Fed policy is bankrupt

With each passing year it becomes more and more obvious that the current Federal Reserve policy regime is finished, and that a new regime will be needed.

The existing regime at the Fed relies on using interest rate control to steer monetary policy.  But they are also reluctant to cut nominal rates below zero.  That means that in a world of low real interest rates (which describes the world of the 21st century) the Fed will not be able to use monetary policy during recessions, if they maintain a low inflation target.

There are several possible solutions.  One solution (favored by Krugman and Blanchard) is to raise the inflation target to 4%.  Another possible solution is NGDPLT. Or NGDP futures targeting. But whatever the Fed decides, one thing is clear—the current policy regime is bankrupt.  The Fed hasn’t yet figured this out, but I suspect that at some level the markets have.  Not that market participants necessarily agree with my specific MM intellectual framework, but rather that they see the failure of the current regime.

I’m told that lots of market participants think low inflation is now a structural characteristic of the global economy, and cite all sorts of factors like cheap imports. Of course that’s nonsense, inflation is never a structural problem, it’s a policy choice. I think what they are actually intuiting is that the Fed is wrong—under the current policy regime we will have very low inflation for as far as the eye can see. And we are seeing that in the bond market.

Today the 30-year TIPS spread fell to 1.71%, a record low.  The 30-year bond yield is 2.74%.  At those rates the Fed won’t be able to use the short term nominal interest rate as a policy instrument during recessions.  The markets are telling the Fed that its policy regime no longer works.  Is the Fed listening?

Update:  The 30-year TIPS spread is not a record low, I relied on a FRED time series that only went back a few years.


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67 Responses to “Fed policy is bankrupt”

  1. Gravatar of dlr dlr
    21. August 2015 at 08:24

    Today the 30-year TIPS spread fell to 1.71%, a record low.

    That is nowhere near a record low.

  2. Gravatar of Liberal Roman Liberal Roman
    21. August 2015 at 08:27

    Are we ready to call Yellen a huge disappointment yet? Moment of truth for her here. Shades of Summer of 2010 when Bernanke pushed against the hawks and fought for QE2. Can Yellen fight off the FedBorg intent on raising rates now, now, NOW!

  3. Gravatar of Ray Lopez Ray Lopez
    21. August 2015 at 08:50

    I’m waiting for this ‘Update’:

    ‘my NGDPLT scheme is only designed to work “one-off” and then stop working, see my post on Japan from yesterday. Luckily, as Ray Lopez says, there’s no harm in my scheme since, absent hyperinflation, money is neutral. But it gives me a sense of accomplishment to think my monetarism scheme amounts to something’.

  4. Gravatar of ssumner ssumner
    21. August 2015 at 08:52

    Thanks dlr, I fixed it.

    Ray, Alas, it seems 120 is just too low to grasp this stuff.

  5. Gravatar of TallDave TallDave
    21. August 2015 at 09:02

    I predict the TIPS spread will continue to predict that the Fed will continue to predict that the Fed will miss the inflation target set by the Fed.

  6. Gravatar of Ray Lopez Ray Lopez
    21. August 2015 at 09:06

    @sumner – dumb it up for me then. I don’t see how your scheme works. You confuse the short-term and the long-term, and then mix inflation targeting with NGDP level targeting with ‘expansionary money policy’.

    However, I think I know your modus operandi: if money expansion ‘works’ to expand RGDP (as it sometimes does simply by chance, remember money is largely neutral, there’s no money illusion, and prices/wages are largely not sticky) then claim NGDPLT works (point to Australia, Israel). If money expansion is insufficient to raise RGDP–as you claim is the case in the USA despite the USA having recovered from the lows and actually has a record GDP, albeit below some hypothetical ‘trend’–then claim the central bank is not following NGDPLT and that’s the reason for slower growth.

    How do you live with yourself being such a fraud?

  7. Gravatar of Tom Brown Tom Brown
    21. August 2015 at 09:14

    Anybody know the pulse of the RWNJs these days? Do they still think this is all just part of the grand conspiracy, and that shills like Scott are just doing their puppet master’s bidding by helping to cover up the hyperinflation that’s ACTUALLY going on? Or have they finally given up on that nonsense?

  8. Gravatar of foosion foosion
    21. August 2015 at 09:21

    Hasn’t the Fed said that they don’t regard the TIPS spread as a useful metric for measuring inflation expectations? I believe the reason was that otherwise they couldn’t raise rates despite their eagerness to do so, but I’m probably misremembering the articulated reason.

  9. Gravatar of Brian Donohue Brian Donohue
    21. August 2015 at 09:29

    Scott, sorry about my part in the confusion. November 26, 2008 looks like the trough for long-term TIPS spreads, but current spreads are lower than anytime since May 2009.

  10. Gravatar of Miguel Miguel
    21. August 2015 at 09:41

    Hmmm,, this is a post with wich I may agree quite completely. Curious

  11. Gravatar of Miguel Miguel
    21. August 2015 at 09:45

    In spite that I don’t buy the NGDP objective as the complete solution.

  12. Gravatar of TallDave TallDave
    21. August 2015 at 09:58

    Yep, the policy has failed, and if the NY mfgr index and the Chinese PMI data are any reliable guide, the Fed will soon be faced with another the test of the kind they screwed up so badly in 2008-9 — they will have to either target price stability or employment/growth.

    And before you Austrian Republicans go thinking this is bad for Obama, remember how we got Obama. And FDR.

  13. Gravatar of kt kt
    21. August 2015 at 10:11

    how do you get that 30yr TIPS spread data before 2/2010 ?

  14. Gravatar of dbeach dbeach
    21. August 2015 at 10:31

    Yes, it’s quite clear that the market realizes the Fed has no chance of hitting its inflation target. How could it not be? They’re missing their target by miles, they’ve been missing it by miles for years, and they are telegraphing that their next policy move will be to take an action that will move them farther away from their target.

