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


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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