When people come at NGDP futures targeting from a financial markets angle, they get hopelessly confused. For instance, they worry about a potential lack of trading in NGDP contracts, whereas they should see that as a sign of success.
Today I’d like to suggest a different way of thinking about NGDP futures targeting. In my view, the Fed can already do a perfectly adequate job of NGDP level targeting, even without tacking on futures markets. So then why tack on the futures markets? The answer is simple, they did not do a good job of maintaining NGDP stability during 2008-09, and NGDP futures targeting would force them to do so.
Go back to the 1990-2007 period, when NGDP rose at a pretty steady rate of around 5%/year. And that was accomplished even without targeting NGDP. Had they been targeting NGDP instead of inflation in the late 1990s, money would have been slightly tighter, making the resulting boom a bit milder, and (probably) also moderating the already very mild 2001 recession. They did extremely well, and if they’d actually tried to target NGDP they could have done even better.
What about 2008-09? It wasn’t just one mistake, it was several. They focused on inflation, which was high in mid-2008, not NGDP growth that which was slowing sharply. They focused on (high) past inflation, not TIPS spreads that showed falling inflation expectations late in 2008. They focused on rescuing banking, not maintaining adequate AD. (Indeed Bernanke basically admitted this failing (in his memoir) for the specific September 2008 meeting.) They were squeamish about using unconventional policy instruments aggressively enough (although rates didn’t even hit zero until December 2008).
Obviously if there had been a NGDP futures policy in effect in late 2008, I would have been selling NGDP futures short like crazy. Lots of other people would have as well, and the Fed would have been exposed to massive losses.
At this point many people get confused, assuming this is how I think things would have actually played out. Not likely. The Fed would have been terrified of losing a boatload on money on bad NGDP bets. Imagine explaining to Congress that you screwed up monetary policy so badly that you created a Great Recession, and to top it off you lost zillions of taxpayer funds. It wouldn’t happen that way.
Instead, the real purpose of NGDP futures markets is to put the Fear of God into the FOMC. They force it to do what it was already quite capable of doing, but held back due to either ignorance or fear of aggressive use of unconventional instruments. Ironically, with a 5% NGDP target in 2008, level targeting, we would never had hit the zero bound, and we would never have had to rely on unconventional tools. But even if we did, the Fed would have done “whatever it takes” to keep NGDP expectations on target.
Because I think the Fear of God would have made the Fed do what it should have done in any case, I think it’s quite possible that there would be little trading of NGDP futures contracts. But I don’t care, because that “little trading” would be a sign of success.
Worst case, the policy fails and I get rich shorting NGDP futures. Now that doesn’t sound so bad, does it?
PS. Think of this as a variation of Lars Christensen’s famous “Chuck Norris effect”. In this case Chuck is in the FOMC conference room in 2008, standing right behind Bernanke. He whispers the following in Ben’s ear:
In your heart, what policy do you think is most likely to provide on-target aggregate demand in 2009? The weak plan your staff prepared, or the aggressive steps you recommended to the Japanese back in 1999? Keep in mind that I have a club in my hand, and plan to beat you all senseless if two things happen:
1. Your plans fails to provide on target NGDP expectations.
2. The market ends up being right and you end up being wrong.
OK Ben, deep down what do you think the Fed needs to do to provide 5% NGDP growth in 2009?
I want FOMC members to quake in their boots, and adopt a policy stance that roughly balances the short and long positions. If that “balance” occurs with zero trades, that’s fine with me. Indeed I hope they are such cowards that they refuse to take a stand, and meekly adjust the base until the long and short positions are balanced. But if they want to take a bold stand . . . well let’s just say I hope it works out better than when they overruled market forecasts, and predicted 4 rate increases in 2016!
PPS. An update to Noah Smith’s recent post provides a great example of how thinking about this market from a finance angle throws people off. Smith says:
Sumner seems to have thought very little about how markets actually become efficient. Scott, you need price discovery.
That’s not what NGDP futures targeting is all about. It’s not price discovery, the price is pegged at 5%, it’s monetary instrument setting discovery. I would recommend Noah look at Bernanke and Woodford’s 1997 JMCB paper, which makes it very clear that for this futures targeting approach to work it must be about forecasting the instrument setting that is appropriate, not about price discovery. (I wonder if John Cochrane has also “thought really little about how markets become efficient”.)
Here’s an analogy. The old international gold standard was not about the “discovery” of the proper nominal price of gold; it was about the discovery of the monetary base that would result in equilibrium occurring at the target price of gold.
And please don’t anyone tell me that the gold standard did not provide macro stability–I know that. But it did stabilize gold prices, and NGDP targeting would stabilize NGDP expectations. And (unlike stable gold prices) that’s a really good thing. With stable NGDP expectations we will no longer have events like 2008-09.
And if it didn’t work, worst case is I get rich.
If Noah Smith wants to seriously challenge the policy he needs to provide a plausible argument for large and time varying risk premia in the NGDP futures markets. So far, no one’s been able to do that. But that’s the sine qua non of any criticism. Otherwise, I simply don’t care. Manipulation? Who are the victims? And did this occur under Bretton Woods?
HT: Foosion