Today I got an interesting question: “does NGDP targeting equate to more quantitative easing (QE) of monetary policy?”.
The simple answer is that it all depends on Chuck Norris, or rather on the Chuck Norris effect. I have earlier defined the Chuck Norris effect in the following way:
“You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.”
Let’s say we have a central bank – for example the Federal Reserve that tomorrow announces a target for the level of nominal GDP (NGDP) 15% higher than the present level and that it will hit that target within 24 months.
The “clever” reader would of course ask how you can achieve that target with interest rates at near zero. Well, through quantitative easing, of course – by printing money. Or rather by increasing the supply of money more than the demand for money.
So the relevant measure is not the supply of money, but rather the supply of money relative to demand for the dollar. The demand for money of course is extremely dependent on the expectation of the future value of money.
So let’s assume that the announcement of the +15% NGDP level target is credible – what would happen? This announcement would effectively mean that the central bank would try to reduce the purchasing power of the money it issues, which effectively of course would equate to “burning” households and companies cash holdings. If we know that the value of cash we have today will be worth less tomorrow we would course do everything to get rid of that cash – that goes for households, banks, companies and institutions.
This is key for how the transmission mechanism works under credible NGDP level targeting. The expectation of a 15% increase in NGDP would cause de-hoarding of cash, which is the same as to say that private consumption and investments would increase, banks would increase lending (ease credit conditions) and the currency would weaken, which would spur exports. This would automatically lead to an increase in NGDP.
Hence, if the Chuck Norris effect is strong enough then the central bank could achieve its NGDP target without undertaking any QE at all.
In the “real world” it is unlikely that any central bank will be able to raise NGDP by 15% without actually increasing money supply. After all, the problem in the present crisis is exactly that the major central banks of the world are lacking credibility about their targets – otherwise for example market expectations in the eurozone would not be below 2%. Therefore, to get the needed credibility the central bank would probably need to announce clearly that it would undertake unlimited amounts of QE if needed to achieve its +15% NGDP target level and probably also define through which channel the increase in the money supply would occur – for example, through the buying of foreign currency (which in our view would probably be the most effective as you would circumvent the crisis-hit banking sector), or through buying or government or corporate bonds, etc.
However, if this were done it is likely that the goal of lifting NGDP by 15% could be achieved by printing significantly less “extra” money than if it simply implemented QE without a clear target of what it wants to achieve. So once again, the central banks need to call in Chuck Norris. It’s all about the anchoring of expectations and you will only achieve this by announcing a credit NGDP and credible strategy of how to achieve it.
Martin
/ December 13, 2011I made a comment on Scott’s blog a while ago, that following the Chuck Norris logic in – I believe Nick Rowe’s example based on yours – the Central Bank would be selling assets to accommodate the demand. I think therefore that QE should be conditional on certain variables reaching certain values within a certain time fame. Otherwise the target would lack credibility, because the market participants would – correctly – expect you not to make good on your threat as their decision to buy would get you to sell.
What the central bank should do and in essence does through the Chuck Norris effect is write a put option on that part of asset prices that is dependent on NGDP.
On a side-note, I found your example of and focus on Chuck Norris to be very stimulating when thinking about other problems in economic policy.
Benjamin Cole
/ December 13, 2011My Market Monetarism Plan for USA:
1. $100 billion a month in QE until NGDP targets are met
2. A decrease in IOR, perhaps to zero.
3. This plan announced publicly.
4. Support for less taxes and regulation on businesses, shorten unemployment comp.
Why the concrete number of $100 billion? So the public would know the Fed is serious, and has a target they must hit every month. After all, the public may not believe that waving a wand and chanting “NGDP” will work. They may believe the Fed will lessen efforts pending some election or other events.
Lars Christensen
/ December 13, 2011Martin, you got a very good point. In reality the Fed – or any other central bank – could write a put option on some financial asset, which is strongly linked to NGDP – for example S&P500 or on the (inverse of) dollar FX rate. That would give a very strong commitment and would automatically be credible.
Joseph Ward
/ December 14, 2011well last time I checked central bankers were not movie star ninjas. the fed has relatively solid central bank credibility, and I don’t think that we could pull this off. or rather, I’d be amazed if we did.
Lars Christensen
/ December 14, 2011Joseph,
How do you define credibility? To me a central bank is credible if the markets (and the general public) expect the central bank to hit the targets it have. The problem of course for the Fed is that the Fed does not have a target. That make it pretty hard to say whether it is credible or not.
Another way of saying whether a central bank is credible or not is to look at the predictability of nominal variables: money suppy, velocity, nominal wages, prices, inflation, NGDP, the exchange rates etc. I am pretty sure that if you estimate of example simple AR-models for these variable you will see the error-term in the models has exploded since 2008. I must, however, say I am guessing here. but I am pretty sure I am right – maybe a econometrician outthere would try to estimate it?
In the case of the ECB the collapse in credibility is pretty clear. The ECB has a two-pillar policy – targeting directly or indirectly M3 growth and inflation. Judging from market expectation for medium term inflation the credibility is not good – in fact it has never been this bad. Inflation expectations are well-below the 2% inflation target. In terms of M3 the ECB has normally targeted a reference rate around 4.5% y/y. The actual growth rate on M3 is much below this “target”.
HOWEVER, if the central banks were indeed so credible then the market should fully believe any nominal target they would announce they would meet. So if the Fed is 100% credible and announce that it will increase NGDP by 15% over the coming two years then there should be no problem meeting this target – without printing more money. What would happen is the money-velocity would jump, which with an unchange money supply would increase NGDP.
During the Great Moderation there was a very high degree of negative correlation between M and V growth. This indicates in view that markets expected the Fed to meet a NGDP and monetary policy became endogenous – pretty much in the same way as in a Selgin-White Free Banking model.
See here: http://marketmonetarist.com/2011/10/31/the-inverse-relationship-between-central-banks-credibility-and-credibility-of-monetarism/