    The staff at the Fed are also evidently aware that they won’t hit their target, but it’s not clear to me whether the members of the FOMC don’t know that they won’t or are pretending that they don’t know.

  15. Gravatar of chris mahoney chris mahoney
    21. August 2015 at 11:04

    I always get annoyed when I read about “global deflationary forces” which translates into falling dollar prices. Proof that deflation is always and everywhere a monetary phenomenon if the long list of countries that currently have high inflation:
    http://www.tradingeconomics.com/country-list/inflation-rate

  16. Gravatar of pras pras
    21. August 2015 at 11:08

    Are they bankrupt (lacking in ideas/incompetent) or corrupt (swayed by outside influences)? If the latter, who gains from a contractionary policy?

  17. Gravatar of Brian Donohue Brian Donohue
    21. August 2015 at 12:34

    30 year TIPS spread today: 1.70%.

  18. Gravatar of ssumner ssumner
    21. August 2015 at 14:32

    Ray, You said:

    “How do you live with yourself being such a fraud?”

    Actually, it’s kind of fun.

    foosion, The Fed uses TIPS spreads in their FOMC meetings. If they are useless, I’m not sure why the Fed would use them.

    Brian, Don’t worry about it. I was confused too.

    Talldave, I think it’s unlikely we’ll have a recession.

    dbeach, I’m not sure either.

    Chris, Excellent list.

    pras, Not really corrupt, most economists outside the Fed also want a rate increase.

  19. Gravatar of foosion foosion
    21. August 2015 at 15:12

    The Fed looks at TIPS spreads, but discounts them due to the difference in liquidity between nominal treasuries and TIPS (research suggests this effect is very small), due to
    changing perceptions of inflation risk and other possible market issues.

    If the Fed really believed the TIPS spread was a useful read, how could they even be considering a rate hike? The rate hike seems premised on inflation rising to 2% in the moderate term, while the TIPS spread suggests inflation well under 2% for 30 years.

    BTW, they’ve also discounted survey data, on the notion that surveys build in the odds of rate hikes and therefore understate what expected inflation would be absent rate hikes.

    Are there any reasonable data which suggest inflation is in any danger of rising to 2%?

  20. Gravatar of John Hall John Hall
    21. August 2015 at 15:22

    Well the TIPs spread is at a record low, because it has only existed for so long. What you meant in the update is that just because 30yr TIPs spread is at a record low, doesn’t mean the 30yr forward inflation rate is at a 30 year low.

    The best source I recall for inflation expectations over a long history is
    https://www.clevelandfed.org/en/Our%20Research/Indicators%20and%20Data/Estimates%20of%20Inflation%20Expectations.aspx

  21. Gravatar of Steve Steve
    21. August 2015 at 16:03

    Scott,

    1) Most market participants seem to view this rout as the inevitable consequence of excessive ZIRP. In other words, higher rates will kill off the carry trade that has been in place–so the market is now attacking carry trades. My view is that market participants are correct in observation, but wrong in explanation. A good carry trade at 0% ff will still be a good carry at 0.5% ff and a decent one at 1-2% ff. However, a good carry at 5% NGDP becomes a bad carry at 2% NGDP. Market players are recognizing that carry is dead, but not necessarily grasping the correct reasons.

    2) “low inflation is now a structural characteristic of the global economy”

    I think market participants are right here, in the sense that it is a huge structural challenge re-employing people from commodity and manufacturing businesses to service businesses. This is a particularly timely issue in oil, where new technologies are less labor intensive, but it applies across the industrial spectrum. The challenge shouldn’t be underestimated, as entire national economies and trade balances are heavily impacted. An obvious parallel is to the 1920s and 1930s, when mechanized farming began displacing a huge share of the labor force around the world.

    In am not disagreeing with your statement that low inflation is a policy choice, just playing devil’s advocate that the challenges are quite real (pun intended). It would be helpful to try to bridge the gap between your (correct) view, and the also legitimate structural concerns.

    3) The big problem now is that the Fed is signalling loud and clear: We are going to miss our policy objectives AND we intend to miss by a wider margin in the future.

    A related observation: In 2008, the Fed decided to “look through” the labor market and focus on the inflationary impact of oil. Today, Bullard said the Fed would “look through” the falling oil price and focus on the inflationary impact of jobs creation.

    Finally, why does the Fed also make policy errors in September? Should Central Bankers be drug tested for Vitamin D doping before being allowed to cast votes?

  22. Gravatar of benjamin cole benjamin cole
    21. August 2015 at 16:44

    Excellent blogging. The 5-year TIPS spread is 1.27%. Of course, the CPI runs about 30 to 40 basis points higher than the PCE deflator, the putative Fed IT.

    Ergo, the market says the Fed will miss its 2% IT by more than 100 basis points, or more than half.

    From 1982 to 2007, in the US, real growth was a little more than 3% and inflation was a little under 3%—not so bad, eh?

    When did microscopic rates of inflation become regarded as a positive?

  23. Gravatar of Major.Freedom Major.Freedom
    21. August 2015 at 17:17

    TIPS spreads do not convey inflation expectations.

    There is an implicit option in TIPS bonds that could make the spread move opposite to inflation expectations.

    Think of an investor who would pay a premium for the change to own a bond the coupons of which would rise when inflation rises.

    Sumner continues to rely on a naive interpretation of TIPS bond spreads.

  24. Gravatar of Steve Williamson Steve Williamson
    21. August 2015 at 17:23

    So, if it were up to you, what would be the policy action you would take right now, and what would that imply for the path of the nominal interest rate? Be as detailed as you want. And don’t just say you’ll wish for a path of nominal GDP and get it. Tell me exactly what instructions you would give to the New York Fed, and what else you might have to set administratively.

