Part 1: Focus on prices, not rates
Many press reports are attributing the fall in oil prices (in dollar terms) to the ongoing depreciation of the euro. I believe this is wrong. If I am not mistaken, the standard argument goes something like this:
- A falling euro means a rising dollar. (So far so good, if we are talking about the euro/dollar exchange rate then this is a tautology.)
- A rising dollar will, ceteris paribus, tend to lower commodity prices. (Again, I agree.)
But here’s what people forget. That same argument implies that a falling euro should raise the euro price of oil. But in fact, the euro price of oil is also falling sharply. So what is going on?
The basic problem here is mixing an absolute price (oil) with a relative price of two monies. Let’s take a simple example. Suppose the euro situation had no effect on the average world price of oil, in real terms. Alternatively, think of the trade-weighted price of oil being stable. Now suppose that the euro and countries loosely linked to the euro are 1/2 the world economy, and the dollar and countries loosely linked to the dollar are the other half. If the euro bloc currencies fall 10% against the dollar bloc, what should happen to nominal oil prices? The initial assumption was stability in the real price of oil. If the world oil price is to be stable, the dollar price must fall 5% and the euro price must rise 5% to reflect the 10% depreciation of the euro bloc currencies. But this is not at all what is actually happening. Oil prices are falling fast in dollar terms, but they are also falling fast in euro terms.
The basic problem here is that exchange rates tell us nothing about absolute values. Two neighboring countries each experiencing 100% hyperinflation might very well have currencies that are stable vis-a-vis each other. But the two currencies would be highly unstable against the prices of all other goods and real assets. So how do we figure out what is really going on?
My suggestion is to try to figure out which currency is unstable in an absolute sense. Yes, a fall in the euro relative to the dollar means (by definition) a rise in the dollar relative to the euro. But in which country has there been a de facto switch in monetary policy? Is money getting easier in Europe? Or tighter in America?
Interest rates are lower in America than Europe, but I think you know by now that interest rates are an even more meaningless indicator of monetary policy that exchange rates. Low rates are just as likely (maybe more likely) to reflect a weak economy suffering from too little money, as they are to reflect an easy monetary policy. Instead of looking at rates, I find an absolute standard in prices. And the most sensitive prices are real asset prices; commodities, stocks and real estate.
We don’t have good real time real estate price indices, but we do have good data for stocks and commodities. Obviously stock prices are falling in both dollar and euro terms. But even oil is falling in both dollar and euro terms. I couldn’t find a graph of oil in euro terms, but this graph shows oil is down 20% in the last month or so, and the euro’s down about 10% from its 1.36 level of April. Based on this data alone, you’d say monetary policy is too tight in both the US and Europe, but especially too tight in America. Thus rather than saying the euro is falling, I’d prefer to say the dollar is appreciating. The euro might actually also be appreciating in an absolute sense, just more slowly than the dollar.
Now of course the asset prices don’t tell the whole story. The most important indicators are not available in real time. These included prices, output, and of course my favorite, NGDP growth expectations. But in the next section I will argue that these broader indicators also suggest money is too tight in both Europe and the US.
Part 2: Dude, where’s my hyperinflation?
I have run this blog for 15 months, and my right-wing readers (which are 90% of my readers), keep telling me I don’t know what’s going on in the real world. People fear high inflation. Double-digit inflation is just around the corner. And for 15 months I have been telling my fellow right-wingers that the real problem is excessively low inflation (or more precisely low NGDP.) How am I doing so far? This is the latest data on core inflation:
WASHINGTON — Consumer prices declined in April for the first time in 13 months while core inflation rose over the past year at the slowest pace in 44 years.
The Labor Department said Wednesday that consumer prices edged down 0.1 percent last month, reflecting a big fall in energy prices. Core inflation, which excludes volatile food and energy, was flat in April. Over the past 12 months, core inflation is up just 0.9 percent, the smallest increase since 1966.
If you take the mainstream “Taylor Rule” approach to monetary policy, the Fed should aim for about 2% inflation, but also be flexible when there are real shocks. Thus if output is below the norm then a bit more inflation is acceptable, and if output is above the norm than the Fed should aim for less than 2% inflation. Output is clearly below normal right now, and hence inflation should be well above 2%. Instead, core inflation is 0.9% and trending downward. And these figures don’t yet include the effects of dollar appreciation.
In Europe the broader aggregates also suggest that easier money would be desirable, even if one ignores the debt problems in the Mediterranean countries.
So the bottom line is that whether you look at market sensitive indicators like commodities, stocks, TIPS spreads, etc, or broader aggregates, money is too tight in Europe. In America it is also too tight; indeed market sensitive indicators suggest that the problem has been getting even worse over the last month. In absolute terms the euro is strong, and the dollar is even stronger.
This is very counter-intuitive, as the shock causing these changes (Greece) would seem to weaken the euro. But that doesn’t seem to be happening–if it did then you might expect real nominal asset prices in euro terms to be rising. Instead the crisis is leading to an increase in the demand for what Nick Rowe calls “the world’s most moneyish money.” It’s a strong dollar crisis that has been misdiagnosed as a weak euro crisis. If this sounds familiar, recall in July – November 2008 the dollar also rose sharply against the euro, and once again 99% of pundits failed to recognize that the excessively strong dollar (reflected in falling asset prices and falling NGDP growth expectations) was the real problem, and the worsening of the banking crisis was a symptom.
PS. Just to be clear, the original 2007 to early 2008 subprime crisis was not caused by a strong dollar—the pundits were correct about the first half of the crisis reflecting banking/regulatory mistakes. It’s late 2008 where the misdiagnosis occurred.
PPS. Yes, I know that exchange rates are actually prices, but there are called “rates,” hence the title of part one–which lumps them in with interest rates.
Update: A commenter named Mark Sadowski sent me this very useful info:
Another piece of the puzzle is core eurozone bond yields. If one looks at 10-year bond yields for Austria, Belgium, Finland, France, Germany, Luxembourg, and Netherlands you will observe that all have fallen by about 70 basis points since last June and about 30 basis points in just the last three weeks. For example the German 10-year bond was trading at only 2.78% as of today. I take this as a sign of falling inflation expectations in the eurozone. (The original comment included Sweden, but he later noted it was not in the eurozone.)
Now think about the media narrative. There is supposedly a collapse of confidence in the euro that is making the euro very weak. But here’s what puzzles me. When there really was a collapse in confidence in the Mexican peso or Thai baht during their crises, I don’t recall yields on long term Mexican and Thai bonds falling to 2.78%. Maybe the media narrative is worth reconsidering.
This reminds me of the international economics experts who told us that the US had to have a severe recession after our banking crisis, because most other countries have had severe recessions after their banking crises. Yes, but in the 1990s did Thailand and Mexico and Sweden see their currencies appreciate strongly in the teeth of their crises, as the dollar appreciated strongly from July to November 2008? To paraphrase James Carville–It’s the tight money stupid.
I know it’s hard for institutions to admit mistakes, but we need coordinated easing from the Fed, ECB, and BOJ. Blame it on Greece.
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