Imagine that a S&P500 future was the Fed’s key policy tool

Here is Yale economics professor Stephen Roach:

“The ECB is pretty much out of ammunition.”

This sentence probably best illustrates what is wrong with monetary policy thinking in today’s world. Obviously the ECB is not out of ammunition, but Roach’s perception is very common.

What Roach fails to realise is that when central banks announce what we in general terms could call the “key policy rate” it is really just announcing a intermediate target for a given market interest rate. What the central bank actually is doing it setting the money base to fix a given market interest rate at a given level. In that sense the interest rates is merely a tool for communication. Nothing else.

The problem is that in most standard macroeconomic models the central bank does not determine the money base – in fact there is no money in most of today’s mainstream macroeconomic models – but rather the “interest rate”. In a world where interest rates are well above zero that is not a major problem, but when the key policy rate gets close to zero you get a communication problem. However, this is really only a perceived problem rather than an actual problem. The central bank can always expand the money base – also if the key policy rate is zero or close to zero.

The mental problem really is that interest rates have replaced money in today’s mainstream (mostly New Keynesian) macroeconomic models. Lets therefore imagine that we constructed a simple macroeconomic model where there is no interest rate, but where the central bank’s communication tool is stock prices or rather stock futures.

Many economists would willingly accept that stock prices can influence both private consumption (through a wealth effect) and investments (through a funding cost effect) and as such that would not be different from the “normal” assumption about how interest rates influence domestic demand. Therefore, by influencing the stock prices the central bank would be able to influence domestic demand. Note of course that I on purpose am “keynesian” in my rhetoric just to make my point in regard to mainstreaming thinking of monetary policy. (Obviously stock prices as well and private consumption and investments are determined by expectations of future nominal income.)

Then now imagine that the central bank every month announces a certain level for the a stock market future instead of announcing a key policy interest rate. So for example in the case of the Federal Reserve the FOMC would every month announce a “target” for a given S&P500 future.

Would anybody question that the Fed could do this? And would anybody question whether the Fed could hit that target? No, of course not. The ECB obviously could do the exact same thing. There would be absolutely no technical problem in using stock prices (or rather stock futures) as a policy instrument.

Do you think Stephen Roach would argue that the ECB “pretty much” was out of ammunition had just increased it’s target for the Euronext 24 month future with 5%? No of course not and that in my view clearly illustrates that the zero bound on interest rates only is a mental problem, but an actual problem.

Finally note that I am not advocating that central banks should target stock prices (I advocate they should target an NGDP future), but I see little difference in such a policy instrument and interest rate targeting. Furthermore, there would not be a zero bound problem if the Fed was targeting S&P500 futures rather than interest rates and Stephen Roach might even realise that the ECB in no way is out of ammunition.


PS over the long run NGDP and stock prices are actually quite strongly correlated and hence if the Fed announced that S&P500 should increase by lets say 5% a year over the coming 5 years and that it would ensure that by buying (or selling) S&P futures then it would probably do a much better job at hitting a given level of NGDP or inflation for that matter than the Fed’s present weird policy of promising to keep interest rates low for longer or the silly operation twist.

PPS I am pretty sure that Stephen Roach full well knows that the ECB is not out of ammunition, but when you talk to journalists you might make some intellectual short-cuts that distorts what you really think. At least I hope that is what happened.

PPPS If the Fed wanted to target the NGDP level then it is pretty easy to construct indicator for future NGDP from S&P500 futures, TIPS inflation expectations, CRB futures and the nominal effective dollar rate and then the Fed could just use that as a communication tool. Then it would never ever again have to talk about QE or running out of ammunition.


Update: When I started writing my post I was thinking that Nick Rowe might have  written something similar. And yes, indeed he actually wrote a number of posts on the topic. So take a look at Nick’s posts:

“The Bank of Canada should peg the TSE 300” – revisited
Why the Bank of Canada should ‘rise’ interest rates
The Fed should buy pro-cyclical assets, not bonds

Leave a comment


  1. Max

     /  July 7, 2012

    Allocating credit is politically sensitive, and most people think the private sector does a better job than government. So I see a big difference between using credit allocation as a policy instrument and using the money rate as a policy instrument.