  25. Gravatar of ssumner ssumner
    21. August 2015 at 17:56

    Steve W., First of all I wouldn’t use interest rates as a policy instrument. They are not very reliable, due to the zero bound problem. But if the Fed insists on using interest rates, here’s what I’d do:

    1. Switch to level targeting. Preferably NGDPLT, but PLT would be second best. This is far more important than anything else.

    2. I’d prefer they abolish IOR, but if they insist on keeping it then set the IOR at a position where the market forecast is for on-target whatever (preferably NGDP, but inflation and employment if the Fed insists on those foolish targets.) That would almost certainly mean a rate cut not an increase. Cutting the IOR rate to zero would be a good start. Negative if necessary. The Fed would have to set up and subsidize prediction markets in the variable being targeted, which they ought to do even if they don’t plan to target the forecast.

    3. If the Fed is not willing to use market forecasts, then set the IOR such that the Fed’s own internal forecast is for on-target whatever (again preferably NGDP, but inflation if necessary.) Right now the Fed’s policy regime will lead to many more years of below target PCE inflation, as it has for most of the past 7 years. Surely the internal forecasters must see this?

    4. The Fed should set up a system to evaluate each past instrument setting, and (a year later) tell us whether in retrospect policy was too contractionary, too expansionary, or about right. This would help markets to better understand what the Fed is trying to do. Right now markets are confused. They say they want 2% inflation, but (as Kocherlakota recently observed) they act like they are targeting a lower rate of inflation. Over the past 7 years the hawks at the Fed have been consistently wrong, but when you hear them speak they act like they don’t even know they’ve been wrong. They act like they don’t even know that we’ve undershot on BOTH inflation and employment over the past 7 years. Why don’t they say they were wrong? Their silence leads people to believe they don’t even want 2% inflation.

    The US economy is actually in decent shape right now. The big problem is not the current instrument setting (which is a bit too tight), but rather the Keynesian interest rate-oriented regime, which (due to the zero bound problem) is incapable of handling (or preventing) the next recession. The Fed’s recent loss of inflation credibility will make it much harder to boost inflation expectations the next time we are sliding into recession. That’s why level targeting is so essential.

  26. Gravatar of ssumner ssumner
    21. August 2015 at 17:59

    Steve (not Williamson), You said:

    “I think market participants are right here, in the sense that it is a huge structural challenge re-employing people from commodity and manufacturing businesses to service businesses. This is a particularly timely issue in oil, where new technologies are less labor intensive, but it applies across the industrial spectrum. The challenge shouldn’t be underestimated, as entire national economies and trade balances are heavily impacted. An obvious parallel is to the 1920s and 1930s, when mechanized farming began displacing a huge share of the labor force around the world.”

    This may be true, but it has nothing to do with low structural inflation. This explains low real GDP growth. Right now Venezuela has all kinds of structural problems and 65% inflation. Brazil has structural problems and 9.5% inflation. Structural problems apply to RGDP growth, not inflation.

  27. Gravatar of ssumner ssumner
    21. August 2015 at 18:01

    I should add, good point about how the Fed tends to focus on one variable at a time (jobs or inflation), which is why we need NGDPLT.

    If they can only walk or chew gum at one time, then make it NGDP.

  28. Gravatar of Steve Steve
    21. August 2015 at 19:18

    “the Fed tends to focus on one variable at a time (jobs or inflation), which is why we need NGDPLT.”

    This might be the most critical point of the night.

    Whenever there is economic turbulence, the Fed tries to suppress the most inflationary variable. Put differently, the Fed becomes more and more conservative (lower median target) on inflation, as a function of economic uncertainty.

    It’s almost as if the Fed is targeting 2% inflation for top end of the 95% confidence interval.

    Yes, we really do need NGDPLT.

  29. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    21. August 2015 at 19:50

    Prof. Sumner
    What is your opinion on the monetary authority using core indexes as inflation estimate, as opposed to all prices index? CPI is running at 0,2% yoy, but core-CPI is 1.8 yoy (core-PCE 1,65%), not so far from the target. Also, you have commented on this before, the fed has a 2% “target”, but in fact, it manages policy so that it looks like they are targeting less, let’s say a range 1% to 2%.

  30. Gravatar of David Hansell David Hansell
    22. August 2015 at 00:54

    I couldn’t agree more and we aren’t peas in a political pod. Keep hammering this shit as long as you’ve got a pulse, cos it’s ludicrous that such a simple issue as monetary policy with such important consequences is misunderstood across left and right.

  31. Gravatar of derivs derivs
    22. August 2015 at 03:13

    “There is an implicit option in TIPS bonds that could make the spread move opposite to inflation expectations.”

    Yes

    “Think of an investor who would pay a premium for the change to own a bond the coupons of which would rise when inflation rises.”

    No. You are addressing a speed of convexity issue. Since it would drop as inflation dropped, the distribution is relatively equivalent on both sides, therefore there would be no added ‘extrinsic value – optionality – premium’ benefit as you suggest. As counter intuitive as it might seem, the embedded option on TIPS is a put.

    Sumner continues to rely on a naive interpretation of TIPS bond spreads.

    If one does not fully understand the components of the valuation of a product, it is difficult to use the price of that product correctly as part of any analysis.

  32. Gravatar of BC BC
    22. August 2015 at 04:48

    derivs, the optionality in TIPS makes those bonds *more* valuable than a bond with no embedded option. Thus, the embedded option lowers the real yield of the TIPS, implying that the effect of the embedded TIPS option is actually to *raise* TIPS spreads relative to the market’s inflation expectation, correct? That would not seem to contradict Scott’s point that TIPS spreads indicate that the market expects the Fed to miss its target.

    In reality, though, there is another effect that usually matters more than the embedded put options in TIPS: nominal treasuries are usually “expensive” due to their liquidity and value as collateral. This liquidity effect lowers nominals’ yields, lowering TIPS spreads. The effect usually seems to be about 0.20-0.40%. Inflation swap rates typically exceed TIPS spreads by that amount. Inflation swaps are pure bets on inflation, so they are probably better indicators of market expectations. To bet on inflation using TIPS, one needs to buy TIPS and *short nominal treasuries*. When one tries to short the nominals, that’s where one “loses” the 0.20-0.40%.

