Monetary Policy: A Blunt Club or a Surgeon's Scalpel?

And a reason why NGDP futures are a critical credibility tool

Should monetary policy be viewed as a blunt club or a surgeon's scalpel? While we often discuss central banks credible actions to accurately hit a policy target, there is less discussion on whether central banks can precisely hit a target. Because while both blunt clubs and surgeons' scalpels can wound and hurt, a club "beats around the bush" while a scalpel (ideally) targets a specific, well defined area. In the language of monetary policy, we know central banks can raise the level of nominal GDP growth, but can they precisely control the magnitude of the increase? How much of a base injection does the central bank do to make the potatoes hot enough without burning our fingers? This precision problem is at least as important as the accuracy problem because it is a key reason for why explicitly declaring a five percent nominal GDP level target is not sufficient. Because there are real costs of extremely high inflation, the central bank is likely to shy away from policies that might "accidentally" lead to excessively high inflation. If economic variables become more volatile, the lack of monetary policy precision can become a major barrier to monetary policy accuracy.

The core of my argument starts from a mechanics-credibility theorem, which states that if policy does not have a concrete mechanism, it can not be credible. This theorem means raising nominal GDP can be credible. We know that central banks have an infinite number of ways to inflate: currency depreciation, asset purchases, forward guidance, nominal GDP futures targeting, among other options.

However, what does the theorem say about policies to raise nominal GDP to a specific, precise level? What do we have to guarantee this? A typical market monetarist response would be that expectations bridge the gap. Because private agents believe that the central bank will raise nominal GDP to reach trend growth, the market will do the work for the central bank. They will invest in riskier assets, hire more people, engage in more research and development projects, and other ventures up until current nominal GDP returns back to the trend line. Once we're back at trend growth, the central bank can just moderate the economy without too much work because the perfectly credible declaration will induce the market to stabilize itself. 

Although this logic is appealing, it is nonetheless circular. According to this line of argument, a precise target is credible because the central bank will inevitably hit the target, but the reason the central bank is precise is because it is credible. Before we can wave the magic wand of expectations, we need to show that there exists a vanilla, "elbow grease" monetary action that can credibly hit a target with both accuracy and precision.

In normal times, the relationship between the short term nominal interest rates is reasonably stable, and central bankers can manipulate the short term rate quite effectively to stabilize nominal GDP. This is a game that the Federal Reserve has played for the entire Great Moderation. However, once the economy is in a liquidity trap, the short term rate loses its effectiveness, and other more drastic measures are needed. Now that we're in uncharted territory, here is where the precision problem arises.

Take asset purchases for example. As noted by Miles Kimball, these asset purchases can have large effects, if implemented on a large scale. There are certain monetary frictions that allow quantitative easing to break out of the liquidity trap, but for those frictions to exert an appreciable effect quantitative easing must take place at a large magnitude. A specific friction that I see is Kiyotaki and Moore's liquidity friction, which states that the bonds central banks purchase are not as liquid as the cash that central banks dish out. Bonds cannot be sold as quickly, so the large stock of bonds represents a promise that the central bank will maintain a higher monetary base in the future. This is how the central bank gets around the Woodford, "double the monetary base in this period and all subsequent periods" credibility problem. While central bank declarations of a future elevated monetary base may not be seen as credible in light of inflation targeting, committing to large scale bond purchases commits the central bank to a brief period of above average inflation by locking in the larger monetary base. In the words of Brad DeLong:

But purchasing bonds for cash has another effect. Cash is a perfect substitute for short-term Treasury bonds now. It won't always be the case. When interest rates normalize, the price level will be roughly proportional to the high-powered money stock. Not all of today's purchases of bonds for cash will be unwound when the economy exits the zero lower bound. If we believe that the high-powered money stock will be roughly $1 trillion after exiting the zero lower bound, and if we believe that a fraction λ of marginal bond purchases won't be unwound, then an extra $100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery.

