Archive for the Category NGDP futures targeting


Britain needs an NGDP futures market

There’s a lot of discussion about whether Britain will have a recession as a result of Brexit.

There has been a pronounced tone-change among UK economics analysts since the EU Referendum: They are in unanimous agreement that the UK will sink into recession in the second half of this year.

They disagree only on the details and depth.

Call it the Silence of the Bulls: no one — literally, no one — is making a bullish case for the post-Brexit economy.

That is what is so scary about this recession. Usually, analysts and economists like to hedge their bets. Their opinions are spread over a range, with outright disagreements. They talk about “the risk” of something happening; they don’t say “this will happen.”

But right now everyone is saying the same thing. Bank of America Merrill Lynch’s Robert Wood put out a note last week whose title says it all: “It’s not looking good.”

There is one glimmer of hope, the FTSE 250 stock index has fully recovered from the Brexit shock.

Screen Shot 2016-07-31 at 11.18.53 AMBut there are two considerations that cut in the other direction.  First, although the FTSE 250 is supposed to be a “domestic” stock index, unlike the multinational dominated FTSE 100, it still has a substantial exposure to international corporations:

As financial markets approach the relatively quiet trading month of August, investors appear equally equivocal about the country’s prospects, in spite of this week’s surprise rebound in the FTSE 250 stock index — seen as a barometer of domestic UK companies — to pre-referendum levels.

Tempting as it is to read the FTSE 250’s rise as proof that all is well, Garfield Kiff, UK fund manager at M&G, cautions that the advance hides a less positive story.

“Put simply, despite the steady aggregate numbers, the stock market has concluded the UK is heading for a sharp economic slowdown,” he says.

The revival of the FTSE 250 looks like a vote of confidence for UK plc, but within the index there has been a clear divergence between the outperformers, which have been largely overseas earners, and domestic businesses such as housebuilders, retailers, and challenger banks.

In addition, British long term interest rates have fallen sharply since Brexit, thus even if future profits are expected to be lower, those profits are being discounted at a lower interest rate.  So maybe the drop in the pound and lower bond yields are masking weaker growth expectations.

Or maybe all the pundits are wrong.  After all, recessions are really hard to predict, especially those that involve substantial increases in unemployment.  It will be an interesting 6 months, as we await the impact of an unusually large “uncertainty shock.”  I’m on record as being somewhat agnostic on this issue, but to avoid being called a coward I have forecasted a 50 basis point increase in the UK unemployment rate.  You might call that a “mini-recession”, or a “phony recession”. My hunch is that employment will hold up better than RGDP.

I was also surprised when the BoE did not move at its first meeting after the Brexit vote:

Markets were wrongfooted on July 14 when the Monetary Policy Committee voted 8-1 to leave policy unchanged. But the minutes of that meeting said “most members . . . expect monetary policy to be loosened in August”, leading market participants to believe with near certainty that action will come on Thursday.

The BoE’s forecasts and policy decision will have to be made in the absence of hard data on how the vote has affected the economy — most of which will not be published until September. In deciding what action to take, the MPC will weigh up the risk of not doing enough against the risk of depleting its limited firepower before knowing exactly what is required.

Hmm, I wonder what sort of futures market would allow the BoE to avoid waiting until September to respond to a shock that occurred in June?  The FT article also speculates that the BoE will lower its growth forecast to roughly zero:

The Bank of England will this week downgrade its growth forecasts following the vote to leave the EU and explain what action it will take in response.

Governor Mark Carney said before the referendum that a Leave vote could result in a “technical recession” — two quarters in a row of the economy shrinking — and Thursday’s announcements will reveal whether or not policymakers think this is the most likely outcome. Growth forecasts are expected to be cut close to, and perhaps below, zero.

The IMF has a more specific forecast:

The International Monetary Fund has already knocked 0.2 percentage points off its forecast for growth in 2016 since the referendum, and 1 percentage point off for 2017.

That’s both very large and very small, depending on one’s perspective.  It’s very large in the sense that it’s quite rare for a single political action to immediately chop so much off the consensus near-term growth forecast. Even electing Trump would probably have only a trivial impact on growth forecasts. And yet it’s small in the sense that the IMF prediction would probably result in only a very small rise in unemployment.  Indeed it looks more like Japan’s three recent “phony recessions, or the UK phony recession from a few years back (when unemployment did not rise), than it does like the actual recessions of 2008-09, when unemployment rose sharply in Japan and Britain.

