.

Instead they pursued a policy which was designed to push inflation higher and they decided that time was of the essence.

In terms of the timing of further asset purchases, there were clear arguments for acting quickly and decisively now that the need for further monetary stimulus had become clear.

As I pointed out at the time clear to whom exactly? They tried to push inflation higher to boost the economy but as I have pointed out many times on here the inflation overshoot led to a sharp drop in real wages which had a contractionary effect. If we consider that both main measures of UK consumer inflation went above 5% per annum then we saw one of the most extraordinary decisions by the Bank of England in my opinion, and I said so at the time.

The Bank of England should finance a further £75 billion of asset purchases by the issuance of central bank reserves,

However we get a very different view of central banking policy because back then an inflation divergence which is size was considerably more than being seen by the Riksbank now was ignored and overlooked. Back then some members of the UK Monetary Policy Committee embarked on a desperate search to find more “helpful” inflation measures only usually to abandon them too as they also rose.

Accordingly we see that “current inflation” can be ignored too as central banks switch not only how important inflation is but whether they choose to concentrate on present or future (at the forecast horizon) inflation.

The Labour Market

If we think back this was an easy target for central banks because unemployment rose and wages fell in response to the credit crunch impact. Thus they were aligned with economic output and it was easy at least initially to justify monetary easing in response to this. However in more recent times using unemployment as an indicator has misfired. From the US Federal Reserve on the 12th of December 2012.

at least as long as the unemployment rate remains above 6-1/2%,

Whilst one might argue that there was no promise to act exactly at 6.5% there is the counterpoint that if you focus attention on a particular level then it is embarrassing to say the least when it surges below it and you do nothing! Currently the US unemployment rate is 5.3% and the Fed has done nothing. The Bank of England had the same problem with a 7% unemployment rate and such policy statements were redacted.

So we now have concentration on the vague concept of “slack” with a soupcon of underemployment thrown in. Also we see emphasis on wage growth which for those who worry that it was in decline pre credit crunch there are genuine fears that this could lead “To infinity… and beyond!” style policies.

What about the US Federal Reserve?

Last night brought something very familiar which was food for both sides of the debate. Let me open with the case for an interest-rate rise.

The labor market continued to improve, with solid job gains and declining unemployment…..as the labor market improves further

Whilst on the other side of the coin we have.

Inflation is anticipated to remain near its recent low-level in the near term,  Market-based measures of inflation compensation remain low;

So I doubt many were swayed by this although I note that market expectations for a rise in September have followed what happened to similar expectations for March and June. It remains “just around the corner” apparently.

Comment

As you can see the central banking playbook has not only been torn up there is little sign of this from Montell Jordan.

This is how we do it

Although mind you some will see echoes of central banking behaviour in some different lyrics from the same song.

But now I’m a big G. The girls see I got the money
A hundred-dollar bills y’all

Ah those happy days when “hundred-dollar” bills were an aspiration of wealth and value! But as I have pointed out today central banking policy is a movable feast between output, the labour market and inflation with more than a soupcon of currency wars thrown into the mix. The US Federal Reserve is quiet about the rise in the US trade-weighted index from 77 to 92 (Via FRED) over the past year. Although on the other side of the coin Brazil last night fired another salvo in a different strategy.

Brasilia – Evaluating the macroeconomic scenario, the outlook for inflation and the current balance of risks, the Copom decided unanimously to raise the Selic rate by 0.50 pp to 14.25% pa, without bias.

So my summary of central banking policy right now comes from OMC.

How bizarre
How bizarre, how bizarre
Ooh baby
(Ooh baby)
It’s making me crazy
(It’s making me crazy)

Odd in a world of Forward Guidance  isn’t it?

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17 thoughts on “Exactly what are central banks targeting these days?

  1. Hi Shaun

    Re the Fed, and despite all the continual noise, I can’t see them raising rates anytime soon. I know what Yellen says and there is no doubt that there is substantial expectation of a (nominal) rise in September(?) but I just don’t believe it and, if I am right, the Fed will begin to look even more ridiculous than it already does – and in my view it already does look pretty ridiculous, as does the BOE.

    You (and others) continually cast doubt on the veracity of the economic statistics we are served up, and with good reason. Is it that the CBs have the same doubts but, because of their position cannot openly disown them so have to frame their policy pronouncements around a dubious base. I suspect that they know full well that the economies of many countries are fragile and could not withstand interest rate increases. However, if this is so, why do they set themselves up as hostages to fortune? It seems to me they are either willingly blind or incompetent; I’m not sure which is best but I do know that I’d prefer it was neither!

    • I don’t think it’s just the fictitious figures; I believe the bank stress tests are about nothing more than (falsely) reassuring the public that our money is safe with banks.
      THAT’s the nub of zirp.

    • How does the Fed look ridiculous? Operation Twist, of which I was very sceptical worked well whilst they haven’t broken any promises re rate rises – see my comment to Shaun for further information.

    • Hi Bob J

      I am not sure about the exact thoughts of the various central bankers but the beat goes on. Whilst the US saw 2.3% (annualised) GDP growth in Q1 and a revised 0.6% on the same basis for Q1 we also saw this.

      “The percent change in real GDP was revised down 0.1 percentage point for 2012, was revised down 0.7 percentage point for 2013, and was unrevised for 2014.”

