Noah Smith has a new blog post where he questions Scott Sumner’s idea that monetary policy should be conducted with the use of NGDP futures.
Here is Noah:
I have a problem with that. The problem is called “excess volatility”. According to some theories, asset prices should be an optimal forecast of (discounted) future payouts – for example, the price of a stock should be an optimal forecast of discounted future dividends, etc. An optimal forecast should not respond to “noise”; in other words, if something happens that doesn’t affect dividends, it shouldn’t affect the forecast. This means that actual dividends should be more variable than prices – the dividends should have lots of “surprises”.
Based on this Noah claims that NGDP futures would also be excessively volatile:
Now back to NGDP futures targeting. An NGDP futures price will probably experience excess volatility too. It will bounce around more than changes in actual NGDP. This means that the Fed will be trying to hit a very volatile moving target. One quarter, futures prices will soar, the next month they will crash, and the Fed will be trying to keep up, tightening dramatically in the first quarter and loosening dramatically in the second. This will happen even if a true optimal forecast of NGDP (which of course no one really knows) is relatively stable! Asset market volatility will cause policy volatility.
Noah of course has a fair point. If we just observe financial markets they might look terribly volatile. However, the real question Noah should be asking is why are financial markets so volatile?
My answer is that financial markets often are “excessively” volatile because of – you guessed it – volatile monetary policy.
Let me explain. What determines stock prices? Stocks is basically determined by three factors: Expectations for future dividends, a risk premium and the “risk free interest rate”. What determines future dividends? Nominal GDP! Over the long-run the capital-labour ratio in the economy is constant (or else Karl Marx is right…) and as a consequence nominal earnings should track NGDP closely.
As NGDP is determined by monetary policy it follows that expectations for future earnings will to a large extent be determined by expectations to future monetary policy. Therefore, if monetary policy is volatile as for example in the 1970s (or now) then stock markets will tend to be volatile (and the risk premium will be higher).
The same obviously goes for the fixed income and FX markets. Bond yields mostly reflect inflation expectations and as inflation is a monetary phenomena excessive volatility in fixed income markets is directly linked to monetary policy volatility. The same obviously goes the currency markets as exchange rates exactly reflect market expectations for the future supply and demand for a currency. The central bank of course determines the supply of the currency.
I have already in a couple of post tried to illustrate that the volatility in the US equity and bond markets in the last four years reflects volatile monetary policy more than anything else.
These two graphs should illustrate that:
The two graphs are from my previous posts “Monetary disorder – not animal spirits – caused the Great Recession” and “Tight money = low yields – also during the Great Recession”
In these two posts I argue that the volatility in the markets over the past fours years primarily has been caused by monetary policy failure rather than “market disorder” and while I certainly do not want to argue that market volatility is only caused by monetary policy mistakes I would like to stress that that at least over the past four years market volatility to a very large extent have been caused by failed monetary policy.
That in my view clearly underscores the need for monetary policy to be rule-following rather than discretionary.
A monetary policy based on NGDP futures is a very strong form of rule-following monetary policy and as a consequence I am convinced that such a policy would significantly reduce financial market volatility.
In that regard it is also worth noticing that the real benchmark for whether a NGDP futures market would be stable or not is not the stock market, but rather the so-called TIPS market. TIPS of course is inflation-linked US government bonds. During the Great Moderation when monetary policy de facto “shadowed” a NGDP level targeting regime TIPS-inflation expectations where extremely stable. TIPS inflation expectations only became volatile after the monetary policy “breakdown” in 2008.
Finally I would also argue that market volatility in that sense of “large swings” in financial markets is not necessarily all bad. In fact it might be a problem if the financial markets are not “volatile” enough. An example is the lack of volatility in exchange rates in countries when the central bank suffers from fear-of-floating. (See the relevant posts below).
Update: The always insightful Bill Woolsey has an excellent comment on Noah Smith.