There are also hints that the BoE will lean a bit in the NGDP targeting direction:

Most independent forecasters predict the recent depreciation of sterling will push inflation up to about 3 per cent next year — well above the BoE’s 2 per cent target. But the MPC is expected to look through this and focus instead on stabilising medium-term output.

However, I’d caution readers that the higher CPI inflation may come from the weaker pound, and that the GDP deflator may not show a similar increase.  Indeed I still expect NGDP growth to slow substantially.

PS.  Over at Econlog I look at Brexit’s near-term impact from a political angle, which is a much more depressing story.

NGDP futures targeting: Putting the Fear of God into the FOMC

When people come at NGDP futures targeting from a financial markets angle, they get hopelessly confused.  For instance, they worry about a potential lack of trading in NGDP contracts, whereas they should see that as a sign of success.

Today I’d like to suggest a different way of thinking about NGDP futures targeting.  In my view, the Fed can already do a perfectly adequate job of NGDP level targeting, even without tacking on futures markets.  So then why tack on the futures markets?  The answer is simple, they did not do a good job of maintaining NGDP stability during 2008-09, and NGDP futures targeting would force them to do so.

Go back to the 1990-2007 period, when NGDP rose at a pretty steady rate of around 5%/year.  And that was accomplished even without targeting NGDP.  Had they been targeting NGDP instead of inflation in the late 1990s, money would have been slightly tighter, making the resulting boom a bit milder, and (probably) also moderating the already very mild 2001 recession.  They did extremely well, and if they’d actually tried to target NGDP they could have done even better.

What about 2008-09?  It wasn’t just one mistake, it was several.  They focused on inflation, which was high in mid-2008, not NGDP growth that which was slowing sharply.  They focused on (high) past inflation, not TIPS spreads that showed falling inflation expectations late in 2008.  They focused on rescuing banking, not maintaining adequate AD.  (Indeed Bernanke basically admitted this failing (in his memoir) for the specific September 2008 meeting.)  They were squeamish about using unconventional policy instruments aggressively enough (although rates didn’t even hit zero until December 2008).

Obviously if there had been a NGDP futures policy in effect in late 2008, I would have been selling NGDP futures short like crazy.  Lots of other people would have as well, and the Fed would have been exposed to massive losses.

At this point many people get confused, assuming this is how I think things would have actually played out.  Not likely. The Fed would have been terrified of losing a boatload on money on bad NGDP bets.  Imagine explaining to Congress that you screwed up monetary policy so badly that you created a Great Recession, and to top it off you lost zillions of taxpayer funds.  It wouldn’t happen that way.

Instead, the real purpose of NGDP futures markets is to put the Fear of God into the FOMC.  They force it to do what it was already quite capable of doing, but held back due to either ignorance or fear of aggressive use of unconventional instruments.  Ironically, with a 5% NGDP target in 2008, level targeting, we would never had hit the zero bound, and we would never have had to rely on unconventional tools.  But even if we did, the Fed would have done “whatever it takes” to keep NGDP expectations on target.

Because I think the Fear of God would have made the Fed do what it should have done in any case, I think it’s quite possible that there would be little trading of NGDP futures contracts.  But I don’t care, because that “little trading” would be a sign of success.

PS.  Think of this as a variation of Lars Christensen’s famous “Chuck Norris effect”.  In this case Chuck is in the FOMC conference room in 2008, standing right behind Bernanke.  He whispers the following in Ben’s ear:

In your heart, what policy do you think is most likely to provide on-target aggregate demand in 2009?  The weak plan your staff prepared, or the aggressive steps you recommended to the Japanese back in 1999?  Keep in mind that I have a club in my hand, and plan to beat you all senseless if two things happen:

1.  Your plans fails to provide on target NGDP expectations.

2.  The market ends up being right and you end up being wrong.

OK Ben, deep down what do you think the Fed needs to do to provide 5% NGDP growth in 2009?

I want FOMC members to quake in their boots, and adopt a policy stance that roughly balances the short and long positions.  If that “balance” occurs with zero trades, that’s fine with me.  Indeed I hope they are such cowards that they refuse to take a stand, and meekly adjust the base until the long and short positions are balanced.  But if they want to take a bold stand  . . . well let’s just say I hope it works out better than when they overruled market forecasts, and predicted 4 rate increases in 2016!

