Bretton Woods as a "guardrails" approach to monetary policy
By Scott Sumner
I now favor a monetary policy rule that I have dubbed the “guardrails” approach, although a more accurate metaphor might refer to the beeper you hear if you are about to hit a car in the front or rear when parallel parking. Under this approach, the Fed would offer to sell unlimited NGDP futures contracts at a price featuring 5% growth, and also offer to buy unlimited NGDP futures contracts at a price featuring 3% NGDP growth. Someone expecting more than 5% NGDP growth would buy these contracts from the Fed, and profit if growth did indeed exceed 5%. A bearish investor would sell 3% NGDP futures contracts to the Fed, anticipating sub-3% growth.
Because this is an unfamiliar concept, I’d like to compare it to the Bretton Woods regime. Under that system, central banks promised to keep the foreign exchange value of their currencies within a band of plus or minus 1% around the official par value.
To make things simple, let’s suppose the Canadian dollar had been pegged to the US dollar at one for one. Then the Bank of Canada (or their Treasury) would promise to sell unlimited US dollars at a price of $1.01 Canadian, or buy unlimited US dollars at a price of $0.99 Canadian. As long as the actual exchange rate was within the band, traders would have no incentive to buy and sell US dollars with the Canadian government. But the plus or minus 1% exchange rate band would provide “guardrails” or limits on the amount of exchange rate volatility that the Canadian government would tolerate.
Now let’s compare the two approaches, Bretton Woods and NGDP futures guardrails:
1. Under both systems, the central bank would be completely free to conduct discretionary monetary policy as they saw appropriate, as long as they adhered to their promise to buy and sell their currencies at the specified guardrails. Despite this flexibility, these are clearly rules-based approaches, which put important limits in discretionary policy. (Just as the US government promise to buy dollars at $20.67/oz. allowed some flexibility, but also put clear limits on discretionary monetary policy during the 1920s.)
2. Under both regimes the system can be “calibrated” to become either more discretionary or more rules based by widening or narrowing the width of the guardrails.
3. The Bretton Woods regime can be regarded as a wager that the Canadian economy would perform best if the exchange rate were kept roughly stable vis-a-vis the US dollar. My guardrails proposal is a wager than the US economy would perform best if NGDP futures prices remained close to a 4% growth target. That wager has two components; the assumption that 4% NGDP growth expectations are desirable, and the assumption that the market price of NGDP growth contracts is close to the market expectation of NGDP growth.
4. Neither system requires the central bank to do anything, unless asked to by the public. Thus the Fed would not have to set up a NGDP futures market, and it would not matter at all if no such market existed. The Fed would not have to watch for fluctuations in NGDP futures prices. They could simply sit back and wait for traders to approach them with offers to buy and sell NGDP futures contracts at the specified price.
5. Both regimes expose the central bank to investment risk, but only if they allow the future value of their target to move outside the guardrails. Thus if the Canadian dollar were to fall to below 99 cents, the Canadian government would suffer losses on the Canadian dollars they had purchased to prop up the exchange rate. If the future level of NGDP fell below 3% growth, then the Fed would lose money on its purchases of 3% NGDP contracts.
6. Neither regime is susceptible to the zero bound problem. The Swiss recently pegged their currency to the euro for a period of over three years, despite being hard up against the zero bound (actually negative rates.) They could have chosen to do so for much longer. At the time, speculators were also buying the Danish krone, and Tyler Cowen suggested that Denmark would provide a good test of the claim that the Swiss were somehow “forced” to revalue. Of course the Danes did not revalue, despite also being at the zero bound, and the Swiss could have also avoided revaluation if they had chosen to. Indeed the Swiss probably erred in revaluing their currency upward, which will make the zero bound problem in Switzerland even more deeply entrenched.
PS. About the guardrails vs. beeper metaphors. My proposal can be seen as like a car beeper in the sense that the “driver” (i.e. the Fed) is free to ignore the warning if he thinks the computer (i.e. market) is not accurate.
On the other hand it can be seen as a guardrail in the sense that it commits the Fed to keep the market price of NGDP futures contracts within the 3% to 5% growth range.