The Fed and nominal GDP and income targets
I have been off the grid of late so I have limited blogging capacity. But I still wanted to present a different perspective on monetary policy here for a second given the recent Fed move to permanent zero.
First, I should say that my view is that monetary policy is a blunt instrument and that low nominal rates lead to resource misallocation by favouring debtors at the expense of savers, by subsidising marginal companies by lowering the cost of capital, and by causing investors to take on risk to seek a nominal return. Low nominal rates can also be toxic to bank net interest margins as the yield curve flattens with interest rate expectations.
This asymmetric interest rate policy has been the unofficial US policy for a generation. Now, the doom loop is coming to an end. The doom loop is where:
a cycle of cheap financing and lax regulation leads to excess risk and credit growth followed by huge losses and bailouts. With interest rates near zero everywhere, the doom loop seems to have hit a terminal state where debt deflation and depression are the only end game unless serious reform measures are taken.
However, with fiscal policy off the table in the US and Europe, what is the monetary agent to do? Post credit-crisis tight money and tight fiscal leads to depression. David Beckworth, an economics professor and blogger at “Macro and Other Market Musings”, argues the monetary agent needs to be accommodative by targeting nominal GDP and nominal income. What does that mean? I asked him to explain. Here’s what he wrote me:
The key for the Fed to be effective is for it to radically change or "shock" expectations about future nominal spending. The Fed would do this by announcing an explicit NGDP level (or price level) target where it publicly committed to buying up as many assets as it needed to return NGDP (or the price level) to some pre-crisis level trend. Since this would mean higher-than-normal NGDP (or price level) growth for some time (until the pre-crisis trend is restored), it would imply the Fed would be purchasing a lot more assets. This would "shock" households and firms into spending their money assets on other riskier assets (like stocks and physical capital) as well as goods and services lest their money assets lose value from the higher expected inflation during the catch up growth period.
- Even if only the riskier financial assets are initially purchased, the sellers of the financial assets would now have money balances they will want to unload because of the higher inflation. They too will start buying up other assets, goods, and services. Eventually, then, the money assets will buy capital, goods, and services. This requires, though, that the Fed continues to buy up assets–including longer-term treasury securities– until this happens, which is the very point of having a spending target like a NGDP level target–keep adding stimulus until nominal spending hits its target.
- The key is to have a level target, not a growth rate target. A growth rate target like inflation targeting lets bygones be bygones. A level target allows for catchup growth and vice versa when there is a deviation from the target. This allows for more aggressive monetary action in the short term, but at the same time creates more certainty over the long term since the policy aims for a target level growth path.
- Having an explicit, well communicated nominal target means the Fed does not need to commit up front to an explicit dollar amount of asset purchases. This makes the policy less controversial, eliminates the need for successive rounds of ad-hoc QEs, and if credible will cause the markets to do the heavy lifting (i.e. if the markets believe the Fed is serious about higher nominal spending and inflation, they will respond on their own before the Fed purchases assets and thus lessen the needed amount of asset purchases by the Fed).
- Not only have corporations, but households too have built up relatively large share of liquid, money-like assets since the crisis. All the talk about household deleveraging ignores that they have also been rapidly building up the share of liquid assets and thus curtailed spending. The process above should help reverse this development.
- Once the nominal spending takes off, there will be real economic gains, not just inflation, given the amount of excess economic capacity. (i.e. the increased spending will put unemployed resources back to work).
- Because of (5), expectations of higher real growth will further reinforce current nominal spending and increase the demand for loans from banks. Banks will respond to the increased demand for credit by extending loans. The money supply grows in turn.