Archive for the Category NGDP futures targeting

 
 

John Cochrane endorses futures targeting

Last year I had an email conversation with John Cochrane about futures targeting.  He seemed intrigued, but I wasn’t sure if he was just being polite.  Now he has endorsed the idea as a way of escaping liquidity traps:

But a commodity standard is impractical for a modern economy. If gold can double in value relative to other goods in the CPI, as it has done recently, then other goods can deflate to half their value if the government fixes the price of gold.

Instead, the Fed can target the thing it cares about – expected CPI inflation – rather than the price of gold.  To do it, the Fed can target the spread between TIPS (Treasury Inflation Protected Securities) and regular Treasurys, or CPI futures prices.  Here’s a simple example. Investors buy a CPI-linked security from the Fed for $10.  If inflation comes out to the Fed’s target, they get their money back with interest,  $10.10 at 1% interest. If inflation is 2 percent below target, the Fed pays $2 extra — $12.10.  This pumps new money into the economy, with no offsetting decline in government debt, just like the helicopter drop. If inflation is 2 percent above target, investors only get back $8.10 – the Fed sucks $2 out of the economy at the end of the year.  If investors think inflation will be below the Fed’s target, they buy a lot of these securities, and the Fed will print up a lot of money, and vice versa.

One might object that these markets are small and undeveloped. I answer that is exactly why the Fed needs to start doing it now, so the markets are large and developed when the Fed really needs them.  And of course the details will be more complex than what I have outlined.

Of course this is an issue that I am especially interested in, having first presented the idea at the AEA in 1987, and I have since published numerous articles on the topic.  And he’s right that the details are more complex that his short description suggests–it must be set up in a way where the Fed induces the market to forecast the optimal instrument setting, in order to avoid the circularity problem.  Not all proposals did that.  (I’d be curious as to what Garrison, White, Bernanke and Woodford think of Mankiw’s approach.)

A number of economists have discussed futures targeting, including Earl Thompson, David Glasner, Kevin Dowd, Bill Woolsey, and Aaron Jackson.  (I apologize to those I forgot.  Robert Hall developed an analogous idea that would affect money demand, not the money supply.  But John Cochrane is the highest profile economist to endorse futures targeting. Great to have him on board.  I don’t know if he recalled our email conversation, but even if not I might have planted the idea in his subconscious mind.

HT:  Adam P

PS.  Comment responses will continue to lag

Krugman on monetary and fiscal stimulus

Recently I’ve wanted to comment on almost everything Paul Krugman posts.  Here is a recent post where he discusses nominal GDP targeting:

But it would be a big mistake to count on monetary policy alone. The zero lower bound on short rates really does matter, even if longer-term rates are positive. The Fed can control short-term interest rates, it can influence long rates “” there’s a world of difference between those two statements. So it’s not safe to assume that the Fed can, for example, hit any target for nominal GDP that it chooses.

I think Krugman is confusing two issues here:

1.  Can the Fed control actual NGDP perfectly?

2.  Can the Fed create any desired expected rate of NGDP growth?

The answer to the first question is obviously no, due to policy lags.  On the other hand there are no policy lags between changes in monetary policy and changes in expected NGDP growth.  So in the reductio ad absurdum case where the Fed is willing to buy up all the world’s assets, and incur all sorts of price risk, then I think the answer is pretty clearly yes.  And I would add that the answer is yes whether we are talking about internal Fed forecasts, or forecasts from an artificially created and subsidized NGDP futures market, or some sort of hybrid, such as having the Fed use TIPS spreads and estimates of the slope of the SRAS to generate the implied NGDP growth forecasts embedded in the market’s current inflation forecast.

The real question is whether such a policy would be so risky that it would not be politically feasible.  I say no.  If the Fed stops paying interest on reserves, and targets NGDP growth at a much higher rate than currently expected, then the real demand for base money would almost certainly be lower than today, not higher.  When you target expectations, the monetary base becomes endogenous.  So the question is not “How much money do we have to create to raise NGDP growth expectations up to the desired level?”  Rather the question is: “What is the real demand for base money if the Fed does target a much higher NGDP growth rate?”

