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. 

Some points:

  1. 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.
  2. 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.
  3. 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).
  4. 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.
  5. 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).
  6. 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.
  1. Rob says

    What’s the transmission mechanism that all this is supposed to work? No new net financial assets are created and this theory from my understanding assumes banks lend reserves which is false.

  2. Rob says

    What’s the transmission mechanism that all this is supposed to work?

    No new net financial assets are created and this theory from my understanding assumes banks lend reserves which is false.

  3. Anon1 says


    Why do you say that about lending out of reserves? It seems rather clear to me from his point 6 that bank lending is the result of this process, not the cause of it. In his story, lending is driven by an increased demand for credit, not because reserves increased. Also, the transmission mechanism seems in a word to be the “hot potato” effect with money when inflation expectations are changed.

    1. Rob says

      I have yet to see any empirical evidence confirming this “hot potato” effect. When the Fed buys an asset any asset it credits a member banks reserve account. Am asset swap. No net new financial assets created. Fiscal stimulus adds net financial assets. Banks do not lend reserves.

      So how does increasing bank reserves add to a “hot potato” effect? This proposal assumes QTM which has been debunked thoroughly by Mitchell, etc

  4. Matty G says

    Rob – I agree. The proposal that Mr. Beckworth presents is interesting, but does not seem to me to be very much related to the reality we live in.

    If I own $50,000 in bonds and want to spend $50,000, I am very much able to do so. I am not constrained in my spending by the fact that it is not technically “cash.” I just hit sell, wait a day or two, and then spend the money.

    If I sell the $50,000 bond to the Federal Reserve, that does not do anything whatsoever to make me more able to spend $50,000 than I otherwise would be.

    Another point – If I think that my savings are going to lose money (whether through inflation, risky asset markets, or 0% interest rates), my response is to say – “Oh no! My savings are not as much as I had counted on them being. I had better cut my spending and save MORE money so that I don’t have to eat cat food when I retire.” Of course, this just furthers the deflationary spiral on the macroeconomic level.

    According to neoclassical economists, I am being “irrational” by doing this. What I would do if I were “rational” is say “screw it – I’ll never save money again – I’ll spend all of that money on worthless junk instead, and eat cat food when I retire after all.”

    Conclusion: neoclassical economists are most definitely not rational.

  5. Bob Kelly says

    So you are saying that the Fed is going to buy a couple of million houses?

  6. Dan Lemnaru says

    So, essentially, he’s proposing a policy of guaranteed, larger, negative real interest rates. Having some savings myself, I know this would force me into buying up something, be it property or anything else that at least seems likely to maintain its real value. So, yes, this could result in more money circulation (feeding the inflation) and possibly getting more people employed. I’m not too sure of any side effects. Much of this spending would be fear driven, hurried and largely irrational. Can an economy be reinvigorated out of that?

    In way, this is also a policy of inflating the whole economy to catch up with overvaluations caused by a bubble. When real estate prices would get back to the 2006 levels, negative equity would be largely a non-issue.

  7. Tom Hickey says

    What NGDP targeting would likely do is drive gold to $3000 pretty quickly. This strikes me as a very dumb idea. It would not provoke either consumer spending since it doesn’t increase effective demand, and it won’t provoke investment either which responds to signals from increasing demand. It will drive assets from one class to another in order to offset perceived inflation, like tank bonds and drive up equities and commodities. Mainstream economists don’t trade so they don’t understand finance, and they don’t get out much so they don’t know how actual people think.

  8. KIrk Hanawalt says

    If I sell the $50,000 bond to the Federal Reserve, that does not do anything whatsoever to make me more able to spend $50,000 than I otherwise would be.

    But you have $50K in cash and so does the person you didn’t sell your bonds to. The Fed punched keys on a computer and created new money to buy your bonds, now you have cash yielding 0% in an inflationary environment. You’ll probably want to buy something that offers the possibility of a positive real return.

    The interesting question is what happens to interest rates. The Fed could theoretically hold bond yields to any desired level across the maturity spectrum, even 0% in the extreme, by buying up to 100% of the available supply. But banks would have to raise loan rates to maintain a positive real return. This raises an objection similar to the Ricardian Equivalence argument against stimulus by deficit spending: NGDP targeting would be inherently self-limiting because high inflation would raise private loan rates and limit the stimulus effect.

    But why get fancy? Why doesn’t the Fed credit every savings account in the U.S. daily with “free” money until NGDP reaches target?

  9. Dave Holden says

    Personally I’m tired of Economist’s grand schemes.

  10. flow5 says

    POMOs between the PDs & the non-bank public create new money. Nominal gDp = MVt (aggregate monetary purchasing power).

    GDP has been revised (sharply lower), all the way back to 2003. Nominal gDp targeting would have prevented some excesses & shortages but wouldn’t have prevented the housing boom-bust. You have to use bank debits as a metric to monitor & control the large housing sector.

  11. David Lazarus says

    This is unworkable. Until very recently there had been a surge in asset purchases. The wealth effect is so marginal at best. Most american households have little or no capital to speculate with. Much personal capital was destroyed in the housing crash, and much of what is left will be burned in the coming crash. Asset deflation is the name of the game now and all these measures will only trash the currency as well.

    As was pointed out fiscal policy is not available. Monetary policy is useless when operating at the extremes. No one is borrowing at the moment because everyone realises that assets are overvalued. Also banks want customers much more equity in a deal before they lend because they want to be insulated from the inevitable falls.

    As Matty G noted people will save if they feel that their reserves are too low. Creating inflation will only work if peoples incomes are growing so that the debt burden falls. For most americans that route ended 30 years ago. All it will do is raise the debt burden as income fall in real terms even faster. For the majority of people they will have to make further cuts to disposable spending.

    As for buying assets what happens when those assets collapse in value? All it will do is devastate their finances.

  12. Aaron R says

    This sounds like a fancy way of monetizing debt. But if consumers stop deleveraging because of an upturn, it may be ineffective.

    Otherwise, this is just another loose money scheme that will create market distortions and a fragile and inefficient economy.

  13. flow5 says

    Purchases and sales between the Reserve banks & non-bank investors directly affect both bank reserves and the money supply. Targeting nominal gDp is a revert-to-the-mean policy, not a jobs program. Such a policy would have averted the drastic downswing that the current policy (targeting interest rates), caused.

  14. flow5 says

    Actually Sumner’s & Beckworth’s strategy is unsophisticated. Mine is better. Currently, OCT will be the bottom in stocks.

  15. Dan Lemnaru says

    “As for buying assets what happens when those assets collapse in value? All it will do is devastate their finances.”

    Indeed, there is no guarantee that the generated inflation will be equal across assets, resulting in an equilibrium. Maybe everybody will see gold as safe, being “sound money”, thinking it will always hold its value (remember the housing prices never went down meme). We could end up with just about everybody buying it up, creating a new bubble.

    “But why get fancy? Why doesn’t the Fed credit every savings account in the U.S. daily with “free” money until NGDP reaches target?”

    Indeed, that’s what I keep asking myself as well, but for another reason, and a in a different fashion. The crisis is about people saving “too much” and people not having enough to cover their mortgages. Say you credit every single individual $30000. Then some people will feel ready to spend more, others will pay down some of their debt. Either way, the economy should gain something.

    1. David Lazarus says

      Why not just pay all unemployment benefits from the Fed, that way they are likely to spend it. Also why not have a lump sum for all people with incomes below $70 000 which gives everyone $10000 each and an extra $5000 for every child. This could be used to pay down mortgage or credit card debts. This will ease personal debt burdens and any excess could be spent.

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