Noah Smith criticizes NGDP futures targeting
One of the frustrations of promoting new ideas is being forced to shoot down the same “zombie” objections over and over again. In a recent post, Noah Smith seems to have misunderstood the nature of NGDP futures targeting. (Actually not in the post, but in this comment.) He implied it was subject to “Goodhart’s Law” because the relationship between NGDP futures prices and future expected NGDP would break down after the Fed started targeting NGDP futures prices. He compared it to bitcoin.
One obvious problem with applying Goodhart’s Law is that there is currently no NGDP futures market, and hence no relationship to break down. But the bigger problem is that he is attacking a proposal that is not being made. He implies that the Fed would look at NGDP futures prices, and adjust policy as needed to keep them close to the target. But that’s not what people like Bill Woolsey and I are proposing.
Imagine the FOMC increased from 12 to 13 members. Does Goodhart’s Law predict that policy would become less effective? Not that I know of. How about 14 members? What about 15? How about 100 million?
And how about compensating each FOMC voter based on the accuracy of their vote. Let policy be set at the median vote for the instrument setting. Then pay people more who were “correct” (i.e more hawkish than average when ex post NGDP ends up above target, and vice versa.) That’s the essence of NGDP futures targeting. Of course the real world system would be more complex. I have a paper coming out soon, but until then my 2006 Contributions to Macroeconomics paper will have to suffice, or this blog post.
It’s not about the FOMC looking to the market for advice, indeed the FOMC would in a sense rely solely on their own internal judgment. They wouldn’t look to any external market. The difference is that the FOMC would be completely open, anyone could vote. The FOMC would become the market. And voters would be held accountable for their mistakes. That’s what makes it so scary for policymakers. Most existing members of the FOMC would probably choose not to vote, as they’d have their own money at stake. That’s good; they’ve been consistently overestimating how fast NGDP would grow, for I don’t know how many years in a row.
We don’t want them voting.
PS. Evan Soltas had a couple good comments.
PPS. I presented this idea at the New York Fed back in the 1980s. They said something like; “Thanks, but no thanks, we know how to keep NGDP on target. We can forecast better than the markets.” How’s that arrogance working out for ya? A comment by Noah Smith suggests that people like Narayama Kocherlakota are just beginning to think about this idea. I suppose it’s better 25 years late than never, but I can’t help being disappointed that he is only in the early stages of exploring this idea. Ten to one that he doesn’t yet know the literature.
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12. April 2013 at 21:24
Noah’s complaint is like saying to Switzerland, “what if you suddenly needed to depreciate your currency?” As long as you can print your currency, you can depreciate it to as cheap an exchange rate as you want, nearly overnight. Just like Switzerland did with its franc in 2011.
The Fed can print as many dollars as it wants. The Fed (with the right law) can sell as many NGDP futures as it wants. So it can move the dollar/NGDP-future exchange rate to wherever it wants, just by announcing the exchange rate it’s willing to honor.
It’s like a gold standard in which the central bank can print both sides of the dollar/gold exchange, not just one. The Fed can flood either side of the trade until the exchange rate hits the desired price. (Suppose the Swiss central bank was the sole printer of both euros and Swiss francs.)
So the only question is, what happens when there’s a shock?
Suppose the Fed wants the economy to come in at $20 trillion NGDP in 2017. It’s been exchanging 2017 NGDP contracts for 2017 bonds at its target exchange rate: 1 millionth of 2017 NGDP buys/sells for $20 million in 2017-payable dollars.
Suppose Noah’s scenario happens and the Fed “gets it wrong”: a shock puts the 2017 economy on track to come in at just $18 trillion. Suddenly expected 2017 NGDP is $2 trillion below the target embedded in the exchange rate. What happens?
Well, lots of people sell the Fed NGDP futures contracts in trade for same-year Treasuries, because you can sell an expected $18 million to get a guaranteed $20 million.
But the Fed can exchange unlimited quantities at its target rate. It will deliver Treasuries for NGDP contracts in whatever quantity the market demands.
So the market gets flooded with bonds until people start selling them. Which drives nominal prices up… until NGDP is close enough to $20 trillion again that there’s no more free money.
As long as people do trade in the NGDP futures market, you can’t have a rationally expected NGDP shortfall (or overshoot), because people will cash in on that shortfall/overshoot in a way that corrects the shortfall/overshoot.
What am I missing?
13. April 2013 at 02:06
Daniel:
I am not sure why flooding the market with treasures drives nominal prices up. And I didn’t quite follow why the market would be flooded with Treasuries if nominal GDP were expected to fall below target.
I think that what happens then is that the Fed would buy Treasuries with newly created base money. And the flood of base money would raise nominal prices. (or rather, nominal expenditure on output.)
Anyway, the “problem” that Smith describes doesn’t apply exactly to where the Fed buys and sells contracts at the target price. However, there is a related problem in that there is no reason for speculators to trade with the Fed if the speculators think the system will work perfectly. There will never actually be any payoffs.
In my view, it is a mistake to set up the system so that the Fed can only change the quantity of money in response to futures trades. Sumner’s proposals all the Fed to set base money as it chooses, and then he requires that it adjust its target based upon futures trades.
If you think of this as a game between “the market” and the Fed, then it provides little benefit. A single trader would never trade with the Fed. But when there are many traders with divergent expectations, they will trade because they they are speculating against the rest of the market.
I think the Fed should be free to adjust the quantity of money as it sees fit, subject to the constraint that it buy and sell the futures contracts. The result is much the same as Sumner’s approach.
13. April 2013 at 03:37
Scott: in defence of those who don’t get your point here: it is not an easy point to understand. Because this stuff is conceptually hard. You have spent a lot of time thinking about it, while others haven’t. I think you are right, but I’m not sure how well I could explain it to anyone else.
13. April 2013 at 04:12
I think from what we know about the relationship between the number of corporate directors and governance, the average quality of governance at the FRB would decline if you increased the board size. That would likely worsen policy effectiveness. The idea is that accountability becomes defuse quickly but knowledge and experience are expanded more slowly, leading to worse outcomes beyond a certain size. Optimal size depends in part on organization size and complexity but large, well run companies often have about ten directors if I recall correctly.
13. April 2013 at 04:29
Daniel, Yes, the Fed can hit any expected NGDP target.
Bill, Yes, I’d be fine with your version as well. They key is that the system MUST allow me a way to get rich when the Fed screws up, as in late 2008. Since I never expect to get rich, I wouldn’t expect the Fed to screw up.
Nick, Fair point, but I’d add that I’ve corrected Noah Smith before on this subject.
oneeyedman, But what’s the optimal size of a financial market?
13. April 2013 at 05:44
The way I think about it is that Goodhart’s Law warns against proxy objectives:
Let’s say you care about X (say NGDP level targeting). However, X seems hard to achieve (bc you never thought up future markets). You notice that Y is historically heavily correlated with X and easy to achieve. So you do Y. Now, you might not actually get X because the correlation broke down (“an indicator breaks if used a lever” is how I like to phrase it). This is Goodhart’s Law.
On the other hand, let’s say you care about X. You build a futures market that tells you whether your current policy will take you above X or below X. Using it, you can hit X exactly. Done. There is no Goodhart’s Law.
So, if a future’s market for NGDP is always a boring line at 5%, that’s not a bug, it’s a feature. In fact, this is why you will need to subsidize the market (otherwise, nobody plays the game)!
(The actual Lucas Critique that applies is: with NGDPLT there may be a lot of political pressure to start indexing all sorts of contracts/benefits/min wage laws to the NGDP level).
13. April 2013 at 06:12
Off the beaten path but a little bit of serendipty ‘US economy grinds to a halt as Ben Bernanke has the insight that money is just a bit of paper in a shared social illusion.’
“What began as a routine report before the Senate Finance Committee Tuesday ended with Bernanke passionately disavowing the entire concept of currency, and negating in an instant the very foundation of the world’s largest economy.”
“Though raising interest rates is unlikely at the moment, the Fed will of course act appropriately if we…if we…” said Bernanke, who then paused for a moment, looked down at his prepared statement, and shook his head in utter disbelief. “You know what? It doesn’t matter. None of this””this so-called ‘money'””really matters at all.”
http://www.theonion.com/articles/us-economy-grinds-to-halt-as-nation-realizes-money,2912/?ref=auto
13. April 2013 at 06:14
“As news of the nation’s collectively held delusion spread, the economy ground to a halt, with dumbfounded citizens everywhere walking out on their jobs as they contemplated the little green drawings of buildings and dead white men they once used to measure their adequacy and importance as human beings.”
“At the New York Stock Exchange, Wednesday morning’s opening bell echoed across a silent floor as the few traders who arrived for work out of habit looked up blankly at the meaningless scrolling numbers on the flashing screens above.”
“I’ve spent 25 years in this room yelling ‘Buy, buy! Sell, sell!’ and for what?” longtime trader Michael Palermo said. “All I’ve done is move arbitrary designations of wealth from one column to another, wasting my life chasing this unattainable hallucination of wealth.”
“What a cruel cosmic joke,” he added. “I’m going home to hug my daughter.”
13. April 2013 at 06:15
” Ten to one that he doesn’t yet know the literature.”
He doesn’t need to. His slides have enough math that a good assistant can turn them into a full journal article with citation’s without any additional i put from Kocherlakota himself:
http://m.minneapolisfed.org/article.cfm?id=4887
13. April 2013 at 06:37
One more quote this is just so great:
“For some Americans, the fog of disbelief surrounding the nation’s epiphany has begun to lift, with many building new lives free from the illusion of money.”
