No Need For NGDP Futures, We Have Market-Based Monetary Policy Already

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The "nominal GDP futures targeting regime" proposal has once again popped up in internet discussion. I have previously avoided the topic, as nominal GDP futures ("NGDP futures") targeting is an inherently silly idea. The only usefulness of the topic is that it allows us to examine the chain of errors that leads to the recommendation.

The justification for nominal GDP futures is that the markets help set monetary policy -- which is exactly the situation right now. Which means that the reason for creating these futures in the first place is flawed; the fact that they cannot be implemented is just icing on the cake. This article discusses the issue of the interaction of markets with central bank policy, and does not attempt to delve into the explanation why nominal GDP futures markets would be useless for policymakers.

(The discussion in this article may raise eyebrows amongst my post-Keynesian readers, and it may appear to contradict what I have written elsewhere. The explanation for this is found later in the article; whether interest rate policy is truly market-based depends upon your stance regarding the debate about the effectiveness of interest rates in steering the economy. I am officially neutral on that debate.)

Background

For readers who are interested in nominal GDP futures, I would suggest the following articles.

My view is straightforward: even if we wave a magic wand to make all of the technical issues highlighted by Michael Sankowski go away (spoiler: we can't), NGDP futures would still not work. No market structure which is tied to policy setting is going to generate useful information for policymakers, and the means to link the futures to monetary policy appears questionable.

Unless my readers want the painful details of why this is the case, I am going to skip to what I view as the interesting bits.

Market-Based Monetary Policy?

The entire premise of NGDP futures is that we need to get markets to set policy. A 2013 paper by Scott Sumner (which he cites in his article above) starts with:

In recent decades, there has been a worldwide shift toward market-driven economic policies, including privatization, deregulation of market access, bandwidth auctioning, congestion pricing, and tradable pollution permits. Yet monetary policy has been relatively unaffected by the "neoliberal revolution." Governments have retained a monopoly in the production of fiat money, the setting of policy targets, and the implementation of monetary policy.

Unfortunately, that is a rather poor characterisation of how monetary policy works. Under normal circumstances, monetary policy is affected by interest rates, which drive the economy purely in a market-based fashion.

The only exception to this was the failed attempt by Monetarists to centrally control the level of money in the economy. Luckily, the free markets prevailed, and red-blooded capitalist financial institutions adapted their behaviour to frustrate that attempt to Sovietise credit creation.

Whenever someone walks into a bank to get a mortgage or business loan, they will be faced with a banker with quote sheets for interest rates on a wide variety of loan structures. Those bank interest rates are entirely priced off of market-based interest rates. The attractiveness of those interest rates will influence decisions that drive the economy. (Under the assumption that interest rates have a measurable effect on economic activity, of course.)

Err, What About The Central Bank?

The fact that a committee of government bureaucrats sets a policy interest rate appears to contradict this rosy pure free market Eden. In my view, this is not really an issue. Just because interest rates are market-based does not imply that they will trade where any particular investor wants them to be (such as self-described loudmouth "bond vigilantes" on financial television).

I will address this in two parts: firstly the question of open market operations, and secondly, the setting of the policy rate.

Open Market Operations: Should Be Market-Based

The central bank transacts in the fixed income markets as part of its normal operations (except for the case of an overdraft economy). These open market operations change the size of the central bank's balance sheet. These open market operations attract a lot of mysticism, because the central bank's balance sheet size is roughly the monetary base (ignoring some items, such as government deposits at the central bank). Since this is one of the "money supply" numbers, clear thinking goes out the window. (This inability to discuss "money" clearly within economics is the central theme of my next book: Abolish Money (From Economics)!".)

If we have a sensible financial system in which there are no bank reserve requirements, the monetary base is equal to currency in circulation. This is the basis of what I refer to as the "Simplified Framework of Government Finance" (link to article which was incorporated into Understanding Government Finance). The Simplified Framework is a good approximation of the normal operation of the modern Canadian financial system.

The amount of currency (notes and coins) in circulation is purely a decision of households and businesses. There is very little government policy can do to affect it (other than cracking down on the underground economy), although there is long-term correlation with nominal incomes. (This is chalked up to either "money neutrality" or a stock-flow norm; a debate I will discuss in the upcoming book.)

Within this system, the only open market operations that the central bank must do is to buy government bonds in exchange for demands for currency from private banks (who then distribute it to the rest of the private sector). Some operations may be needed to keep short-term rates near a policy rate, but the assumption is that these operations do not affect the size of the central bank's balance sheet. (I return to the policy rate below.)

Unlike the central planners of Monetarism, or the brain trust that is behind Quantitative Easing, a central bank within the Simplified Framework leaves its balance sheet size to be determined by the needs of the private sector for currency.

If we mistakenly insist on banks holding reserves, the picture is only slightly more complicated. The central bank needs to engage in extra operations to create new required reserves. However, the magnitude of these operations should be entirely guided by market signals. (For example, is the traded rate for fed funds greater than target? If so, add reserves.)

