Should the Fed engage in insider trading? Maybe.

Earlier I argued for Lars Svensson’s definition of policy efficiency, equate the policy forecast and the policy target.  (Bernanke sort of endorses Svensson’s idea here.)  In other words, if your goal is 5% growth in nominal GDP, then increase the money supply until nominal growth is expected to be roughly 5%.  But what if conventional monetary policy has run out of ammunition, if buying ever more zero yield T-bills has no effect?

Some are now advocating unconventional open market purchases, involving long term bonds, stocks, and Hamilton even suggested foreign bonds.  If the policy of reflation succeeds then long term T-bond prices might fall, but stocks and foreign bonds might well appreciate in value.  This is important because bank reserves have risen to more than 10 times their normal level, and it is widely expected that the Fed will have to sell some assets to rein in the monetary base once we escape from the “liquidity trap.”

This raises an interesting question:  Would Fed purchases of stocks or foreign bonds constitute insider trading?  And should the Fed engage in insider trading?  Here’s a suggestion.  First, the Fed should announce a nominal GDP (or CPI) growth target, and indicate that they will keep buying up all sorts of assets until expected GDP growth rises to acceptable levels.  Then see how the various financial markets respond to this announcement.  If the Fed promise is credible, inflationary expectations will rise immediately.  Stocks and risky bonds may appreciate sharply, T-bonds will fall in value.  If the market response is powerful enough to push us away from the zero interest rate bound, then conventional monetary policy can resume. When looking to do safe trading, consider reading this blog about trade fx.

But what if investors don’t find the Fed’s promise credible?  Then the Fed should punish those markets ruthlessly by buying up assets that will appreciate when the Fed carries out it’s policy of reflation (i.e stocks, foreign bonds, etc.)  The Fed has valuable inside information–they know just how determined they are, even if the markets do not.  But there’s nothing unjust about this–markets would have been given fair warning.

My proposal is not motivate by spite.  I have nothing against the speculative markets.  Rather, it offers two very pragmatic advantages.  First, it reduces the net national debt, and thus the future tax liabilities of the public.  Of course this is also an argument for using monetary stimulus rather than fiscal stimulus.  Second, in the future speculators will think twice before dismissing the Fed’s announced policy intentions.  And credibility is a very valuable asset for central banks, it makes it much easier to implement monetary policy.

In 1981, some suggested that if the federal government was really serious about reducing inflation, they should stop issuing 30 year bonds at yields of 15%.  Treasury officials countered that it would be unwise to rely on short term borrowing.  They made a costly mistake.

P.S.  One might view this as an amusing thought experiment, rather than a serious policy analysis.  I would agree that that in the unlikely event the FOMC read my blog and became determined to implement my proposal, it is very unlikely that they would be able to keep that determination secret from the markets.  The beauty of the proposal is that the public benefits either way.

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This entry was posted on February 05th, 2009 and is filed under Efficient markets hypothesis, Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.