Market mimicking monetary policy
By Scott Sumner
My preferred monetary policy would involve stabilizing the price of NGDP futures contracts. Under this regime, important variables such as the money supply and interest rates would be determined by the market, set at a level that the market expected would lead to on-target growth in NGDP.
This sort of regime is not likely to be adopted in the near future, and thus I’ve also recommended a long series of incremental policy reforms that are more politically feasible. These include:
1. A more nimble process for adjusting the policy instrument.
2. A “whatever it takes” approach to setting the policy instrument.
3. Targeting the market forecast.
4. Level targeting.
As I look back on all these posts, I see a pattern. My “pragmatic” suggestions represent an attempt to mimic the performance of a market-based regime, under the existing (discretionary) regime. I.e., sort of like when the Singapore government instructs (state-owned) Singapore Airlines to “run yourself like a private company”.
1. I’ve recommended that the target interest rate be adjusted daily to the nearest basis point, set at the median vote of the voting FOMC members (which might be emailed in to the Fed each day.) Thus on any given day, rates would be equally likely to go up or down. This is very different from the current regime, where adjustments are made by at least 25 basis points, at six week or longer intervals, with a presumption that the next change is likely to be in a certain direction. My proposal is closer to how real world asset prices move, closer to a random walk. More importantly, my proposal is closer to how the interest rate would move under an NGDP futures targeting regime.
2. When economic or financial conditions change dramatically, the Fed tends to move more slowly than the markets. Thus if the natural rate of interest declines, the Fed is likely to cut rates, but not as fast as the fall in the natural rate. I favor a “whatever it takes” approach, where the rate is always moved aggressively enough so that policy goal is expected to remain on target. When interest rates are at zero, I favor a QE program that is aggressive enough to insure that policy remains effective, even if it means buying up the entire world. (And there are worse things that owning the whole world!) Some might point to the danger of hyperinflation, but if that’s actually a risk then you don’t have a demand shortfall problem; you don’t need stimulus.
Again, this is how markets behave. When new information causes an equilibrium asset price to move sharply, market prices immediately move as far as necessary to restore equilibrium, not in a series of small quarter point moves, spaced out over time.
3. I’ve advocated that the policy instrument be set at a position where the market forecast of growth in the policy goal variable (say NGDP) was equal to the target. Here the market analogy is a bit weaker, as markets don’t have policy targets. Nonetheless, this policy idea is consistent with the spirit of efficient markets, where prices reflect the wisdom of crowds. Thus if the 2-year forward fed funds futures is trading at 97.8 (par value 100), that can be seen as a market forecast that the actual fed funds rate will be roughly 2.2% in early 2021. Current asset prices reflect the collective wisdom of traders regarding futures cash flows, interest rates, among other variables. My “target the forecast” idea relies on the wisdom of crowds in a very similar fashion.
4. There is no exact market equivalent to “level targeting”, as markets don’t target variables. However, as with level targeting of the price level or NGDP, efficient markets do not engage in “let bygones be bygones” when mistakes are made. Thus if a certain stock ends the day trading at $47, and unexpectedly bad news comes out an hour later, it will immediately become clear that the market made a mistake. Traders do not simply ignore this mistake; they try to correct it on the following day by moving the stock price to the appropriate level. Traders don’t focus on the appropriate rate of change in stock prices, it’s about returning the price to the equilibrium level, after forecasting mistakes cause a temporary deviation from that equilibrium.
Similarly, under level targeting, a deviation of the price level or NGDP from the target path calls for a later adjustment to bring it back to the pre-determined trend line.
All four ideas in this post have been discussed in previous posts, but I think it’s important to stand back and see how they are all part of a pattern. If I were invited to the Fed’s June conference on monetary policy reform ideas, I would not waste time advocating NGDP targeting. I have very little new to offer there, as the advantages of NGDP targeting are increasingly well understood. Instead I’d explain why Fed policy should continue to move in the direction of mimicking a market-based process. If I have anything both useful and novel to offer, then it is in this area.