Bill Woolsey is very familiar with index futures targeting, but also knows the details of how futures markets actually work much better than I do. Thus I thought this letter from him would help clarify the nuts and bolts of the plan from the perspective of real world futures markets. I would also like to mention that the commenter “123” noted that the Fed might have to take a large long or short position if there was a sudden change in money demand during a financial crisis. Bill mentions that perhaps the Fed should be allowed to trade on its own account.
On further reflection, I would like to add to my previous suggestion that before each auction the Fed should adjust for predictable variations in base demand due to trend, seasonal and day of the week factors. Now I think they should try to estimate the equilibrium base demand before each auction, so that (ex ante) their expected net long or short position is zero. I think this would make the market work more efficiently, require less trading, and allow the Fed to take less risk. The Fed would do the “heavy lifting” and the market would merely fine tune the Fed’s forecasts (as well as keep them honest of course.) The rest of this post is Bill’s suggestions and clarifications:
Sumner proposes that the Fed target nominal GDP on May 17, 2010 to be $15.9 trillion. He proposes that the Fed create and then buy and sell unlimited quantities of an index futures contract on NGDP at that value. He proposed that the contracts be defined at one trillionth of NGDP, and so the Fed would buy and sell unlimited futures contracts at a price of $15.90.
Perhaps the most important element of the proposal, however, is that the Fed will make ordinary open market operations in parallel to the trades of these futures contracts, and these open market operations will impact base money.
Trades in the futures contract will be at the initiative of “the market,” specifically, futures speculators. Because the “market” initiates the trades, it has sometimes been called “index futures convertibility.”
If a speculator chooses to buy a contract at the price of $15.90, the Fed will create and sell the contract for $15.90. At the same time the Fed sells the future, it will simultaneously make an open market sale. Presumably, it would sell treasury bills. Sumner proposes that it sell five times the dollar value of the contract, so $79.50 worth of T-bills would be sold per futures contract the Fed sells.. (In my view, $15.90 is a very low value for a future contract. Perhaps one hundred millionth of NGDP, or $159,000 would create a future contract more typical.)
If a speculator chooses to sell a contract at the price of $15.90, the Fed would create and buy the contract for $15.90. At the same time the Fed buys the contract, it also makes an open market purchase, presumably buying Treasury bills worth $79.50. (Sumner also lists other sorts of securities the Fed might buy.)
What exactly do these contracts mean? Sometime after May 17th, 2010 the level of nominal income would be calculated for that particular date. (Some weighted average of first quarter 2010 NGDP and second quarter 2010 NGDP.) And then contracts would be settled.
If NGDP is exactly $15.9 trillion, then nothing will happen at all. These are index futures and all settlements are with cash. If settlement value is equal to the price then there is nothing to settle.
Suppose that NGDP is $16 trillion; $100 billion above the target. Then the contracts will be settled. The longs, who had bought the contracts, will be paid 10 cents for each contract. The shorts, who had sold the contract, must pay 10 cents for each contract.
But what if NGDP is only $15.7 trillion; $200 billion below the target? Then the settlement will require a payment to the shorts, who had sold the contract, of 20 cents, and the longs will be required to pay 20 cents.
If a speculator expects that NGDP will be above the target, then she will have an incentive to buy a contract in order to receive a profit at settlement. However, if that speculator’s expectation was in error, and NGDP is below target, she will suffer a loss.
In the opposite situation, a speculator who expects that NGDP will be below target, has an incentive to sell a contract, to make a profit from settlement. Similarly, he will risk losing money if NGDP unexpectedly rises above target.
From the Federal Reserve’s perspective, if speculators who expect NGDP to be above target (bulls) purchase contracts in an equal quantity to the number sold by speculators expecting NGDP below target (bears,) then at settlement time, the Fed acts as an exchange and transfers funds between the longs and the shorts depending on the actual value of NGDP. In this situation, the market has provided no signal that NGDP is expected to deviate from target and provides no impetus to open market operations and changes in base money.
If the speculators expecting NGDP to be above target (bulls) purchase more contracts than those expecting it to be below target (bears) sell, then the Fed must make up the difference in the market and is a net seller of the contracts. In Sumner’s proposal, this triggers an open market sale on T-bills equal to five times the value of the Fed’s short position. The open market sales decrease base money today, this begins to decrease nominal GDP and so decrease the expected level of NGDP one year from today.
If the speculators expected NGDP to be below target (the bears) sell more contracts than the speculators expecting it to be above target (bulls) buy, then the Fed must be a net buyer of the contracts. The Fed makes open market purchases of T-bills equal to five times the amount of the Fed’s long position. The open market purchases increase base money today, and increase the expected level of NGDP one year from today.
Equilibrium requires a level of base money such that the market expectation of NGDP is on target. Speculators may trade the contract, but with the market expectation of NGDP on target, that means that purchases and sales by speculators balance. The Fed takes no net position on the contract and base money is unchanged. If, on the other hand, the market expectation of NGDP is not on target, then speculators will take a short or long position on the contract, with the Fed taking the balancing long or short position on the contract, triggering open market operations in T-bills, and changes in base money. If base money is “too low,” it will rise. If base money is “too high,” it will fall.
In my view, rather than require the Federal Reserve to make open market operations equal to some multiple of its short or long position, the Fed should be given discretion to make open market operations as it chooses, subject to the general requirement that it seek to keep its position on the contract at zero.
Like in ordinary futures markets, Sumner explains, there would be margin accounts for the speculators in the contracts. This will be 10% of the value of contract and the Fed is supposed to pay interest on these margin accounts.
It is helpful to remember that “margin accounts” for future contracts are also called a “performance bond.” Its purpose is to make sure that those who suffer losses on the contract will make payment at settlement.. Therefore, it is really a requirement that investors pledge collateral.
In my view, while the Fed could create special deposit accounts for speculators and pay them interest, having speculators put up T-bills for collateral, much like banks must do for primary credit loans, would avoid those complications. The relevant question is whether the value of the collateral will be sufficient to cover the loss generated by an unfavorable move in NGDP.