Thursday, June 14, 2012

Can You Tell Me How to Get, How to Get to NGDPLT?

How quickly can bank reserves unravel?

Why are we always focused on the equilibrium, but not the disequilibrium dynamics that get us to that point? Noah Smith made this point in an old post about DSGE models, but it seems like there's a similar problem when it comes to an NGDP target. No doubt, in the end, an NGDP targeting regime would have incredible benefits, but how do we first get there? Specifically, how does the Fed adjust its balance sheet so that it doesn't trip on the "concrete steppes"?

Given the large expansion of the monetary base through excess reserves and IOR, the Fed cannot simply let all of the expansion become permanent. If the expansion were permanent, one would expect prices to be about four times higher than they were in the beginning of 2000. While I certainly support higher levels of inflation to support real growth in recessions, even I find that much inflation a bit unpalatable. It would certainly go beyond the 5% NGDP target that most market monetarists advocate and would result in massive political backlash. Most tragically, this would discredit the entire market monetarist enterprise, jeopardizing one of the most important revolutions in stabilization policy.

Thus, how do we control this unwinding? The typical market monetarist response is that a credible NGDP target establishes a bound on the expansion. The target can anchor market expectations to prevent inflation from getting out of control. But what happens when the policy is not fully credible? Again, I don't mean to say the central bank can not inflate. My concern is with the other side of the target and the possibility of above trend NGDP growth. When you're dealing with such a large expansion of reserves, you need to be cautious with how much is unwound as well as how quickly it takes place.

Ala Eggertsson-Woodford, we know the permanence of the monetary expansion is the critical determinant of the path of NGDP. This is confirmed in some private email correspondences, which brought up the possibility of banks paying higher dividends, or perhaps even venture capital as outlets for bank reserves. However, those options are not viable if the reserves aren't seen as permanent. A particularly striking line was:

The standard Keynesian story has been that in a zero interest-rate economy, it makes perfect sense for government to borrow a ton and invest now, because low rates don't last forever; well, guess what, it makes sense for the private sector too. Both the government and the private sector can think of ways to use more money, and if it wouldn't hurt for government to borrow and spend more, it won't hurt for business to borrow and spend more either.

While this means a credible expectations based regime can easily inflate, it should also remind us that controlling inflation and NGDP growth can be a non-linear task, subject to type-2 extremistan variation. We're not playing with bank balance sheets as much as we're playing with bank's beliefs. Beliefs can change on a whim. Once a certain threshold of expectations or interest rates are passed, banks will rapidly unwind their excess reserves and put their money to use. There is a critical level that we cannot observe, but once we pass it the monetary effects will be significant.

A possible argument out of this problem is that, if the banks knew what fraction of the reserves would be taken out of the system, they could plan ahead so that they don't expand by too much. However, the market is not a platonic game. There is no social planner that will only take a fraction from each bank; the banks have to reach a decentralized solution. Assuming each bank's reserves are small relative to the total stock of excess reserves, it would be in the interest of each bank to spend all of their excess reserves into higher yield assets or dividends so that they can take advantage of the limited permanent expansion of the base. It would be incredibly difficult on the part of the banks to coordinate, because how would they know the level of NGDP? Moreover, if the NGDP level overshot, why should private agents expect the Fed to step in? If central banks are inertial, the credibility of the NGDP target could be compromised. The FOMC only meets eight times a year, how could policy direct the path of NGDP well enough?

Fundamentally, there's two uncertainties that NGDPLT has to deal with. First is a band on the rate of NGDP growth. It can vary around the 5% goal. Second is the band on the timing of when the target is hit. If central banks are slow on adjusting policy, the market may see a bubble opportunity and jump in to make money. Timing is especially problematic because it's something that can cause bubbles even when market participants are rational about fundamentals.

To get around these problems, NGDPLT has to be implemented in a very careful fashion with strong forward guidance on what market participants should expect in terms of NGDP. Scott Sumner often discusses proposals for NGDP futures to help guide policy, but given these disequilibrium dynamics in the transition to NGDPLT, the futures markets are actually a prerequisite. Importantly, these NGDP futures should give information over a variety of time horizons, so banks, both central and private, can know more and plan for the future. With all this information, the central bank would need to be much more active in tuning the rates. While the instability of the rates might seem problematic, they would be instrumental in proving the credibility of the central bank in maintaining a smooth transition. This transition should also be slow, so that the return to trend growth is not too sudden. Thus, NGDP growth does not need to speed up too quickly before it's identified as "overshooting" the path that the Fed plans. It's not a simple act of "shooting for it". The Fed's balance sheet is incredibly large, so we need to be careful so that the easing process does not cause too many problems.

There is little doubt that a credible NGDP target regime with a small monetary base will yield incredible benefits for stabilization policy. But we can't let the perfect be the enemy of the good, and such a regime shift will require great caution.

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