The next step

On September 13th I argued that with QE3 the Fed took two important “baby steps” toward a sound monetary regime.  Their promise to keep policy expansionary well into the recovery was an incremental move toward level targeting.  And their switch from a fixed QE to an open-ended policy was a tiny step toward “targeting the forecast.”  But very tiny.  An actual targeting the forecast policy would call for the Fed to do enough QE to raise NGDP growth expectations up to the desired level.  Of course that’s easier said than done.  The Fed certainly isn’t going to adopt the NGDP futures market approach any time soon (although such a market will almost certainly be an important part of policy in the second half of the 21st century.)  And given the problem of “multiple equilibria,” it’s very hard for the Fed economists to come up with a reasonable estimate of the amount of QE that would be likely to get the job done right now.

I’m going to propose a compromise between the current policy of $40 billion bond purchases each month, and a radical policy of immediately targeting the forecast.  Have the Fed start QE3 at $40 billion per month, and then increase their purchases at a rate of 20% each month, until they have achieved their policy goal (of equating predicted nominal growth with desired nominal growth.)

Obviously 20% looks like a number plucked out of thin air.  That begs the question of why not 0% or 100%?  The problem with zero percent increases is that they may be too small.  Even three years of QE3 will add less than $1.5 trillion to the Fed balance sheet.  And in the absence of other initiatives like level targeting, no one has any idea whether that would be enough to achieve their objectives in a reasonable time frame.

So why not increase the monthly purchases by 100% per month?  As that king learned in the old story of the chessboard, 100% growth rates rapidly lead to extremely large quantities.  And the Fed would be starting out with $40 billion, not a single grain of wheat.  The Fed is still attached to the “wait and see” approach, where they do some easing and then look at the result in terms of various market and output indicators.  So they want to see a few months worth of  data before making radical adjustments.

And this is the beauty of the 20% monthly increase proposal.  At first the QE builds rather slowly:  $40 billion, $48 billion, $57.6 billion . . . .

But before too long the amounts would become quite large.  The Fed would no longer have to worry that even three years of QE might not be enough.  Believe me, it would be plenty large. I haven’t even worked out the numbers, but I think purchases would increase more than 8-fold each year.  Fortunately, as David Beckworth recently showed, the Fed has barely made a dent in the T-securities market.  And of course all those MBSs issued by the GSEs are also de facto Treasury securities.

Better yet, the “shock and awe” of this proposal would allow the Fed to quickly achieve Svensson’s “target the forecast” equilibrium.

I don’t actually expect the Fed to adopt this 20% growth rate proposal.  It’s too radical.  But for God’s sake make it higher than 0%!  Does anyone seriously believe that if the Fed is struggling to find a way to provide enough demand stimulus; that 0% is superior to a 1% or 2% monthly increase?


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26 Responses to “The next step”

  1. Gravatar of Gabe Gabe
    26. October 2012 at 05:23

    I like your proposal. Now the parameters of debate are set…20% is radical and 0 % is just dumb…a good conservative compromise would be 6%.

    That allows the monthly injections to increase about 100% every 12 months. So now 100% annual increases in monthly injections are conservative. I think my trading algorithm would do well in this environment….god’s speed!

  2. Gravatar of Simon Simon
    26. October 2012 at 05:25

    $1.5 trillion dollars here, another trillion there, eventually we start talking about real money.

  3. Gravatar of dtoh dtoh
    26. October 2012 at 05:40

    Scott,
    Two points.

    1. Since this is post on less radical solutions, why don’t you drop the idea of an NGDP futures market and instead push for NGDP indexed securities (GAINs – Growth Adjusted Income Notes). It would be much easier to implement and politically a lot easier to get done.

