I’ve talked a lot about the need for level targeting, i.e. setting a growth trajectory for NGDP and promising to make up for any near term overshoots or shortfalls. And I’ve also talked a lot about the idea of targeting the price of NGDP futures contracts. But I don’t recall talking about the connection between these two policies, which might shed some light on the importance of level targeting.
Policy lags are one of the difficulties that face monetary policymakers. The Fed often doesn’t even know that the economy is in recession until several months after the downturn has begun (based on the retrospective dating of the cyclical peak by the NBER.) It turns out that both level targeting and futures targeting help address this issue, in fairly similar ways.
Imagine a model where millions of people and businesses observe local demand shocks, and that data is aggregated 3 months later in the quarterly NGDP numbers. It’s quite possible that the “market” would know things that no single individual would know—as the market will reflect aggregate optimism and pessimism, which is partly based on all those local demand shocks.
The advantage of NGDP futures targeting is obvious when there are policy lags. The market will sense velocity changes before the Fed does, and offset them with adjustments in the base (or fed funds rate if you prefer to think in Keynesian terms.) But how about level targeting, how is that like futures targeting?
Suppose that pessimism causes velocity to drop 2% before the Fed is able to notice and take corrective action. Also suppose the Fed is doing plus 5% NGDP level targeting. The markets will expect the Fed to return the economy to the trend line over the next 12 months. This means they will now expect 7% NGDP growth; the normal 5%, plus another 2% to offset the near term shortfall. This means they will expect easier money than if the Fed was doing growth rate targeting, and letting “bygones be bygones.” More expansionary than if they settled for 5% growth after the 2% shortfall.
Now let’s assume that the markets notice the shortfall before the Fed does, and they expect the Fed to ease as soon as the shortfall is noticed. That is, imagine a period like September 2008, when the TIPS market saw rapid disinflation but the Fed was still worried about high inflation. In that case the markets will expect Fed easing before the Fed does. Now recall than in modern new Keynesian economics the current level of aggregate demand doesn’t just depend on current short term rates, but also expected future short term rates. I.e. it depends partly on longer term rates. The anticipation of Fed easing will immediately reduce future expected short term rates, and will immediately reduce long term rates. The market does the Fed’s work before the Fed even realizes there is a problem.
So with level targeting the market will be moving expected future interest rates around in such a way as to keep expected future NGDP (12 months out) right on target. And here’s the best part of all. Remember my initial assumption that NGDP temporarily fell below target, before the Fed corrected the problem? It turns out that with level targeting the initial deviation from the target trajectory will be much smaller than if there was growth rate targeting, even if the Fed makes no immediate attempt to get the economy back on track. Because the market will depress future expected rates, they will boost AD in the current period, even before the Fed noticed that there was a problem.
It’s not quite as good as NGDP futures targeting, but it comes so close that I’d guess it would deliver more than 90% of the potential efficiency gains from NGDP futures targeting, maybe 95%. Given the current sorry state of monetary policy, that’s a lot of $100 bills lying on the ground waiting to be picked up. Let’s hope the Fed notices them when it meets next week.