    In any event, 30-yr inflation swap rates are at 1.96%, down from 2.5%-3.0% for 2009-2014, which itself is down from pre-recession 3.0%. CPI has historically exceeded PCE inflation, so the market does appear to expect undershooting.

  33. Gravatar of Steve Williamson Steve Williamson
    22. August 2015 at 07:56

    Scott,

    OK. We’ll take what seems to be your most-preferred approach. The target is a path for nominal GDP and, as you say, the Fed should then set up and subsidize a prediction market in nominal GDP. I guess the best thing would be markets in which securities contingent on nominal GDP, say one month, three months, six months, etc. (something like Treasury securities) are traded.

    So, suppose we start there. What exactly do you mean by “set up and subsidize?” Then, once we have these markets, how exactly does the Fed intervene? What assets is it buying and selling? What would the FOMC be voting on, and what would it then be telling the New York Fed to do?

  34. Gravatar of dtoh dtoh
    22. August 2015 at 08:07

    @MF, Jervis, BC

    I made that point to Scott 3 years ago. I guess he forgot.

    [Scott] “By that logic TIPS spreads ought to give a “perfect” indication of inflation expectations. But they clearly don’t.”

    [dtoh]TIPS principal goes up but never down so they are in effect a fixed income security plus a synthetic inflation option. Accordingly the price reflects a volatility component (inflation risk component for the simple minded)… when volatility rises the price will rise and vice-versa….

    Like I said, principal can’t go down. But your points are well taken, and the volatility/option value can be reduced by pricing them above par. I think you will agree though that TIPS can’t be “mispriced.” Any pricing differential (other than for inflation expectations) has to be explained by either a volatility (option) component, duration/convexity, or liquidity. If not, arbitrage will occur to bring pricing into line.

  35. Gravatar of dtoh dtoh
    22. August 2015 at 08:24

    @steve williamson

    What I have suggested repeatedly to Scott over the last several years is that the Fed should issue Growth Adjusted Income Notes, e.g. “GAINS” in exchange for Treasuries. Issued in various maturities of 90 days and longer. Pays the same rate of interest as a Treasury of comparable maturity. Principal is linked to NGDP growth over the life of the note or the quarter immediately prior to maturity. E.g. with a 5% target NGDP, if at maturity NGDP in the proceeding quarter is 7% you get 102% on your principal. If it’s 5% you get 98%.

    FED OMO could then consist solely of buying and selling GAINS to keep the price equal to Treasuries of comparable coupon and maturity. E.g. if GAINS are trading at 99% of comparable TSY (expectation of below target NGDP growth), the FED keeps buying until the price equalizes with the Treasury.

  36. Gravatar of Major.Freedom Major.Freedom
    22. August 2015 at 08:24

    The idea of the whole existence of the Fed is what is bankrupt.

    That is why every past “policy” has been bankrupt, and why all future “policies” will be equally as bankrupt.

    The Fed is not a market institution. Ideas from individuals are not permitted to be put into action constrained to individual rights. It is this way for all, or else to prison you go.

    You are engaging in a fool’s quest.

  37. Gravatar of Steve Williamson Steve Williamson
    22. August 2015 at 10:19

    Scott,

    Do you agree with what dtoh suggests? That doesn’t seem to involve any subsidy. It’s just another Fed liability – a marketable security, or set of marketable securities which are claims contingent on the path for nominal GDP.

  38. Gravatar of Major.Freedom Major.Freedom
    22. August 2015 at 12:39

    derivs:

    “You are addressing a speed of convexity issue. Since it would drop as inflation dropped, the distribution is relatively equivalent on both sides.”

    Not so, because the option always adds a positive value to the purchase price; the benefits of the option accrue to the long position only.

    There is no symmetric normal distribution here.

    This has nothing to do with “speed of convexity”, if what you mean by that is the first moment of a bond, or the extent of convexity. Never heard of “speed of convexity.”

    dtoh gets it.

  39. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    22. August 2015 at 12:46

    @dtoh, Steve Wiliamson, Prof. Sumner

    No need for hybrid securities. Just a series of derivatives, the same way we have with treasury yields, but this time the underlying index is NGDP growth. No need to have a cash instrument (e.g. Growth Adjusted Income Notes) associated with the NGDP payoff, althought that would do the job. The derivative is easier to price and have a direct effect. The Fed would have two options:

    1. Base actual monetary policy on the difference between the current NGDP futures and the target. Assuming the preferred path would be NGDP 4%, and considering that hypermind’s NGDP future for 2015 right now is 3,5%, the FED would be doing more QE at this point, at a predefined monthly rate, for as long as it took for HGDP futures go to 4%.

    2. The fed could be the counterpart on the futures trading, selling the target rate on the various futures on NGDP when the market is below, and buying the target when the market price is above the target rate. This means that when the FED is wrong and actual NGDP ends up being below the target, the FED automatically did some more QE. In the opposite situation, the FED ends up sucking money from the market, which is equivalent to reselling bonds it bought earlier …

    I would just add that having a term structure of NGDP futures contratcts, let’s say, one contract on full year 2016, another on full year 2017, or better yet, forward agreements on each future quarter’s expected NGDP would allow the monetary authority to act on the piece of the curve it thought best to achieve its goals, let’s say people believe that monetary policy can only influence nominal variables 2 years hence, therefore, today, the FED could be targeting july 2016 to june 2017 forward agreement …

  40. Gravatar of Major.Freedom Major.Freedom
    22. August 2015 at 12:51

    “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” – Mises.