    2. Your statement – the “Fed has hardly made a dent” is off base. Two problems with the statement. You’re only looking at nominal pricing. You need to look at expected real returns, i.e. what has happened to inflation expectations. TIPS spread indicate inflation expectations have increased. Therefore the expected real return on Treasuries has decreased, which will cause economic players to exchange Treasuries for real goods and services. Second, you can’t just look at Treasuries, a reduction in the supply of Treasuries will cause investors to buy other financial asset increasing the price of those other assets. Same effect, higher financial asset prices = more spending on real goods and services.

  4. Gravatar of Alex Godofsky Alex Godofsky
    26. October 2012 at 06:05

    I propose that the Fed promise to do -$1 billion of QE until NGDP hits a proposed path.

  5. Gravatar of Saturos Saturos
    26. October 2012 at 06:45

    “until they have achieved their policy goal (of equating predicted nominal growth with desired nominal growth.)”

    But that isn’t their goal. And if it were, they’d probably say so. And then the proposal wouldn’t be needed at all.

    As you’ve said before, the market knows the Fed better than it knows itself. Nothing will work until the Fed knows where it wants to go. And once it does make up its mind, the market will have already adjusted, we’d already be there.

    But their existing framework (as of the last meeting) almost suggests your kind of thing – except on a quarterly basis. But they don’t really know where they want to go, they’ve only finally come round to the vague idea that they need more.

    Probably it wouldn’t happen that quickly, but the key thing is to get the whole Fed to a point where they are comfortable with your kind of thinking. After that specific proposals won’t matter.

  6. Gravatar of W. Peden W. Peden
    26. October 2012 at 06:56

    Does the Fed set a limit of how many government bonds it will purchase per issuance by the Treasury?

    Also, if the Fed isn’t going to target the Federal Funds rate, then why target the monetary base either? Why not target its inflation goal directly i.e. commit to increasing the monetary base until the inflation rate = the target rate? Presumably, it’s because the Fed is likes to be coy and unaccountable regarding its inflation targeting. However, Americans would be foolish if they let their public institutions be coy and unaccountable simply because it is bureaucratically convenient.

  7. Gravatar of Tommy Dorsett Tommy Dorsett
    26. October 2012 at 07:06

    Scott, market-based indicators are pointing to faster NGDP. Even with crude slipping, breakevens are holding up nicely:

    http://research.stlouisfed.org/fredgraph.png?g=cbF

  8. Gravatar of Saturos Saturos
    26. October 2012 at 07:27

    The IMF has a paper out defending full-reserve banking: http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf

  9. Gravatar of Saturos Saturos
    26. October 2012 at 07:28

    Off topic – isn’t this an excellent idea? http://ineteconomics.org/ross-mckitrick-breaking-climate-change-stalemate

  10. Gravatar of Saturos Saturos
    26. October 2012 at 07:45

    US RGDP growth is picking up: http://www.aljazeera.com/news/americas/2012/10/2012102613312512108.html

    And the Economist is about to get off big time: http://www.guardian.co.uk/world/2012/oct/26/silvio-berlusconi-sentenced-four-years

  11. Gravatar of ssumner ssumner
    26. October 2012 at 09:08

    Tommy, TIPS spreads react with a lag to oil prices, because of the indexation formula. I expect them to fall fairly soon.

    Saturos, NGDI rose much less that NGDP. We won’t have the full data until next month, but look for a smaller NGDI number.

    In addition, I’m not reassured that some of the 2% growth was a blip in defense spending. Defense is highly erratic, and could well fall next month.

  12. Gravatar of Kevin Dick Kevin Dick
    26. October 2012 at 09:20

    Scott, it’s really hard to beat the psychological anchor of 10%.

    But strategically, your arguing for 20% is probably optimal. It’s not so high as to sound completely crazy. But then it’s easy for someone who fancies himself “moderate” to propose 10% as a compromise.

    Even at 10% per month, you’re tripling every year.

  13. Gravatar of Matt Matt
    26. October 2012 at 10:02

    Unrelated, can you please, please nail Paul Krugman on this one?:

    http://krugman.blogs.nytimes.com/2012/10/25/triumph-of-the-electoral-nerds/

    The spread between intrade odds of Obama winning and Nate Silver’s odds of Obama winning is obviously due to a ***risk premium***. It boggles my mind that Paul Krugman didn’t even consider that.

