Wednesday, August 31, 2011

A Sharp Expectation Shock is Needed

Via the FT's Alphaville we learn that Goldman Sachs is discussing some "radical" options the Fed could use if economic conditions deteriorate further. One of the options discussed is a nominal GDP level target. It would be a radical change from way the Fed currently operates, but such a shock is exactly what the public now needs.  For the past few years the economic outlook of households and firms has been dismal and consequently they have had been accumulating a large stock of money assets.  If the Fed were to announce a nominal GDP level target it would provide a big expectation shock that would reverse much of this buildup.  

One of the ways this shock would play out is through the many more observers who would be wailing about the reckless course of monetary policy, the horrors of debasing the dollar, the end of Western Civilization, and other hard money concerns.  Similar concerns were raised when FDR effectively did the same thing in 1933 with his own QE and price level target program.  These concerns about FDR's program provided a much needed shock to nominal spending and inflation expectations.  As a result, there was robust recovery from 1933 to 1936.   A nominal GDP level target would provide the same kind of shock today if it were properly signaled and followed through by the Fed.

It would require the Fed to buy up assets until the nominal GDP level target was reached. In other words, the Fed would be committing if needed to a permanent increase in the monetary base, something it has yet to do as recently noted by Michael Woodford.  The effectiveness of such a shock would not be contingent on increased financial intermediation (though it ultimately would be affected too). Rather, this shock would work two ways. First, by raising inflation expectations, it would increase the cost of holding money assets for the non-bank public. This would create a hot-potato effect for non-bank holders of money assets and that, in turn, would lead to a mother-of-all portfolio rebalancings. Ultimately, this rebalancing would end with higher nominal spending. Second, it would simultaneously cause nominal spending forecasts to rise and this too would lead to more current nominal spending. Given the large slack in the economy, the increase in nominal spending would mean a rise in real economic activity.

But enough from me. Here is what Goldman Sachs has to say about nominal GDP targeting:
[W]e have again received some questions about the possibility that the FOMC might move to a nominal GDP target ... It’s important to note that depending on the interpretation, the Fed’s dual mandate (in which policy responds to both employment/real GDP and inflation) already has some similarities with a nominal GDP target (in which policy responds to the product of real GDP and the price level). The key differences are that (1) an announced nominal GDP target is much simpler and therefore more powerful than the hazier dual mandate, which is interpreted differently by different people; and more importantly, (2) the dual mandate is defined in terms of rate of change of prices, while a nominal GDP target depends on the level of prices. ...The implication is that a nominal GDP target, Fed officials attempt to “make up” for past undershooting of inflation via future overshooting. In other words, a move to a nominal GDP target is tantamount to a temporary increase in the inflation target.
I am glad to see Goldman Sachs telling its clients about nominal GDP targeting.  The fact that nominal GDP targeting is now being discussed by Goldman Sachs, The Economist, The Financial Times, The Wall Street Journal, The Telegraph, The National Review, and other media outlets means this idea is gaining traction. The public needs a sharp expectation shock and a nominal GDP level target is radical enough to do it.


  1. I'm reading Selgin's Theory right now which boils down a basic question: How does a central bank decide how fast it should grow the money supply? It has to speculate, just as an entrepreneur does, about future prices and such.
    It seems to me that a level target is still inferior to a futures target, since at the FOMC meeting the data would still be backward-looking. The Fed can know that it didn't grow the money supply fast enough, but still has to guess about the future.

    Which makes me think we'll always get sub-optimal policy without targeting a futures price, be it TIPS spread or currently non-existent NGDP futures. I know the goal of the level target would be to convince the market about what the level would be going forward. But how does the Fed know the market is convinced without some specific futures price to monitor?

  2. Yes, I agree with the idea of a positive shock. Back to older time, when confidence was well stablished, is nor easy. But only when confidence will be restablished the demand for money would be normal and stable.
    For me the most important is to rise inflation expectative, that is the key to acelerate the deleveraging process. This process is not short, so we need some years of nomibal growth above normal rate.

  3. I understand Woodford's point about committing to a higher level of base money, but I think it is wrongheaded.

    I think that if the Fed cut base money by 60% over the next month, and then committed to keeping it at that low level, it would be expansionary.

    In fact, I support quantitative easing, but there should be no suggesting that the resulting increase in base money is permanent.

    As you write elsewhere, the Fed should commit to increasing base money whatever amount is needed for NGDP to be on an explicit growth path target, _and_ it should commit to decreasing it however much is needed to get it back down to that target if it overshoots.

    It is almost certainly the case that staying on a target for a growth path of NGDP would require substantial decreases in the quantity of base money over the next 5 years--not only from some hypothetical higher level resulting from QE3, but from the current level.

    Further, it is possible, and even likely, that this reversal in the quantity of base money would need to occur very soon, even before any QE3 were to occur.

    The Fed's approach with QE2, of making a committment to buy $600 billion of longer term bonds, was the wrong approach.

    Similarly, its talk about keeping short term interest rates at .25% for the next 2 years was a mistake.

    It should committ to having NGDP being $16.5 trillion, (or $18.5 trillion.) It might be helpul if they made it clear that they wouldn't bat an eye if that mean a base money of 4 trillion (25% of that NGDP,) and had some idea of what kind of assets they would buy. But they shouldn't commit to keeping base money at $4 trillion for any particular lenth of time.

    Similarly, they should say that if long treasuries have yeilds of .01%, then they will accept that. Negative T-bill yields.. might happen across a variety of maturities. But they should promise to keep them there over any time horizon. The only promise is that NGDP will be at some level next year. (or 2 years from now.) Interest rates and base money? Could be higher, lower, we don't know.

  4. JDTapp,

    Yes, it would be better if we had a NGDP futures market. We have to start somewhere though.

  5. Bill,

    I don't think Woodford meant that all of the increase in the monetary base should be permanent, only that some of if should be. He is for a price level target after all.

    I think his point is that if the public knows that in the future most of the base created will be pulled out like with Japan then there will be no permanent increase in the price level. On the other hand, knowing that the Fed will allow some of the base to be permanent (and assuming it eventually lowers its IOR), would mean the price level would eventually rise and thus raise inflation expectations today.

  6. Excellent blog. I think Beckworth also contributed to the public's increasing acceptance of NGDP and QE.

  7. There is no evidence that the fed can achieve a targeted level of NGDP. There is no evidence that if the fed achieves this target it will restore the economy to health rather than destabilize it.

    Under the current microeconomic policy mix, there is less slack in the economy than many economists think.

    This is not the 1930s. The fed has much less influence over money, banking and economic activity.

  8. This (admittedly unsourced) chart of corporate profits to gdp is interesting. 1932 was the trough historical level; 2011 is the peak. Real investment then was profit constrained. The 1933 expectations shock had the effect of lifting both profits and investment. Today, real investment is "future demand" constrained. The implication is that an expectations shock must "transmit" through household income expectations (rather than profit growth) to be effective.