“It’s back to basics for me,” Bernard Polk of Waverly, OH said. “I’m going to till the soil for my own sustenance and get anything else I need by bartering. If I want milk, I’ll pay for it in tomatoes. If need a new hoe, I’ll pay for it in lettuce.”
13. April 2013 at 06:37
I’m not sure I understand the link between the NGDP futures market and the real economy under the set-up you would propose. In the case of the Fed targeting NGDP futures based on their market price, I could see how a market based NGDP forecast below the target would lead to monetary injections, thus leading to increased turnover in, among other things, the consumption market. But when the FOMC is removed from the equation and the market at large “becomes” the FOMC, where does the monetary expansion come from? Are you implicitly assuming an endogenous money supply based on leveraged bets on the futures market?
Who is the counterparty to NGDP futures market speculators in the real economy? I assume there has to be such a non-speculative counterparty for the effects to be propagated properly?
13. April 2013 at 09:22
Why simply use treasuries as the instrument. The fed has an arsenal so why not make an orderly anf tiered system. If NGDP contracts fall below a certain price then a new threshold of easing is activated. For instance, if interest rates are above 0 (doubt it), then they are lowered, after that is exhausted, QE is activated doubling monthly until it reaches 25% of the economy, if that doesn’t work then negative IOR, expanded asset purchases etc. That way the market knows there’s no point in testing fed resolve since each “threat to ease” will simply activate.
13. April 2013 at 09:31
Actually after about 20 members, the efficiency of the FOMC would break down.
http://arxiv.org/abs/0808.1684
(Not to say that a phase transition to a different mode of organizing, such as a NGDP futures market, could restore that efficiency much like shifting gaits from walking to running reduces the energy use and mechanical stress.)
13. April 2013 at 11:07
I’m still waiting for Dr. Sumner’s explanation on how NGDP futures prices that by definition and by policy planning do not fluctuate in any way as against market forces, are supposed to convey information about investor expectations of future NGDP.
The reason futures in oil, sugar, and wheat are traded is because they convey information on investor expectations of future oil, sugar, and wheat demand. If you as an individual investor believe the future spot price is going to be higher[lower] than the prevailing futures price (discounted), then you have the opportunity to buy[sell short] what you regard as an undervalued[overvalued] security.
But if we introduce the stipulation that these futures contracts are going to remain fixed throughout their lives, then they would cease communicating any information on investor expectations of future demand!
This is, IMO, the biggest weakness of NGDP futures theory. There are other, somewhat more minor problems.
13. April 2013 at 11:13
I am interested in hearing what many of you on this blog who support NGDP targeting, have to say about this article:
http://mises.org/daily/6402/Can-This-New-Fad-Save-the-Fed
13. April 2013 at 14:13
Geoff wrote:
“But if we introduce the stipulation that these futures contracts are going to remain fixed throughout their lives, then they would cease communicating any information on investor expectations of future demand!”
Not true. If you announced that you would buy or sell unlimited oil futures contracts at a price of $100 per barrel, then market expectations of the future price of oil would affect whether you are a net buyer of contracts or a net seller of contracts.
13. April 2013 at 21:20
Michael:
“If you announced that you would buy or sell unlimited oil futures contracts at a price of $100 per barrel, then market expectations of the future price of oil would affect whether you are a net buyer of contracts or a net seller of contracts.”
I don’t think that’s good enough Michael.
The information conveyed by being a net buyer or net seller of oil futures (which are fixed in price), does not convey the market’s expectation of the future spot price of oil.
Suppose an investor expected the future spot price of oil next month to be $X per barrel. Given that the futures price is fixed at $100, this investor has decided to sell futures short. OK, so now he who announced that he will buy and sell unlimited futures contracts, is a net buyer of oil futures.
What is this investor’s expectation of the future spot price of oil?
—————
Back to NGDP futures: how would the Fed being a net buyer or seller of NGDP futures, fixed at say $100 per, convey what the market’s expectation of future NGDP happens to be at that time?
14. April 2013 at 00:33
Surefire way of avoiding problems with Goodhart’s Law:
1)Set up prediction markets of NGDP at many different periods of time, probably 1 per quarter for the next 10 years. Subsidize them.
2)Require monetary policy to minimize the sum squared differences between stable path and expected path. Conditional trades would make this easy. This would prevent, for example, tightening to increase NGDP in 1 year if it would push NGDP over its target in year 2.
This approach would also deal with issues such as what time period of NGDP we should be targeting. Should we target NGDP a quarter from now? A year? 2 years? Doesn’t matter in this system. It would also allow for predictions of bubbles that pose a threat to the macroeconomy if you’re into that sorta thing.
Thoughts, anyone?
14. April 2013 at 00:37
Whoops, correction:
This would prevent, for example, EASING to increase NGDP in 1 year if it would push NGDP over its target in year 2, UNLESS the gains in year 1 pushed NGDP closer to trend than it did away from trend in year 2.
14. April 2013 at 01:14
The issue with using markets as indicators is uni tended consequences. The TIPS market is a perfect example. The treasury presumably wanted a way to have a market forecast for inflation. And it worked, for a while. Then came the theory of risk parity, and hedge funds realised that the risk profile of TIPS, making money when growth surprises down and/or inflation surprises up, makes them an excellent hedge against certain economic conditions. Moreover, this yields a negative correlation with stocks, ESP high beta stocks, and so now it can make sense to buy tips at negative real returns to allow you to lever up a strategy. Thus tips breakevens are diverging from the clevland fed’s calculation. As soon as an item becomes widely used as a hedge, it ceases to be a useful indicator.
NGDP futures would likely share this property. Moreover, if it was (seen to be) controlling policy, it might be possible to manipulate the market in a bear raid: depress the futures market, wait for other asset prices to fall in response, and then buy those other assets more cheaply. To prevent this it would need a daily volume in at least the hundreds of millions.
Of course, none of that might actually happen. Financial markets are tricky beasts, and might well not behave in the way you expect.
14. April 2013 at 05:42
Phil:
I am not sure what would happen if there were some kind of NGDP futures market, but if the Fed were buying and selling the futures at a target rate, there is no “bear raid” causing NGDP futures to fall.
It would be possible to sell futures, but the Fed would just buy them. The Fed would end up long on the futures. If the response of base money is automatic, then there would be an expansion in the quantity of money.
Now, somehow, this is supposed to cause other assets prices to fall. I don’t think that is the likely response.
I don’t favor automatic adustments of base money in response to futures trades. I don’t think the Fed’s position on the contract could really be taken as a signal of much of anything other than Fed disagreement with other market participants.
Buy or sell? Who do you trust, the Fed or the rest of the market?
I wish more people would think about index futures convertility, but it is impostant to understand the basics.
14. April 2013 at 08:17
Woosley,
A hypothetical:
The Jan. 2014 one year NGDP futures contract is targeted by the Fed at $15.
During the late summer 2013, NGDP growth slows dramatically as oil prices plunge. The conditional probability of a 2014 target miss spikes. Short interest accumulates in September and spikes in November.
The Fed eases while keeping the contract price at $15. There is not enough time for easing to affect 2014 NGDP.
By December, it is clear NGDP will fall short of target. Short interest mushrooms in an apparent arbitrage opportunity. Investment banks use their balance sheets to accumulate futures contracts in the hundreds of billions.
The Fed, faced with enormous losses, announces that it will no longer buy contracts if open interest exceeds $50b. Thus, contract prices can now deviate from target.
The prices of the 2 and 3 year futures contracts plummet. The
The Fed abandons NGDP futures targeting.
———————————————————-
Possible? In the end, the problem with NGDP targeting is that the Fed has no way to adjust for conditional probabilities during the life of the contract other than adjusting the target. If it adjusts the target, the contracts lose their effectiveness. The whole scheme is predicated on the Fed’s ability to almost instantaneously adjust NGDP, even on the last day before expiry. I suppose another possibility is to limit the volume of trading on any particular day, which, again, would render the contract meaningless as a policy tool.
14. April 2013 at 08:18
Sorry, above should have read, “there is not enough time for easing to affect 2013 NGDP”
14. April 2013 at 20:33
Anon,
Your argument makes sense if outside events can change NGDP faster than monetary policy can act.
But historically, the big driver to NGDP crashes have been monetary (bank tightening / bank collapse) events themselves.
Unemployment didn’t soar immediately on the stock market crash of 1929, but instead rose steadily from 1930 to 1933. And as Scott always points out, NGDP didn’t crash in the USA when housing prices turned down in 2007, but only when banks started getting into trouble, many months later.
So based on the historical record, there’s plenty of time for monetary policy to counteract economic events, because the events that have crashed NGDP have themselves been monetary.
But maybe in a smaller country, a “real” event (like a quarantine on the main export) could plausibly swamp all monetary action?
14. April 2013 at 23:53
Scott,
How does an NGDP futures market stay active if the Fed always intervenes to maintain NGDP? Is that why you propose that the Fed subsidize trading in the NGDP futures?
If the Fed sometimes fails to maintain NGDP, you can get rich betting on NGDP futures.
But if the Fed is reliable in intervening to maintain NGDP, you instead get rich betting on bond prices. (If the Fed is about to inject cash, financial assets are about to rise in value.)
So the more reliable the Fed is in maintaining NGDP on target, the more often Fed-anticipating trades will occur in the bond market, not the NGDP futures market.
