Sunday, October 12, 2014
The market monetarist smell test
I gave myself a quick whiff this week to determine if I pass the market monetarist smell test. This is by no means definitive, nor is this an officially administered MM® test.
To be clear, my preferred policy end point is market choice in centralized banking. In other words, you, me, and my grandma should be able to start up a central bank. But that's a post for another day. First-best option aside, here's my reading of a few market monetarist ideas.
Target the forecast
**** 5 stars
Big fan. Targeting the forecast would take away the ad hoccery and mystique that surrounds central banks. We want central bankers to be passive managers of yawn-inducing utilities, not all-stars who make front covers of magazines.
First, have the central bank set a clear target x. This is the number that the central bank is mandated to hit in the course of manipulating its various levers, buttons, and pulleys. Modern central banks sorta set targets—they reserve the right to be flexible. Bu this isn't good enough. To target the forecast, you need a really clear signal, not something vague.
Next, have the central bank create a market that bets on x. Either that, or have it ride coattails on a market that already trades in x. If the market's forecast for x deviates from the central bank's target, the central bank needs to pull whatever levers and pulleys are necessary to drive the market forecast back to target.
The advantage of targeting the market forecast is that the tasks of information processing and decision making are outsourced to those better suited for the task: market participants. Gone would be whatever department at the central bank whose task is to fret over incoming data to determine if the bank is on an appropriate trajectory to hit x. Gone too would be the functionaries whose job it is to carefully wordsmith policy statements. The job of Fed-watching—the agonizing process of divining the truth of those policy statements—would disappear, just like lift operators and bowling alley pinsetters have all gone on to greener pastures. Things would be much simpler. If the market bets that the central bank is doing too little, its forecast will undershoot the target and the central bank will have to loosen. Vice versa if the market thinks the central bank is doing too much.
Targeting the forecast is the "market" in market monetarism. It's elegant, workable, and efficient—let's do it.
*** 3 stars
Meh, why not?
If we're going to target the forecast, we need a number for the market to bet on. Using the same target that central banks currently use is tricky. Most central banks are dirty inflation targeters. They try to keep the rate of change in consumer prices on target, but reserve the right to be flexible. Central banks have been willing to tolerate a little more inflation than their official target, especially if in doing so they believe that they can add some juice to a slowing in the real economy. Alternatively, they may choose to undershoot their inflation target for a while if they want to put a break on excessively strong output growth.
An NGDP target may be a good enough approximation of a flexible inflation target. NGDP is real GDP multiplied by the price level. If a target of, say, 4% NGDP growth is chosen, and the real economy is growing at 3%, then the central bank will only need to create 1% inflation. But if output is stagnating at 0.5%, then it will create 3.5% inflation.
So NGDP targeting affords the same sort of flexible tradeoff between the price level and real output that dirty inflation targeting affords, while serving as a precise number for markets to bet on.
The quantity of base money
* 1 star
Market monetarists have a fixation on the quantity of base money. This is where the monetarism in market monetarism comes from. Specifically, market monetarists seem to think that a central bank's policy instrument is, or should be, the quantity of base money. The policy instrument is the lever that the Carneys and Draghis and Yellens of the world manipulate to get the market to adjust the economy's price level.
But modern central banks almost all pay interest on central bank deposits. The quantity of money has effectively ceased to be a key policy instrument. (The Fed was late, making the switch in 2008). Shifting the interest rate channel (the gap between the interest rate that the central bank pays on deposits versus the rate that it extracts on loans) either higher or lower has become the main way to get prices to adjust.
This doesn't mean that the base isn't important. Rather, the return on the base is the central bank's policy instrument—it always has been. This is a big umbrella way of thinking about the policy instrument, since the return incorporates both the interest rate paid on deposits and the quantity of money as subcomponents. Reducing the return creates inflation, increasing it creates deflation.
Market monetarists seem to think that the interest rate channel ceases to be a good lever once interest rates are at 0%. But this isn't the case. It's very easy for central banks to reduce the return on deposits by imposing deposit rates to -0.5% or -1.0%. Going lower, say to -3%, poses some problems since everyone will try to immediately convert negative yielding central bank deposits into 0% cash. But if a central bank imposes a deposit fee on cash, a plan Miles Kimball describes more explicitly here, or withdraws high face value notes so that only ungainly low value notes remains, which I discuss here, there's no reason it can't drop rates much further than that.
If anything, it's the contribution of quantities to the base's total return that eventually goes mute. In manipulating the quantity of central bank deposits, central banks force investors to adjust the marginal value of the non-pecuniary component of the next deposit. Think of this non-pecuniary component as package of liquidity benefits that imbue a deposit with a narrow premium in and above its fundamental value. Increasing the quantity of central bank deposits results in a shrinking of this premium, thereby pushing their value lower and prices higher, while decreasing the quantity of deposits achieves the opposite. At the extreme, the quantity of deposits can be increased to the point at which the marginal liquidity value hits zero and the premium disappears, at which point further issuance of central bank deposits has no effect on prices. Deposits have hit rock bottom fundamental value.
So in sum: yes to targeting the forecast, and I suppose that an NGDP target seems like a good enough way to achieve the latter, and to hit it let's just keep using rates, not quantities. Does this make me a market monetarist?
Of course there's more to market monetarism than that, not all of which I claim to understand, but this post is already too long. Nor am I wedded to my views—feel free to convince me that I'm deranged in the comments.
Incidentally, if you haven't heard, Scott Sumner is trying to launch an NGDP prediction market.