PPS.  An update to Noah Smith’s recent post provides a great example of how thinking about this market from a finance angle throws people off.  Smith says:

Sumner seems to have thought very little about how markets actually become efficient. Scott, you need price discovery.

That’s not what NGDP futures targeting is all about.  It’s not price discovery, the price is pegged at 5%, it’s monetary instrument setting discovery.  I would recommend Noah look at Bernanke and Woodford’s 1997 JMCB paper, which makes it very clear that for this futures targeting approach to work it must be about forecasting the instrument setting that is appropriate, not about price discovery.  (I wonder if John Cochrane has also “thought really little about how markets become efficient”.)

Here’s an analogy.  The old international gold standard was not about the “discovery” of the proper nominal price of gold; it was about the discovery of the monetary base that would result in equilibrium occurring at the target price of gold.

And please don’t anyone tell me that the gold standard did not provide macro stability–I know that.  But it did stabilize gold prices, and NGDP targeting would stabilize NGDP expectations.  And (unlike stable gold prices) that’s a really good thing.  With stable NGDP expectations we will no longer have events like 2008-09.

If Noah Smith wants to seriously challenge the policy he needs to provide a plausible argument for large and time varying risk premia in the NGDP futures markets.  So far, no one’s been able to do that.  But that’s the sine qua non of any criticism.  Otherwise, I simply don’t care.  Manipulation? Who are the victims?  And did this occur under Bretton Woods?

And if it didn’t work, worst case is I get rich. Now that doesn’t sound so bad, does it?

HT: Foosion

Roger Farmer on NGDP targeting

Marcus Nunes directed me to a very interesting post by Roger Farmer (written right after the Brexit vote.) Farmer suggests that the Bank of England needs to do whatever it takes to prevent uncertainty from depressing aggregate demand. Indeed it should consider buying shares in an index fund, if necessary.  He then provides a comment from Thomas Hutcheson:

“This is fine so far as it goes, but we should deal as well with the policy response of the ECB and the Fed, as well. Whatever long term damage may occur from slightly less free trade (including investment to trade) cannot be prevented by central banks, but they can prevent the damage that comes from uncertainty about the future course of NGDP. It is expectations about that they should seek to stabilize.”

Farmer replies to Hutcheson as follows:

I am in broad agreement with the proposal to stabilize expectations of future NGDP growth and, in the simple models that guide my thinking, stabilizing asset price growth and stabilizing expectations of NGDP growth amount to the same thing. The question is: how to achieve that goal?

If central banks simply substitute NGDP targeting for inflation targeting, and if they continue to try to achieve their objective by adjusting short term interest rates, not much will have been achieved. Scott Sumner has proposed instead, that central banks should trade NGDP futures. Robert Shiller goes further and advocates that national governments finance their borrowing requirements by issuing equity-like instruments that pay a trillionth of GDP: Shiller calls these ‘trills‘. I wholeheartedly endorse both of these proposals. Creating a market for nominal GDP futures, and actively trading trills for Tbills would have much the same effect as stabilizing asset price growth.

Needless to say, I’m very pleased to see that Farmer is receptive to NGDP futures targeting.  We both have a longstanding interest in the relationship between asset prices and macroeconomic stability, which perhaps puts us a bit on the fringe of the mainstream.  But Farmer is much better known than I am (he teaches at UCLA) so any support from him is very welcome.

I did find the next paragraph a bit confusing:

I differ from Scott in one important respect. Whereas Scott sees NGDP targeting as a substitute for inflation targeting, for me, it is a complement. Central banks should set interest rates to target inflation, and they should set the growth rate of some other object, be it asset prices, NGDP futures, or the price path for trills, to target the unemployment rate.

I’d need to know more, but here’s my initial reaction.  Normally economists think that you need two independent tools to hit two distinct policy targets.  Farmer would probably say that his plan contemplates two tools (interest rates and NGDP futures.)  But I see basically only one tool.  The Fed would presumably use standard monetary policies (open market operations, interest on reserves, etc.) to affect both interest rates and NGDP futures.  Can slightly different monetary tools have two independent impacts?  Buying T-bonds and stocks, for instance?  Maybe, but I’m an old school monetarist in the sense that I believe it’s the liability side of the balance sheet that really matters, not the asset side.  So unless I’m missing something, I’m skeptical of Farmer’s claim.