  2. Max, thanks for your comments.

    1) I do clearly state that I do NOT advocate that central banks should target stock prices. My comment is an attempt to show that there is NO liquidity trap and the idea that central banks some how are out of ammunition is seriously flawed.

    2) I certainly do not think the central bank should allocate credit. In fact in my optimal world there would not even be central banks, but as long as we have them I think they (at least the large ones like ECB and the Fed) should target the NGDP level.

    3) That said, IF the central bank was targeting a future for the stock market then that is not more or less change market allocation than any other monetary policy tool. Let’s for example say Reserve Bank of Australia (RBA) tomorrow cut its key policy rate by 200bp. What would be the impact on Australian stocks? Or on the Aussie dollar? I am pretty sure Australian stocks price would increase quite a bit – lets say 3%. How would that be different from the RBA coming out an saying that it had increased it’s operational target on Aussie stock by 3%? It would be that exact same thing and it would not influence the RELATIVE pricing of stocks, bonds and FX compared to had the easing been done via the interest rate. Again, I do not advocate targeting the stock market, but technically there is not much difference – it is just targeting different financial prices. Money market rates are no less a price than stock market prices.

    See also these two blog posts that might shed some more light of my views on these issues:

  3. Diego Espinosa

     /  July 7, 2012

    The Willshire 5000 total market index is probably the best proxy we have for NGDP futures. Barring margin volatility, we should expect NGDP targeting and Willshire 5000 targeting to be similar in effect. What, then, is the problem with targeting stock prices?

    100% credible NGDP/stock index targeting represents a put written on equities with a strike at the current index level (and a 5% annual strike price increase). The put is awarded by the central bank for free to current equity holders. Since this put has value, someone must pay for it. The cost of writing the insurance falls to taxpayers, who must recapitalize the central bank in the event the put is exercised at a loss.

    What is interesting to think about is the effect of that put on investor portfolios. After a one-time gain (a transfer of value from taxpayers to credit and equity investors), expected returns would fall along with the risk premium. To restore expected portfolio returns, investors would have the incentive to add leverage. A significant increase in aggregate portfolio leverage would also raise the value of the put (as the put is protecting the portfolio from default). Throw in agency issues (managers would extract rent by raising the put value), and the potential cost to the taxpayer would escalate. The risk to the regime is that the taxpayer contingent liability becomes politically unsustainable.

    • Diego,

      I must once again stress that my post is meant as an illustration that there is no liquidity trap and not a policy recommendation.

      However, you concerns are of course important. It is clear that the risk premium on equity basically should disappear as the S&P500 future basically would be as safe as government bonds as there would be basically no volatility in the stock market other than the one coming from changes in “monetary policy”. Nick Rowe makes a similar point in the first of his posts that I link to above.

      However, it should also be noted that the present risk premium actually might exactly reflect uncertainty about monetary policy. Some of my own (unpublished) research shows that there is a quite close correlation between NGDP volatility and the equity risk premium.

  4. Diego Espinosa

     /  July 7, 2012

    Nick argues getting rid of the equity risk premium is a feature, not a bug. He states, ‘The main rationale for the policy would be the hope that it would tame financial bubbles and crises.” I have to disagree. Monetary regimes that work by reducing the volatility of real variables have the unintended effect of encouraging the build-up of leverage and systemic risk. I argue this flows directly from portfolio theory, and that, in their effect on optimal portfolios, NGDP targeting is little different from stock index targeting.

  5. Brad

     /  July 8, 2012

    “actually is doing it setting the money base to fix a given market interest rate at a given level”

    That’s contradictory. And the “base” is not now, & has never been, a base for the expansion of new money & credit.

    Monetarism is where the Fed targets money flows using legal reserves. Milton Friedman wasn’t a monetarist & didn’t know much about money & central banking.

    Targeting nominal-gDp is an ipsedixitism. The “trading desk” can only target monetary flows. Rates-of-change (roc’s) in MVt is a proxy for roc’s in nominal-gDp. Monetary policy should permit the roc in MVt to exceed the roc in real-gDp by c. 2 – 3 percentage points.

