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NGDP Targeting and the Great Recession

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NGDP Targeting and the Great Recession The Real Problem Was Nominal: The Great Recession and Nominal GDP Targeting Scott Sumner, Bentley University and the Mercatus Center Part I: Think outside the box “Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?” The consensus view “The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed.” (Robert Hall, JEP, 2010.) Real GDP: 2007-2010, (monthly estimates from Macroeconomics Advisors) Nominal GDP: 2007-2010 Friedman on low interest rates “Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.” (WSJ, Dec. 1997) Mishkin’s key lessons for monetary policy 1. It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates. 2. Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms. 3. Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero. Real interest rates on Treasury bonds with a roughly 5 year maturity; July to Nov. 2008 Commodity prices in 2008 The value of the dollar in late 2008 Other Asset Markets Stock prices crashed in late 2008 Commercial real estate prices started falling sharply about the same time as NGDP, and long after the subprime bubble Residential real estate prices in the heartland (Texas, etc.) had been stable during the 2006-08 subprime crash, and started falling in late 2008 along with NGDP TIPS spreads (i.e. inflation expectations) fell sharply. Bernanke on monetary indicators The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman . nominal interest rates are not good indicators of the stance of policy . The real short-term interest rate . is also imperfect . Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. If you insist on using interest rates The housing crash was mostly over before the unemployment rate began rising sharply. Jan. 2006: starts = 2,303,000, completions = 2,058,000, average = 2,180,000, U-rate = 4.7% April 2008: starts = 1,008,000, completions =1,014,000, average = 1,011,000, U-rate = 5.0% October 2009: starts = 527,000, completions = 745,000, average = 636,000. U-rate = 10.0% Two examples of fiscal austerity: The US NGDP (red line) and the Eurozone NGDP (blue line) Slow Eurozone NGDP growth depresses bond yields The “musical chairs model” Why NGDP growth is important Nominal wage contracts. Nominal hourly wage growth is very “sticky”. When NGDP slows unexpectedly, businesses don’t earn enough revenue to pay workers at existing wage rates Unemployment rises. Nominal debt contracts. Nominal GDP is the total income available to people, businesses and governments to repay nominal debts. Less NGDP Financial stress. Imaginary conversation Wittgenstein: Tell me, why do people always say it’s natural to assume the Great Recession was caused by the financial crisis of 2008? Friend: Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008. Wittgenstein: Well, what would it have looked like if it had been caused by Fed and ECB policy errors, which allowed nominal GDP to fall at the sharpest rate since 1938, especially during a time when banks were already stressed by the subprime fiasco, and when the resources for repaying nominal debts come from nominal income? Nominal GDP targeting Can the central bank target NGDP? Advantages over inflation targeting Advantages of level targeting Target the forecast Use market forecasts Market Monetarism: Taking Pre- 2008 macro seriously Low rates don’t mean easy money (Friedman, Mishkin, Bernanke) Monetary policy highly effective at zero bound. (Friedman, Mishkin, Bernanke) Fiscal policy not an effective stabilization tool, even at zero bound. (Krugman) Level targeting is more effective at the zero rate bound. (Eggertsson, Woodford) Central banks should target the forecast (Lars Svensson) Expectations are rational, asset markets are efficient. (Lucas, Woodford, Fama, etc.) NGDPLT (arguably the least important aspect of market monetarism) Share of Treasury debt held by the Fed Apparent monetary ease is often a symptom of monetary tightness On any given day, a lower fed funds target is more expansionary. (Keynesian view) Over any extended period of time, however, lower rates reflect more bearish forecasts. (NeoFisherian perspective) What do current eurozone and Japanese i-rate forecasts imply about NGDP growth in those two regions? Don’t “do more”, do different. Level shifts vs. growth rate shifts In January 2015, the Swiss simultaneously cut IOR from negative 0.25% to negative 0.75%, and appreciated the franc by more than 10%. Both level and growth rate shifts were contractionary. In most cases, level and growth rate shifts move in opposite directions. (Dornbusch overshooting) Needed: Level and growth rate shifts that are both expansionary. I.e., Japan could suddenly depreciate the yen by 20%, and then fix to the dollar. The policy would be expansionary, despite raising Japanese interest rates. What’s wrong with inflation targeting? NGDP better reflects the “welfare costs of inflation” (especially excess taxation of capital income, and sticky wages) National income targeting is easier for the public to understand. Ask Bernanke about his attempt to explain to the public (in 2010) why the Fed was trying to raise their cost of living during a recession. NGDP targeting better stabilizes labor and debt markets. Why level targeting? Policy is more credible, in terms of growth rates. (Contrast an inflation and PL target that each undershoot by ½% each year.) Creates stabilizing expectations. Inflation expectations rise during periods of undershooting, such as 2009, which reduces longer term real interest rates. Most importantly, that makes the recession itself milder (in NK models). How to make NGDPLT operational One could create a Taylor Rule-type reaction function, with an NGDP level targeting objective Would not be dramatically different from actual Taylor Rule. Alternative -- “target the forecast”: 1. Use internal central bank forecast (Svensson) 2. Target market forecasts, using discretion or NGDP futures markets. (Market monetarists) NGDP futures targeting Target external NGDP futures market. Problems: circularity problem, lack of liquidity. Internalize NGDP futures market---Fed buys and sells unlimited quantities of NGDP futures at price equal to policy goal. Transactions lead to automatic adjustments in the monetary base. Multiple contingent NGDP futures auctions for various possible instrument settings. Transactions occur only at instrument setting where long and short positions roughly balance. Central banks reluctant to give up all discretion 1. What if unanticipated shock made “automatic” setting inappropriate? 2. Risk premium in NGDP futures prices. 3. Risk of futures market manipulation. Constrained discretion Set an NGDP level target along a 4% growth path. Renew the target each year, based on previous year endpoint, but not outside 3% to 5% growth range. Fed promises to take a “short” position on any NGDP futures contracts at 5% growth, and a long position on any 3% NGDP growth contracts. Fed makes a profit if actual NGDP ends up inside the range, and still avoids losses if Fed bets are “balanced” when NGDP is outside the range. If it works, gradually narrow the “guardrails”. Making the world safe for classical economics Goal is to keep NGDP expectations growing at a slow but steady rate. In this world there is no paradox of thrift or toil. No argument for mercantilism. No argument for fiscal stimulus. No argument for bailing out companies to “save jobs”. Standard classical assumptions about opportunity cost would once again hold true. Paul Krugman in 1999 “What continues to amaze me is this: Japan's current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do - even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy - the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance - are rejected as dangerously radical and unbecoming of a dignified economy. Will somebody please explain this to me?” .
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