    Since “monetary policy” no matter the “target” always adversely affects credit, since it is primarily by credit expansion that the aggregate money supply and volume of spending is increased so as to achieve said inflation “target”, and since the Fed relies on the member banks to expand their lending if the money the Fed prints is going to increase bank balances for the greater part of the population so as to affect aggregate spending and price levels, it follows that even if the Fed only looks at aggregate spending, and even if Sumner prattles on that aggregate spending is the only statistic the Fed should look at, it is nevertheless the case that the Fed inflating at all for the purposes of targeting any variable upwards year after year, will invariably adversely affect credit, and bring about an unsustainable boom.

    The correction will come regardless. It cannot be avoided by an attempt to make permanent a rise in aggregate spending targeting.

  41. Gravatar of ssumner ssumner
    22. August 2015 at 13:25

    Jose, Sometimes the Fed acts like it has a 2% ceiling, other times it doesn’t. There seems to be no rhyme or reason.

    BC, Good comment. I’d add that the tail risk of high inflation biases the TIPS spreads upward, and may explain why prior to this year the implied inflation forecast was usually closer to 2.5% or 3.0%. Even then, 2.0% might have been viewed as the most likely outcome.

    Steve, Subsidized trading would mean paying a high enough interest rate on margin accounts that the market is highly liquid (although I’m not sure that tha i s actually essential.) The Fed would actually peg the price of NGDP futures (perhaps 1 year or 2 year contracts) at the target level of NGDP. This would be analogous to pegging gold prices under the gold standard. Thus if the Fed wanted NGDP to be 4% higher in one year, they’d offer to buy and sell unlimited NGDP futures contracts at that price. That would keep the market expectation of future NGDP close to the target level.

    http://mercatus.org/publication/market-driven-nominal-gdp-targeting-regime

    There are multiple ways to do this, as indicated in the link above. Again, using the gold standard analogy, you can make the system fully automatic, or with some discretion, just as under a gold standard. The sine qua non is that the NGDP futures price must be pegged, just as gold prices are pegged under a gold standard. It’s essentially like a gold standard, except operating under the working assumption that macroeconomic stability is better provided by NGDP expectations rising smoothly at 4%/year, than by the price of gold stabilized at $35/oz.

    Initially the Fed would probably want some discretion. So the market would constrain Fed behavior by making them reluctant to set policy where the market bets were extremely one-sided, opening the Fed up to large potential losses. In the opposite extreme the Fed would not take any significant position, and market purchases and sales of NGDP futures would automatically adjust the base to the point where on-target NGDP growth is expected (abstracting from any risk premia) in the futures price.

    The Fed could buy any assets, but my preference would be T-securities, and if those were exhausted then Treasury backed MBSs, then other high quality debt like German bonds, AAA bonds, etc. If it ever gets beyond T-securities I’d strongly suggest an alternative target, high enough so that the monetary base is not bloated. But that’s up to the Fed. In an earlier post I talked about the choice between inflation and socialism. If you set the NGDP target path low enough the Fed has to buy up much of the economy, as base demand becomes huge.

    dtoh, I certainly did not “forget”, I know how TIPS work. The fact that the value cannot fall is of no practical relevance for a 30 year bond. Nobody expects deflation in the US over 30 years. (Japan is a different story)

    Steve, I don’t really understand dtoh’s point. First of all there must be a typo, he presumably meant if 3% then 98. But he seems to be describing a sort of TIPS indexed to NGDP instead of the CPI. That’s fine. But then if you are targeting the spread (as Robert Hetzel first proposed) it has nothing to do with the Fed buying the actual indexed bonds, you do so via ordinary OMOs that move the market expectation of future NGDP, until the interest rate spread is right on target. Having the Fed do monetary policy by buying the actual indexed bonds might bias the risk spread. Or maybe I’m just misunderstanding his post. But yes, you are correct that there would be no subsidy. On the other hand the subsidy I originally proposed was just to address the concern that there might be a lack of trading of NGDP futures, but I now think the subsidy might not be needed.

    My preference for NGDP futures over NGDP indexed bonds is related to the various liquidity issues discussed in some of the earlier comments (conventional bonds are more liquid than TIPS), which slightly bias the TIPS spread, especially during times of market stress, like late 2008.

    And finally, even if all my policy ideas are worthless, the Fed (or Treasury) really ought to set up a NGDP prediction market, if only to assist the research staff. The cost would be trivial by Federal government standards, and the real time information on expectations would be very valuable, especially during confusing periods like 2008.

  42. Gravatar of ssumner ssumner
    22. August 2015 at 13:29

    Steve, One other point. If you are seriously interested in this idea I’d suggest talking to John Cochrane. He seemed to like the idea when I described it to him, but he also knows far, far more finance than I do, and would be better able to evaluate any potential flaws.

    Jose, Good comment. I think we are on the same track, and indeed if you look at my comment we seem to have been posting roughly the same idea at about the same time.

  43. Gravatar of Ray Lopez Ray Lopez
    22. August 2015 at 16:17

    Sumner: “And finally, even if all my policy ideas are worthless, the Fed (or Treasury) really ought to set up a NGDP prediction market, if only to assist the research staff. The cost would be trivial by Federal government standards, and the real time information on expectations would be very valuable, especially during confusing periods like 2008.”

    Why? NGDP is about as useful a statistic as the number of moving parts in a car is to an automobile maker. NGDP = RGDP + inflation. And since money is neutral except in extreme hyperinflation, it does not matter what inflation is. The only metric of interest is RGDP.

    BTW I find it funny that Sumner thinks the US economy is OK now. So he is conceding that with the old money framework, things worked out after a few years. Hence adopting Sumner’s framework, with all its uncertainty that could lead to hyperinflation, would have only at best sped up the recovery by a few years, by Sumner’s own implied admission.

  44. Gravatar of Major.Freedom Major.Freedom
    22. August 2015 at 16:39

    Ray,

    Money is not neutral even by your own offered standard of Bernanke’s paper that calculated an average of 8%.

    A neutral money is a contradiction in terms.