In principle, the condition where the Fed is expected to be perfectly reliable is a condition where the market raises asset prices without the Fed having to do anything (because everyone’s trying to make money anticipating the Fed’s move). But presumably every so often the Fed would really need the information provided by NGDP futures trades.
I suppose the Fed could make it a condition of access to its banking functions that institutions take a minimum position (either long or short) on NGDP. “If you want to bank with us, you have to bet on the economy for us.”
15. April 2013 at 06:40
I do not understand the advantage of a subsidized NGDP futures market over the creation of NGDP-linked T-Bonds. I remember Prof. Sumner mentioned an issue about the self-consistency of these NGDP-linked T-Bonds, but I was not able to wrap my head around his argument.
Couldn’t the market financially engineer NGDP futures contracts using these Treasury securities? Without subsidization.
15. April 2013 at 08:49
Fed pegs NGDP futures prices at $100 per contract.
Fed pays interest on margin accounts for NGDP futures investors.
Fed does this, Fed does that.
Where are the market forces and how are these forces communicated nominally, given that the Fed pegs the price and the return on NGDP futures?
15. April 2013 at 12:32
@Geoff, to oversimplify, the relevant market forces are these:
– market participants who believe NGDP will be under target will buy futures; those who believe NGDP will be over target will sell futures
– the Fed creates rules to ensure that net purchases of futures cause the money supply to grow
– growing money supply raises NGDP
Everything else is just tuning to “make things work.” You pay interest on margin accounts so that people are willing to have margin accounts even though their net gains from investing in the futures contracts are de minimis. Etc.
Since price and return are fixed, the intent is for “forces to be communicated nominally” by the Fed looking at net long/short interest. This is what Noah didn’t understand when he tried to apply Goodhart’s Law.
Now, while I like this as a concept, I don’t think it works. The reason is that AFAICT (I don’t have a copy of the Sumner 2006 paper and haven’t read it) market monetarists haven’t shown that NGDP must converge to precisely the target as the contract approaches expiration. I think it’s very unlikely that it would converge _precisely_ to the target, because I don’t think that NGDP is controllable on an instantaneous basis, no matter what happens to the money supply.
For example: One week before the end of the quarter, dirty nukes explode in Manhattan, downtown LA, and San Francisco. Everything there stops, in a massive negative shock to the real economy. You’ve only got one week guys and everyone is panicing. Yet market monetarists seem to think it’s no problem for the Fed to ramp up NGDP within that week to compensate. Pardon me if I think they’re absolutely nuts.
So the idea that these contracts have fixed return is also nuts. If the Fed sets the price, then I should buy and sell quite a few of them, in a net neutral position, just to capture this option value. And then close out my positions a day in advance.
And if they don’t have option value, because regardless of what actual NGDP is there is no payout, then this isn’t a market, it’s a board game and EMH doesn’t apply to board games.
15. April 2013 at 14:08
@polymath
If dirty nukes exploded and everything ground to a halt that would indeed be a shock. However if NGDP stayed on course it would be a supply shock. The fed could still loosen policy instantaneously if there were an emergency such as the one you speak of. Instead of depressed demand it would just depress supply, same with a hurricane hitting the gulf coast and screwing over refining capacity. This would raise inflation but it wouldn’t have to necessarily lower nominal spending. Either way adjustment periods could be taken into account with these contracts, as long as expectations don’t deviate from targeted growth, then catchup would be in line with a target.
15. April 2013 at 15:56
Laurent,
The self-consistency / circularity problem and the “NGDP-linked bonds” problem are actually different.
1. Why no NGDP-linked bonds?
Scott’s observed that if NGDP-indexed bonds were “close but less liquid substitutes” for regular bonds, then the NGDP-linked bonds would change prices when liquidity preference changed (as TIPS-linked bonds have done), independent of actual changes in the NGDP forecast.
(When an inflation-protected bond declines, is it because people are predicting less inflation, or because they want to hold a more liquid type of bond?)
2. What’s the circularity problem?
The Fed has a circularity problem when it targets an instrument that is more responsive to Fed credibility than the actual overall financial system is.
If NGDP futures prices move just on anticipating Fed action, but the rest of the financial system doesn’t move as responsively to mere anticipation, then the change in NGDP futures prices may understate how much the Fed needs to inject/remove cash from the financial system.
So instead of monetary policy lagging because the Fed takes time to make up its mind, you’d have monetary policy lagging because it took the NGDP futures market time to realize the broader financial system needed action, and not just credibility, from the Fed.
15. April 2013 at 16:05
The key information seems to be the balance of long/short positions, not the change in NGDP prices.
If everyone “knows” the Fed needs to add money or NGDP will go down, then they’ll take a short position on NGDP futures. The price of the futures may not change, because people expect the Fed to do its job. But the balance of the bets on POSSIBLE moves will be downward.
So the Fed’s job is to inject money into the economy until the market is net neutral again, long and short NGDP futures cancelling.
Meanwhile, the Fed pays interest on people’s posted margin on their NGDP futures position, so that they’re motivated to place a bet that (usually) neither gains nor loses.
(How do we prevent people from placing hedged bets and just making money off the Fed’s interest payments?)
(Bill Woolsey explains this more here: http://monetaryfreedom-billwoolsey.blogspot.com/2010/12/index-futures-and-circularity-problem.html)
15. April 2013 at 18:01
polymath:
“- market participants who believe NGDP will be under target will buy futures; those who believe NGDP will be over target will sell futures”
“- the Fed creates rules to ensure that net purchases of futures cause the money supply to grow”
“- growing money supply raises NGDP”
What is the gain to be made, how is a gain to be made, by buying futures that are fixed in price, and can only be bought and sold at that fixed price?
Suppose NGDP futures prices are fixed at $100. Suppose an investor believes NGDP will be below target. What is the incentive to purchasing a security for $100, the margin accounts of which earn a rate of interest stipulated by the Fed, that is different from that same investor believing NGDP will be above target?
As far as I can tell, the only return an investor can earn from investing in these futures is the interest they earn just by holding the securities. Thus, the only reason an investor would want to buy a futures contract would be if the rate of interest paid on the margin accounts is greater than the rate of return that can be earned on other (risk free?) securities, such as government bonds.
“Everything else is just tuning to “make things work.” You pay interest on margin accounts so that people are willing to have margin accounts even though their net gains from investing in the futures contracts are de minimis. Etc.”
If the point of investing in NGDP futures is to earn a government set interest rate (rate Fed pays on margin accounts), what does actual NGDP have to do with it?
Futures contracts only have value because ultimately the futures contract pays the long position the underlying security or commodity. For example, long oil futures pays oil, long sugar futures pays sugar, long stock futures pays stock, and so on.
But you can’t deliver NGDP to the long position investor of an NGDP futures contract.
I am not seeing the connection between NGDP itself, and the market forces that convey investor expectations of NGDP.
“Since price and return are fixed, the intent is for “forces to be communicated nominally” by the Fed looking at net long/short interest. This is what Noah didn’t understand when he tried to apply Goodhart’s Law.”
But the long and short positions for these NGDP futures, it seems to me, to be a function of the return paid on the futures, and other returns payable on other securities. If the rate the Fed pays is too low, then investors will invest in other securities that pay a higher return. If the Fed pays a rate too high, then investors will buy NGDP futures.
Investors, as far as I can tell, won’t be investing in the NGDP futures based on NGDP expectations at all, but rather the difference between the rate paid on margin accounts, and the rates paid elsewhere in other investment opportunities.
“Now, while I like this as a concept, I don’t think it works. The reason is that AFAICT (I don’t have a copy of the Sumner 2006 paper and haven’t read it) market monetarists haven’t shown that NGDP must converge to precisely the target as the contract approaches expiration. I think it’s very unlikely that it would converge _precisely_ to the target, because I don’t think that NGDP is controllable on an instantaneous basis, no matter what happens to the money supply.”
What convergence are you talking about? The NGDP futures price is fixed the entire time.
“So the idea that these contracts have fixed return is also nuts. If the Fed sets the price, then I should buy and sell quite a few of them, in a net neutral position, just to capture this option value. And then close out my positions a day in advance.”
“And if they don’t have option value, because regardless of what actual NGDP is there is no payout, then this isn’t a market, it’s a board game and EMH doesn’t apply to board games.”
Seems like all my questions to you above are really moot, since you seem to be seeing the same problems I am seeing.
15. April 2013 at 18:05
Daniel:
“If everyone “knows” the Fed needs to add money or NGDP will go down, then they’ll take a short position on NGDP futures.”
What return would an investor earn by going long or short on a fixed price NGDP futures contract, given that the return is the interest paid on margin accounts, determined by the Fed’s discretion?
Wouldn’t the Fed not be able to sell any futures if the rate they pay is less than a comparable risk free security, and wouldn’t the supply of NGDP futures have to go to infinity if the rate paid is higher than other comparable securities, since Dr. Sumner has said that the Fed would sell as many futures as the market would desire?
It seems to me that the only information that the Fed can discern from these futures contracts, are investor demands for interest payment returns, and nothing to do with actual NGDP at all.
15. April 2013 at 18:15
Daniel,
Thank you for the explanation. It is quite clear.
15. April 2013 at 21:02
Geoff,
I agree that it seems like simple NGDP futures would not reliably incentivize investors.
Here’s the odd thing:
Sumner himself laid out what seems like a great solution, seven years ago, in a paper he did with Aaron Jackson (“Velocity Futures”, unfortunately not online).