Krugman is too pessimistic on two different levels.  In other posts he sees the currently bloated monetary base doing little to boost AD, and assumes that a much larger monetary base would be required to generate the appropriate level of nominal spending.  He is an expert on the importance of central bank credibility, but doubts whether the market would find a more aggressive NGDP target to be credible.  But if we target the forecast, then that’s not a problem.  The Fed needs to do whatever it takes to make the policy credible.  There may be some indeterminacy problems here, but they can be circumvented if you let the market forecast the instrument setting that will hit the target.  And level targeting can greatly reduce any indeterminacy.

Krugman is also too pessimistic about long term interest rates.  He wonders whether the Fed can reduce long term rates enough to get the desired nominal growth.  But that is the wrong question to ask.  The real question is “What is the equilibrium long term interest rate if NGDP is expected to grow at the target rate?”  It is very likely that much more rapid expected NGDP growth would be associated with higher nominal long term rates, and there are plausible forward-looking models where even the real long term rate would rise with monetary stimulus (due to higher expected real growth resulting from reflation.)

Krugman might argue that all of my ideas are pie in the sky, and that the Fed won’t be willing to take these sorts of radical steps.  And of course he’d be right.  The longest journey begins with a single step.  I am just trying to get people to think about these issues from a Svenssonian perspective—TARGET THE FORECAST!

Part 2:  Did Keynesian stimulus work in Asia?

Maybe, but how would we know?  Krugman says we know from this table:

In early 2009, the IMF estimated the size of stimulus programs (pdf) in G20 countries:

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Do you see any pattern?  I sure don’t.  I see developing countries that did lots of stimulus, and which recovered quickly (China, Korea) and developing countries that did little stimulus and recovered quickly (India, Brazil.)  I see developed countries that recovered quickly (Australia, Canada) and which did about the same about of stimulus as developed countries that didn’t recover quickly (US, Japan, Britain.)  And I see relatively little difference between the size of stimulus packages in countries that had very different economic outcomes (China, Japan.)
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I suppose Korea would present the best case for stimulus.  But Krugman himself has warned us that you can’t look at fiscal policy in isolation, you also need to consider what was happening to exchange rates.  The Korean won fell from somewhere in the 900s (to the dollar) in early 2008 to somewhere in the 1400s in late 2008.  That’s a pretty massive devaluation for a trading nation.  In 2009 the won partially recovered, as the Korean economy rebounded, but remained far below early 2008 levels.  In contrast, the Japanese yen has actually appreciated against the US dollar during the current recession.  And remember that Japan and Korea are close competitors, both selling products like cars, ships and electronics.  Is it any wonder the Korean economy has done better than the Japanese economy?  Indeed given the dramatically different paths of their exchange rates, I’m surprised the gap in economic performance isn’t even bigger.  Of course the same argument applies to China, which stopped appreciating its currency once the crisis hit.  Given the rapid productivity growth in China (and the Balassa-Samuelson effect) a stable yuan/$ exchange rate is equivalent to depreciation of the yuan.
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It’s also worth mentioning that the sort of stimulus done by China could not possibly have been done in the US, even if we had wanted to.  The Chinese go out and build subways, high speed rail and airports at the drop of the hat.  We’d probably need at least 5 years to get the necessary permits and fight off all the NIMBY lawsuits, maybe 10 years.  We could do tax cuts quickly, and I favored cutting the employer share of the payroll tax in order to overcome wage rigidity, but Krugman argues that those are the sorts of fiscal stimulus that are the least effective.  So there was no prospect of the US following the lead of China, and there is very little evidence that differences in the size of fiscal stimulus packages explain differences in economic performance, particularly when other variables such as exchange rates are brought into the picture.
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BTW, I think the Chinese stimulus did probably boost GDP.  But how much was actual government spending, and how much was regulatory changes making it easier for state-owned banks to make loans to state-owned firms?  They have a very different system.
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PS.  David Beckworth also comments on Krugman.
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Update; 7/26/10:  PSS.  Tyler Cowen has some good observations on automatic stabilizers.

Look! The economy’s sinking! Someone should do something!