  14. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    26. October 2012 at 10:17

    Someone should ask Calvo, Coricelli, and Ottonello what they think of the idea.

  15. Gravatar of Major_Freedom Major_Freedom
    26. October 2012 at 10:20

    The people who are working and earning a living clearly haven’t yet been bilked enough by inflation to allegedly benefit those who are unemployed.

    More reduced purchasing power for those who are working just may get those unemployed people to work, which is the seeming goal of market monetarism.

    Seeing as how that is the seeming goal, why don’t market monetarists be more efficient and advocate for those unemployed people to work directly FOR the Fed, in exchange for newly created money? They could all be sent to Alaska to dig for oil using hand shovels, and the people who are earning money already can compete with the newly hired people for goods and services, and end up purchasing fewer goods.

  16. Gravatar of Suvy Suvy
    26. October 2012 at 12:31

    I think one of the biggest problems with people understanding why the Fed isn’t printing enough money is that they don’t understand how the money supply works. The total supply of money is equal to the amount of base money plus the amount of credit. Right now, the amount of credit in the economy is falling because of defaults, debts being paid off, etc. What the Fed has done is increase the amount of base money to offset some of the collapse in credit money. However, the amount of injections they’ve done is not enough. The private sector is not creating money because there’s a deleveraging taking place. The amount of debt/credit in the economy is being destroyed. This collapse in the money supply is highly deflationary, which means that demand would absolutely collapse if it were not for the monetary/fiscal injections of the Fed/government.

    There was too much money/credit creation(too much lending) over the past 30 years that was used for unproductive purposes(mainly used to buy assets–houses–that wouldn’t provide enough of a cash flow to pay the debt back, like genuine business investment would be able to). Everyone started to realize this in 2007-2008(the financial crisis) and now we’re caught in a situation where the debts are being wiped out(by bankruptcy, liquidation, debt restructuring, etc). In that process, the turnover of money and the supply of money falls(as it is right now). The problem with running deficits to inject money is that public debt goes up; which creates its own problems. Therefore, we need to inject money into the system without increasing the debt. In other words, the Fed needs to print more money.

    I think that the best way to do this is by simply monetizing the deficit. Then, use those deficits to cut taxes across the board. I think our government is too large and we need to find a way to downsize it. One way of doing this would be to start by cutting both taxes and spending, but to cut taxes more than spending in the short term while phasing out much of the spending in the long run.

    I’d start by getting rid of the payroll tax, then finding a way to phase out social security(you can’t simply get rid of it because of all of people that were promised benefits won’t receive them). Then, finding a way to downsize health care by controlling costs–we simply can’t take care of everyone, it’s not possible. Cutting defense spending is also a good idea(I think the US spends more on defense than the rest of the world combined).

  17. Gravatar of mpowell mpowell
    26. October 2012 at 13:04


    I’d start by getting rid of the payroll tax, then finding a way to phase out social security(you can’t simply get rid of it because of all of people that were promised benefits won’t receive them). Then, finding a way to downsize health care by controlling costs–we simply can’t take care of everyone, it’s not possible. Cutting defense spending is also a good idea(I think the US spends more on defense than the rest of the world combined).

    I might agree with you that the gov is too big, but SS is a terrible example. Administration costs are tiny and the tax compliance burden is extremely minimal. And it’s a great program! Very few seniors living in poverty! There used to be tons. And inflation indexed annuities simply don’t exist.

    Also, we can’t take care of everyone, it’s not possible? That’s ridiculous. Every other country in shouting distance of the US in GDP/capita has figured this out. The UK provides publicly funded care for everyone at the same cost/capita as we pay for just seniors. Maybe you don’t support it, it certainly represents big government, but it’s certainly possible!