    The problem was that Bernanke first initiated a contractionary money policy coinciding with the peak in housing prices (March 2006) for 29 consecutive months & then absolutely drained all bank liquidity in the 4th qtr of 2008 (precipitating liquidity runs).

    Just when liquidity injections were most needed – Bernanke drained legal reserves. This triggered the Great Recession’s cumulative & reinfocing commercial bank credit contraction & accompanying deposit destruction. This volatile & disorderly reaction was quickly transmitted through out the entire banking system. (beginning 2008-10-29 @ $9,507.3t & ending 2010-03-24 @ $8,824.3t).

    Nominal gDp’s 2 year roc (the FED controls its proxy – MVt), peaked in the 2nd qtr of 2006 @ 12%. Bernanke let it fall to 8% by the 4th qtr of 2007 (or by 33%). It fell to 6% in the 3rd qtr of 2008 (another 25%). It then plummeted to a -2% in the 2nd qtr of 2009 [gasp] another 133%.

    POSTED: Dec 13 2007 06:55 PM |
    10/1/2007,,,,,,,-0.47,,,,,,, -0.22 * temporary bottom
    11/1/2007,,,,,,, 0.14,,,,,,, -0.18
    12/1/2007,,,,,,, 0.44,,,,,,,-0.23
    1/1/2008,,,,,,, 0.59,,,,,,, 0.06
    2/1/2008,,,,,,, 0.45,,,,,,, 0.10
    3/1/2008,,,,,,, 0.06,,,,,,, 0.04
    4/1/2008,,,,,,, 0.04,,,,,,, 0.02
    5/1/2008,,,,,,, 0.09,,,,,,, 0.04
    6/1/2008,,,,,,, 0.20,,,,,,, 0.05
    7/1/2008,,,,,,, 0.32,,,,,,, 0.10
    8/1/2008,,,,,,, 0.15,,,,,,, 0.05
    9/1/2008,,,,,,, 0.00,,,,,,, 0.13
    10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
    11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
    12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
    Exactly as predicted:
    The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.

  6. Brad,

    “Monetarism is where the Fed targets money flows using legal reserves. Milton Friedman wasn’t a monetarist & didn’t know much about money & central banking.”

    Well, you are probably the only person in the world with the definition of monetarism. Monetarism is not some kind of operational set-up, but an economic school. And that you claim that Milton Friedman “monetarist & didn’t know much about money & central banking” is simply outrageous.

    Could you then please explain who Karl Brunner was thinking of when he coined the phrase “monetarism”?

    And great you forecasted all this in December 2007 you must be a very wealthy man.

  7. Benjamin Cole

     /  July 8, 2012

    Excellent blogging. I don’t know why so many “economists” say the “Fed is out of ammo.”

    Really? A central bank that cannot cause inflation? After first printing enough money to boost demand?

    If true, then the USA should monetize its national debt. That alone would brighten the picture a lot. Imagine, our child inherit a debt free nation, with very low inflation (same for you Euros too!).

  8. flow5

     /  July 8, 2012

    You can’t point your finger in the other direction when Karl Brunner doesn’t have a clue about monetarism to begin with. Monetarism is more than watching the aggregates. It also involves controlling them properly. Monetarism has never been tried. If the money supply is controlled properly, the determination of interest rates can be left to market forces.

    • Sorry flow5, now I am seriously confused. Karl Brunner – coined the phrase monetarism – is not a monetarist? Neither is Milton Friedman? Who the hell are then monetarist?

      And by the way both Friedman and Brunner very much said that the determination of interest rates should be left to the market. But again please tell me who is a proper monetarist?

      But yes, I would agree that monetarism in its Friedmanite form was never really tried. The closest we get is the Volcker disinflation, but obviously Volcker was using interest rates to determine the money demand rather than controlling the money supply. Something both Friedman and Brunner was very critical about. And if you read any Market Monetarist today we would all be extremely critical about “interest rate targeting”.

  9. flow5

     /  July 8, 2012

    Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired rates-of-change (roc’s) in monetary flows (MVt) relative to roc’s in real GDP.

