Scott Sumner  

Ricardo Reis on price level targeting

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I've devoted much of my life to promoting market-based approaches to monetary policy. To better understand the idea, let's start by assuming the goal is simply a stable price level. Since the value of base money is the inverse of the price level, there are two ways that the price level can be stabilized.

1. Give market participants an incentive to move the supply of base money to the level expected to promote stable prices.

2. Give market participants an incentive to move the demand for base money to the level expected to promote stable prices.

I believe supply of money approach was first advocated by Earl Thompson in 1982. Thompson's (never published) paper is one of the 5 most important macro papers of the past 100 years, and almost no one has heard of it.

I've also done work in this area, as have a number of other researchers including David Glasner, Kevin Dowd, Robert Hetzel and Bill Woolsey. John Cochrane advocated something similar in 2010.

Robert Hall pioneered the second (demand for money) approach in 1983 (in the Journal of Monetary Economics). In Hall's proposal, bank reserves earn interest, and the interest rate is indexed to the price level. This means that the demand for bank reserves rises when banks expect inflation, and falls when banks expect deflation. Because rising money demand is deflationary, and vice versa, these shifts in money demand will automatically tend to stabilize the price level.

Cloud Yip has a series of interviews called "Where is the General Theory of the 21st Century?" In the comment section of a recent post where I criticized interest on reserves, Cloud directed me to a very interesting interview of Ricardo Reis, and suggested that I focus on this passage:

Q: In brief terms, how can the proposed payment on reserve process help central banks achieve the targeted price level?

R: The intuition is as following: the reserve is a very special asset that has one particular property - reserves are the unit of account in the economy. One dollar of reserves defines what the dollar is. It is one unit of deposit in the central bank that defines what a dollar is.

People of course more used to thinking, "Oh no! It's the piece of paper with some printing of the queen that defines what a pound is!" But remember those pieces of paper are nothing but something that exchanges one to one with reserves in the central bank. So, reserve is the unit of account of the economy. One unit of reserve always worth one dollar.

Now imagine that instead of promising to pay them the nominal interest rate, you promise that the interest rate, i.e. the remuneration of the reserves, is indexed to the price level. So, in de facto, the reserve essentially pay a real payment in the same way that the inflation-indexed government bonds do. There is no barrier to doing this. After all, it is the same way government issued the inflation-indexed bonds, so can the central bank.

The central bank can say that, instead of paying 3% of nominal interest on reserve, it will pay 3% times the price level tomorrow. If it does that, note that central bank is promising a real payment tomorrow to whoever hold the reserve.

On the other hand, there is a real interest rate pinned down in the economy that has to do with investment opportunities and how impatient people are. If the central bank promises a real payment, under the no-arbitrage condition, this pinned down the real value of the reserves today, as the real payment tomorrow divided by the real value today is equal to the real return.

The payment on reserve pinned down the real value of reserve today. And back at the beginning, we realized that the reserve is worth a dollar. So, if we have pinned down the real value, what also have we pinned down? We have pinned the price level. This is because the real value of one dollar of reserves is precisely given by the price level.

So, by choosing this remuneration of reserves, and making it a real payment indexed to the price level, you have de facto pinned down the real value of reserve today, which is nothing but the price level.


The last paragraph makes the outcome seem a bit more tautological than it actually is, but Reis is basically right. This sort of system would automatically stabilize the expected future price level. You could replace the FOMC with a computer. Unless I'm mistaken, this is essentially Hall's 1983 proposal.

You could also think of it as being sort of like the gold standard, except for two differences:

1. Instead of dollars being redeemable into 1/35 oz. of gold, they are redeemable into a fixed basket of goods and services.

2. The redemption applies to bank reserves, and guarantees that one dollar in reserves can be redeemed a year from today for enough dollars to buy one plus the real interest rate worth of goods and services.

Thus if the real interest rate today is 3% (say on one year TIPS), and if prices were to rise 1% above target over the next year, holders of reserves would receive 4% interest on their deposits at the Fed.

Of course if people expected prices to rise 1%, then the expected return on reserves would exceed the return on TIPS, the demand for reserves would rise, and this would automatically restrain the rise in prices.

Today, only banks can deposit money at the Fed, but if we are serious about this system then it makes sense to allow the general public to also have deposits at the Fed. The more the merrier when it comes to the "wisdom of crowds".

I still slightly prefer the supply of money approach pioneered by Thompson, because the zero interest rate lower bound (which might be more like minus 1%) can create problems for monetary policies that rely on adjusting the interest rate on reserves, rather than the quantity of reserves. Even so, I'd strongly support Reis's proposal as a sort of second best option, as long as the policy goal was shifted from a stable price level to a gradually rising NGDP.

Both of these market-based approaches to policy, the Thompson supply of money approach and the Hall demand approach have survived on the fringes of macroeconomics for many decades. Every so often an elite mainstream economist like Reis or Cochrane rediscovers the idea. I believe that we are about 10 years away from this approach going mainstream, and becoming an important part of macroeconomics.

PS. Here is a Tyler Cowen post on the colorful Earl Thompson, and here is his picture:

Screen Shot 2017-03-16 at 11.25.11 PM.png
A decade from now the profession will still be trying to catch up to his 1982 paper.


Comments and Sharing






COMMENTS (13 to date)
John Hall writes:

No reason that this can't be nominal GDP in levels instead of the price level, correct?

Alternately, no reason you couldn't say x% of a futures contract on the price level?

Joao Eira writes:

You don't get to say that it is one of the top 5 papers without saying what the others are!

David Friedman writes:

I don't know the Earl Thompson piece you cite, but Earl was one of the smartest people I've known. I have an old blog post partly about him.