Ben Bernanke doesn’t think the economy needs any more monetary stimulus, even though many types of monetary stimulus are essentially costless.  Oddly, however, Bernanke does seem to think we need fiscal stimulus, even though fiscal stimulus is extremely costly, imposing huge dead-weight costs on the economy from future tax increases:

Federal Reserve chief Ben Bernanke told Congress on Thursday that the economy needs continued government stimulus spending to strengthen the recovery and reduce unemployment. But more stimulus spending would be a tough sell with congressional Republicans, who say the first round hasn’t helped enough.

This has never made any sense to me.  In the comment section of a recent post, Andy Harless provided the most plausible explanation that I have seen thus far:

Under today’s circumstances, fiscal policy is more precise than monetary policy. (It’s easy to get a vaguely reasonable estimate of the effect of a fiscal policy move, e.g. extending unemployment benefits, on AD. Much harder to estimate the effect of, say, a $200 billion purchase of 5-year T-notes by the Fed.) I think this is somehow related to the conception that most people seem to have that fiscal policy affects real output and monetary policy affects the price level. I’m not sure exactly how.

The term ‘today’s circumstances’ refers to the current monetary base setting and near-zero interest rates.  Harless is arguing that this fulfills the “other things equal” assumption required to get relatively accurate fiscal stimulus multiplier estimates.  Elsewhere I have criticized that view, noting that Fed signals about future policy intentions (exit strategies, etc) are its most powerful tool.  But as this is a minority view, I’d like to focus on some other issues.

1.  The first thing I’d say is that if the Fed believes it doesn’t have any precise tools to use, then it has no one but itself to blame.  In 1988 or 1989 I presented a paper at the New York Fed advocating the targeting of NGDP futures.  The audience assured me that the Fed already had all the tools it needed to target NGDP, and didn’t need any help from futures markets.  So how’s their interest rate targeting working out now?  Even worse, if you run out of interest rate “ammunition,” you’d presumably want to turn to QE.  Unfortunately the Fed began paying interest on reserves in October 2008, which essentially sterilized the effects of QE.  The Fed is like someone who puts on boxing gloves, and then complains that they are having trouble sewing on a button.  Take off your gloves!

2.  The Fed definitely needs to move toward level targeting, and give up on the inflation targeting approach, which has obviously failed.  Under level targeting the economy is much less likely to overshoot toward high inflation, because commodity speculators will know that if inflation rises above target, tight money will later bring it back down to the target.  Even better, since markets are forward-looking, the mere expectation of future corrective action will make overshooting much less likely (as with a credible currency peg.)

3.  But even if the Fed sticks with inflation targeting, they ought to be able to prevent overshooting.  I think many economists are still over-reacting to a very painful episode in American monetary history, 1965-1981.  As you may recall (if you are an old guy like me), the economics profession was continually surprised by unexpected increases in inflation during that period, as the trend rate rose from about 1% to over 10%.  But there are two very good reasons why that won’t happen today.  Unlike during 1965-81, we have TIPS markets which allow us to measure inflation expectations in real time.  And second, the Fed has a much greater understanding of the risks associated with letting inflation expectations drift to higher levels.

You may ask why I focus on inflation expectations, and not inflation.  After all, market expectations can be wrong.  It turns out that it isn’t just me; the Fed also focuses on inflation expectations.  The reason is that transitory movements in actual inflation, which don’t get embedded into expectations, are not very harmful to the economy.  For instance, inflation might rise temporarily because of an oil shock.  But if inflation expectations don’t rise then the temporary rise in actual inflation won’t become embedded in core inflation and wages (which respond to inflation expectations.)

If inflation starts to creep up to unacceptable levels the Fed can raise rates.  There is nothing equivalent to the zero rate bound on the high side.  And the mere fact that markets know the Fed can do this will tend to keep inflation expectations well anchored.  Of course all of this would be much easier if the Fed came up with an explicit price level, or better yet, an NGDP target.

Since I’ve responded to Harless’s comment, I’ll give him the last word.  In a different post’s comment section he expressed skepticism about whether TIPS spreads can be counted on to accurately measure inflation expectations:

Also, it risks getting whipsawed by changes in risk/liquidity premia associated with TIPS vs. nominal bonds. (I’m guessing this might be an even bigger problem with long-horizon NGDP futures, since my impression is that futures with distant settlement dates usually have low liquidity, and I can’t see a way to do NGDP futures with a settlement date before the actual horizon date.)

Advice on NGDP futures

One of my commenters (John Salvatier) is thinking about using his own money to set up some NGDP contracts on Intrade.  He sent me an email with this information, and asked for suggestions:

Each contract would be based on the BEA final estimate of NGDP for the specified quarter and the quarter two quarters before (i.e. 6 months before). The formula for the contract payout would be
payout = ln(NGDPend/NGDPstart) * periodsInYear * 1000
if payout > 100: payout = 100
if payout < 0: payout = 0.

This specification has the nice property that payout/10 = continuously compounded annual growth rate of NGDP during that period (in %). However, the drawback of this specification is that 2008q4, 2009q1 and 2009q2 would all have had negative payouts so they would have paid out 0 instead, which means  you would have had trouble gauging expected the severity of the downturn.

An alternative specification is

payout = ln(NGDPend/NGDPstart) * periodsInYear * 500 + 50
if payout > 100: payout = 100
if payout < 0: payout = 0

This specification would have had positive payouts even during the most severe phase of the downturn, but it makes the contract prices more difficult to interpret and reduces the variation in contract payouts.

I would have contracts for the 6 month intervals between now and 2.5 years from now. When one contract expired, another one would be started for 2.5 years from now. I would consider using quarterly contracts instead of semi-annual contracts if people thought that was important.

I will be making markets in these contracts, ensuring a small spread. This will effectively subsidize informed traders by giving them the option to trade a little cost. I may do this manually at first, but I hope to be able to build an automated market maker to do this for me.

A few comments:

1.  I strongly favor NGDP futures markets, and thus am obviously happy to see one being set up.  But I fear that without government subsidies, there will be very low volume.  That’s why I favor having the Fed subsidize trading in an NGDP futures market (by paying higher than market rates on the margin accounts.)  Nevertheless, I greatly appreciate John’s willingness to put his money on the line.

2.  I am not an expert on futures markets, so John and I would appreciate any advice on how best to set up the contracts.  We’d like to make them customer friendly, but also able to provide point estimates of expected NGDP growth.  And I believe John’s proposal does that.   I believe there are currently some RGDP contracts that merely involve binary outcomes, such as whether growth will be higher or lower than 3%.

3.  If this is set up I am going to ask all my readers to please consider trading a few contracts.  The price of the contracts are pretty low (I believe $10), and since NGDP is somewhat predictable it’s unlikely you’d lose more than a few dollars on each contract.  Is that too high a price to pay to show solidarity with the entire Money Illusion project?   I will certainly buy some contracts.   If no one trades the contracts I might just go on strike and not post for a while.    🙂

I’ll keep you posted.

Against models: The Good, the Bad, and the Ugly

I got to thinking about macro models while reading a recent Mark Thoma post on the debate between those who defend modern macro models, and those like Krugman and DeLong who wish to move away from highly abstract and unrealistic models (new Keynesian or new classical)  and toward something more realistic.  I’m not quite sure what that is, but I believe they think it would be something that incorporates insights from people like Keynes and Minsky, and something able to deal realistically with policy options at the zero rate bound.

I know this is going to sound arrogant coming from a pipsqueak at Bentley, but I think both sides are wasting their time.  I think we need to move away from macro models, or at least macro models of the type that are the primary subject of dispute.  I can think of at least three types of macro models:

1.  Models that attempt to explain in very simple terms how key macro variables get determined; IS/LM, AS/AD, money supply and demand, loanable funds and interest rates, etc.

2.  Models that try to show the relationship between changes in macro variables like the price level and output, and unobservable changes in the social welfare function (such as the menu cost of inflation, or involuntary unemployment.)

3.  Models that attempt to predict movements in the key macro variables, and make conditional predictions based on various settings of monetary and fiscal policy levers.

The first type of model is fine, as a pedagogical device.  The second are useful in principle, but in practice we mostly go with the gut.  We assume that demand policy probably doesn’t affect the long run rate of real growth, so we try to reduce the amplitude of the business cycle.  We also believe that inflation should be predictable.  Many economists believe that a stable price level minimizes the welfare cost of inflation, almost all believe the optimal inflation rate in the US is between about minus 2% and plus 4%.  We really don’t have any way of showing who’s right, although the answer might depend to some extent how well we deal with the third problem.

