Imagine a game of billiards with rules requiring that you call the ball that you plan to pocket, but prohibiting you from striking that ball directly: your cue ball must hit either one rail or one other un-called ball first. Think about how you would play this game. Once you’ve figured it out, you will be qualified to be a central banker!

This is precisely the game that central bankers play: their cue ball is the overnight policy rate, which they control by fiat; but they can not aim it directly at their ultimate goals (or targets) of price stability and maximum employment. Rather, a central bank must aim its policy rate, technically known as its instrument, at some intermediate variables, sometimes known as intermediate targets, which have a predictable impact on price stability and maximum employment.

And what are those intermediate variables? Once upon a time, they were deemed the monetary aggregates, also known as the money supply. Indeed, the Humphrey Hawkins Act of 1978 explicitly required the Fed to establish and announce targets – yes, they were explicitly called targets! – for the monetary aggregates. Implicit in declaring the aggregates to be the intermediate target of choice was a presumption of a stable, or at least a predictable, causal link between money growth and nominal GDP growth (real growth, and thus employment, plus inflation).

Technically, this link is called Velocity, the rate of turnover of the stock of money. Non-technically, think of Velocity as the pace of beer drinking at a fraternity party. If the pace is stable, or at least predictable, the barkeep could target the final goal of moderate buzzdom at the end of the party by simply supplying kegs at a constant rate, or a pace-adjusted predictable rate, and let the market figure out the price at which to ration the beer. In this case, you could call the barkeep Milton Friedman.

Alternatively, the barkeep could seek the ultimate goal of moderate buzzdom at the end of the party by pegging the price for his product, hiking the peg when chugging became too exuberant and cutting the peg when the imbibing became feeble. In this case, you could call him John Maynard Keynes.

Conceptually, either approach could work. Indeed, life for the barman Mr. Friedman would be much easier than for Mr. Keynes: just supply the right number of kegs at the right time and read a book the rest of the time. But that approach would be the right approach if, and only if, he could be confident in his assumption about the Velocity of drinking, that it was either constant or predictable. If his assumptions proved not to hold, there would be wild, market-driven volatility in the price of beer. In that case, the job should go to Mr. Keynes.

Poole on Playing Monetary Pool
This whole question of what a central bank should operationally target is the topic of one of the most famous theoretical papers in monetary economics, written in 1970 by none other than William Poole, current President of the St. Louis Federal Reserve. ¹ His essential argument was that the Fed should peg growth in the money stock (be a monetarist) if it had higher confidence in its ability to forecast Velocity than in its ability to predict the economy’s sensitivity to interest rate movements, and do the exact opposite, targeting interest rates (be a Keynesian) if the higher confidence rests with forecasting the economy’s reaction to interest rate fluctuations.

Well, technically, that’s not quite right, because the predictability of Velocity is nothing more than the predictability of the demand for money relative to the demand for goods and service. Put more bluntly, the whole concept of Velocity is nothing more than a demand for money function in drag! And giving proper respect to Bill Poole, a colossally smart man, he knew this when he wrote his seminal article. Bill ain’t a lazy monetarist who simply assumes that Velocity is either constant or predictable; for those conditions to hold, there must be “no money demand disturbances.”

Indeed, in an email exchange several months ago with Mr. Poole, when we were having an intellectual debate about the Taylor Rule (a Keynesian methodology), Mr. Poole reiterated the essence of his famous 1970 paper:

“ There is another interpretation of the Taylor rule, which I believe John discussed in his original paper. ² Suppose there were no money demand disturbances and the Fed followed a policy of steady money growth. Then, interest rates would fluctuate in the market as changes in inflation and real GDP occurred. You can invert the money demand function to solve for the interest rate, and you will have coefficients on real GDP and the price level. A conventional formulation of the money demand function has an income elasticity of 1.0 and an interest elasticity of about -0.5. When you invert the function, for 

a fixed rate of money growth you get a coefficient on both income and the price level of 2.0.

 

The approach can be generalized if you think of a money stock rule that has income and the interest rate as arguments, instead of assuming that money growth is constant. This was my approach in my 1970 QJE paper. Then, when the LM function (the solution of the money demand and money supply functions) is inverted, you get a Taylor rule with coefficients that reflect the money demand and supply coefficients, assuming no money demand disturbances. The Taylor rule is a way of thinking about a monetary policy structure designed to automatically ignore, or offset, money demand disturbances.

