If I knew the answer to that question . . .
By Scott Sumner
I can’t find the quote, but I recall reading that Milton Friedman was once asked about his plan for school vouchers. The reporter wanted to know how the education provided by voucher schools would differ from the education provided by public schools. Friedman relied something to the effect (my words, not his) “If I knew the answer to that question I would not favor school vouchers, I’d instruct public schools to provide that sort of education.” (Hopefully, the anecdote is not apocryphal.)
People sometimes ask me where the Fed should set interest rates. I’m tempted to respond, “If I knew the answer I wouldn’t be a market monetarist, I’d be a new Keynesian.” I suppose this requires a bit of explanation:
1. I believe that monetary policy is most effective when markets set interest rates. The appropriate interest rate can change quite rapidly during a period of turmoil. The Fed should set policy at a level where markets expect roughly 4% NGDP growth. Whatever interest rate results from that policy is appropriate. Whatever price of zinc results from the policy is also appropriate.
2. There are times when I’ve argued that monetary policy is too easy or too tight. But even then I don’t have strong opinions on interest rates. An easier monetary policy might result in lower interest rates (Keynesian effect) or higher interest rates (Fisher effect.)
3. The Fed does (foolishly) use interest rates as a policy instrument, and also a signaling device. In most cases, a sudden and unexpected increase in interest rates represents a tightening of monetary policy relative to a day earlier. But it does not necessarily represent a tightening of policy relative to a month earlier, even if the target rate previously had not changed for several months. This is very hard for most people to grasp.
4. During the Great Recession, policy was clearly too tight. Today, policy seems roughly on target, so I have no opinion on how the Fed should adjust its interest rate target today.
More broadly, market monetarism is not a method for determining where interest rates should be set, it’s a method for discovering where other people (the market consensus) think interest rates need to be set in order keep the macroeconomy stable.
Most importantly, the Fed urgently needs to set up and subsidize a highly liquid NGDP futures market. I am currently not anticipating a recession in the next couple of years, but the risk seems to be increasing. It’s imperative that the Fed stops “flying blind”. Congress should immediately authorize funding for a highly liquid NGDP futures market. Something on the order of $20 million/year would be more than adequate, but the more the better. The subsidy could take the form of above market interest paid on the margin accounts of the NGDP futures traders.
In the future, economists will look back on the current lack of a highly liquid NGDP market in utter disbelief. Like, why would you not care to learn the market forecast?
Here’s are some recent Hypermind NGDP prediction markets. Divide by 10 to get the expected growth rate for NGDP: