Yet another year of asymmetrical monetary policy - revisiting the Weidmann rule
Nearly a year ago - January 2 - I wrote a blog post on what I termed the Weidmann rule. In the blog post I argued that the ECB is basically following a rule - named after Bundesbank boss Jens Weidmann - which is asymmetrical. The ECB will tighten monetary conditions in the event of a positive aggregate demand (velocity) shock, but will not ease in the event of a negative demand (velocity) shock to the euro zone economy. This means that the ECB monetary policy set-up basically ensures that we are in a classical world when demand is picking (the budget multiplier is zero), but is in a basically keynesian world when we have negative demand shocks (the budget multiplier is positive). The world is not "naturally" keynesian, but the ECB's policy regime makes the euro zone economy is essentially 50% keynesian. A year ago I argued that the Weidman rule would be deflationary. Hence, "if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule)." This is of course exactly what we have seen over the past year - US NGDP remains on its 4% path, while euro zone has averaged less than 1% over the past year and the gap between US and euro zone NGDP is therefore growing larger and larger. Add to that that euro zone has seen as least two negative demand shocks in 2014. First of all and likely most important the Russian (Ukrainian) crisis, which is likely to lead to a double-digit contraction in Russian real GDP in 2015 and second renewed concerns over the political situation in Greece and other Southern European countries (particularly separatist worries in Spain). These shocks are so far not major shocks and with a proper monetary policy set-up would like have very limited impact on the European economy. However, we do not have a proper monetary policy set-up and therefore every even smaller negative demand shock will just push Europe deeper and deeper into a deflationary spiral. It is correct that the ECB has done a bit to offset these shocks - which in quantity theoretical context essentially are negative velocity shocks - by cutting interest rates and indicated that we will get some sort of quantitative easing in 2015. However, with the euro zone money base basically still contracting, M3 growth being lacklustre, inflation expectations declining and NGDP growth being very weak it is hard to argue that the ECB has done a lot. In fact it has not really done anything to even offset the negative velocity/demand shocks we have seen in 2015. Therefore, we unfortunately have to conclude that the Weidmann rule still the name of the game in Frankfurt and all indications are that the Bundesbank remains strongly opposed to any quantitative easing. What the ECB needs to do is of course to once and for all to demonstrate that it will indeed offset any shock to velocity - both negative and positive to ensure nominal stability. A 4% NGDP target rule would do the job (see here) and would be fully within ECB's mandate. PS These days Jens Weidmann is arguing that things will be a lot better in the euro zone because the drop in oil prices is a positive demand shock (yes, this is basically what he is saying) and that monetary easing therefore is not needed. In 2011 the Bundesbank of course was eager to see interest rate hikes in response to increased oil prices because the risk of "second-round effects" (horrible expression!). It is hard to get any better illustration of the just how asymmetrical the Bundesbank's preferred monetary policy rule is. PPS Tim Worstall has an excellent post on Jens Weidmann and the Bundesbank here.