Imagine that you have a company pension plan that invested in a set of ultra-low cost stock and bond index funds. Then someone suggested that the company should change the plan by hiring a manager to try to select stocks and bonds that would beat the market. Each year that stock picker would be paid a commission equal to 1.5% of your retirement assets. How would you feel about that decision? I don’t know about you, but I’d be pretty unhappy.
Now imagine that the US already had an NGDP futures targeting regime in place—something similar to the “guardrails approach” that I advocated in chapter 5 of my new book. Market forces nudged policymakers until the policy instruments were set at a level consistent with 4% expected nominal GDP growth, including reversion to trend after a deviation. Then someone suggested getting rid of the program, and hiring Jay Powell to set the Fed’s policy instruments at a level that he thought was appropriate. How would you feel about that decision?
One problem with my thought experiment is that we tend to have status quo bias. Right now, the US has a discretionary policy regime. In my thought experiment, we start with a rules based regime that uses market forces, and moves to a discretionary regime. There are good reasons to be cautious when abandoning a system and adopting a new approach. (Think about examples such as “Chesterton’s Fence”.)
If we currently had my preferred system in place, I don’t believe we would blow it up and move to a discretionary regime. But how can we overcome status quo bias and get to this sort of regime? That’s not obvious.
In my view, the best option is to move gradually to a market-oriented rules-based regime. Thus the central bank might begin by creating a NGDP futures market and taking a short position on contracts linked to 6% NGDP growth and a long position on contracts linked to 2% NGDP growth. If that went well, the following year the range could be reduced to 5.9% and 2.1%. Each year, the guardrails would get a bit closer together. Through trial and error, you could eventually determine what sort of band is optimal.
PS. I know nothing about highway engineering, but I assume that something similar must have occurred with actual roadside guardrails. If the guardrail is set 20 feet from the edge of the road, it’s too far away to do much good. If it’s set one foot from the edge of the road, then even a momentary lapse in concentration from a driver could cause a costly scraping of paint from the passenger side of the car. Most guardrails that I’ve seen are about 6 feet from the edge of the road.
READER COMMENTS
Michael Sandifer
Jan 15 2024 at 7:18pm
It seems highly unlikely that the Fed would create and subsidize an NGDP futures market. This is because it could potentially make them much more accountable for their decisions, and if they do a good job targeting NGDP, explicitly or implicitly, it would be clear that most of the people working on monetary policy at the Fed aren’t needed. Monetary policy could be automated. How many people are willing to make themselves redundant? How many organizations want to plan to downsize?
Such a change may occur one day, but it seems it would need to be forced on the Fed legislatively.
Thomas L Hutcheson
Jan 16 2024 at 10:55am
Treasury could also create a set of real GDP securities of various tenors, just as it should have already created TIPS of various tenors. [Markets could figure out the NGDP implications.]
Michael Sandifer
Jan 16 2024 at 2:55pm
Or, the US government can go with Shiller’s idea of replacing debt financing with equity financing, via Trills. Then, perhaps private markets will offer futures on Trills.
https://www.forbes.com/sites/nathanvardi/2012/07/10/robert-shillers-favorite-financial-innovation-an-ipo-for-the-usa/?sh=7ef5256f3876
steve
Jan 16 2024 at 10:00am
You are clearly a West coast or Midwest guy. You should try driving some of the parkways in Connecticut and elsewhere in the East where the guardrails are more like 1-2 feet off the road for long stretches. Anyway, is any other country using NGDP targeting? I think few non-economists would understand what you have been talking about. Can you imagine a Fed chair trying to explain to the morons in Congress what they were going to do if they changed and we would be the first country to try this?
Steve
Scott Sumner
Jan 16 2024 at 4:54pm
I’ve driven the Merritt Parkway many times. Those gaps are bigger than they look from the car.
Thomas L Hutcheson
Jan 16 2024 at 10:40am
IF I thought Powell would in fact be running a FAIT régime around a real income-maximizing inflation target, I’d go with “discretion” (constant updating estimates of the values of the policy instruments most likely to keep/restore the target rate. Granted this is subject systemic anti-inflation bias as the disastrous Bernanke-Yellen regime showed, but I’d I would like to see this approach tried for a while before changing to something new.
KG
Jan 16 2024 at 10:48am
I think one big unanswered question is whether the market would even want to trade an NGDP market or would it just be the Fed every day at the bid/offer. It’s often hard to predict which products gain traction and liquidity, and which ones are complete flops. If you look at CME they have hundreds of products with close to zero trades per day and settlements are conducted by broker assesments. If the market does not want to trade NGDP futures, then open market operations on NGDP futures will never actually happen, and this guardrail mechanism won’t work either. Just as a thought experiment, suppose your mechanism completely managed to stabilize NGDP expectations at 4% per year with the Fed’s bid/offer on the 5 year strip as 3.9%@4.1% every day (super tight guardrails). this would be the most boring “market” ever and I can’t imagine anyone would be interested in trading it.
However, I’m sure there is some way you could restructure the product get more market interest. For example, replace TIPS with NGDP linked govt bonds. Even the Fed using TIPS as the instrument to implement your policy would preferable to the current regime, although there are some liquidity concerns about TIPs vs normal govt bonds.
Scott Sumner
Jan 16 2024 at 4:56pm
I don’t think you understand what I’m proposing. It’s no problem if no one trades the contract. Would you worry if highway guardrails were not being brushed up against?
KG
Jan 17 2024 at 9:01am
It certainly is a problem since your method requires intervention in an untradeable market by the fed to correct deviations. For example let’s say the “true” ngdp price is -1% (market expectations given current policy) but the ngdp contract nevertheless is settled at 4%. This represents a big market inefficiency. Someone could come in and sell the contract to make $ but if there’s no volume or open interest in this contract then there are also no $ bills lying on the sidewalk. Meanwhile the fed will see ngdp marked at 4% and think everything is fine. Go to kalshi and you’ll see there’s a bunch of contracts there with pretty much zero activity. NGDP futures could be the same. Any private actor (CME) could offer these contracts but the lack of any private market demand suggests that an NGDP futures market subsidized by the fed would not receive much interest either.
Scott Sumner
Jan 17 2024 at 2:42pm
You really ought to look at what I’m proposing before commenting. It’s clear you haven’t done your homework.
Todd Ramsey
Jan 16 2024 at 10:48am
Could a NGDP futures security work if it was issued by a private company and traded on a public exchange?
Lots of potential problems foreseeable. But (probably) due to status quo bias, the Fed has not created a NGDP futures security. Perhaps you could convince a private company to implement to provide proof of concept?
Koch brothers, are you listening?
Scott Sumner
Jan 16 2024 at 11:21am
There doesn’t seem to be adequate market demand for such a security.
Michael Sandifer
Jan 16 2024 at 2:56pm
Shiller was pushing the idea of governments offering equity in GDP years ago. Private markets then might be willing to supply Trill futures.
https://www.forbes.com/sites/nathanvardi/2012/07/10/robert-shillers-favorite-financial-innovation-an-ipo-for-the-usa/?sh=7ef5256f3876
spencer
Jan 16 2024 at 11:22am
It would be easier to reinstate the G.6 release, where M*Vt = P*T. M*Vt = AD.
Comments are closed.