Sumner and Jackson’s solution: don’t do “NGDP futures” but “NGDP options” — futures with a policy strike price.
When you buy or sell an option, you don’t just go long or short — you specify a strike price at which the option comes into the money.
In their 2006 proposal, the “strike price” on the NGDP security would be the policy rate at which the investor expected NGDP to fall over/under the Fed target.
So, instead of just saying “I bet NGDP will be under the target of $15 trillion”, an investor would say,
“I bet that if the 3-month Treasury rate is above 1%, NGDP will be under $15 trillion.”
Then the Fed moves the policy rate to the weighted average of all these bets.
Using NGDP options instead of NGDP futures has two advantages.
First, the Fed’s policy move is explicitly indicated by the weighted sum of the NGDP options purchased.
If everyone thinks the Fed will make target at 1%, the Fed lives up to their expectations and sets policy to 1%.
So with NGDP options instead of NGDP futures, no circularity — the securities explicitly specify the policy expected to achieve target outcome.
Second, Fed compliance with the market no longer stops an investor from making money.
If you think NGDP will fall short unless the rate is 0.5% or below, and everyone else bets on 1%, the Fed will go to 1%.
If you’re right and NGDP falls short, you make money in proportion to the shortfall. If you’re wrong and NGDP is at or over target, you’ve lost the purchase price of the option, and the person who sold you the option has made money.
It’s true that an investor who chooses a strike price exactly equal to the market weighted average will merely dictate the Fed’s policy stance, and so won’t gain or lose money. But any investor whose opinion is below or above the average stands to gain or lose money.
(Technical note 1: Sumner and Jackson’s actual proposal is slightly differently constructed than “policy rate as an option strike price”. I think it’s equivalent. One of them might correct me!)
(Note 2: You could use the size of the monetary base as a policy strike price instead of the interest rate. If you did use an interest rate, then as rates neared the zero lower bound, the central bank would want to sponsor trading in interest rates on longer bond terms.)
I don’t know why Sumner doesn’t like the “NGDP options” security and prefers to talk about pure “NGDP futures”. Is it because he thinks options make it too complicated? Not liquid enough? Something else?
15. April 2013 at 22:36
NGDP options (drawing on Jackson/Sumner 2006) more concisely:
Option contract pays X% of NGDP excess (shortfall) if and only if yield on policy instrument is below (above) Y.
Fed regularly adjusts its policy instrument to the yield Y* where the market value of an NGDP call (option on excess NGDP) is equal to the market value of a put (option on insufficient NGDP).
Fed subsidizes market-makers as needed to keep the market active enough to be relied on for setting policy.
Multiple policy instruments (e.g., bonds of varying terms, prime rate) are possible (and necessary if any given instrument nears the zero lower bound). Also the quantity of a particular asset (e.g. monetary base) could be the instrument instead of its price or yield.
(I should reiterate that Jackson & Sumner do not formally structure their “Velocity Futures Markets” as options, as far as I can tell, but as a future in the log ratio of NGDP and the policy instrument. But they look operationally like options to me, and so I’ve presented them here that way. Everything foolish about the above description is my fault, not theirs.)
16. April 2013 at 05:37
Geoff wrote:
“Suppose NGDP futures prices are fixed at $100. Suppose an investor believes NGDP will be below target. What is the incentive to purchasing a security for $100, the margin accounts of which earn a rate of interest stipulated by the Fed, that is different from that same investor believing NGDP will be above target? ”
In the Woolsey post cited above (hopefully I won’t butcher his explanation):
1. The Fed sets the price of the contract *for a fixed period of time* by buying or selling an unlimited number of contracts at that price (i.e. so no one with a brain would buy at a higher price or sell at a lower one). We’re in 2Q 2013, so let’s say that during this quarter, the Fed will be buying or selling contracts that will be settled based on 2Q NGDP. In practice the contracts would be settled some time after the end of 2Q 2014 since actual NGDP for this quarter would not be available right away.
2. At the end of this quarter, the Fed stops buying and selling contracts for 2Q 2014 NDGP. Either these contracts no longer trade, or they trade at variable prices (since the Fed is not buying and selling contracts at $100, prices will fluctuate).
3. Once 2Q 2014 NGDP is available, the contracts will be settled. Sellers pay buyers $100 plus 1% for every 1% NGDP is above target, or $100 minus 1% for every 1% NGDP is below target.
4. If individuals in the market, on net, think that NGDP will exceed its target, the Fed will start to find itself on the wrong side of the contracts and exposed to risk of losses when they are settled. This would be a signal for the Fed to pursue contractionary monetary policy via higher IOR, OMOs, or higher reserve requirements.
On the other hand, if the net expectation is that NGDP will come in below target, the Fed will have to take the wrong side of that trade or pursue expansionary policy via lower IOR, OMOs, etc.
16. April 2013 at 07:00
Michael:
Thanks for your explanation. Questions:
In this post:
http://monetaryfreedom-billwoolsey.blogspot.ca/2012/07/noah-smith-wrote-critique-of-scott.html
Woolsey writes:
“Sumner proposes having the central bank buy and sell the futures contract at a target price. There would be zero volatility in the price of the futures contract.”
“I believe that Sumner has in mind a system where the target price increases at a 5% annual rate. However, it would also be possible to define an index by dividing the actual value of nominal GDP by the target, which would mean that the price of the future contract would never change.”
“Of course, what this means is that the central bank always takes a position opposite to the net position of market traders. If there are more bulls than bears on the market, the Fed must be a bear too. If there are more bears than bulls, the Fed must be a bull. Smith’s argument would then be that because stock prices vary more than actual dividends, the Fed’s position on the futures contracts would vary more than actual fluctuations of nominal GDP. Since nominal GDP varies so much, then the Fed’s position on the contracts would vary a tremendous amount.”
These comments suggest that Woolsey’s conception of NGDP futures are not to fluctuate at all, let along fluctuate according to Fed stipulation (which would still make it non-market driven fluctuations).
I don’t want to say you butchered Woolsey’s arguments, but it does seem like what you said is not consistent with what he said.
16. April 2013 at 07:34
Geoff, I see this Woolsey post:
http://monetaryfreedom-billwoolsey.blogspot.com/2010/12/sumner-and-delong.html
16. April 2013 at 08:24
Michael:
Woolsey writes:
“Only if the Fed is compelled to take a position on the contract and that position loses money, does the Fed pay out and so, create money. And, similarly, if the Fed must take a position on the contract and it makes money, the Fed collects the funds and destroys money. However, any such changes in the quantity of money are undesirable, and the Fed should sterilize such changes. If the Fed makes money, it should buy ordinary securities–maybe T-bills–with its profits. Similarly, if it loses money, it should sell off ordinary securities, such as T-bills to fund its payoffs.”
Wouldn’t sterilization itself influence NGDP, and so become a circular logic, endogeneity problem? If the market knows the Fed will reverse the market’s expectations as based on the quantity of longs and shorts, by selling t-bills if the market thinks NGDP will be below target, and by buying t-bills if the market thinks NGDP will be above target, what’s the incentive for investors taking any position at all?
16. April 2013 at 08:26
Sorry, typo:
“If the market knows the Fed will reverse the market’s expectations as based on the quantity of longs and shorts, by buying t-bills if the market thinks NGDP will be below target, and by selling t-bills if the market thinks NGDP will be above target, what’s the incentive for investors taking any position at all?”
16. April 2013 at 09:47
I think the sterilization is a side issue. If trading volume were high enough, the trading itself (plus required margin posting) could affect M if not sterilized.
Regarding your second question… people would only trade in this market if they expected that NGDP was going to come in above or below target.
16. April 2013 at 16:55
Michael and Geoff,
Wooseley’s problem is he ignores conditional probabilities. By the end of a quarter, it should become much more clear whether NGDP will miss target. Imagine you are George Soros. The high frequency economic data points to NGDP of $15.5tr, and the target is $16tr. This is a virtual arbitrage opportunity: you can short the contract in the billions and the Fed will take the other side, no matter what the high frequency (monthly) data indicates. As you (Soros) sell short, contracts outstanding grow. Other market participants observe this and begin to pile into the trade. Outstanding contracts escalate into the hundreds of billions. Sure, the Fed’s losses may lead to money base expansion, but its too late for that to influence the quarter’s NGDP at the end of the quarter. The Fed, faced with enormous losses, stops buying. The contract expires at $15.5tr, and you make a killing. Now that the Fed has backed away from one quarter’s target, it is open season on speculating against them in future quarters. Just wait until the end, see how the high frequency data stacks up, and bet.
Unless you think the Fed can control NGDP from one month to the next (highly doubtful), the above is quite plausible.
16. April 2013 at 17:07
Seems like only the rarest minds can visualize what the NGDP futures trading market would look like.
And none of them are as yet able to communicate their vision to the rest of us.
Until then, can we agree that NGDPLT could be a better tool , a better target, for the FED than inflation ?
16. April 2013 at 17:20
So will the NGDP market be the first ever to be incorruptible ?
17. April 2013 at 02:40
Anon,
Scott Sumner actually proposes daily contracts that are settled based on NGDP one year later (e.g. today’s contract (4/17/2013) is settled based on NGDP on 4/17/2014.
In Woolsey’s example, he does refer to contracts traded quarterly, but again, settled based on NGDP one year out. So the contract trading today (Q2, 2013) would be settled based on the NGDP for Q2, 2014.
Taking a huge position at the end of a quarter would still seem to be “betting against the Fed” as such a position would lead to changes in the stance of monetary policy.