  18. Gravatar of Morgan Warstler Morgan Warstler
    26. October 2012 at 13:38

    2% GDP growth came from…. guess where?

    http://mercatus.org/publication/third-quarter-increase-gdp-growth-came-biggest-increase-government-spending-over-two

    note: digging through your archives is a giant pain in ass.

  19. Gravatar of Major_Freedom Major_Freedom
    26. October 2012 at 13:46

    Suvy:

    The total supply of money is equal to the amount of base money plus the amount of credit. Right now, the amount of credit in the economy is falling because of defaults, debts being paid off, etc. What the Fed has done is increase the amount of base money to offset some of the collapse in credit money.

    This is all correct as far as it goes, but you have to remember that the money the Fed creates not only serves as a component of the aggregate money supply, which temporarily acts as primarily a replacement to existing credit deflation, but it also serves as a “springboard”, as it were, for fractional reserve banks to expand credit beyond the rate of voluntary savings in the future.

    Once that process gets underway, then if the Fed is going to avoid overheating inflation, then it will have to reduce its own extent of inflating reserves, which will bring on another correction (recession).

  20. Gravatar of Suvy Suvy
    26. October 2012 at 13:47

    mpowell,

    About social security, there’s not a bigger disincentive for saving out there. You’re taking my money away from me now and giving it to me at a later point in my life, which makes no sense. Why not just give me my money now and encourage me to save it for retirement? With social security in its current form, you’re encouraging reckless behavior with people’s money. I don’t think that’s right.

    As for the publicly funded health care in the UK and in other countries, I met someone from Canada who had to wait 8 months to get ACL reconstruction surgery on his knee. Is it even desirable to have a health care system like that?

    I think a better alternative is to change the definition of insurance. Car insurance doesn’t pay for your oil change, similarly, health insurance shouldn’t pay for your regular check ups. The whole point of insurance is to deal with extreme instances, not daily checkups. I agree the US spends way too much on health care, but the best solution isn’t to socialize it.

  21. Gravatar of Suvy Suvy
    26. October 2012 at 13:51

    I’d like to add, I have no problem with social security giving money to orphans, widows, etc–like it was designed to do(it’s relatively cheap and you can fund this out of general revenue). I have a problem with social security taxing you now and giving you your money back later. That makes no sense. I could get more out of that money than putting it in a fund and giving it back to me later.

  22. Gravatar of Doug M Doug M
    26. October 2012 at 13:58

    Regarding the NGDP futures market, neither the government nor the fed creates the contracts that they would like to see trading on the exchanges. The exchanges create contracts that they think the public wants to buy. If there is no interest the contract goes away.

    Even if the Fed said that they were going to target GDP doesn’t mean that the market would create a GDP futre. The CME tried CPI futures, but there was no interest.

    There is an active market in Fed Funds futures, though.

  23. Gravatar of Rajat Rajat
    26. October 2012 at 21:04

    I think this is a good idea. And when I have thought in the past about a mechanism by which the Fed might actually implement NGDP targeting, I have thought of something like this, which will eventually reach a point where the Fed buys the world. That allows the backward induction to work quite well and get people moving now.

  24. Gravatar of RebelEconomist RebelEconomist
    27. October 2012 at 01:49

    20% increase in QE a month? I appreciate that this is just shock economics designed to grab attention, Scott, but you ought to consider the possibility that such aggression could be dangerously destabilising. Have you never heard of Brainard uncertainty? While the economic system might not be sufficiently well known to apply optimal control theory formally, some of its ideas at least might be useful here.

  25. Gravatar of Benjamin Cole Benjamin Cole
    27. October 2012 at 03:32

    Nice ideas. I like the 20 percent monthly hike idea.

  26. Gravatar of Browsing Catharsis – 10.27.12 « Increasing Marginal Utility Browsing Catharsis – 10.27.12 « Increasing Marginal Utility
    27. October 2012 at 04:08

    [...] Moving epsilon further in the direction of NGDP targeting. [...]

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