Last year I had an email conversation with John Cochrane about futures targeting. He seemed intrigued, but I wasn’t sure if he was just being polite. Now he has endorsed the idea as a way of escaping liquidity traps:
But a commodity standard is impractical for a modern economy. If gold can double in value relative to other goods in the CPI, as it has done recently, then other goods can deflate to half their value if the government fixes the price of gold.
Instead, the Fed can target the thing it cares about – expected CPI inflation – rather than the price of gold. To do it, the Fed can target the spread between TIPS (Treasury Inflation Protected Securities) and regular Treasurys, or CPI futures prices. Here’s a simple example. Investors buy a CPI-linked security from the Fed for $10. If inflation comes out to the Fed’s target, they get their money back with interest, $10.10 at 1% interest. If inflation is 2 percent below target, the Fed pays $2 extra — $12.10. This pumps new money into the economy, with no offsetting decline in government debt, just like the helicopter drop. If inflation is 2 percent above target, investors only get back $8.10 – the Fed sucks $2 out of the economy at the end of the year. If investors think inflation will be below the Fed’s target, they buy a lot of these securities, and the Fed will print up a lot of money, and vice versa.
One might object that these markets are small and undeveloped. I answer that is exactly why the Fed needs to start doing it now, so the markets are large and developed when the Fed really needs them. And of course the details will be more complex than what I have outlined.
Of course this is an issue that I am especially interested in, having first presented the idea at the AEA in 1987, and I have since published numerous articles on the topic. And he’s right that the details are more complex that his short description suggests–it must be set up in a way where the Fed induces the market to forecast the optimal instrument setting, in order to avoid the circularity problem. Not all proposals did that. (I’d be curious as to what Garrison, White, Bernanke and Woodford think of Mankiw’s approach.)
A number of economists have discussed futures targeting, including Earl Thompson, David Glasner, Kevin Dowd, Bill Woolsey, and Aaron Jackson. (I apologize to those I forgot. Robert Hall developed an analogous idea that would affect money demand, not the money supply. But John Cochrane is the highest profile economist to endorse futures targeting. Great to have him on board. I don’t know if he recalled our email conversation, but even if not I might have planted the idea in his subconscious mind.
HT: Adam P
PS. Comment responses will continue to lag
Tags: Futures Targeting