Targeting the Forecast

Over at Cato Unbound, Scott Sumner is leading a discussion on the conduct of monetary policy during this crisis. True to form, he is arguing the Fed was effectively too tight in the second half of 2008 and, as a result, caused aggregate demand to collapse during that time. He also makes the case that the nominal spending collapse of 2008 could have been avoided if the Fed had been targeting the forecast. His argument for targeting the forecast is posted below. Jim Hamilton, George Selgin, and Jeffrey Hummel are scheduled to reply to Sumner's lead article.

Lars Svensson has advocated a policy of targeting the forecast — setting the central bank’s policy instrument at the level most likely to hit its policy goal. Thus, if a central bank had a goal of two-percent inflation, it should set the fed funds rate at a level where its own forecasters were forecasting two-percent inflation. Once one starts to think of monetary policy this way, any other policy seems unacceptable. After all, why would any central bank ever want to adopt a policy stance that was expected to fail.

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I have advocated a policy where the Fed pegs the price of a 12-month forward NGDP futures contract and lets purchases and sales of that contract lead to parallel open market operations. In essence, this would mean letting the market determine the monetary base and the level of interest rates expected to lead to five-percent NGDP growth. When I first proposed this idea in the 1980s, I envisioned the advantage in terms of traders observing local demand shocks before the central bank. The logic behind this idea is often called “the wisdom of the crowds.” But I no longer see this as its primary advantage. Although last fall the market forecast turned out to be far more accurate than the Fed’s forecast, in general the Fed forecasts pretty well.

This crisis has dramatized two other advantages to futures targeting, each far more important that the “efficient markets” argument. One advantage is that the central bank would no longer have to choose a policy instrument. Their preferred instrument, the fed funds rate, proved entirely inadequate once nominal rates hit zero. Under futures targeting each trader could look at their favorite policy indicator, and use whatever structural model of the economy they preferred. A few years ago I published this idea under the title “Let a Thousand Models Bloom.” I am not an “Austrian” economist, but this proposal is very Austrian in spirit. (And my preferred policy target, NGDP, is also the nominal aggregate that Hayek thought was most informative.)

Only last fall did I realize that there was another, even more powerful advantage of futures targeting-credibility. The same people forecasting the effects of monetary policy would also be those setting monetary policy. Under the current regime, the Fed sets policy and the market forecasts the effects of policy. To consider why this is so important, consider the Fed’s current dilemma. They have already pumped a lot of money into the economy, but prices have fallen over the past year as base velocity plummeted. Certainly if they pumped trillions more into the money supply at some point expectations would turn around. But when this occurred, velocity might increase as well, and that same monetary base could suddenly become highly inflationary. This problem does not occur under a futures targeting regime. Rather, the market forecasts the money supply required to hit the Fed’s policy goal, under the assumption that they will hit that goal. Today we have no idea how much money is needed, because the current level of velocity reflects the (quite rational) assumption that policy will fail to boost NGDP at the desired rate.

I especially look forward to Selgin's reply since he too is an advocate of nominal income targeting.