 

As you point out, another way to derive the Taylor rule is to start with a Phillips curve. That fact points to one of the strengths of the approach – several different theoretical conceptions get you to the same policy framework, which is surely a source of robustness of policy design.”

As you can see, Mr. Poole didn’t mention Velocity at all, but rather the stability of the demand for money (or lack thereof, as in “money demand disturbances”). If you have them, then pegging interest rates consistent with a Taylor Rule, rather than targeting growth in the money stock, is the appropriate policy approach.

Ironically, Paul Volcker did just the opposite shortly after taking charge at the Fed in 1979, shifting the Fed from an interest rate pegging regime to a money growth pegging regime. Intellectually, it was not a defensible switch, because it occurred simultaneously with enormous de-regulation of the banking and thrift industries, a development that could, a priori, be expected to generate huge “disturbances” in the demand for money.

As a practical matter, however, and very much to Mr. Volcker’s credit, his switch to a monetarist approach had nothing to do with economic theory at all, but rather was a political cover for “letting” interest rates go as high as necessary to induce a recession, which was the only viable solution to virulent inflation. He could have simply hiked rates explicitly in the context of the interest rate targeting regime that he inherited and produced the same inflation-cleaning recession. But he would have been lynched if he had. Indeed, even with the “cover” of monetarism, he was still almost lynched.

And part of the reason was that he not only “let” interest rates go to blood-curdling levels but because of the technique he used, interest rates were also blood-curdlingly volatile, especially in 1980, when the Fed funds rate both fell and rose by some 1000 basis points. Learning from that predictable externality, which essentially confirmed the wisdom of Poole’s seminal article a decade previously, the Fed returned to pegging interest rates in 1982, so as to bring them down and prevent a depression. And it has been pegging the Fed funds rate ever since, at first implicitly and explicitly ever since 1987.

And How Is This Relevant Right Now?
Interesting history, you say, but what’s the relevance for today? Glad you asked! It is relevant because it bears directly on the key intellectual debate in global monetary policy circles: should central bankers incorporate assets prices directly in their Keynesian reaction functions (the Taylor Rule, for example)?

The Fed argues no, with the intellectual charge led by none other than Chairman Bernanke, as detailed here two months ago. ³ Mr. Bernanke’s view, shared by the overwhelming majority of the FOMC, is that policy makers should incorporate asset prices into their policy only to the extent that they are having an unwanted effect on aggregate demand relative to aggregate supply potential – otherwise known as the output gap or the degree of slack in resource utilization – and, therefore an unwanted effect on the outlook for inflation.

Thus, increases in the demand for credit and, thus, the demand for money associated with rising asset prices are not, in the FOMC’s view, by themselves a reason to tighten monetary policy. That would be the case if, and only if, the rising asset prices imply an unwelcome increase in the demand for goods and services, putting unwanted upward pressure on resource utilization. Fed Governor Kohn recently described this approach as the “conventional” strategy. ⁴

In contrast, both the European Central Bank and the Bank of Japan do believe that they should include asset prices directly in their reaction functions, above and beyond their effects on aggregate demand and the outlook for inflation. Mr. Kohn called this approach the “extra action” strategy. Here is how it was described last year in an article ⁵ published by the ECB:

“This approach amounts to a cautious policy of ‘leaning against the wind’ of an incipient bubble. The central bank would adopt a somewhat tighter policy stance in the face of an inflating asset market than it would otherwise allow if confronted with a similar macroeconomic outlook under more normal market conditions. It would thus possibly tolerate a certain deviation from its price stability objective in the shorter term in exchange for enhanced prospects of preserving price and economic stability in the future.”

And how would/does the ECB justify that “extra action,” above and beyond that which would follow from a Taylor Rule? You guessed it: growth in the money stock! Again, in the ECB’s own official words:

“The ECB singles out money from within the set of selected key indicators that it monitors and studies closely. This decision was made in recognition of the fact that monetary growth and inflation are closely related in the medium to long run. This widely accepted relationship provides monetary policy with a firm and reliable nominal anchor beyond the horizons conventionally adopted to construct inflation forecasts. Thus, assigning money a prominent role in the strategy is also a tool to underpin its medium-term orientation. Indeed, taking policy decisions and evaluating their consequences not only on the basis of the short-term indications stemming from the analysis of economic and financial conditions, allows a central bank to see beyond the transient impact of the various shocks and avoids the temptation of taking an overly activist course.”