I should add that I am assuming this is a sort of business cycle argument.  I take it as a given that monetary policy doesn’t affect the long run trend rate of unemployment, and hence you cannot choose independent long run targets for inflation and unemployment.  (At least without other tools, beyonds monetary policy.)

PS.  Off topic, I greatly enjoyed Tyler Cowen’s recent interview at the IEA.  There was virtually nothing with which I disagree.  That’s not to say I could make the same arguments; he’s a much better social scientist than I am.  I just point this out because I have a habit of mostly responding to posts I disagree with, and so if you want to see where our views agree, that interview is a great example.  (Covers the Great Stagnation, Brexit, negative rates, education, a bit on Trump, and a few other topics.)

PPS.  Zachary David responded to my recent post on NGDP futures:

In true Sumnerian fashion, he begins with an off-hand remark about how I ignored/didn’t read his proposal. Any long time follower of his, like me, knows that this is Sumner’s standard opening move for responding to all criticisms of NGDP targeting. I’ve read it all; it’s still goofy. (though not as goofy as the time he called Arctic Monkeys a one-hit wonder)

I was giving him the benefit of the doubt.  If he actually read that paper, and then still wrote his deeply misleading post, then that’s much worse.

Let’s start here:

He wonders why NGDP futures would be such a good idea, given that the private sector hasn’t already created such a market. Perhaps that’s because the private sector is not legally allowed to do monetary policy.

Oof. This is embarrassing. Sumner attempts to imply that we haven’t seen a private sector futures contract linked to NGDP because it would necessarily “do monetary policy” which the private sector cannot. It’s a gross non sequitur and completely ignores my point. In the main piece, you’ll see that there are no fundamental or market structure issues preventing the creation of an NGDP futures contract. I use the unpopularity of the former unemployment-linked contracts as an analogous example of why his market might have problems gaining traction. Dressing up a futures contract as “monetary policy” does not make it any less of a futures contract.

The only thing embarrassing is David’s failure to understand what I wrote.  I never said an NGDP futures market would necessarily do monetary policy, I said that would be the logical motivation for creating such a contract.  If the private sector is not doing monetary policy, why would it want to create such a market?  Yes, there are no barriers to creating such a market.  Indeed I created one.  So what’s the point?

As far as not gaining traction, why would I care?  If monetary policy stabilizes the price of NGDP futures, it really doesn’t matter whether there is any trading at all.  I explained all this in the paper that he insists he read, but somehow didn’t understand.  If David’s too lazy to read the entire paper, he can try the section entitled “What if No One Trades”, which begins on page 18 and goes all the way through page 21.  Don’t you think it’s a bit silly to read that entire section, and then whine that Sumner doesn’t realize that no one might trade his contracts?

The rest of his response is more of the same.  He quotes me, and then misrepresents what I said.  Perhaps the funniest example is where he claims I was advocating a gold price peg:

. . . did an economist really just extol the virtues of gold standard pegging?

Um, no.  Why do you ask?

HT:  Dilip,  James Elizondo

Our most data-driven FOMC member

James Bullard is perhaps the most data-driven member of the Fed, and thus one of my favorite FOMC members.  His only agenda is getting policy right; he’s perfectly willing to shift his views as new data comes in. However in the past I’ve occasionally been critical of his attempts to second-guess the markets.  This is from a post from 3 years back (beginning with a CNBC article):

But the St. Louis Fed president said in Friday’s “Squawk Box” interview, “I think policy is much easier than it was last year because the outright purchases are more potent tool than the ‘Twist’ program was …

Yes, but only because Twist was very weak.

. . . I don’t think markets have fully absorbed that switch.”

That’s not Bullard’s job.  He hasn’t been hired to outguess the markets.  If he wants to do that he should go run a hedge fund.  His job is to be led around by the markets like a stupid ox with a steel nose ring being dragged along by a farmer.

For the year, Bullard predicted gross domestic product (GDP) growth at 3.0 percent.

It’s not going to happen.  Ironically one of the reasons it’s not going to happen is because James Bullard thinks it is going to happen.

For the 100th time: No subsidized NGDP futures market = criminal negligence.