    Nominal GDP, can then be used as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used as a policy standard.

    Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, the FOMC should follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2-3 percentage points.

    Nominal gDp targets are appropriate only in periods of subpar economic growth and/or when emerging from a recession/depression. Otherwise real-output is unnecessarily impeded.

  10. Brad

     /  July 9, 2012

    Targeting nominal-gDp just CAPs the standard-of-living for the average American. Try selling it to the Chinese where current price gDp averaged 15.74% per each qtr for the last 20 years (rose 39.4% 1st qtr 1994).

    And Paul Volcker’s version of monetarism (along with credit controls: the Emergency Credit Controls program of March 14, 1980), was limited to Feb, Mar, & Apr of 1980. With the intro of the DIDMCA, total legal reserves increased at a 17% annual rate of change, & M1 exploded at a 20% annual rate (until 1980 year’s-end).

    Why did Volcker fail? This was due to Volcker’s operating procedure. Volcker targeted non-borrowed reserves when at times 10 percent of all reserves were borrowed. One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was immaterial. A new advance could be obtained, or the borrowing bank replaced by other borrowing banks. That’s before the discount rate was made a penalty rate. And the fed funds “bracket racket” was simply widened, not eliminated. Monetarism has never been tried.

    Then came the “time bomb”, (which Prichard foretold), the widespread introduction of ATS, NOW, & MMMF accounts at 1980 year end — which vastly accelerated the transactions velocity of money (all the demand drafts drawn on these accounts cleared thru demand deposits (DDs) – except those drawn on Mutual Savings Banks (MSBs), interbank, & the U.S. government).

    This propelled nominal gNp to 19.2% in the 1st qtr 1981, the FFR to 22%, & AAA Corporates to 15.49%. My prediction for AAA corporate yields for 1981 was 15.48%.

    By the first qtr of 1981, the damage had already been done. But Volcker never changed policy (supplied an excessive volume of legal reserves to the banking system), as late as 1982-83.

    My friend (Dr. Leland J. Pritchard) defined monetarism. Pritchard received his doctorate from Chicago in 1933. Pritchard challenged the ABA as it conspired to remove Reg Q ceilings (banks pay for what they already own). SEE: “Profit or Loss from Time Deposit Banking” — Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

  11. Brad

     /  July 9, 2012

    IOeRs alter the construction of a normal yield curve, they INVERT the short-end segment of the YIELD CURVE – known as the money market.

    The 5 1/2 percent increase in REG Q ceilings on December 6, 1965 (applicable only to the commercial banking system), is analogous to the .25% remuneration rate on excess reserves today (i.e., the remuneration rate @ .25% is higher than the daily Treasury yield curve almost 2 years out – .27% on 4/18/12).

    In 1966, it was the lack of mortgage funds, rather than their cost (like ZIRP today), that spawned the credit crisis & collapsed the housing industry. I.e., it was dis-intermediation (an outflow of funds from the non-banks).

    Just as in 1966, during the Great Recession, the Shadow Banking System has experienced dis-intermediation (where the non-banks shrink in size, but the size of the commercial banking system stays the same)
    The fifth (in a series of rate increases), promulgated by the Board and the FDIC beginning in January 1957, was unique in that it was the first increase that permitted the commercial banks to pay higher rates on savings, than savings & loans & the mutual savings banks could competitively meet (like the CB’s IOeRs now compete with other financial assets [held by the non-banks], on the short-end of the yield curve).

    Bankers, confronted with a remuneration rate that is higher (vis a’ vis), other competitive financial instruments, will hold a higher level of un-used excess reserves (i.e., will both 1. absorb existing bank deposits within the CB system, as well as 2. attract monetary savings from the Shadow Banks).

    SEE: The inverted Eurepo curve spells trouble

    “Securities purchased (and sold) by the Fed, for example, could be absorbing assets that were held by the non-bank private sector or by the banking system itself.”

    But the Chicago Fed’s research staff missed the corollary – IOeR’s “could be absorbing (no attracting) assets that were held by the non-bank private sector or (yes absorbing) by the banking system itself.”

    Click to access ennis_wolman.pdf

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