To be sure, the ECB doesn’t say anything about asset prices in this official description of its money “pillar.” But ECB President Trichet made no mistake about it when, speaking last June ⁶, he said:

“The ECB’s two-pillar strategy rests on a broad analytical framework, which is well suited to detecting risks to price stability and to the economy as a whole. It also helps to identify the underlying distortions in asset prices. The ECB singles out money in its monetary analysis in recognition of the fact that monetary growth and inflation are correlated in the long term. However, the monetary analysis also contributes to assessing the extent to which excess creation of liquidity and over-extension of credit can be a driving force behind excessively valued assets. Detecting and understanding this link helps the ECB to form an opinion on whether an observed movement in monetary aggregates and their counterparts might already reflect the inflating of an asset price bubble. It is then clear that a case-by-case analysis based on sound information on the monetary variables (mainly broad money and credit), on the counterparts of monetary aggregates (including the net external asset position of monetary financial institutions) and on the related functioning of the asset market is indispensable.”

Bottom line: In the ECB’s view, asset bubbles are facilitated by the creation of credit, which
tautologically generates increased demand for money. This is what the ECB is most worried about right now, as evidenced by Mr. Trichet’s comments at a press conference, on April 6:

“Turning to the monetary analysis, the latest developments confirm that the stimulative impact of the low level of interest rates remains the dominant factor behind the high trend rate of monetary expansion. Moreover, the annual growth rate of credit to the private sector has continued to increase over recent months, with borrowing by households – especially loans for house purchase – and non-financial corporations rising rapidly. Overall, strong monetary and credit growth in an environment of ample liquidity in the euro area continues to point to upside risks to price stability over the medium to longer term.”

Ah, house prices! The ECB isn’t officially targeting them, but as a practical matter, it is, just one step removed, as it tries to slow growth in credit, and thus money.

Turning to the Bank of Japan, there is a similar concern about money growth, even though the BOJ doesn’t explicitly target money growth, as is the case (in the intermediate- to long-run) with the ECB. In detailing the BOJ’s “New Framework for Monetary Policy,” following the end of Quantitative Easing on March 16, BOJ Governor Fukui said:

“To date, the Bank has released its assessment of the current state and outlook for economic activity and prices through the Monthly Report of Recent Economic and Financial Developments and the Outlook Report. Henceforth, the Bank has decided to supplement this assessment with additional examinations of economic activity and prices from the following two perspectives, which are of particular relevance to the conduct of monetary policy, and then to release them.

 

The first perspective involves examining, as regards economic activity and prices one to two years in the future, whether the outlook deemed most likely by the Bank follows a path of sustainable growth under price stability.

 

It should be added that, in order to implement the appropriate policy for achieving sustainable growth and price stability, it is not sufficient merely to assess the economic and price situation according to the first perspective. Needless to say, any forecast entails uncertainty. It is for this reason that the Bank’s Outlook Report contains detailed descriptions with regard to upward and downward risks affecting the scenario deemed most likely by the Bank. Among risk factors, there are those that will have a significant impact on economic activity and prices should they materialize, even though the likelihood of materialization is low. Such risks include that of falling into a deflationary spiral, or conversely, the risk of sparking inflation or generating an asset price bubble. In conducting monetary policy, the Bank needs to do its utmost to prevent the materialization of such potential risks.

 

The economic projection described in the Outlook Report covers a period of about one and a half to two years. There could, however, be risk factors that might affect economic activity and price development in the medium to long term, beyond the Outlook Report’s projection period. Experience inside and outside Japan shows that wide swings in asset prices and significant changes in the financial environment, including those affecting the intermediation function of financial institutions, may impact on economic activity and price development with a considerable lag. In addition, when the public’s longer-term expectations of inflation change, this can have a significant impact on the existing relationship between economic activity and prices.

 

The second perspective, therefore, involves examining, over a longer horizon, the various risks that are most relevant to conducting monetary policy aimed at realizing sustainable growth under price stability. Major central banks seem to share the opinion that to conduct monetary policy putting too much emphasis on achieving price stability in the short term results in large swings in economic activity, and this in turn impedes long-term price stability and the sound development of the economy.”

Three important lines of thought are presented here.

