Ben maybe you should try “policy futures”?

My readers will know that I think that the Federal Reserve has taken a step in the right direction with its latest policy action. I do think that the fed finally after four years of failure is moving towards a more rule based monetary policy. However, it is certainly far from perfect and there is still a lot of risks involved.

The Minutes from the latest FOMC meeting was published yesterday and it is clear that the FOMC is well-aware that it needs to address it’s communication problem. That’s positive. However, it is also clear that the fed still don’t have a proper communication policy in place and even though we are moving towards a more rule based monetary policy it still not completely clear what the rule is and it is not entire clear how it should be implemented. We are still far away from Milton Friedman’s ideal of having a computer control monetary policy. However, I think that the fed should move in the direction of that ideal and it could start the journey toward this goal by introducing what we could call “policy futures”.

It is obvious that the fed is aware that there is problems with the present forecasting set-up within the fed. The key problem is one that every central bank in the world is facing – should the central bank forecast that it will fail? That is effectively what the fed has been doing so far when it is saying that it expect a fragile and weak recovery.

Scott Sumner has suggested that monetary policy should be “pegged” to a NGDP future, which would mean that the money base is increased or decreased continuously as market expectations for future level NGDP changes. This is basically the Friedman ideal of a computer – or rather the market – controlling monetary policy. However, a less radical plan where futures are “just” used for policy guidance and forecasting is also possible and that is what I suggest that the fed should look at.

There are some very clear advantages of using the market to forecast. First of all the fed would not have to know the “real model” of the US economy. Second the forecasts would be unbiased. Third the fed would have real-time forecasts of its policy variables.

It is pretty clear that the fed is now moving towards some kind of Evans rule where changes in the money base is a function of unemployment and inflation. We don’t know fed’s reaction function, but a version of the Evans rules could take the following form:

(1)    ∆b = α(U-U*)-β(π-πT)

Where ∆b is the change in the money base, α and β are coefficients, U is unemployment and U* is the fed’s unemployment target or the structural unemployment, π is inflation and πT is the inflation target.

There plenty of reasons to be skeptical about the fact that the fed is so clearly targeting real variables (employment/unemployment). However, by using policy futures it might be possible to greatly reduce these risks.

I imagine that the fed set up a futures or an options market on for example inflation, employment/unemployment and obviously NGDP on different time horizons.

Let’s say that the fed has the target of reducing unemployment to 6%, but also want to maintain long term price stability (keeping inflation around 2%). If structural unemployment is higher than 6% then that would obviously not be possible – and if the fed tried to push unemployment below 6% then inflation would explode. A policy future would greatly help assess this risk.

Hence, the fed could issue a put option that would be knocked in if unemployment dropped by 6% and inflation was below 2 or 3% at some future date – for example January 1 2013. Such an option would give an assessment about whether it is likely that the fed will hit it’s policy objectives. If the market assess that structural unemployment is above 6% then that would be reflected in the pricing of the put option.

If the fed issued a number of different policy futures and options on the key policy objectives it could get the markets’ assessment of whether it is on the right track in terms of fulfilling it’s monetary policy objectives or not by cross-checking the pricing of different policy futures.

Such policy futures could also greatly help the fed in it’s communication with the markets and it would probably also be much easier to get consensus on the FOMC about the possible risk to monetary policy.

The fed would very easily be able to set up such policy futures markets, but the informational gains would in my view be tremendous. The only “problem” would that the fed would need fewer economists to do forecasting…

Related posts:
Yet another argument for prediction markets: “Reputation and Forecast Revisions: Evidence from the FOMC”
Benn & Ben – would prediction markets be of interest to you?
Prediction markets and government budget forecasts
Central banks should set up prediction markets
Markets are telling us where NGDP growth is heading
Scott’s prediction market
Robin Hanson’s brilliant idea for central bank decision-making

Noah Smith should ask why stock markets are volatile

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).


Related posts:

“Understanding financial markets with MV=PY – a look at the bond market”

“Fear-of-floating, misallocation and the law of comparative advantages”

“Exchange rates are not truly floating when we target inflation”


Update: The always insightful Bill Woolsey has an excellent comment on Noah Smith.

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