Scott Sumner  

Why not both?

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Alexander Schibuola directed me to a recent speech by Fed Vice Chair Stanley Fischer:

Committees and rules may appear to be in opposition as approaches to policymaking. One might even argue that if a central bank ever converged on a single monetary rule, there would be no need for a monetary policy committee. In practice, the Fed operates through a committee structure and considers the recommendations of a variety of monetary rules as we make monetary policy decisions. Our decision is typically whether to raise or reduce the federal funds rate or to leave it unchanged. Committees can aggregate large amounts of diverse information--not just data, but also anecdotes and impressions that would be hard to quantify numerically. Good committees also offer a variety of perspectives and underlying economic models for interpreting the economy. In contrast, a policy rule, strictly defined, is numerical and constrained to a single perspective on the economy.
Alex noticed that this is a good argument for using markets to set monetary policy.

You can think of markets as a sort of super committee with 7.3 billion potential members, instead of 12. Markets are privy to even more useful anecdotes and impressions than is a committee of 12, and markets have even more perspectives and underlying models.

So why not have the Fed set a 4% NGDP target, level targeting, and offer to sell unlimited NGDP futures at 5% and buy unlimited NGDP futures at 3%? In that case, the rule would be that the Fed is forced to put its money where its mouth is, anytime their policy views sharply diverged from the market consensus on expected NGDP growth. As a practical matter, the huge mistake of late 2008 would have been impossible under my "guardrails" approach because investors like me would have gone short NGDP futures at the 3% price, as it was very clear we were going to have sub-3% NGDP growth in 2009. (NGDP actually fell by roughly 3% from mid-2008 to mid-2009.) If the Fed didn't respond adequately, their losses would have been massive.

In this vision of monetary policy we have the best of both worlds. The "wisdom of crowds" that you get from decision-making by committee, as well as the rigorous constraints on monetary policy imposed by rules.

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COMMENTS (4 to date)
Thaomas writes:

I agree, but even the committee should be guided by a rule. At a minimum, that monetary policy be symmetric with respect to the inflation rate which is the same thing as price level trend targeting. The GDP guardrail would prevent real GDP from falling if we ever got into a 2% "stagflation."

marcus nunes writes:

Stan Fischer:
My take is that rules are extremely useful reference tools, but they are likely to work best as inputs into a committee decision. Why? Let me reiterate some points I made in Warwick.

First, the economy is very complex, and models that attempt to approximate that complexity can sometimes let us down. A particular difficulty is that expectations of the future play a critical role in determining how the economy reacts to a policy change. Moreover, the economy changes over time-‑this means that policymakers need to be able to adapt their models promptly and accurately in real time. And, finally, no one model or policy rule can capture the varied experiences and views brought to policymaking by a committee.

All of these factors and more recommend against accepting the prescriptions of any one model, policy rule, or policymaker.

Interestingly, Yellen also has said that the Fed shouldn´t “be chained to any rule whatsoever”. Why? Because monetary policy requires “sound judgment”. And rules won´t provide that:

"I´m not a proponent of chaining the Federal Reserve Open Market Committee in its decision making to any rule whatsoever. But monetary policy needs to take account of a wide range of factors some of which are unusual and require special attention, and that´s true even outside times of financial crisis."

Scott Sumner writes:

Thaomas, I agree.

Marcus, I think the problem is that they have a fairly restrictive conception of rules, limited to Taylor Rule type policies.

bill writes:

Clarification question. Futures contracts are "entered into", as opposed to bought and sold, correct? Money is paid to one side when the futures contract matures and we know whether the actual NGDP is over or under the threshold in the contract. Money could be posted by the non-Fed party when the contract is entered into.

I think that unlimited is too much. Markets can move discontinuously. Think 1987 or flash crash. There is certainly a daily limit that would send a clear message to the Fed that markets fear, say, an NGDP growth rate below 3% but without the risk that the Fed would have to pay out several trillion dollars. The daily limit itself could be raised if it's hit several days running.

Another question. Would the contracts be set up so that only the Fed is the one paying out when NGDP growth is below 3% and only the non-Fed players would be paying in when NGDP growth is over 5%? That would make the contract payments themselves function to bring NGDP back towards the target (which is good). Non-Fed players paying cash to the Fed during an NGDP shortfall and the Fed paying out cash during a boom would be perverse.

One last question. What is the timeframe for entering into the futures contracts and the related payouts? That is, for the fourth quarter 2017 NGDP contract, what is the last date a market participant can initiate a contract? And what date would the contract be settled?

One more suggestion. The could/should start offering NGDP insurance/options for NGDP shortfalls below say the 3% (or even a 2% or 2.5% in the beginning to work out the kinks) threshold. The Fed should panic if demand for the insurance goes up. The difference between these options/insurance and the futures is that the Fed would set a price that the market players could pay up front for the insurance and that means that the buyer would not be open to unlimited risk if NGDP comes in way high over the threshold.


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