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Interest rate smoothing through two crises
Why bring policy to the cycle when the cycle will come to you?
In 2008, Australia had an inflation problem. The CPI was running at 5% y/y. Nominal GDP was growing at double-digit annual rates. Inflation expectations were becoming unanchored. The RBA had been too slow to tighten and faced the prospect of having to induce a domestic downturn.
Then the financial crisis hit. Australia went into the crisis with a huge nominal buffer. It was an important factor in mitigating the downturn, far more so than the subsequent fiscal stimulus, which in the popular and elite imagination still gets too much credit for Australia avoiding the technical definition of a recession.
It would be perverse to say that this was a case of good luck rather than good management, since there was nothing lucky about the global or the domestic downturn in 2008, but it did immediately solve the RBA’s inflation problem. The RBA came away from the crisis with its reputation enhanced. No one is going to call you on the counterfactual.
The RBA’s hawkish policy errors in the lead-up to and during the pandemic have also left the RBA in a rather fortuitous position relative to the rest of the world, which implemented more aggressive monetary policy responses, and now have greater inflation pressures to show for it. The FT Editorial Board noted that the RBA is an outlier in terms of global inflation pressures and the need for a policy response. The FT attributes this status to low nominal wages growth, but both are attributable to monetary policy, a point seemingly missed by many.
The best you could say for it is that the RBA smoothed its way through both crises. As De Brouwer and Gilbert noted way back in 2005, the interest rate smoothing parameter in the RBA’s reaction function looks like ‘deep stasis.’ That was before Governor Lowe left interest rates on hold from September 2016 until the middle of 2019. Why bring policy to the cycle when the cycle inevitably comes back to you? Of course, excessive policy activism is to be avoided too, but I think it is clear which side of that balancing act the RBA falls on. Rather than a systematic hawkish or dovish bias, the RBA has an inaction bias, which can work out in a hawkish or dovish way depending on where we are at in the cycle.
The case for the US now having a demand-driven inflation problem is best illustrated with respect to the Mercatus measure of the nominal GDP gap, which stood at +3% in Q4. Note that the Mercatus measure is the difference between the level of nominal GDP and the level implied by the long-term expectations of forecasters. The US real output gap, the difference between the level of real output and potential, is currently nowcast at 3% for Q1 2022 using the Berger, Morley and Wong methodology.
Macrobond have helpfully suggested what the Mercatus NGDP gap implies for a Taylored Fed funds rate conditioning on the Laubach-Williams estimate of the equilibrium real rate. The Mercatus gap implies a lower Fed funds rate than a simple re-weighting of a Taylor rule with a calibrated coefficient of one on the inflation and output gap, but the implied direction for policy is pretty clear.
Note the Macrobond chart over-states the gap with respect to the Wu-Xia measure of the Shadow Fed Funds rate, which stood at -0.2% at the end of January, very close to effective Fed funds. Even Scott Sumner thinks the Fed is behind the curve on tightening.
You might think this now puts the RBA in a better position than the Fed, but that’s very much an ex post judgement. Ex ante, it was arguably better to over-do the monetary policy response to the pandemic than to under-do it given that things could have turned out much worse than they did. In the more severe downside scenarios that were contemplated, the RBA’s response looks very much under-cooked. The RBA conceded as much when it belatedly embraced QE in November 2020. As I noted of Tim Congdon’s dire inflation predictions for the US, a lot would have to go right in order to validate them. Higher inflation is not the worst problem to have compared to the alternative, not least because monetary policy can respond to it fairly straightforwardly. Remember when people said monetary policy was no longer effective? You’re hearing it less and less.
US non-farm payrolls for January came in better than expected at 467k, which was consistent with the direction picked by our model. The cron did take a big bite out of that number (which is why Goldman Sachs were calling for a 250k drop), but it was offset by other factors. The revisions to November and December payrolls were the biggest in history on a seasonally-adjusted basis and the level of the series was upwardly revised (see Joey Politano for the decomp). This highlights the problem that while previous months’ data contain important information for forecasting NFP on a historical basis, the most recent history is always going to be incomplete at the time the forecast is made. We can mitigate this to some extent by conditioning on other variables (24 are represented in the model), but it’s an obvious limitation. The unemployment rate came in higher than expected at 4%, although our model seems right in suggesting that the pre-pandemic low of 3.5% is not too far off.
Note that Governor Lowe appears before the House Economics Committee on Friday, with Jason Falinski taking over as committee chair. We will review Lowe’s testimony next week.
Rather than reading the NYT on MMT, read Eric Leeper on why progressives should reject it.