      So the growth has just been wiped out by downwards revisions (mostly the industrial production I have mentioned before). Not much of a cause for an interest-rate rise…

  2. Great column, Shaun, as usual. I was struck by your phrase: “Back then some members of the UK Monetary Policy Committee embarked on a desperate search to find more “helpful” inflation measures only usually to abandon them too as they also rose.”
    Right now the Bank of Canada is showboating a new common component of CPI measure of underlying inflation, a hugely defective measure that does have the redeeming virtue, for our central bank that is, that it has been showing inflation rates of 1.6% or 1.7% from 2014Q3 forward, where the highly flawed but vastly superior CPIX measure has been showing inflation rates from 2.0% to 2.2%. My friend Sam Boshra noticed that while the new common component of CPI measure is showing lower inflation rates now, it was showing ludicrously high inflation rates during the last recession (i.e. from 2008Q4 to 2009Q2):
    CPIX CC of CPI
    2008-Q1 1.4 2.2
    2008-Q2 1.5 2.3
    2008-Q3 1.6 2.5
    2008-Q4 2.2 2.7
    2009-Q1 1.9 2.8
    2009-Q2 1.9 2.7
    2009-Q3 1.7 2.3
    2009-Q4 1.6 2.1

    At least part of the explanation lies in the mortgage interest CPI, which the CPIX measure quite properly excludes, but seems to be more heavily weighted in the common component of CPI measure than in the official CPI itself. It certainly isn’t excluded. You would think this kind of performance by a measure of underlying inflation would have dissuaded the Bank of Canada from ever publishing it, but next year it could actually replace the CPIX series as our central bank’s operational guide.

    • Hi Andrew

      Thanks for the update of the Canadian experience. I can add one more similarity which is that both the Bank of Canada and some at the Bank of England shifted the goalposts on inflation when they wanted to justify more easing! Perhaps the BoC is shifting the ground in case it feels the need to cut interest-rate further from the current 0.5%.

  3. Hello Shaun,

    With MSM bleating ” what a wonderful life ” at the BoE pronouncements its good to hear some reality

    Frankly its laughable that Cam-moron goes on about fighting crooks buying London property but cannot see anything wrong with the Tax payer support for the City and the support for bogus , if not out right lies , for CPI and GDP figures

    Forward guidance ? Yogi did say

    It is difficult to make predictions, especially about the future.

    ho ho , Mark .

    Banking remains the same , say what ever it takes and do as little as possible

    raising rates will ruin your Government and therefore you future pay rise !

    Forbin

    • Hi Forbin

      The issue over laundered money buying UK property has been around for a while so Prime Ministerial prouncements have the problem when you have had the job for over 5 years have an obvious issue. It suited at the time to help pump up the UK (London) housing market.

      Not such a good day for corn futures so you may have to wait for some cheaper popcorn…

  4. I reckon we should replace the ECB rate setting committee with 9 jesters who receive jesters wages. At very least it would give us a good laugh and help with over a million quid of austerity off the UK’s deficit.

  5. Hi Shaun “what was once analysis of financial markets has often become simply front-running the next central banking move”

    Yes, that’s what I’ve been mostly doing since 2008 and I’ve trebled my money so far!! I can recommend it! But you do have to be able to work out what they’re really up to. Next move – Fed. I have been confident (and stating on this forum since last September)they would increase in September 2015 but that confidence level has now subsided to “fairly confident” as (you have now correctly identified)the Fed has always said it was looking for signs of embedded growth before it would do anything about raising rates and this is why it’s done nothing. Economic indicators have softened in the last couple of months which I know the Fed will look at and is why I am now only fairly confident of a September rise – they never said unemployment was the be all and end al of any indicators they were looking at so why should they raise rates at 6.4% or less unemployment when other indicators show potential slowing? IMO this is a practical level headed and sensible approach, unlike the BOE and I have no idea what theRiksbank is up to, luckily, it’s not a major CB player. .

    If you want to make money investing nowadays you have to watch and second guess the CB’s.

    The trouble is, imo all this has virtually no effect on the real economy as the financial and real economies have become completely decoupled thanks to the CB’s and this is a bad thing.

    The BOE pursues the Holy Grail of inflation because it naively believes that employers will automatically award higher pay rises, but that runs contrary to a capitalists heart so employers will resist doing that as much as possible, especially when you consider unemployment. Therefore the expected explosion in tax revenues to fund the expanding National Debt doesn’t materialise, honestly, I had that worked out when I was doing O level economics!!

    • Hi Noo2

      I am pleased that you have made money out of front-running central banks. But as you are far from alone it brings us to Goodhart’s Law or the Lucas critique as an explanation of why it has disappointed in terms of the real economy.

      I wonder how much notice the Fed will take of the downwards GDP revisions today that I mentioned to Bob J above?

      • Yes I agree and this is probably where my A levels in sociology and psychology pay dividends as I predict how individual investors and the masses will react as they see policy unfold.

        So far, I’ve predicted correctly most of the time, but did OK before the Credit Crunch too although I didn’t use investor psychology any where near as much as now preferring in those days to concentrate on fundamentals.

        In terms of the real economy it’s quite simple – why should banks lend money to the real economy when they can make more gambling on the markets or round tripping the Government? Every one thinks the Banks are there to serve the economy. The bankers mindset is to maximise profits and has no interest in social obligations which they don’t recognise any way, so taking measures to improve the real economy via intermediation of the banks is doomed to failure. It requires direct intervention from Government and extensive use of Credit Unions and, you probably think this bizarre, but much greater involvement with Islamic banking which follows excellent business principles, never seeking to make excess profits (which invariably leads to bubbles and boom/bust economies) and no, I’m not a Muslim, but I recognise good business practice when I see it.

        • A final comment- If you try to model economies or investments using purely econometrics as I studied years ago you will fail as econometrics is based on a series of false assumptions – all market participants have perfect and equal knowledge, market participants behave rationally, all variables remain constant (ceteris paribus) etc.

  6. Hi Shaun,

    Just like Alice, the CBs are lost deep in the woods.

    They’re looking for strategies to run successful economies with a bunch of bust banks.

    I noticed “whatever it takes” was uttered 3 years ago …

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