17. April 2013 at 04:14
Michael has it right.
The Fed does not fix the price of the contracts for 2nd quarter 2013 nominal GDP until the day the statistic is announced.
Exactly what quarter’s future it would be best to trade this quarter is something that deserves more study. But fixing the price up until settlement day (after nominal GDP has already been determined, just not calculated) would be foolish.
Also, it is important to remember that it isn’t the trades of the future or profits from them that impact the quantity of money. It is some other, more conventional tool of monetary policy.
Changing the target for the Federal Funds rate doesn’t change the quantity of money. It is the open market operations that do that. (or loans from the discount window, changes in the interest rate paid on reserve balances, or changes in reserve requirements.)
Again, it is future expected nominal GDP that is being targeted, not the one that has already been determined or is being determined now.
Further, it is expectations that nominal GDP in the future will be on target that keeps current nominal GDP on target.
It isn’t that current monetary policy is pushing the economy to some new equilibrium state.
If there is a monetary regime that lets NGDP vary, then it would take an active monetary regime to push nominal GDP around to hit some target. If there is a monetary regime that keeps nominal GDP on target, then it would take an activist monetary regime to push it away.
If we target inflation, it would be hard to push the economy in a way such that nominal GDP is at some particular level at some future date. But the proposal is to get rid of inflation targeting and replace it with nominal GDP targeting.
By the way, only for an oil producing country does a lower oil price have any tendency at all to lower nominal GDP. Import prices don’t impact nominal GDP. And even then, it could leave nominal GDP unchanged, lower it, or raise it. It depends on the price elasticity of the demand for oil.
If velocity and the quantity of money is held constant, then if the demand for oil is inelastic, so a lower price of oil from a supply shock results in less spending on oil, this is offset by more spending on other goods. Buyers spending less on oil do so because they would rather spend the extra money (due to having to pay less for the oil they were using) to also purchase other things rather than just use more oil.
If the buyers choose to save those funds rather than purchase other goods and services, then this is either an increase in the demand for money (which is lower velocity) or an increase in the demand for finanical assets, which lowers market interest rates in line with the lower natural interest rate.
If this situation is expected to persist into the future because the monetary regime (say the Fed) will fail to raise the quantity of money to match the demand or will prevent market interest rates from falling, then there is an incentive to sell the futures contracts.
If, on the other hand, market particpants expect the Fed to do the right thing, or else expect that oil prices will rise back, then they won’t trade the futures contracts.
The error was to treat nominal GDP as the product of the price level and real output. The price of oil falls, and so the price level falls. Multiply that by real GDP, and nominal GDP is lower.
But in reality, the price of oil and the quantity of oil are jointly determined by supply and demand, and the product goes into nominnal GDP directly. Then, you can calculate some kind of price index and then, you can calculate real GDP. Real GDP and the price level are calculated. Nominal GDP is caculated by a summation process, of course, but the amount spent on oil (and each and every other thing) is something that actually happens. How does a reduction in the price of oil impact spending on oil. How does that impact aggregate spending? It is a mistake to say how does it impact some price index and how does it impact nominal GDP deflated by that index (some measure of real GDP,) so how does it impact nominal GDP.
17. April 2013 at 06:42
As has been discussed in the past, the futures market concept is awkward and unworkable in its current form.
Michael said that Scott proposes daily contracts, which was also how I read his proposal. That idea should never have made it past the drawing board. The most liquid futures contracts in the world have monthly or quarterly contracts, and open interest is only significant in one or two of them at any given time.
It’s also worth noting that the most liquid futures contracts are the ones that settle soonest – the “front month”. Asking investors to bet on NGDP one year in the future increases their risk significantly. This means the interest rate they will demand will be that much higher.
To the extent that it makes traders indifferent to capital gains or losses on their position, the interest proposed to keep the markets liquid interferes with the market’s supposed purpose.
In the blog post Scott linked to, he says traders will only trade each contract for one day. So they’re being asked to deposit margin which they won’t see again for 14 months, in return for the opportunity to bet against the Fed. The trader takes his money, or his clients’ money, and uses it to show the Fed what the monetary base should be to achieve a given NGDP growth target, so that the Fed can then conduct OMOs to move NGDP against your position.
If you’re a small trader that might not be such a big deal, because the Fed acting against you is a smaller factor than what your position is relative to the other traders (because the Fed reacts to the net market position). If you’re Goldman Sachs, however, you know that as your net position gets bigger, the likelihood of being stomped on by the Fed gets larger as well, because you make up a larger portion of the total market.
All this system will do is create a “Follow the Fed” game. Traders will watch the Fed’s net long/short like hawks, and any time the Fed starts to take on a net position, they do the same (flattening out the Fed’s position). If you read that and thought “exactly! So the system will regulate itself and interventions will be less necessary over time!”, then you don’t know how markets work. There is no price discovery here, which is what futures markets are supposed to do. All the incentives are to simply obey the Fed’s price target for the NGDP contract, with virtually no incentive to take meaningful position against it.
If this market were liquid at all, it would be because the interest rates are attractive. In that scenario, traders would put on horizontal spreads (which are virtually risk-free since the daily contracts nearly eliminate any real price difference between one NGDP contract and the only directly after it), and no relevant information can be gleaned.
17. April 2013 at 08:51
Agree with Tyler above. Betting on next year’s NGDP for one day? Who cares.
17. April 2013 at 17:04
I have no idea why speculators would “watch the Fed’s net position like a hawk” and then flatten it out.
I have no idea why “liquidty” is important for these index futures. With the Fed buying and selling them at the target price, they are perfectly liquid from the point of view of any speculator.
I don’t agree that the purpose of futures contracts is “price discovery.” I grant that futures have that consequence, but I think the purpose is hedging and gambling. Price discovery is a side effect.
However, the purpose of index futures converibility is not hedging, and that allows for gambling.
The purpose of index futures convertiblity is not to provide an instrument for hedging or gambling. It’s purpose is to constrain a monetary regime.
Think of a gold standard, where money is redeemable for gold. The purpose of this is not to encourage people to trade gold, improve the liquidity of gold markets, to let people gamble regading gold prices, or increase the liquidity of the gold market. The purpose is to limit and constrain the monetary authority.
18. April 2013 at 10:35
That really reinforces my belief that you gentlemen have not invested enough time talking to people who actually work in the financial markets.
You start with the belief in a central bank which market monetarists expressly have said can not try to create inflation and fail. Fine. You sell this new monetary policy on the idea that policy surprises are bad, and predictable NGDP growth is good. Okay. *Then* you set up a financial market in which the traders, simply by taking any position at all, express the opinion that the Fed will fail to achieve its NGDP goal. Can you not see how perverse this is?
If your NGDPLT system works, the speculators will flatten out the Fed’s net position because they know the Fed will almost certainly hit the target or come very close. The Fed’s net position is a price-proxy because it tells you what action the Fed will take to ensure the NGDP target is hit.
That’s why this idea is so absurd. If, and from what I understand it is not settled “if” even among big-name economists, the system works and the Fed can always control the monetary base and therefore inflation and therefore NGDP, the very fact that the system works will disincentivize participation in this futures market. It’s that simple. The bigger that the Fed’s net position gets, the more likely it is that it will take significant action to move NGDP back towards the target, which will directly affect the traders’ positionss.
Liquidity is a factor in any and all financial products. The accuracy of this NGDP thermometer you propose to create depends on the number of participants in it. Hence the proposed interest paid on margin accounts. The fact that there is always a counter party to buy or sell the contract on the one day that it trades for does not somehow magically negate the 14 month holding period during which the contract cannot be traded.
You don’t have to agree with me on the purpose of futures contracts, but you’re wrong.
“Competitive price discovery is a major economic function””and, indeed, a major economic benefit””of futures trading. Through this competition all available information about the future value of a commodity is continuously translated into the language of price, providing a dynamic barometer of supply and demand. Price “transparency” assures that everyone has access to the same information at the same time.”
-From the National Futures Association
The purpose of the gold standard was not to encourage people to trade gold, but trading gold, the liquidity of gold markets, speculation in gold (think the Hunt brothers with silver), etc. all effected the efficacy of the gold standard – something you should know, since one of the main complaints about the gold standard is that gold is not just money, but also a commodity subject to its own supply and demand factors completely separate from monetary issues.
It therefore follows that if you create a market to control your fiat currency, you should attempt to eliminate the factors that you had a problem with in gold. A lack of participants (liquidity) in the market makes it an ineffective measure of what monetary policy should be. An interest rate incentive which outweighs possible capital gains/losses reduces the effectiveness of your tool. The tendency of market participants to simply follow the Fed’s target because they know that the Fed (which as market monetarists have said, can be 100% effective when it comes to creating inflatino/deflation) will, without near-perfect accuracy, shift NGDP against their position, also reduces the effectiveness of this tool.
What really is ironic about this is that, at least to me, the concept of a futures market to determine monetary policy is really interesting. I love the concept. I just hate your proposed method. Seriously, buy a Series 3 study guide and take the licensing exam – it will help. The futures markets exist in their current form for a reason. It may not be the best possible form, but it’s not an arbitrary one. Learn more about what already exists.
18. April 2013 at 10:39
To clarify, I’m not suggesting that the Hunt brothers were trying to affect the value of the dollar, only that commmodity-backed currencies could be manipulated in a similar fashion to what they did.
18. April 2013 at 12:11
Tyler,
“A lack of participants (liquidity) in the market makes it an ineffective measure of what monetary policy should be.”
