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 supposed 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….

About

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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BenoitEssiambre
2 years 2 months ago

I’m not totally sold on NGDP targets either but don’t forget that Sumner is advocating for an ngdp *level* target. The expectations channel works better with level targets where central banks promise to do some catching up if they fail to meet their targets.

If people think that their central bank could regain price control through conventional means such as interest rates within some horizon and that when it does so, it will push prices up aggressively to catch up, people, businesses and banks will be less likely to stockpile cash that risks being devalued sooner or later. This pushes prices up immediately.

That is all you need for the expectations channel to work.

Guest
2 years 2 months ago

I understand that, but what is the transmission mechanism by which this occurs? The Fed says it’s going to do “whatever it takes” and then you run out and buy more goods and services in anticipation? How does the expectations channel actually translate to higher inflation? No Market Monetarist can explain this to me in simple english. The reason they can’t explain this is because they simply don’t have a real world transmission mechanism.

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BenoitEssiambre
2 years 2 months ago

Do you believe central banks are able to affect prices through conventional interest rates when they are not at the ZLB? Prices are not sticky forever. Eventually you get out of the ZLB.

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Cullen Roche
2 years 2 months ago

Depends. What’s the transmission mechanism again? Central Banks are just clearinghouses for the real banks. The monetary base has almost no impact on the real economy other than to help banks settle interbank payments. It impacts the price at which banks set the terms of their loans, but only indirectly. We don’t have to understand sticky prices and ZLB to know whether a central bank has power. We just have to look at its structure within the banking system and understand that central banks are indirect players in the financial system as opposed to the price setting money supply setting entities that many textbooks portray them as.

But I’d ask again because I still notice that no MM supporter can answer the simple question – what is the transmission mechanism by which NGDPLT works? If it’s just expectations then there’s nothing to it….plain and simple.

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BenoitEssiambre
2 years 2 months ago

What is a “transmission mechanism” to you? To me, central bank interest rates when not at the ZLB is an obvious one.

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Cullen Roche
2 years 2 months ago

Yes, that is correct. By altering interest rates the Central Bank engages in a transmission mechanism which has a real impact on the way banks manage their businesses. The CB can fundamentally alter the profitability of the banking system via this mechanism.

I am trying to figure out what the specific transmission mechanism is in NGDPLT. Sumner has stated that the CB doesn’t even need to do anything. They just need to alter expectations. But I am not sure how this actually results in real world economic changes….

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BenoitEssiambre
2 years 2 months ago

Good, you agree on at least this conventional mechanism, I can proceed with the argument.

So I am a bank or a business. The central bank is currently stuck at the ZLB and somewhat powerless. However, I know that there is a non zero probability that it will regain traction within some time horizon. In addition, because it is using a level target, when it does regain traction, it will do aggressive catching up on prices. Inflation will be high, money will be devalued.

Do I:

a) Keep my extra savings as idle cash? They risk being devalued whenever the CB gets the chance

b) Buy some business equipment or infrastructure (or if I am a bank, lend to some business that will do this) before prices rise? I can get it now at a likely cheaper price and there is a good chance I will be able to sell the products I create with this equipment at a higher price later.

If the central bank wasn’t using NGDPLT, wouldn’t I be much more likely to pick a)?

Guest
2 years 2 months ago

You’re not answering the question though. What will cause the CB policies to “gain traction” at some point. That’s the crucial element here.

I run a business. I am not going to go hire people just because the Fed waves its hands and says that inflation might come at some point in the future. That’s not how business owners think. Now, if they did something that actually had a fundamental impact on my business (like providing me with a loan to fund investment) then I might actually do something. But what you’re describing is just hand waving. There is no transmission mechanism in what you describe….

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BenoitEssiambre
2 years 2 months ago

This has nothing to do with “hand waving”. All financial instruments rely on promises.

I admit that if we are confident to be stuck at the ZLB for a very long time, the expectations channel can get largely neutralized. The way I see it, the expectations channel is a mechanism that takes any predictable central bank traction in a reasonable time horizon and makes it work immediately.

To me the existence of a “transmission mechanism” is pretty clear, though there might be some debate as to amplitude of the effect we can get from this channel. This is just a reason to combine it with some fiscal help (Sumner might disagree). However, oftentimes, sticky prices are not expected to stay sticky forever. Keep interest rates at zero for long enough and natural variations in supply will predictably make returns take off and the natural interest rate rise. A central bank promise that there will be catching up when this happens and a certain likelihood that it will happen soon enough makes it work today. Plus, once you get above the ZLB, high enough inflation targets or better targets will prevent you from falling to the floor again.

And consider the “Sumner critique” that says if we don’t have good enough targets, fiscal easing risks being largely negated by central banks tightening prematurely as we approach the bad targets. I am not as convinced as Sumner that you can solve all monetary problems without fiscal help, but it seems likely, that in many conditions, it will be very difficult to solve them with only fiscal maneuvers. So why not try the better targets first?

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Dan
2 years 2 months ago

I don’t want to make a whole long thing, but I will just say: everything you’ve just said in this post applies just as much to inflation targeting. And nobody thinks that central banks can’t inflation target, or that trying to inflation target is a fool’s errand.

Well, to a first approximation, NGDP targeting is the same as inflation targeting except you “lean against the wind” with respect to supply shocks, accommodating them as temporarily higher inflation rather than hits to real growth.

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Cullen Roche
2 years 2 months ago

Is that true? There seems to be quite a bit of debate about how effective inflation targeting has been in the last 5 years….

