Wednesday, July 9, 2008

Central Banks: Shooting at or hitting targets?

After today’s comments looks like the IMF and Trichet are getting apoplectic over inflation.

Who to blame?
It’s a bit of a quandary isn’t it? They want to reassure or to assure us that they are in control. Yet, when inflation seems to have gone adrift they need to sound a note of resolve. But isn’t inflation’s result the outcome of their previous action (along with market forces oil etc)? So if it is unacceptable are they taking the blame by being critical? If they are what is the remedy – I refer to a remedy that is different from the policies that got ‘us’ ‘here’? Or would CB’s do it the same all over again- if given the chance? Do they defend what they have done or not? I find the posturing by Trichet/the ECB curious.

Is it excessive money growth?
ECB/Italy’s Draghi blames excessive money growth for oil’s price...but isn’t oil priced in dollars –or am I confused about this?

Why it's not money...
If someone else prints too much money (non US country) shouldn’t their currency fall without direct impact on oil? Ironically the dollar has been falling but the US has some of the weakest money supply growth and trends of the G-7! (guess that’s e-Zone and Japan). M2 and MZM in the US are negative over 3months and four weeks. M2 is negative over six months as well. What excess is there to ‘fuel’ higher oil prices? So much for the notion that money supply begets oil prices…

It’s the ECB that has accommodated continuing strong money and credit growth and IT pretends to care about money and credit growth…

Back to inflation…

Headline inflation targeting SIMPLY DOES NOT WORK!!!
My own view is that a central bank cannot target headline inflation in the short or even medium term especially amid an ongoing oil prices shock (or shocks). Even for the single-mandated ECB the implied pain on the economy to hit that target (stay under the ceiling) is just too great. Simple arithmetic says you would have to squeeze NonOil prices lower fast enough to compensate for the weighted rise in oil prices. {EG if gas prices rose 20% and if gas were 5% of the CPI non-gas prices as a group would have to fall by 1% (20% rise times 5% weight) to hold the price level in place}. With repeated shocks this would have to happen again and again. Can you imagine how hard it is to force nonoil prices to fall in such an environment? Negative 5% GDP growth might be required- or worse with repeated shocks. This is why CBs are missing their own headline inflation targets. They are missing them ON PURPOSE.

A 'good' policy choice wreaks credibility -
This admission/belief implies that ECB policy TARGET is wrongly focused. With repeated ‘oil shocks’ headline inflation is constantly shocked above the core rate. In time it destroys credibility –unless a central bank adopts a core target like the Fed. That sort or target can be more effectively managed by the BANK and it can be explained – although the Fed has NOT done that well. .

Once a CB has let these repeated shocks blow out headline inflation –and it really has little choice in the matter- getting credibility back is a bit like reclaiming your virginity. It’s easier to pretend that ‘last night did not happen’ than to convince people that the last several years of inflation overshoot did not happen (or maybe Dr Who could help with a time machine approach).

Contrast ECB to FED
So the ECB has a problem of its own making. What’s wrong is an issue of choosing the wrong policy target. The ECB and FED face very similar inflation results (headline; core) but the Fed is controlling its measure relative to ‘target’ (…actually it’s not a real target but the Fed speaks of comfort zones and inflation is inside the Fed’s Zone on some measures). The ECB is simply NOT hitting its target and NOT dealing with that very well.

Find ANALOGY with money supply targeting:
I compare all this to the ‘good old days’ of money supply targeting. We used say that weekly money numbers are money ‘demand’ since the Fed did not control weekly money. But over time the Fed would adjust ‘monetary policy’ to bring the growth rate of its chosen aggregate back into target. In the current scheme, headline inflation is playing the role of weekly money supply and core inflation is more the role of longer term money growth. But central banks DO NOT articulate their policy this way. Not even the BOE is very clear about what is the acceptable divergence from it’s ceiling but it is clearer in speaking of the problems than either the ECB or Fed.

Despite transparency: "Mums the word"
Basically CBs are reluctant to say what we know. A long as oil SHOCKS continue they (central banks) cannot hit any headline target! It’s just that simple. But when the shocks stop core and headline inflation will merge and CB’s want to make sure they merge at the core pace and at a moderate core pace.

CBs walk the walk but don't talk the talk
All of this gets to MY ongoing concerns that central bankers know how to make policy better than communicate it. I think the Fed and ECB are each doing about the right thing. But that is not the perception. It isn’t even the ECB’s implicit assessment of itself! To be tough on yourself can be good- but too tough and you suffer a nervous breakdown. Let’s hope that the ECB knows when to stop its self inflicted public flagellation.

1 comment:


Central banks are the problem.