It is only when policymakers do something that is blatantly stupid (for example, quantitative easing), that they have to think about the magnitude of open market operations. (In any event, the complete lack of impact of Quantitative Easing on the economy tells us that these operations do not matter a great deal.)

The Policy Rate -- Planned, Or Not?

Obviously, a committee of government bureaucrats sets the overnight rate. (This is normally unchanged until the next policy meeting, so you might think of it as a six-week rate, so long as you embed an emergency rate cut/hike option into that six-week rate.)

The question is: how do they set it?

If we take the pre-Financial Crisis mainstream economic consensus at face value, the central bank is following an inflation target. The policy rate needs to follow the dictates of a "reaction function" which keeps the inflation rate near target. The central bank has some leeway in the parameters of its reaction function, but once it is picked, rates are determined by the conditions of the markets within the economy. That is, it is market determined, as the markets have set whether the economy is above or below potential, and the current set of inflation expectations, etc.

An alternative (mainstream) way of looking at the above argument is that the market determines the real interest rate; the nominal interest rate is indeterminate. The government sets the inflation rate by policy, and nominal rates have to end up where they are by the assumed action of the Fisher effect. Forcing the government to keep the price level (or gold price level) stable is exactly what free market zealots have been screaming about for decades.

We can easily argue that real world is complicated; there are various qualitative factors that affect the reaction function. This is not particularly novel; qualitative factors always influence behaviour. The desire pursue virtual monsters on cell phones is probably going to damage productivity growth over the next few months; it would be hard to quantitatively model a "chasing virtual monsters" factor into a DSGE model.

It is no secret that I do not take the pre-Financial mainstream economic consensus at face value. For skeptics like myself, there are two options to pick from.

  1. Monetary policy roughly acts in the same way that the economic consensus believes. (Higher rates slow the economy; lower rates boost economic growth.) If the policy committee sets the overnight rate at the "wrong" level, interest rate market participants can signal the error by moving the yield curve. For example, if the policy rate is "too low," the curve would steepen, which raises term rates for borrowers in the real economy. The market action tightens financial conditions, which means that the interest rates that matter are not fully affected by the policy rate mistake. If the central bank is indeed wrong, it will later miss its inflation objective, and will have to follow the path of pricing indicated by the forward curve.
  2. Monetary policy is ineffective in controlling the economy. In this case, who cares where they set the rate of interest?

In other words, if you think interest rates matter, they will have to end up close to where the market is supposed to have put them in the first place. Given that the credit and equity markets can misprice assets for years, industrial capitalism can survive a mispricing of the overnight interbank rate for six weeks.

If you are skeptical about the importance of interest rates (such as many MMT'ers), yes, the central bank has considerable latitude to determine where interest rates are set.

Throwing Out Market Information

My discussion here is somewhat idealistic; I assume that central bankers pay attention to market signals about interest rates. This ignores the reality that a spectacular amount of mathematical work has been undertaken to obliterate the information that is easily extracted from market prices.

On the analytical side, half-baked affine term structure models are used to explain that most yield movements are the result of term or inflation-risk premia. "Sure, breakeven inflation rates have collapsed, but that does not mean that we are making a policy error -- that is just inflation risk premia moving!"

Meanwhile, we have been treated to the spectacle of hawkish central bankers showing off their inability to forecast inflation by lecturing bond market participants that they are setting forward rates too low (for about six years in a row).

The obvious solution is to force a return to a culture of secrecy and opacity at the central bank; all the Federal Reserve System should have is a two sentence policy statement (one for Fed Funds, one for the discount rate).

Advantages Versus NGDP Futures

Circling back to NGDP futures, the current framework has two huge advantages versus them.

  1. There are extremely deep and liquid yield curves that provide strong signals to policymakers where they should set the policy rate. (When is the last time that the Fed set a rate that was wildly different from where Fed Funds futures were trading, not counting emergency rate cuts? All the argle-bargle by policymakers could just be a sham; they could just look at the Fed Funds futures strip and then get some interns to make up stuff for the policy statement and minutes.)
  2. The forward rate curve provides guidance in exactly the form needed to set the policy rate. There is no need to translate the market signal into new units. (If the NGDP futures market transacts 100 contracts at an implied growth rate 0.5% below target, what does that imply about changes to the stance of monetary policy?)

The fact that there would be no useful market signals provided by NGDP futures was implied by Michael Sankowski's critique, but it could be extended to any conceivable market framework. There is no way the Fed would get useful information from any market based on predicting nominal GDP, it it were tied to monetary policy in the manner that Sumner suggests.

The second issue -- that the units of NGDP futures are mismatched versus policy instruments -- is what I find most interesting about this topic. Scott Sumner's discussion of how monetary policy would be affected by NGDP futures is yet another example of why money needs to be abolished from economic theory. (I hope to discuss that topic within my book.)