But if it is an ineffective measure, due to lack of participants, then there is money to be made there (if Fed relies on this information to set money supply). If there is money to be made there, there will be more participants in the market.
A likely result of the Fed generally being able to hit its target is that trading volume would normally be low and probably balanced. It would just be a few goldbugs who think massive inflation is always around the corner and a few Roubini types who have predicted 25 of the last 2 recessions.
Trading volume would only rise if the Fed made a mistake in either direction or failed to respond appropriately to nominal shocks. Both of these things would call its ability to hit the target into question and people would trade. Since 2009 the Fed has consistently failed to hit its own projections of NGDP (based on its undershooting of its RGDP and inflation forecasts). That’s different, of course, than failing to hit an explicit policy target – but the Fed has been consistently failing to hit its explicit inflation target, too.
18. April 2013 at 12:54
Michael,
My argument was that liquidity is important in order for it to be an effective measure, and it sounds like you agree. You chose not to challenge my points explaining why the market would be illiquid.
To address your argument, an inefficient market stemming from a lack of liquidity can lead to profit opportunities, but that is not the same thing as saying that it always does. The market for real estate on asteroids is pretty illiquid at the moment, but I’d venture to say the profit opportunities are nonetheless limited.
“A likely result of the Fed generally being able to hit its target is that trading volume would normally be low and probably balanced. It would just be a few goldbugs who think massive inflation is always around the corner and a few Roubini types who have predicted 25 of the last 2 recessions.”
So now our monetary policy is being decided by goldbugs and Roubini types, if in reverse of their expectations. I fail to see why this is a good result. Nor does this address the issue of the market being undesirable as an investment – goldbugs buy gold, which has the benefit of being a solid commodity which can be stored in your basement. Why would they trade an esoteric device created by their own boogeyman, the Fed?
I don’t feel that you (or anyone else) has adequately addressed the fact that the market Scott proposes is intentionally and fundamentally set up to lose money for investors. It is inherently self-defeating, because the better it works, the more traders lose when betting against the Fed. And the system is reliant on those traders to participate.
18. April 2013 at 17:28
Tyler Joyner wrote:
“So now our monetary policy is being decided by goldbugs and Roubini types, if in reverse of their expectations. I fail to see why this is a good result. Nor does this address the issue of the market being undesirable as an investment – goldbugs buy gold, which has the benefit of being a solid commodity which can be stored in your basement. Why would they trade an esoteric device created by their own boogeyman, the Fed?”
No, of course not. The point of this market is not to “decide monetary policy”. It’s to provide a source of information – and accountability – for the Fed. Low trading volume is to be expected when the Fed is conducting appropriate policy; the information the Fed gets from low volume trading is that monetary policy is on target. It is only when for whatever reason the Fed is expected to fail – one way or the other – that trading volume would pick up and the Fed would find itself with a substantial long or short position.
Having a position against market expectations is a way to force accountability on the Fed, too. Under such a system, if the Fed fails to hit the target, they are exposed to financial losses.
18. April 2013 at 18:57
Joyner:
We have long understood that speculators on futures markets have nothing to contribute to understanding index futures convertiblity.
There are no short term trading profits to be made, and that is what futures traders.
People do hold securities, even risky ones, for long periods of time. Much longer than 18 months. For example, people using a buy and hold strategy for stocks hold a risky asset for a very long time.
An ability to buy a “large” amount rapidly and then later sell that “large” amount without impacting the price much is clearly something that people trying to make trading profits find important.
I have never agreed with Sumner’s proposal to pay bonus interest on margin accounts. I think those taking positions on the contract should post T-bills as a margin account. I don’t think the Fed should charge trading fees to cover the costs of trading.
But I am uncomfortable about having people take positions on the contract as a cost of obtaining the benefit of earning extra high interest on a special high interest account.
I don’t see any benefit in having lots of people take positions on the future contract. In particular, having people who expect nominal GDP to be on target hold the contract as an unfortunate burden in order to gain the benefit of bonus interest on margin accounts is a mistake.
19. April 2013 at 06:43
Michael,
The NGDP futures market’s purpose is to tell the Fed what monetary policy is necessary in order to hit the NGDP target. So if goldbugs and Roubini types are the ones influencing the instrument by which the Fed determines what actions to take, then yes, they are determining monetary policy. After a fashion.
Your argument that trading volume would only pick up when the Fed is expected to fail is interesting, but doesn’t address the fact that the market is inherently punishing the participants – if it works. Say I think the Fed is no longer on the path to meet the target, so I take on a position. Other people agree with me and the Fed now has a net long/short of what it considers to be a significant size. The Fed then undertakes unlimited OMOs to get NGDP back on track. I lose money and so does everyone else. That is a broken market.
Woolsey,
To demonstrate remarkable ignorance of how futures work and what purpose they serve, and then arrogantly say that “speculators on futures markets have nothing to contribute to understanding index futures convertiblity” [sic] just shows how foolish it would be for policy makers with actual responsibility to listen to you.
Futures traders do a variety of things. Sometimes they make markets for bona fide hedgers, sometimes they take on long term positions and roll their position from month to month, and yes, sometimes they take directional positions for short term profits.
People do hold securities, even risky ones, for long periods of time. Did you also know that the expected profit must be commensurate with the various risks involved, to include liquidity risk? People who hold stocks, even those pursuing a buy and hold strategy, nearly always have the ability to get out of their position. Because the market is liquid. Private equity, on the other hand, is far less liquid, and for that reason (among others) the expected profit in private equity is higher.
So how much profit do you think a NGDP futures contract speculator should expect in return for locking up their money for 14 months, with no ability to flatten out their position? Knowing that the Fed fully intends and has publicly expressed that it will undertake unlimited action in order to hit that target? Easy answer: a lot of profit.
“I don’t see any benefit in having lots of people take positions on the future contract.”
So this whole system is supposed to harness the all-mighty market to determine our monetary policy (or constrain the monetary regime, as you said), and you don’t even care if lots of people participate in it? Exactly how much useful information do you expect to glean from a market with only a few participants, who are supposedly smart enough to know whether the Fed will hit its target, but aren’t smart enough to know that their very participation in this system sets them up to lose money when the Fed *actually listens to their opinion* and takes action accordingly, which would be against their positions.
This whole debate really just bewilders me. You don’t know why it would be necessary to have many participants in the market? Why have any participants at all? Why not just play a game of rock-paper-scissors with Scott, and the winner gets to be supreme emperor of the Fed?
This is your big plan to save the economy? To reinvent our monetary policy regime? At first I thought this blog was awesome because it’s a chance to interact with influential economists and learn from them, but now I see the man behind the curtain is no wizard at all. And it’s scary.
19. April 2013 at 12:29
this is completely off topic, but you may be pleased to know anyway. Last year an exam essay question for the ‘Money and Banking’ undergrad module at Oxford University is “Critically assess the argument that the Federal Reserve should link the current level of the federal funds rate to explicit targets for nominal GDP”.
19. April 2013 at 17:11
Joyner:
Everyone who claims practical expertise in futures markets has been just like you. Focused on short term trading profits.
Who is going to make markets in these futures?
Well, the answer is the Fed. With a gold standard, the central bank is obligated to buy and sell gold at a fixed price. When people show up to the gold window, the Fed accepts deposits of gold (buys gold) at a fixed price. The Fed covers gold withdrawals (sells gold) at a fixed price.
Can you imagine a gold trader today asking who would make a market in gold with the price of gold fixed? Well, it just isn’t a problem.
How can people have stategies where they buy gold at a low price and then sell it at a high price? How can clever speculators make trading profits in gold? They cannot. The price of gold is fixed.
Will people hold positions on these contracts? Only if they expect nominal GDP to be sufficiently far from target to compensate them for the risk and yes, the requirement that they must post securities as a bond to cover possible losses.
Those who believe that nominal GDP will be near the target won’t trade.
The only people who will trade are those who believe nominal GDP will be signicantly different from target and are willing to wait 15 months for a payoff.
Of course, people might trade the futures after the Fed quits trading them and making a market at a fixed price. People might well be able to close out there position whenever they want.
I don’t think that people who speculate in existing future contracts would have any special abilities or skills that would apply to index futures convertibility. None.
I don’t think people who use existing futures markets to hedge storable commodities they produce or use to produce their products have any special abilities or skills that would apply to index futures convertibility.
GDP isn’t all that volitile. It isn’t storable. There is no way to “beat the market” by buying before a price increase and then rapidly selling to take the profit. There is no way to sell before a price decrease and buy soon after to take the profit.
Nothing that futures speculators do has any application.
I don’t really think that nominal GDP futures would be very useful to hedge anything.
It is about forecasting nominal GDP one year in the future. The only reason to trade is because of an expecation that nominal GDP will deviate from target and that your forecast is different from others. Krugman sells and Taylor buys. Krugman sells because the thinks the Fed is too tight and Taylor buys because the thinks the Fed is too loose.
If no one expects nominal GDP to deviate from target, then no one should trade the futures contract.
To think there needs to be alot of trades of the futures contract is like thinking that there needs to be alot of activity at the central bank’s gold window for the gold standard to work. Only if lots of people are depositing gold at the central bank and lots of (other?) people are withdrawing gold, will a gold standard work. No, the gold standard can work even if no one actually deposits gold or withdraws gold. And it doesn’t work any better if there is lots of activity at the gold window.