Thaomas writes:

Clever rules to get the Fed to act as if it had an optimal policy [for the price level portion of its mandate] -- a symmetric inflation rate target = a price level trend target -- instead of the policy is actually has -- a soft inflation rate ceiling -- are interesting, but really have to deal with the political economy of why the Fed's actual policy is not optimal and why we could expect the clever rule to circumvent the constraints that lead to the suboptimum policy.

Scott Sumner writes:

John. Your first point is correct. I'm not sure I understand the second point.

Joao, I'm not sure. Maybe Irving Fisher's "Phillip's Curve" paper from 1923. Friedman's natural rate rate paper from 1968. Lucas's "Critique". And one more . . . ? Perhaps something by Mundell. Krugman's "expectations trap" paper from 1998 would be pretty high on my list. Barro's "Ricardian Equivalence" is another seminal paper. Of course Hick's IS-LM paper is important, and in my view a pretty fair interpretation of Keynes, but I hate the IS-LM model.

David, Thanks, that's a nice post.

Thaomas, Why not pursue both objectives?

Jerry Brown writes:

Professor, a few days ago you wrote an article titled "Time to abolish interest on reserves" at The Money Illusion. http://www.themoneyillusion.com/?p=32380

That blog post was one of those notably rare exceptions where I agreed with absolutely everything you said, (although I usually agree with a great deal what you write, even if its not apparent).

But today I am confused because parts of this article seem to advocate a system of Fed interest payments on reserves in order to control inflation. So is it time to "abolish" IOR or not? Or is there a nuance to the word abolish that I just am missing? Please don't give me the Spicer interpretation of what quotation marks mean :)

Jeff writes:

Earl Thomson himself, in the Congressional testimony at your link, acknowledges that his proposal is basically the same as the Compensated Dollar program originated by Simon Newcomb in the 1870's and most famously advocated by Irving Fisher for many years. The only real difference is the price targeted. Fisher wanted to stabilize the general price level, Thomson would rather stabilize the average nominal wage.

In your explanation of the Reis system you say:

Thus if the real interest rate today is 3% (say on one year TIPS), and if prices were to rise 1% above target over the next year, holders of reserves would receive 4% interest on their deposits at the Fed.

Of course if people expected prices to rise 1%, then the expected return on reserves would exceed the return on TIPS, the demand for reserves would rise, and this would automatically restrain the rise in prices.

Is the supply of reserves taken to be fixed or otherwise predetermined here? I suppose it must be, because if the Fed decided to accomodate the higher reserve demand by creating more reserves, prices wouldn't be restrained, and the Treasury would find no market for TIPS as everyone would prefer holding central bank reserves instead.

Nick Rowe writes:

Scott: I read your good post, then the Ricardo Reis interview, then tried to collect my thoughts in
my own post

[Hey! I think I've finally managed to work that link thingy!]

Scott Sumner writes:

Jerry, I am opposed to the sort of discretionary IOR regime we currently have. But if it were a market-based monetary system, then I'd be fine with IOR. In other words, a market-based approach is so good that it overshadows the disadvantages of IOR.

Jeff, It has similarities to the compensated dollar, but Thompson was being too modest. He uses market forces to overcome policy lags in a way the Fisher plan does not.

The supply of reserves does not have to be completely fixed. I'm not sure I understand your last point.

Jerry Brown writes:

Scott Sumner: I am opposed to the sort of discretionary IOR regime we currently have. But if it were a market-based monetary system, then I'd be fine with IOR.

Ok, that makes sense to me. It might even lessen banker's reflexive intolerance of any inflation whatsoever even when recession would be the cost of inflation phobia at times. But like you say, I would hope that the public would also be able to hold reserves under this policy. Thanks for the reply!

But I would like to see a way to target nominal income growth that was not directed through bankers first but through the general public. But I don't know how the Fed could do that.

Thaomas writes:

Scott,
I do want the Fed to pursue both policies. Even if we had agreement on how to pursue the "inflation" objective -- let's say price level targeting -- I would still want the Fed to trade off some overshooting of the price level target (if necessary) to come closer to the employment objective. In practice an NGDP target might be a good trade-off. And a "clever scheme" like standing willing to buy and sell unlimited quantities NGDP futures contracts might be a good way to pursue that trade-off.

But that discussion seems intellectually premature without a clear conception of why the Fed should have an "inflation" objective (which would define what the target should be -- presumably a price level trend whose rate would depend on a model of how the trend affected real income growth) and a model of why the Fed has seemed to have a soft in inflation ceiling objective or (if that was not its objective) why it has seemed constrained in use of policy instruments (IOR, QE, ST interest rates, or whatever) to pursue its unobserved objective and where those constraints come from.

Scott Sumner writes:

Thanks Nick, If you haven't read Robert Hall's 1983 JME paper then I recommend you take a look at it.

Your post seems right to me, and I don't think it's very hard for the central bank to pay interest on reserves (or even cash) without that interest actually changing the monetary base. Offset would be easy.

Jerry, You said:

"But I would like to see a way to target nominal income growth that was not directed through bankers first but through the general public."

That would be easy:

1. Return to positive interest rates.

2. Get rid of IOR, or have it apply only to non-banks.

3. Do OMOs only with non-banks.

Cloud writes:

Thanks, Prof. Sumner, for the insightful discussion of my interview piece.

Here is a response from John Cochrane on his suggested approach to stabilizing inflation, he thinks the gist is the fiscal side of the government: (http://en.econreporter.com/en/2017/03/cochrane-responses-sumners-discussion-inflation-stablization-regimes/)

...my proposal works even if there is no “base money,” anymore, which is a good thing now that we live in the world of abundant interest bearing reserves which are indistinguishable from liquid government debt.

My proposal works, really, by committing the government’s fiscal policy to price stability...

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