The problem with this approach is that it is not robust to shifts in expectations. Working with Brad's terminology, λ is positively correlated with the scale of bond purchases. As a result, expected inflation is non-linear with respect to bond purchases. Initial bond purchases may not raise inflation expectations by much, but past a tipping point at which λ start rising quickly, inflation expectations could drastically shift. Even if such bond purchases occur at a steady rate so as to avoid sudden changes, expectations can still suddenly shift if an unforecasted shock occurs. If key economic parameters, such as money velocity, become increasingly unstable, expectations fragility will only grow worse. An example of this kind of "expectation fragility" is with the Swiss National Bank's currency floor. While the fundamental value is below the floor, we get suppressed volatility. Once the fundamental value rises, even if it's purely because of static, there can be lots of chaos as a previously fixed price is now allowed to move. In the context of monetary policy, given the large stock of currency reserves, a slight unforecasted rise in inflation expectations can be the trigger for a massive investment reallocation.

Lars Svensson, in his paper on a "foolproof" way to leave a liquidity traps, also highlights this uncertainty:

It is difficult to determine how large an open-market operation would be needed to reduce the long interest rate, because of difficulties in estimating the determinants of the term premium of interest rates (that is, the difference between long and short interest rates and its dependence on the degree of substitutability between short and long bonds). However, Bernanke (2002) has proposed an elegant operational solution to this problem. The central bank simply announces a low (possibly zero) interest-rate ceiling for government bonds up to a particular maturity, and makes a commitment to buy an unlimited volume of those bonds (that is, potentially the whole outstanding volume) at that interest rate. This commitment by the central bank is readily verifiable – since everyone can verify that the central bank actually buys at the announced interest rates – and achieves the desired impact on the long interest rate, without a need to specify the precise magnitude of the open-market operation required. The central bank may have to buy the whole outstanding issue of the long bond, though.  

In the absence of an expectations mechanic, there is a wide range of uncertainty on the policy response. Other forms of unconventional monetary policy, including currency depreciation or forward guidance, all suffer from this "how much is too much?" problem. Once you inject a few non-linearities into the stories, and have market expectations change at unknown threshold, you realize that prospects for precision are grim.

When the monetary policy result is uncertain, central banks are less likely to use the tools to raise nominal GDP. They may fear excessively high inflation or other side-effects of over-expansionary monetary policy, and choose to be "cautious" and live with high levels of unemployment instead. This is the reason why limits in precision can become limits in the accuracy or effectiveness of monetary policy.

A historical counter-example to this theory of uncertainty would be FDR's dollar devaluation program, which Scott and Marcus Nunes have shown to be very effective in restoring both the price level and output during the Great Depression. Yet I  don't find their example to  contradict my argument about the imprecision of monetary policy at the zero lower bound. Perhaps FDR got lucky. Perhaps the price level was already so depressed that you would have needed hyperinflaiton. Perhaps, back then, finance was not as tightly coupled and the investment effects of getting out of treasuries wouldn't have been as strong. Nonetheless, in our faster, more leveraged, more volatile world, this granularity and imprecision of monetary policy is a bigger impediment.

Scott Sumner often uses Australia as another example, pointing out that their monetary base to nominal GDP ratio is much lower than that in the United States. This shows that Australia has not had to inject as much money into their banking system to stabilize nominal GDP, demonstrating that the stabilizing nominal GDP growth should not be very difficult. But Australia is unique in that it never was at risk of the zero lower bound. While part of this may have just been good monetary policy, it still leaves open the possibility of a large, unforecasted shock that puts a county at the zero lower bound.

However, one form of nominal GDP targeting seems to sidestep these problems: nominal GDP futures targeting. This would allow market participants to instantly improve estimates of future inflation by bidding on futures contracts. Their bidding one way or another would immediately translate into changes in central bank open market operations such that nominal GDP always stays on track. This approach sidesteps the non-linearity of expectations because it allows the market to aggregate all the necessary information and automatically has the central bank adapt to the new found information. Even if expectations did shift in response to unforecasted shocks, the policy response would be immediate and taken in decentralized steps as individual investors bid on futures contracts. In this case, mechanics-credibility theorem is satisfied because the mechanic by which the Fed earns its nominal GDP credibility directly interacts with market expectations while avoiding the circularity problem. Market expectations of nominal GDP feed into futures market volumes, which directly changes the monetary base. The market answers the questions of "how much" with the level it thinks is "just right".

This is one of the key advantages of an nominal GDP futures targeting regime relative to a conventional "wait-and-see" regime. It cements in credibility, and rolls with the waves of external volatility. In a sense, it floats like a butterfly and stings like a bee. It takes monetary policy from the world of "Bernanke Smash" to "Sumner Slice", and allows for greater accuracy and precision in the control of a central nominal aggregate: nominal GDP.