Index futures convertibility develops out of the gold standard. Step 1. Rather than gold use a bundle of goods.
Step 2. Rather than redeem with all of the items in the bundle, redeem with a variable amount of some good that has a current market value equal to that to the sum of the market prices the items in the bundle
Step 3. Redeem money now with some good at it its market value, and then later adjust the settlement by the deviation of the total price of the bundle from its defined price.
Step 4. Notice that this is settlement with something at market prices plus a future contract on the bundle.
Step 5. Notice that this makes it possible to use the market basket of goods and services defining the CPI. Redeem with something at market prices and sell a future against the CPI.
Step 6. Notice that the redeeming at market value isn’t important, it is the futures contract that is contraining the central bank.
Step 7. Notice you can do this with just about anything you want, including nominal GDP, which happens to be a better target than the CPI.
If the monetary regime allows the price level to fluctuation, then a index future can forecast a market expectation of the price level. But if the price level is targeted, there really isn’t all that much fluctuation to forecast.
But that doesn’t mean that index futures contracts cannot constrain the central bank.
20. April 2013 at 09:15
Bill Ellis –
“Until then, can we agree that NGDPLT could be a better tool , a better target, for the FED than inflation ?”
I agree, the key point is to define the dollar as a share of NGDPLT and keep it as close to that as possible. If futures are the best way to do that, I’m for that. If giving the Board a mandate that says “If you come within +/- 1% of the target you keep your job, otherwise you lose it” is a better way, I’m for that. Or if there’s some other better way, I’m for that.
Having said that, I really enjoy the discussion of the implementation details, I’m learning a lot from it.
20. April 2013 at 17:05
Negation of Ideology says..
” I really enjoy the discussion of the implementation details,..”
Me too.
” I’m learning a lot from it.”
I am trying ,in good faith, but so far when it gets to the futures market, I just can’t see it yet.
22. April 2013 at 06:46
Woolsey,
I’m not focused on short term trading profits, I’m focusing on the intent of the market and how to achieve that intent.
The comparison with a gold standard is a false one; I’m surprised you would even attempt to make that claim.
In Scott’s post detailing his proposed futures market, it says that for every $100 of futures traded, the Fed would conduct $500 in open market operations (those numbers were placeholders I think, but you get the idea). So the NGDP futures market is not constraining a monetary regime a la the gold standard, but rather a mechanism that tells you how much inflation it will take to hit the NGDP target.
The dollar is not being held constant under the NGDPLT scheme, but rather will gain or lose value relative to the things it can buy, with potentially large gains or losses in volatile times. The gold standard constrained governments by putting hard limits on how much currency they could print. NGDPLT, on the other hand, promises to print as much currency as it takes to hit a nominal target. Not the same.
I can see why you would blow off any concerns about the futures market, since apparently what you want is not a market at all, but rather a promise. The way you describe it, the market essentially serves no purpose whatsoever. Under a gold standard, one could buy gold if you believed the government might print more currency than it could back, or were doing business with people who felt that way and wanted gold.
Under the NGDPLT market you describe, you could lock up dollars for 14 months, with no additional interest, in return for a possible profit (which you apparently think should be small), and to be paid out in dollars. And this is supposed to constrain the central bank how? Oh right, because if it behaves badly people can buy the futures contracts and make money from it?
So the thing constraining the central bank is a market which has considerable risk for the user, which you have expressly said does not need to have many or any active participants, and in the rare instance that the Fed actually does miss the target and have to pay out on some of the contracts, it can print dollars to do it with. Sounds pretty constraining.
“GDP isn’t all that volitile. It isn’t storable. There is no way to “beat the market” by buying before a price increase and then rapidly selling to take the profit. There is no way to sell before a price decrease and buy soon after to take the profit.”
“Of course, people might trade the futures after the Fed quits trading them and making a market at a fixed price. People might well be able to close out there position whenever they want.”
More contradictions. First, not all of what underlies futures contracts currently is storable. There are treasury futures, equity index futures, etc. Second, if people can trade the futures amongst themselves in a secondary market, there is an opportunity to “beat the market”. Third, if people can trade the futures on a secondary market, there will be very little incentive to buy the futures directly from the Fed, as a 14 month contract is much more risky than one closer to expiration. What would likely occur is that (provided it was profitable) some people or firms would purchase set amounts of the contracts at issuance, usually using some type of spread in order to limit their own risk, and then resell them when it gets closer to expiration.
Last but not least, Scott apparently does think liquidity is important, and in his post he said, “Trading would continue until the market reached equilibrium. This would occur when the monetary base had settled at a level where there was no longer any demand for trades.” And he has described at various times the merits of using an open market to determine what monetary actions are needed to hit the NGDP target.
Certainly this is the first I’ve heard about the NGDPLT market being specifically for the purpose of constraining the central bank. If there is a difference of opinion as to the primary purpose of the futures market, perhaps that ought to be settled.
22. April 2013 at 07:47
Tyler J wrote:
“So the thing constraining the central bank is a market which has considerable risk for the user, which you have expressly said does not need to have many or any active participants, and in the rare instance that the Fed actually does miss the target and have to pay out on some of the contracts, it can print dollars to do it with. Sounds pretty constraining.”
No. If the central bank has an NGDPLT, it cannot “print money” (or destroy money) beyond what is necessary to hit its target.
22. April 2013 at 08:06
Michael,
You’re missing the point. Any government or central bank anywhere could say “I promise never to print money against the interests of our citizens. Really!” The gold standard existed to instill confidence in paper money. It signified the government’s commitment to its currency.
Woolsey claims that NGDPLT will have a similar purpose. That’s false. Under a gold standard, if a gold bug or whoever has an issue with the central bank, he or she is free to go get gold at a window. Normal citizens don’t exchange their dollars for gold because, if the central bank is true to its word, their dollars and gold are interchangeable, and dollars are easier to carry around.
This NGDPLT futures market is not comparable. Note that I’m not advocating a gold standard, nor making any kind of broader economic argument. I’m simply saying that Woolsey claimed the NGDPLT futures market functions to constrain the monetary regime similar to a gold standard, and that he is wrong. What it amounts to is a promise to pursue a certain predictable monetary policy, with no actually mechanism of constraint. A 14-month contract which pays out in dollars if the Fed fails to hit its NGDP target is not a meaningful constraint. And the only thing keeping the Fed from printing those dollars to pay out for losses is you (or someone like you) saying “but it won’t work that way!”
22. April 2013 at 08:47
Tyler, let’s say we have a NGDP level targeting Fed and a Woolsey-type NGDP futures market, with the Fed buying/selling unlimted contacts at a fixed price.
What happens if the Fed pursues a monetary policy of excessive (i.e. above target) NGDP growth?
What happens if the Fed pursues a monetary policy of “opportunistic disinflation” (i.e. below target NGDP growth during a recession)?
22. April 2013 at 09:57
Michael,
Good question. I guess you could have been asking a couple of different things when you say “what happens”, but I’ll assume you’re asking for possible scenarios of how an investor or trader would use the market itself.
With futures it’s just as easy to go short as long, so if it’s okay with you I’ll only answer the first question. If you think there’s an important distinction between the two I’ll give the second a go as well.
“What happens if the Fed pursues a monetary policy of excessive (i.e. above target) NGDP growth?”
First, as a participant in the NGDPLT futures market, I have to anticipate that the Fed will miss its target to the upside, but I have to correctly predict this 12 months in advance. Let’s say that the NGDP futures market is settled by the difference between the contract price (which is really like a strike price), and actual NGDP 12 months later. If the tick size is .01% of NGDP, and the tick value is $100, and actual NGDP was in fact .2% higher than the target, then I will have realized a $2000 profit when the contract settles 14 months after I buy it. I made those numbers up; to my knowledge there are no working numbers for the market as yet when it comes to tick size/value/etc.
From the Fed’s side, they sell me 1 contract at the fixed price, and that afternoon undertake an open market operation to adjust the monetary base according to the net positions held by everyone else and me. It’s worth noting that this is, according to everything I read until this discussion with Woolsey, the whole point of the market. After netting out the various longs and shorts, the Fed learns that the market believes it will overshoot its target, then it will take appropriate monetary action to get back on target.
Woolsey posits that this will somehow constrain the Fed. Presumably he believes that, similar to a commodity standard, people who think the Fed will devalue the dollar to bail out the US government (or whatever scenario they believe will occur) can then go ahead and buy contracts at the market. In my opinion, this is not comparable to a commodity standard, because 1) there is no limit to the size of the Fed’s position, whereas a run on gold is a real threat to governments which use a gold standard because they can’t just magic up more gold, and 2) hedging against central bank impropriety by buying what to the average person will be a quite esoteric financial product, created and guaranteed in dollars by the very same Fed that you think may misbehave, will seem a bit foolish.
I understand that one possible counterargument is that the more the Fed misbehaves (and therefore misses its target), the more money you will make on the futures position. To this I would say that although your nominal profit may rise in the event of the Fed overshooting its target, your real profit will be either small or nonexistent. That is unless the contract is relatively highly leveraged, as existing futures contracts are, but that increases risk right along with profit. And then you have to compare it to your other options – which is something I don’t believe Woolsey or Scott have done. Woolsey just assumes that there will be people who don’t mind taking the risk, probably because he doesn’t care if anyone actually uses this market. To him the fact that it exists is enough.
22. April 2013 at 10:38
Luis, Very few contracts are currently indexed to inflation, so I doubt NGDP indexing would become popular.