    If money were neutral, nobody would use it. It is precisely because money is a factor that affects what people do, and thus what people produce, that the doctrine of money neutrality is absurd.

    The notion of a neutral money, do you even know the history behind the idea? That it was proposed not as a theory of what money is, but as a political activity? Something to strive for where otherwise there would not be neutrality?

    You keep claiming that money is neutral when it is not in fact neutral at all.

    Money is not neutral no matter what the inflation rate. It is always non-neutral because it is an object of economic action. People act in order to both acquire and to spend money, and, importantly, money is valued. One dollar is valued differently than two dollars. That is why prices exist. It is why sellers and buyers haggle prices all the way down to pennies.

    When money is either produced in a free market or printed out of thin air in a socialist commonwealth, it is always produced or printed by certain people who do certain things. More money in the hands of only a portion of the population, which is what takes place in the existing circumatances, because it affects what those people do relative to what others do, necessarily act to change the whole economy, for better or for worse.

    Everyone changes the whole economy to some degree.

    You have already conceded that the only reason you keep saying money is neutral, is out of the belief that if you didn’t, then you would be conceding everything to the Monetarists.

    How utterly misguided and dishonest!

    You would not be conceding an inch by admitting the truth that money is not neutral. In fact, if you are going to claim that Monetarism makes the economy worse, which you have done on more than one occasion, then you would actually require money to be non-neutral for that to even be possible! You can’t claim Monetarism does anything, unless it is not neutral.

    No, money does not suddenly become non-neutral when some arbitrary statistic like the number of parts in a car, grows beyond an arbitrary number, like 10%. That is ridiculous. It is ridiculous because it presumes money thinks and acts. That if the organism money has enough growth, then it will suddenly start to act for or against humanity.

    But the whole time humans were in control of it. The reason money is not neutral at greater than 10% inflation is the same reason money is not neutral at 1%. You are like a fish in a fish bowl, unable to detect just how much even 1% inflation affects both relative production, and total production (again for better or for worse, temporarily).

    We did not have hyperinflation prior to 2007 and yet the economy tanked anyway because of the monetary system. Clearly money does not have to go to hyperinflation before it affects the economy as a whole.

    Ray, you are wrong, it is high time you admitted this.

  45. Gravatar of Major.Freedom Major.Freedom
    22. August 2015 at 16:43

    Ray, you continue to contradict yourself.

    You said:

    “BTW I find it funny that Sumner thinks the US economy is OK now.”

    But it must be according to you, because in your (very false) statements, “money is neutral.”

    Well, we don’t have hyperinflation or hyperinflation, and have not since 1913, so ACCORDING TO YOUR OWN PRONOUNCEMENTS, nothing the Fed has done since 1913 has any affect at all on the economy, and so by your admission, you would have to agree with a Monetarist such as Sumner who says the economy is doing well on the basis that the Fed is “saving us.”

    Well, if the Fed is making the economy worse, without there being hyperinflation, then you are saying that money is not neutral, in a bad way.

  46. Gravatar of Derivs Derivs
    23. August 2015 at 03:01

    @BC .. “derivs, the optionality in TIPS makes those bonds *more* valuable than a bond with no embedded option. Thus, the embedded option lowers the real yield of the TIPS, implying that the effect of the embedded TIPS option is actually to *raise* TIPS spreads relative to the market’s inflation expectation, correct?”

    Yes, you are correct. One would be willing to receive less in yield on the surface knowing they would be receiving the ‘hidden’ option in return. My point was just to illustrate that assumptions are being made based on a product, the valuation of which is not being deconstructed correctly. I equate it to my reaction had someone on a desk told me they were arbing a spread and then I were to find out they didn’t know their was an embedded option in one of the products of the spread they were trading. For obvious reasons, a stop would be put to that person very very quickly.

    MF.. dtoh gets it…

    Appears so, BC as well… but you don’t understand why. What you think of as an option is not the option, and where there is an option, you don’t see it. The option is a 0 strike option! Options only exists where P+L graphs ‘kink’ i.e, buy a 5% TIPS and draw payout at -4,-3,-2,-1,0, 1,2,3,4% inflation…result will be payout of 5,5,5,5,5,6,7,8,9… see the kink? That’s your strike! There is your option @ 0.

    the benefits of the option accrue to the long position only. (That’s a giant can of worms, best left unopened). As for me calling it convexity.. Let’s just say, if as BC correctly pointed out, ‘arbitrage will occur to bring pricing into line.’ My comment would be perfectly understood by the guy with the fun job of trying to hedge that book to flat every night.

    @scott.. “dtoh, I certainly did not “forget”, I know how TIPS work. The fact that the value cannot fall is of no practical relevance for a 30 year bond. Nobody expects deflation in the US over 30 years. (Japan is a different story)”

    Option valuation does not work on that principal. One most certainly does not need an option to expire ‘in the money’ for one to have made money on that option. Owning an option allows you to micromanage your hedges in a positive way, always buying low and selling high, little by little, day after day, Time is essentially the same as volatility and is very valuable. The fact you think it can’t go below 0 is not a determinant of value.

  47. Gravatar of ssumner ssumner
    23. August 2015 at 04:44

    Ray, You said:

    “Hence adopting Sumner’s framework, with all its uncertainty that could lead to hyperinflation, would have only at best sped up the recovery by a few years, by Sumner’s own implied admission.”

    Yup.

    Derivs, It is relevant to whether that option value has a significant impact on price.