• First, the BOJ explicitly identifies one of the fat-tail risks it faces to be that of “generating an asset price bubble.” 
• Second, the BOJ explicitly says that such a risk should be “prevented,” in contrast to the Fed’s doctrine of refusing to identify bubbles until they have proved their existence by blowing up, at which point policy “mops up” the damage by easing. 
• Third, the BOJ explicitly eschews excessive emphasis on short-term fluctuations (or lack therefore) in inflation in goods and services, implicitly embracing the ECB doctrine noted above of being willing to “tolerate a certain deviation from its price stability objective in the shorter term in exchange for enhanced prospects of preserving price and economic
  stability in the future.”

Consistent with the BOJ’s view that asset bubbles matter above and beyond their role in influencing aggregate demand in a Taylor Rule context (the Fed’s view as to how and when they matter), BOJ Board Member Mizuno revealed ⁷, a month after the BOJ announced the end of Quantitative Easing, that:

“ A local equity bubble might have been formed in Japanese emerging stock markets around the end of 2005 and beginning of 2006 due to speculative investment by individuals and the rising impact of margin trading by semiprofessional investors. This served as a reminder of the adage that a bubble will always arise in a different manner than earlier cases. The biggest lesson from the bubble’s collapse in the early 1990s was the vital importance of a forward-looking monetary policy taking into account the signals sent by a broad range of asset prices.”

Bottom Line
It is often said that central banking is an art, as well as a science. That is unambiguously the case, since central bankers can’t directly influence their goal variables: price stability in goods and services and maximum employment consistent with price stability. Thus, central bankers are always, explicitly or implicitly, hostage to their understanding of the transmission mechanism of what they do control – their monopoly power to peg either the price or quantity of high powered money (also known as the monetary base, which is the right hand side of a central bank’s balance sheet).

In the first instance, this raises the age-old monetarist versus Keynesian debate: peg rates or peg growth in money? In a narrow sense, this is a sterile debate, as all central banks now peg the overnight policy rate. In a broader sense, however, this debate is the essence of current monetary policy ferment: should a central bank peg the rate solely to influence growth in aggregate demand for goods and services relative to aggregate supply, or should a central bank do that while also adjusting the peg so as to influence growth in demand for credit generated in asset markets?

Put more simply, should a central bank be willing to deviate from the short-rate path implied by real economic conditions of growth, employment and inflation so as to influence asset prices, notably to either preempt or prick asset price bubbles? The Fed says no, while both the ECB and the Bank of Japan say yes. This difference is hugely relevant to understanding – and forecasting! – relative monetary policy between the three institutions and, thus, the prospective course for relative exchange rates.

Right now, the Fed is signaling that it anticipates a meaningful slowing in growth in aggregate demand toward growth in potential supply, notably in response to slowing appreciation in home prices (which, of course, the Fed is not “targeting”!). If the Fed’s forecast is realized, the Fed will not just pause in its tightening campaign, but bring it to an end. In contrast, both the ECB and the Bank of Japan seem hell bent to “normalize” up their policy rates, not primarily to slow growth in aggregate demand for goods and services, but rather to slow growth in the demand for credit – and thus, money – that is supporting bubbly asset markets.

Yes, we in America, as President Nixon famously intoned, are all now Keynesians. Or perhaps more accurately, we are all now Taylorites. In contrast, there is a new breed of monetarism infecting Keynesian thought at the ECB and the BOJ: using credit and money growth as a symptom of bubbles, and including money growth as a shadow independent variable in their Taylor Rules.

Such a configuration of policy choices is a siren signal for the Euro and the Yen to appreciate against the dollar. We here at PIMCO are listening!

Paul A. McCulley
Managing Director
May 2, 2006
mcculley@pimco.com

1 “Optimal Choice of Monetary Instruments in a Simple Stochastic Macromodel”, Quarterly Journal of Economics, 84,197-216 (1970)

2 “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Series on Public Policy, North-Holland, 39, 1993, pp 195-214.

3 “Comments Before The Money Marketeers Club: Musings on Inflation Targeting,”
Fed Focus, March 2006,

4 http://www.federalreserve.gov./boarddocs/speeches/2006/20060316/default.htm

5 European Central Bank (2005), “Asset Price Bubbles and Monetary Policy” (1.7 MB PDF), Monthly Bulletin (April), p. 58.

6 http://www.ecb.int/press/key/date/2005/html/sp050608.en.html

7 http://www.boj.or.jp/en/type/press/koen/ko0604b.htm#0201