Rademaker. NGDP futures targeting doesn’t affect RGDP directly. It controls actual NGDP, and stable actual NGDP leads to more stable RGDP.
Daniel J. That’s actually pretty close to what I have in mind. But I doubt they’d ever need to go to negative IOR.
Geoff. The market information is the market’s forecast of the instrument setting required to hit the NGDP target.
Shilo, There isn’t much new there, is there?
Phil, Actually the TIPS market was an EXCELLENT indicator that monetary policy was disastrously off course in late 2008. It’s not ideal, but way better than actual policy. NGDP futures targeting would be even better.
Daniel, If no one participates then that means the Fed is doing its job. My subsidy proposal is mostly to reassure skeptics.
Laurent, My proposal is simpler–I want a clean bet, with no bond market add-on attached.
Tyler, You are looking at things from a trader perspective, whereas you need to consider a “macroeconomics outcome” perspectives. I.e. suppose no one trades. Is that bad?
22. April 2013 at 10:43
Scott,
Well, that depends on the purpose of the market. I was under the impression, from things that you have written, that the market’s primary purpose was to tell the Fed what action needs to be taken in order to hit the NGDP target. Woolsey says that the primary purpose is to constrain the central bank. In your own words, what is the purpose of the futures market?
23. April 2013 at 08:12
Tyler, The purpose is to insure that expected NGDP growth never strays very far from target NGDP growth. That did happen in late 2008, but could not happen under NGDP futures targeting (without making it incredibly easy to get rich.) Woolsey and I are looking at two sides of the same coin.
A gold standard both targets the price of gold, and prevents the central bank from injecting an amount of currency that is incompatible with the gold price peg.
23. April 2013 at 10:01
I’m not being intentionally difficult, but does that mean that you intend the NGDP futures market to both 1) provide signals for what actions the Fed will need to take to hit the NGDP target, and 2) constrain the central bank?
In order to achieve number one, you definitely need a large number of participants. If the purpose or one of the purposes of the futures market is to provide meaningful information to the Fed about how to hit the NGDP target, then a liquid market is necessary. The idea of using a futures market to determine Fed action got me excited back when I first started reading your blog precisely because futures markets are very good at price discovery, which is basically what that is.
Woolsey brought up the topic of constraining the monetary regime, which I have not seen in your works before. Not that I’ve read everything you’ve written, but I have previously read the permanent links on your sidebar and have also used google searches to try and find other key posts or articles you’ve written.
I hope we can agree that if the purpose is the gather useful market signals, a liquid market is necessary. If the sole purpose of the NGDP futures market is to constrain the central bank, I think there are other – but different – problems.
I understand the principle that, under the sort of scheme Woolsey described, an individual who correctly predicted a Fed failure to hit the NGDP target could profit, and if the Fed was really misbehaving people could profit quite a bit. I can see how, in a general way, you might call that “constraining the central bank”.
Whether it would be effective is another matter. Any constraining effect is reliant upon the effectiveness of the constraining measure. A quick list of things that come to mind:
-Many investments offer some form of protection against central bank inflation. Most of those are immediately more attractive to investors than this NGDP futures market – largely because they’re far more liquid, and offer more diverse profit opportunities (investing in equities denominated in other currencies, for example, as an option beyond just holding a foreign currency in an account). You could view this as either limiting the constraint that the NGDP futures market places upon the central bank, or you could see it as making the NGDP futures market redundant in that function (there are extreme examples where a foreign currency becomes the de facto currency in times of hyperinflation, which is a form of constraint on the central bank).
-Since the Fed is the one paying out on these contracts, the only real “constraint” it experiences is that you have to create more new currency to pay those debts. In a very serious black swan type scenario where large numbers of people would want to take advantage of the futures market precisely because the central bank is way out of line, it seems just as likely that the market would be “temporarily halted”. It’s like when our congresspeople vote to create negative consequences so that they’re forced to come to an agreement – in the end they just hold another vote and another vote to keep delaying those consequences.
-Profits in this market are going to be positively (perfectly?) correlated with inflation once above the NGDP target. So unless the market itself is leveraged, real profit will be zero. If the market is leveraged, real profit will exist, but the decision to invest becomes more risky. To the extent that the market is unattractive, it is ineffective as a constraining measure.
So, although the issues are different depending on which side of the coin we’re talking about, I think they are still considerable. I’ve mentioned this before, but I think you should at least consider whether it would be more effective to keep the NGDPLT target, but use a RGDP market to hit it. This removes the Fed from the actual market operation, and gives the market only one mandate – discover what projected RGDP will be at some date in the future. The Fed can use this information to adjust inflation and hit the NGDP target. I don’t see the futures market as a credible constraint on the central bank in its current proposed form. Better to use it for what futures are good at – price discovery.
23. April 2013 at 15:23
[…] fair to say the power of each member of the FOMC is significantly reduced. (As Sumner recently put it to Noah Smith, this would be liked increasing the FOMC size to millions, where good votes are […]
23. April 2013 at 16:02
Tyler,
The point of this market is to provide “early warning” in the event that the Fed misses key signals (as it did in 2008) or makes an error. Also, to enforce some accountability on the Fed for failing to meet its policy goals (as it has consistently failed to do for the past four years – and as it consistently failed to do during the 70s, if ti had policy goals back then).
It is NOT to provide information the Fed can use to “fine-tune” NGDP. If fine-tuning of NGDP was necessary, a market that had a lot of trading activity might be necessary. But it doesn’t really matter whether actual NGDP is exactly on target or not, as long as long term deviations from trend are avoided and expectations of NGDP growth are maintained.
Under an NGDP level target the Fed cannot avoid losses by “creating more new currency to pay those debts”. Doing so would increase the Fed’s losses exponentially, as more and more people would invest more and more money in this market.
24. April 2013 at 05:58
Tyler, I strongly oppose any attempt to target RGDP.
The market would be infinitely liquid, as the Fed would buy and sell unlimited quantities of NGDP futures at zero transactions costs.
If no one trades, that means the Fed has already discovered the correct policy on its own–which is very possible.
24. April 2013 at 06:04
“Tyler, I strongly oppose any attempt to target RGDP.”
Is this even possible? The only way I can imagine it be so is to accept an intolerable level of inflation… which defeats the “real” part.
If it were possible it would really be like a free lunch, yes? Because inflation should socially/politically be fully acceptable as long as real growth far outpaces it – in the long-run. But any simple understanding of AD/AS says that’s not the case.
The closest runner-up would be supply-side policies, but you obviously can’t “target” this.
24. April 2013 at 06:23
Nice post Ashok.
Michael,
If that’s true, someone needs to fire the marketing department around here. The quote below is from “Re-Targeting the Fed”:
“This would be an “open market sale,” which would automatically tighten the money supply and raise interest rates. The Fed’s role would be passive, merely offering to buy or sell the contracts at the specified target price, and settling the contracts a year later. Market participants would buy and sell these contracts until they no longer saw profit opportunities, i.e., until the money supply and interest rates adjusted to the point where NGDP was expected by the market to grow at the target rate.”
So, according to Scott, the market’s purpose is to determine money supply and interest rates. I’m not inclined to accept your assurance that many participants are not necessary to do this. The selling point of using a futures market was to put the invisible hand to work. We already have a small group of people who decide what money supply and interest rates should be.
“Imagine the FOMC increased from 12 to 13 members. Does Goodhart’s Law predict that policy would become less effective? Not that I know of. How about 14 members? What about 15? How about 100 million?”
Scott in this blog post. Apparently he thinks more participants is a good thing – and I agree. This business where you want the legitimacy of a market-based system without actually having a functioning market does not strike me as a good idea.
“Under an NGDP level target the Fed cannot avoid losses by “creating more new currency to pay those debts”. Doing so would increase the Fed’s losses exponentially, as more and more people would invest more and more money in this market.”
My point is that, similar to how politicians like to spend money now and promise to save more in the future, and then rewrite the savings out of the law later, there is no reason to believe that this measure really constrains the Fed any more than what we have right now.
And aside from what history has to teach us about how governments abandon their monetary (and fiscal) commitments when it suits them, the actual constraining mechanism is not particularly effective. It takes 14 months to see any profit whatsoever, even if you correctly predict that the Fed will significantly miss its NGDP target. Trading futures requires market knowledge that most people don’t have, as mechanically it functions differently from stocks. With futures you can lose more than you have, a lot more. Existing avenues for speculating/hedging against misbehavior by the Fed are more attractive to the end user. To the extent that this makes people unlikely to actually use the NGDP futures market, it is ineffective as a constraining tool. I think I said that before.
24. April 2013 at 06:34
Scott,
I didn’t say anything about targeting RGDP. I said using a futures market to more accurately forecast RGDP, and target NGDP based on that information, would avoid many of the issues your NGDP futures market presents.
“If no one trades, that means the Fed has already discovered the correct policy on its own-which is very possible.”
Yeah this practically screams “flawed”. So if you start up this futures market, and no one wants to use it because it’s horribly designed, then the economists can pat themselves on the back and say “mission accomplished”, because there is no trading and thus the Fed has the correct policy. This is a “heads I’m right tails you’re wrong” set-up which will accomplish nothing.
Is it really so hard to imagine that it’s possible for a market to exist which no one wants to take part in? I feel like I’m taking crazy pills.
“We don’t need many participants for the market to work, so it doesn’t matter whether it’s attractive or not”
“If there is no trading, it means the Fed is doing the right thing”
^^ This is ridiculous. It is also what is being proposed.