  48. Gravatar of Steve Williamson Steve Williamson
    23. August 2015 at 07:46

    So, let me see if I have this right. Let’s deal with our actual policy problem in the United States, as that seems to be what you’re interested in. I looked at year-over-year growth rates in quarterly nominal GDP. Roughly, that averages about 4% in the recent time series. So I’m assuming, given your displeasure with the Fed, that you think that should be higher. Suppose you want 6% sustained growth in nominal GDP. The current state is that there is a large central bank balance sheet, a large stock of reserves outstanding, and the central bank is paying interest on reserves. Now, suppose that there were, in fact, a market in contingent claims on future nominal GDP, and the prices of those securities are giving you a forecast of future nominal GDP growth of 4%. It looks like your policy recommendation is that the Fed lower the interest rate on reserves into negative territory (assuming we could – whether that’s legal in the U.S. is questionable) and conduct large scale asset purchases until the market securities forecast nominal GDP growth of 6%, for example.

    Question: What assurance do we have that nominal GDP will actually grow at a higher rate, given the asset purchases and the interest rate on reserves in negative territory?

  49. Gravatar of ssumner ssumner
    23. August 2015 at 14:55

    Steve, You said:

    “Roughly, that averages about 4% in the recent time series. So I’m assuming, given your displeasure with the Fed, that you think that should be higher.”

    You are confusing several unrelated issues. One is what sort of policy target I’d prefer. Another is what I think of current Fed policy, given the Fed’s own announced targets. Those are completely separate issues. I’ve said many times that I’d have no problem with the recent growth rate of NGDP, if the Fed had a 4% NGDPLT policy regime. But that’s not the policy regime. They have an announced 2% PCE inflation target, they’ve been undershooting it, and they will probably continue to undershoot it. If you have a target you really ought to try to hit it, and you shouldn’t tighten monetary policy when you are falling short.

    You said:

    “Question: What assurance do we have that nominal GDP will actually grow at a higher rate, given the asset purchases and the interest rate on reserves in negative territory?”

    I could give lots of answers to the question:

    1. Worst case, the Fed owns the entire world.

    2. What makes anyone think they could not? After all, inflation has averaged 2% since 1990, when the Fed begin trying to achieve 2% inflation. Is that just a coincidence? Perhaps, but more likely the Fed caused the 2% inflation to happen. Any central bank that can target inflation can, ipso facto, target other nominal aggregates like NGDP.

    3. The low interest rates and bloated base are a delayed reaction to the Fed’s very tight monetary policies. The same thing happened in the Great Depression, and more recently in Japan. The lagged effects of tight money policies has no bearing on the question of whether easy money policies are capable of boosting NGDP. The higher the trend rate of base growth, the lower the ratio of base demand to GDP. So the same bloated base that seems to undercut some old fashioned monetarist arguments, actually supports the market monetarist interpretation. And we even have a beautiful example with the ECB, which tightened policy in 2011 and now has considerably lower interest rates than the Fed, and is doing QE while the Fed is contemplating a rate increase.

    4. Many people wrongly assume that the zero rates indicate the Fed has tried and failed to boost NGDP. But that can’t be true because if it were then the Fed would obviously not be contemplating a rate increase. Their intention to raise rates is evidence that NGDP is roughly where the Fed would like it to be. Rather than a liquidity trap, what we have is an example of Milton Friedman’s claim that very low interest rates are evidence that money has been tight.

  50. Gravatar of Ray Lopez Ray Lopez
    23. August 2015 at 16:11

    MF: “If money were neutral, nobody would use it. It is precisely because money is a factor that affects what people do, and thus what people produce, that the doctrine of money neutrality is absurd.” and “One dollar is valued differently than two dollars” — sorry Major Freedom, that’s not what money neutrality means. Google it and learn something instead of doing silly Austrian type thought experiments in your head. While you do make good points at times, no wonder Sumner does not take you seriously. Note by contrast how he jumps to respond to me when I make a comment; that should tell you something.

  51. Gravatar of dtoh dtoh
    24. August 2015 at 06:55

    @scott
    As I keep saying you need to ignore reserves. The NY Fed trading treasuries for deposits with Chase is no different than the NY Fed trading treasuries for deposits with the St. Louis Fed. It has no impact on RGDP, NGDP, or inflation. You need to look at MB – ER.

    @Steve
    I don’t think there is any legal requirement that the Fed even accept ER. It seems unquestionable to me that the Fed can control the level of reserves.

    @all
    Interest rates (negative or otherwise) are not important. What is important is whether the Fed can cause a marginal increase in the exchange by the non-banking sector of financial assets for real goods and services. Until I can get a 100 year 0% fixed rate interest only mortgage loan, that also is IMHO unquestionable.

  52. Gravatar of Charlie Jamieson Charlie Jamieson
    24. August 2015 at 08:14

    If the Fed can’t or won’t hit its inflation targets, why do you have faith it can an NGDP target?
    After all, to hit this necessary NGDP target of 6 pct, you would need much higher inflation.
    I believe the Prof. Sumner believes the Fed can set the price of all financial assets, which still seems like an academic exercise based on the idea that market participants will just go along with whatever it does (the Fed buys the world!) and bewilders those of us who are most interested in the real economy.

  53. Gravatar of W. Peden W. Peden
    24. August 2015 at 08:25

    “If the Fed can’t or won’t hit its inflation targets, why do you have faith it can an NGDP target?”

    Nice slide from “can or won’t” to “can’t” there.

  54. Gravatar of Charlie Jamieson Charlie Jamieson
    24. August 2015 at 10:49

    W.Peden — I allow for the possibility the Fed could hit its inflation target but believes that if it does it will cause some other mischief. The Fed may believe that if it starts inflation it won’t be able to stop it.
    ..
    I agree with the Major’s quotes mises (above.) We have had a long credit expansion that is not generating growth anymore, which is why solutions like the Fed buying debt (monetizing debt, as it were) are looked upon favorably.
    While I think that monetizing debt is the inevitable solution, it’s a political solution. Last time the Fed saved certain financial actors and effectively liquidated less powerful actors. In the coming crisis, hopefully it buys up student debt, for example.

  55. Gravatar of Benny Lava Benny Lava
    24. August 2015 at 20:23

    A few years ago I read an article that blamed high inflation in Brazil on loose money in the US. Instead of, you know, Brazil.

