Why NGDP Targeting Won’t Work in Reality

Congratulations to Scott Sumner on his new career and fund raising for a NGDP futures market. It looks like his dream of NGDP targeting could really come to fruition at some point. That’s a good thing because it means we might actually get to see whether there’s some real world effect behind all the theoretical talk.

While I try to be open-minded about the efficacy of monetary policy (I am most certainly not against the use of monetary policy) I also am not convinced that NGDP targeting is the cure to our economic problems. For instance, here’s a comment from Sumner that makes me wonder just how realistic all of this is:

“Most people correctly understand that the zero bound is bad news for monetary stimulus, but they don’t know why. They think it’s because monetary stimulus works through lowering interest rates, and nominal rates cannot be cut significantly below zero. In fact, monetary stimulus is easy to do at the zero bound, just peg NGDP futures contracts at a price 5% above current NGDP and your policy will be expected to succeed. In all likelihood no QE will be needed.”

I don’t think that’s really correct. Most people who are critics of NGDP targeting don’t see the transmission mechanism. Of course, Market Monetarists will say that the transmission mechanism is expectations – the Fed doesn’t even need to do anything if it sets expectations properly. That is, the Fed doesn’t have to fire a bazooka if you expect it to fire the bazooka – markets will react before the Fed even has to do anything. The problem is, the Fed doesn’t really have a bazooka. It has a bunch of AK-47s, which are fun to shoot and effective to some minor degree, but they’re not a bazooka.

The problem is multifaceted.  First, there are very real limitations as to what a Central Bank can buy.  According to Section 14.1 of the Federal Reserve Act the Fed can purchase:

• Gold
• US Government Treasury Debt
• Agency Debt
• Bankers Acceptances and bills of exchange.
• State and municipal debt (limited to terms of 6 months)
• Foreign debt (limited to a term of 6 months)
• Foreign currency overnight deposits.

Section 13.3 gives the Fed the ability to lend to individuals and corporations based on collateral it deems appropriate under “unusual and exigent circumstances” (such as the financial crisis).

Theoretically, there is a lot of room for the Fed to engage in the markets. The aforementioned assets amount to over $30 trillion and potentially more if you think the Fed would just lend at will and buy foreign currency at will.  But how realistic is all this?  Not very.  In reality the Fed is just not going to buy up all of the world’s financial assets. There’s been some hesitancy by Fed members about buying even a fraction of the potential assets. The markets know that there’s no situation in which the Fed would just buy anything and everything. It’s just not a politically feasible action. But that’s not the main problem.

The main problem is that even if the Fed’s bazooka worked then the cure becomes the disease.  That is, if markets expect NGDP targeting to work then they would anticipate that any Fed actions would actually lead to the very growth/inflation that results in Fed tightening. There is no such thing as convincing the markets that anything is permanent – traders just won’t buy it because they are too risk averse. So, expectations of higher NGDP must naturally lead to expectations of tighter Fed policy which could lead to lower NGDP expectations.*

And none of this even touches on the actual transmission mechanism to begin with. If all this asset swapping isn’t that impactful to begin with, then expectations shouldn’t change much anyhow.  And if the transmission mechanism isn’t believed to be effective then the whole concept of expectations works in theory, but doesn’t matter much in reality.

Here’s to hoping we get to see this policy in action. I’d love to think it works, but I am still very much in doubt….

* The point being, if the Fed hits a 6% NGDP target for instance, and there’s 6% inflation then it’s highly unrealistic to assume that the Fed or other policy makers won’t be pressured to do something that reduces the RGDP. The markets will begin to expect policymakers to react to the fact that all of the growth is nominal….

** None of this touches on the operational flaw in NGDP Futures which would be ripe for manipulation in the market as explained by Mike Sankowski.