Yikes, that sounds too negative today, I certainly didn’t mean to suggest Bullard is a stupid ox; I just want him to behave like one.  No, that doesn’t sound right either.  Anyway, TravisV sent me to an article that makes me more hopeful about future Fed policy:

One of the U.S. Federal Reserve’s most prominent advocates of higher interest rates on Wednesday declared it “unwise” to move any further in light of weak inflation and global volatility, suggesting the Fed is stepping further away from plans to continue to hike rates.

St. Louis Fed President James Bullard argued steadily last year for the U.S. central bank to tighten policy and sounded alarms over the risk that continued low rates would create dangerous asset bubbles.

But on Wednesday he said the steady drop in U.S. inflation expectations is now his chief worry and said he will not be comfortable with further hikes until the trend reverses. . . .

Bullard is a voting member of the Fed’s rate-setting committee this year. . . .

“I regard it as unwise to continue a normalization strategy in an environment of declining market-based inflation expectations,” Bullard said. One other “pillar” of the Fed’s decision to hike rates in December has also weakened, he said, because falling equity prices and other tightened financial conditions have made the risk of asset bubbles “less of a concern.”

The Fed, he said, now has “more leeway” to take its time with rate hikes. Bullard said he in particular won’t be ready to move again until inflation-linked bonds signal that investors expect prices to rise at the Fed’s target 2 percent rate.

In a presentation to a group of financial analysts here, Bullard noted that the expected rate of inflation built into some bond prices has fallen as much as 50 percent since mid-2014. Bullard said he at first dismissed the slide as likely linked to the falling price of oil, but now views it as more endemic.

To hike rates in that situation, he said, would put the central bank’s credibility at risk because the Fed remains far from reaching its 2 percent inflation target, considered an important sign, alongside low unemployment, of the U.S. economy’s health.

“Central banks need to defend their credibility. That is why this is worrisome,” Bullard said. [Emphasis added]

The Fed taking its marching orders from the markets?  Does that remind you of a small heterodox school of thought?

India pushes into Asia one inch at a time.  But eventually you see that these incremental shifts have created the world’s highest mountains.  The role of expectations seeps into macro a little bit at a time.  How long before we wake up into a market monetarist world?

PS. I can’t believe I thought I could win friends and influence people with that sort of post back in 2013.  Replace “stupid ox” with “a man so wise that he understands that nothing exceeds the wisdom of crowds.”

Update:  TravisV pointed to this comment, from Bullard’s Powerpoint presentation:

Modern theory suggests that inflation expectations are a more important determinant of actual inflation than traditional “Phillips curve” effects.

Great stuff.

Australia needs an NGDP futures market

The Wall Street Journal sees Australia skirting on the edge of a recession:

SYDNEY””From the vast mining pits that dot Australia’s arid northwest to the multimillion-dollar luxury homes with views across Sydney Harbour, economists are seeing red flags that point to a looming economic slump.

Thousands of kilometers away, China is providing another cause for concern. The country buys roughly a quarter of resource-rich Australia’s exports. But its slowing economy translates into less construction of skyscrapers, bridges and railways””hurting demand for raw materials like iron ore.

The darkening outlook, underpinned by deeply disappointing data in recent days, has prompted several economists to warn that Australia””which has gone 24 years without any severe downturn””may finally be ripe for a recession, commonly defined as two straight quarters of contraction.

Some economists, including from UBS, Goldman Sachs and Morgan Stanley, believe the first contraction may already have happened””in the second quarter, for which data is due Wednesday.

Meanwhile, The Economist magazine’s panel of forecasters predicts good times ahead, with 2.4% RGDP growth for 2015, and 2.8% RGDP growth for 2016.

Who’s right?  I don’t know, and neither do you.  But this shows the need for market forecasts of 12 or 24 month forward NGDP.

PS.  Australia has never faced the zero bound problem and thus can easily avoid a NGDP collapse using conventional monetary policy, if it wishes to do so.

PPS.  After the WSJ piece was published, Q2 came in at 0.2%, and 2.0% over 4 quarters.

PPPS.  Suppose Australia had more recessions than the US; what would people say?  They’d say America has a well diversified economy, while Australia is reliant on the highly unstable global commodity cycle.  Instead Australia has far fewer recessions than the US, and my commenters tell me that’s because Australia relies on commodity exports.

HT:  Marcus Nunes