  56. Gravatar of ssumner ssumner
    25. August 2015 at 05:43

    dtoh, What do you mean? I do think the MB is far more important than reserves. Always have. What statement are you referring to?

    Charlie, If the Fed consistently missed it’s NGDPLT target by exactly as much as it consistently misses it’s inflation target, we’d be in heaven.

    You said:

    “I believe the Prof. Sumner believes the Fed can set the price of all financial assets,”

    Moronic, just moronic.

  57. Gravatar of Charlie Jamieson Charlie Jamieson
    25. August 2015 at 10:09

    How can it be moronic when you stated that in this very thread? To ensure the NGDP targets are hit consistently, you wrote:
    ‘In a worst case, the Fed owns the entire world.’

    The idea that the Fed or any central bank can set the price of financial assets is error, imo. So is the idea that the Fed or any central controls inflation.
    But that seems key to your theories — that the Fed has the power to do these things, even just the threat of doing them.
    Now we’re seeing in China that the central bank can control it stocks prices for a time, and only when real economic conditions are in their favor, but certainly not permanently and not when structural conditions are working against them.

  58. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    25. August 2015 at 12:12

    @ Charlie Jamieson
    Are you saying that a Central Bank cannot control de price level? If you are saying that a Central Bank cannot controlerelative prices I agree with you. But If the Central Bank doubles or triples base money overnight, I am sure it will change the price level … Don’t let the recent failure of central banks to achieve their inflation targets lead you to believe they could not do it should they use correct tools … (and use the right “thermometer”, NGDP growth). A central bank can continue to monetize all sorts of assets until some of the extra money in the economy spill over into prices. In the aggregate, some agents will be led to spend more, creating a pressure that will increase some prices and the average price level.

  59. Gravatar of Charlie Jamieson Charlie Jamieson
    25. August 2015 at 12:29

    Hi, Jose.
    I subscribe to the theory that money is created in the private sector by the banks making loans … albeit with support from the central bank. Normally, the Fed can stimulate or tighten lending with interest rate maneuvers; but at this point, with rates so low and real growth so limited, it doesn’t seem to be working. Probably if rates were negative or if the Fed bought the right kind of assets (if it bought student loans with the intent of forgiving student debt) then it could trigger inflation.
    Another way to create inflation might be massive deficit spending — I view T-bonds as pretty much the equivalent of deposits, plus deficit spending gets money spent directly in the economy at the grass roots level. But the Fed can’t do that.
    But it’s important to remember that to create inflation, the central bank has certain practical considerations to overcome, and also the reality that in creating inflation it creates uncertainties we can only guess at. Bankers are cautious by nature, and when they go out on a limb as they did in 2008-09, it’s only to save their fellows.

  60. Gravatar of dtoh dtoh
    25. August 2015 at 13:03

    @Scott,
    You said, “What do you mean? I do think the MB is far more important than reserves. Always have. What statement are you referring to?”

    MB is UTTERLY and TOTALLY meaningless. Unless you subtract out ER, it tells you absolutely NOTHING, NADA, ZERO. You should never, ever, ever refer to the “Base,” the “Monetary Base,” “Base Money” or MB unless those words are immediately followed by “less ER.”

  61. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    25. August 2015 at 19:51

    @ Charlie Jamieson

    I think the banking landscape has changed drastically. All the constraints on leverage and capital requirements for all practical terms made the credit channel innefective. Yes, may be a decade ago a slight change in rates would set banks to increase or decrease their own leverage and therefore have an amplified effect on M1 and then inflation. Although this effect may still exist, if I had to bet I would bet it is much smaller than in the past. That is precisely why the Fed can monetize all sorts of other assets without producing the expected inflation.

  62. Gravatar of ssumner ssumner
    26. August 2015 at 05:37

    Charlie, You said:

    “The idea that the Fed or any central bank can set the price of financial assets is error, imo.”

    Agreed, but this has nothing to do with the statement you quoted (which was of course a joke) I never said anything about the Fed controlling asset prices.

    You said:

    “Now we’re seeing in China that the central bank can control it stocks prices for a time”

    Actually we saw exactly the opposite, they failed to control stock prices even in the short run.

    dtoh, I misunderstood your comment.

    Yes the base is utterly meaningless, but reserves are even less important, say utterly, utterly meaningless.

  63. Gravatar of dtoh dtoh
    26. August 2015 at 05:48

    @scott
    I agree. I would only note that the existence of reserves leads to an epic misunderstanding of monetary polciy

  64. Gravatar of dtoh dtoh
    26. August 2015 at 05:50

    @scott
    I agree. I would only note that the existence of reserves leads to an epic failure by many people to understand monetary policy

  65. Gravatar of dtoh dtoh
    26. August 2015 at 05:53

    Excuse the duplication. BTW – Did I mention that the existence of reserves leads to…..

    ….never mind.

  66. Gravatar of Rod Everson Rod Everson
    26. August 2015 at 08:18

    Steve,

    I started adding some posts to my long-dormant blog recently. The last post is “What Will a Fed Tightening Look Like?”

    http://ontrackeconomics.blogspot.com/2015/08/what-will-fed-tightening-look-like.html

    Its a fairly long post because it’s intended for those who don’t pay much attention to the details of the Fed’s operating procedures, but the nub of it is that the when the Fed does tighten it will do so by announcing an increase in the interest rate it pays on bank reserves, probably to 0.5%.
    Also, depending upon how it phrases the announcement it could be interpreted by the public as an obvious tightening, or as just a simple adjustment to the Fed’s relationship with the banking system.
    I haven’t seen this get much discussion elsewhere and am wondering what you and your readers think will be the actual process when the Fed finally tries to tighten.

  67. Gravatar of Rod Everson Rod Everson
    27. August 2015 at 14:22

    Sorry Scott, I wrote “Steve” when I meant you in the above comment.

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