In an earlier post I discussed my favorite monetary policy regime, under which the Fed buys and sells unlimited CPI or nominal GDP futures contracts at a price equal to the policy goal. There is actually a fairly large literature on this idea, including people like Kevin Dowd, Bill Woolsey, David Glasner, and (my coauther) Aaron Jackson. Slightly different approaches were taken by Robert Hall and Robert Hetzel. At one time I thought that I had discovered the concept back in 1986, but I later learned that Earl Thompson had already mentioned the idea, but never published it.
Because it’s such an unusual way of thinking about monetary policy, it might help to compare it to the gold standard. The U.S. successfully pegged the price of gold at $20.67/oz. from 1879-1933, and at $35/oz, from 1934 to 1968. So in a technical sense a gold standard is very doable, even the devaluation of 1933-34 was not done because we ran out of gold, but rather to further FDR’s macro objectives. But that is also exactly what is wrong with a gold standard, pegging the nominal price of gold does not stabilize the relative price of gold (in terms of other goods.)
So why doesn’t the Fed peg the price of a composite good, where the weights are the same as in the CPI? Because there are no highly liquid commodity markets for most components of the CPI. This problem, however, suggests an obvious answer–peg the price of a CPI futures contract. Of course Barney Frank might complain to Bernanke that inflation targeting doesn’t meet the Fed’s legal obligation to worry about both inflation and employment, the so-called “dual mandate.” If so, then switch to a 4% or 5% nominal GDP target, which is a hybrid inflation/real growth target (and in my view is a better target anyway.)
Under that sort of regime we never would have experienced the dramatic economic crash that occurred last fall. That is, expectations of nominal GDP growth would have remained at about 5%, instead of falling into negative territory. Of course actual nominal growth can briefly undershoot market expectations, but as long as expected growth is in the 4-5% range, there is no liquidity trap.