Sunday, August 3, 2014

Monetary regime change

I'd previously noticed that monetary policy can undergo a "phase transition" (or regime change) where the information transfer model changes from one set of fit parameters (or even particular solution to the differential equation) to another. Both cases I've seen (US and UK) involved a period with pegged interest rates during WWII (see the previous links for the US and see this link for the UK). Working with Swiss data I recently found going back to the 1980s from my last post, I noticed another case:


This new case didn't involve a wartime economy or pegged interest rates (however, Switzerland may have imported interest rates through this mechanism, obscuring any information there). Switzerland changed their monetary target from a 1-year monetary base target to a 5-year target in 1990, and then transitioned to a completely new target that involved base growth, interest rates and price stability (inflation) more reminiscent of the US dual mandate (except without employment) that became official in 1999.

In this transition, Switzerland rapidly changed from an almost perfect "quantity theory of money" economy to an almost perfect "liquidity trap economy":


The Swiss economy also rapidly transitioned from relatively high NGDP growth to more modest growth (the smooth black line is LOESS curve):


It is a good sign that these two calculations are consistent with each other at the transition.

So now we have three examples of monetary phase transitions/regime changes. Two (US and UK) are likely due to the wartime pegging of interest rates and in the US may have been accompanied by a bout of hyperinflation. The third (Switzerland) is a more ordinary change in the monetary policy target (it may have been accompanied by a brief bout of hyperinflation as you can see in the first graph, but the period is too short to be conclusive [1]).

In Switzerland, the information transfer index was slightly below 0.5 before the 1990s -- that would cause the price level to increase more rapidly than the monetary base. Because of that, the SNB would see their monetary base target was producing too much inflation and therefore they would think they needed to change to a different target. In the monetary economics paradigm, it probably would have been thought that "expected" inflation was at a higher level than the concrete steps the SNB was taking, so they had to influence expectations. That's why the SNB changed from a 1-year to a 5-year base growth guidance.

[1] I have no doubt the hyperinflation solution would fit to the period 1990-1995, it just wouldn't be very illuminating. In the US, the solution operates over almost 20 years from 1940 to 1960; 5 years in Switzerland is just not long enough to be conclusive.

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