The debate is focused on the various structural models of the economy.  What happens if we cut the fed funds rate by 1/2%, or increase the budget deficit by $300 billion?  We expect answers from our models, and the more Keynesian models generally give slightly different answers than the so-called “freshwater” models.

What I find so odd about this debate is that modern macro theory is often assumed to generate some sort of highly technical structural model featuring rational expectations.  But that’s not at all what modern macro theory implies.  Modern macro theory implies that policymakers should get the optimal forecast of the policy goal variables, conditional on various policy settings.  And modern macro theory suggests that the best way to do that is to create and subsidize futures markets that trade contracts linked to variables being targeted by policymakers.  Indeed in the case of monetary policy, money should be convertible into those contracts.  And since the price of those contracts presumably has no zero bound, there is no case for fiscal stabilization policy.

You might object that if we don’t build these models, then the markets will lack the sort of information required to make intelligent forecasts.  I suppose that’s possible, but I have two problems with that argument.  First, there will always be people trying to model the economy, so I’m not worried about that.  I’m not even opposed to having the government fund a couple hundred model-builders at the Fed on the grounds that the information it would provide is a public good.  What I oppose is the Fed actually using the information from their economic research unit.  Let the markets use that information, if they think it’s useful.

Will the markets think it’s useful?  Ask yourself this question:  In the first 10 days of October 2008, when markets rapidly scaled back NGDP growth forecasts as they received extremely bearish reports regarding AD all over the world, and saw the Fed policy seemingly helpless to arrest the decline, which macro model were markets looking at?  Don’t these models usually put in lagged macro data of various sorts, the sort of data that’s reported monthly or quarterly?  What sort of data would have caused such bearish sentiment that stock prices fell 23% in 10 days?  I suppose you could put in market data measured in real time, but if you are going to do that, why not skip the middleman?  Just create a market in the variable you care about, don’t try to infer NGDP growth by putting other real-time market indicators into your model.

So here’s how I see things:

The Good:  Create a NGDP market and stop trying to outguess the markets.  If you don’t like NGDP, create separate price level and RGDP futures markets, and stabilize a weighted average of the two contracts along the desired growth trajectory.

The Bad:  Try to create a structural model of the economy, under the assumption that the public sees the world the way you do.  I.e., if you think X causes Y, don’t assume the public believes that X doesn’t cause Y.  In other words, use consistent expectations (unfortunately these are misleadingly called rational expectations–it has nothing to do with rationality.)  Input data and predict.

The Ugly:  Create a model that assumes you are smarter than the public.  Also assume that monetary policymakers are really dumb, and don’t know how to do policy at the zero bound even though your model says they can do monetary stimulus at the zero bound.  But fiscal policymakers are wise, and free of all political influence.  Once all these assumptions are built in, you are free to indulge your wildest left-wing fantasies.  All the laws of economics go out the window.  No more opportunity costs—build pyramids in the desert, or high speed rail between Tampa and Orlando.  Payroll tax cuts cost jobs, but higher minimum wages actually create jobs.  Protectionism is also great, especially when directed against oriental people people who live in high-saving cultures.

I suppose that in the debate between the bad and the ugly I should support my freshwater alma mater.  But I can’t even get up enough enthusiasm to enter the fray.  Once you start thinking in terms of NGDP futures targeting, everything else seems pretty pointless.

PS.  Don’t tell me markets are irrational.  The point is to stabilize NGDP expectations; according to modern macro theory (Woodford, etc.) unstable expectations of future NGDP causes unstable current NGDP.

Update 5/28/10:  Nick Rowe has a related post on this issue.  I agree with his commenters that there is an important distinction between unconventional forecasts (aka witchcraft) and making conditional forecasts based on alternative policy choices.  But even the latter are inferior to futures markets.  After I did this post I realized that I should not have implied that all policy issues revolve around NGDP—I was thinking of demand-side policies.  It would be considerably harder to set up prediction markets to evaluate supply-side policies, but nevertheless there is no reason in principle that it couldn’t be done.  Interested readers should look at Robin Hanson’s work on “futarchy.”