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Dan
2 years 2 months ago

There’s been a lot of debate about “liquidity traps,” to be sure, and yet, a real honest-to-God liquidity trap suggests that the whole mechanism for inflation targeting has broken down. But has any major central bank replaced inflation targeting with something else, or really even talked about it? Have many mainstream economists proposed abandoning the inflation target? No. And yet if I say, “let’s keep doing inflation targeting,” the response is, “okay, sure, whatever,” but if I say, “let’s try NGDP targeting,” the response is, “but you have no transmission mechanism! Liquidity trap! What a wild and crazy idea!”

What I’m asking is, why the asymmetric response? If we really feel that the monetary transmission mechanism has broken down, we’re just as screwed under NGDP targeting as we were under inflation targeting.

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EOrr
2 years 2 months ago

This bothers me too. It all comes back to political restraints. NGDP targeting is just easier than IT to administer but it isn’t fundamentally different.

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Garry Shilson-Josling
2 years 2 months ago

It is fundamentally different. NGDP includes exports, CPI doesn’t. For a country like Australia with wild terms of trade swings, NGDP targeting would be nuts.

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tom
2 years 2 months ago

You’re right but could say it more simply: NGDP targeting can’t work in all situations without a fiscal agent getting involved.

The central bank could break the old taboo and spend directly in the real economy. Which is currently mostly illegal, but those restrictions could be repealed or maybe snaked around somehow.

Or a government could practice NGDP targeting, modulating its spending financed by a captive central bank. Call it NGDP targeting Myanmar style.

Otherwise the central bank is relying on independent other parties to decide whether they feel like spending or not in response to whatever the central bank does to try to get them to spend. And that sometimes doesn’t work. For example for the last six years.

But Scott can never face these realities because he likes to think he’s a Friedmanite and can’t face that NGDP targeting would after all be a very leftist program. Better leave him alone with Duda, the elves and the orcs.

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Tim Young
2 years 2 months ago

I followed the link from FT Alphaville.
“The central bank could break the old taboo and spend directly in the real economy. Which is currently mostly illegal, but those restrictions could be repealed or maybe snaked around somehow.”

Looking at the list of what the Fed can buy above, isn’t that what “Bankers Acceptances and bills of exchange” are? That is, tied, albeit indirectly, to real economic activity.

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tom
2 years 2 months ago

Hence what I said about it being “mostly” illegal. Yes the Fed could legally lend to non-financial companies by basically buying their commercial paper. By doing so the Fed would become a fiscal policymaker and also an industrial policymaker, deciding how much the public will spend financing industry and which companies deserve financing. There would be a political backlash of course.

Guest
2 years 2 months ago

I think the outstanding balance of BA and BOE is virtually zero. I could be wrong. The Fed has some flexibility as to how it could interpret its limitations, but I often see the MM people claim that the Fed could buy anything or that they can make their statements more credible by saying they’ll do “whatever it takes”. But the simple reality is that they can’t do “whatever it takes”. Just look at the SNB today. The rumor is that they backed off the peg for political reasons. The “do whatever it takes” works great in Sumner’s theoretical world and doesn’t actually work in the real world. I think that’s why people like me, who work in the actual finance world, don’t see that his ideas translate to reality. I’m in reality and Sumner is in a textbook. His world doesn’t apply to my world in the way he seems to think….

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Cullen Roche
2 years 2 months ago

Agreed. If the Fed could implement something that was effectively fiscal policy then there’s no doubt that it would “work”. I’ve called this my “bag o dirt” theory”. That is, if the Fed could buy bags of dirt for $1,000 each then there’s no question that this would create inflation. But they can’t buy non-financial assets at a mark-up. They must engage in swapping assets at market value. As QE has shown, that’s not a very effective way to boost the economy.

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EOrr
2 years 2 months ago

This is why his whole
‘the fed can do whatever it takes” is so disingenuous. It ignores political realities while he uses the “Sumner Critique” to imply fiscal intervention is useless because of political realities forcing the FED to tighten.

Admin
2 years 2 months ago

Yes, it is hard to believe the CB could follow NGDP targeting rules any better than the IT rules they are supposed to follow.

Imagine political fight over making NGDP rules automatic, and in that world, those rules never get implemented.

We had some of the most prominent economists sign a huge op-ed where they were accusing the fed of pushing us into hyper-inflation. These rules will never get implemented.

Additionally, it’s pretty clear if the fed expands outside of the current list of assets they are engaging in fiscal policy and not monetary policy. If that’s the case, then why not make it explicit?

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Britonomist
2 years 2 months ago

Good post, I agree with a lot of what you say, I may give a more detailed reply later. But I think I just want to point out something quickly:

“Most people who are critics of NGDP targeting don’t see the transmission mechanism.”

Actually, the vast majority of critics Scott gets seems to be from the Austrian side, who conversely thinks that not only is the transmission mechanism strong, but in fact far too hyper stimulative, so much so that they make ridiculous claims about hyperinflation etc.. this is what much of the fierce criticism consist of and the kind of debates Market Monetarists constantly get bogged down into. I think this is why a lot less attention and focus has been given on how strong the monetary transmission mechanism actually is, because they’re too busy trying to reassure Austrians that it wont cause hyperinflation.

Guest
2 years 2 months ago

I don’t think anyone needs to worry what Austrian economists think…. 🙂

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EOrr
2 years 2 months ago

Can we stop calling them economists? Or is there some other instance where an identifying characteristic of a subgroup is the rejection of being included in the group. An Austrian Economist is an oxymoron and has been since Mises died. (unless they are actually Austrian)

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testing
2 years 2 months ago

This is just a test.

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