Clearing up Some Miscommunication

Hamilton and I are still miscommunicating on two points.

Professor Hamilton continues to argue that if the Fed promised to buy or sell unlimited amounts of 12 month forward NGDP futures contracts at a five percent premium over current NGDP, it might lead to an almost infinite demand for such contracts if someone expected six percent NGDP growth. One problem with this argument is that a margin payment would be required for each trader. And wealth is not infinite. Nonetheless, I do concede that a very wealthy individual or investment bank could theoretically purchase an extremely large number of such contracts. But Hamilton overlooks a much more important point; the policy envisions each trade changing the money supply.

In the example cited by Hamilton, each trader took a “long” position on NGDP, expecting above five percent NGDP growth. Thus each trade triggers an offsetting open market sale by the Fed. What Hamilton appears to overlook is that long before an infinite position was established, the monetary base would fall to zero. When traders forecast NGDP they don’t make unconditional forecasts, rather they make forecasts conditional on the money supply after the trade is completed. I defy anyone to come up with a plausible model where six percent NGDP growth would be expected at a zero money supply. Yet that is the implication of Hamilton’s counterfactual. Note: I am not talking about a zero growth rate, but rather a zero level of the money supply.

I think this counterargument is sufficient. But in case anyone is worried about some rogue trader willing to sacrifice huge amounts of wealth in order to destabilize monetary policy, I did suggest in my 2006 paper that the Fed could limit the net position of any one trader to some reasonable level, where “reasonable” is defined as a level where other institutions such as investment banks would be able to provide a sufficient counterweight if the expected future NGDP diverged significantly from its target value.

The second issue has to do with policy lags and the potential for monetary policy to impact short run movements in NGDP. I would like to clear up two misconceptions.

First, I do not believe that the Fed would ever be incapable of hitting a five percent NGDP growth target over a three month time frame. The miscommunication was my fault, as I said something that could have easily been read the other way. I said that I wasn’t claiming that the Fed had this ability. I meant this to refer to my proposed policy regime. They are certainly capable of rapidly creating explosive inflation if they wish to. What I meant to say is that if the Fed had an appropriate policy — say, targeting one or two year forward NGDP growth at five percent per annum — then they might not also be able to prevent NGDP from coming in somewhat below target in the next quarter. This is the familiar “one tool two targets” dilemma. But is this really such a big problem? We often have fairly wide variation in quarter-to-quarter NGDP growth without sliding into recession.

Another way of looking at this is that when we do have recessions, we virtually always have one or two year forward NGDP growth coming in well below pre-recession estimates. The only exception that comes to mind is the 1974 recession, which was distorted by both a big energy shock, and the removal of price controls (which increased measured inflation.) I don’t see how anyone could say energy prices are the main problem in 2009, as they have been generally lower than 2007, when unemployment was quite low. Rather, the problem is now low NGDP. (Although I agree with Hamilton that energy prices did slow the economy in early 2008, when unemployment was still low.)

I also think it is important not to confuse two distinct problems. One is the very real difficulty that policymakers have in convincing the markets that they intend to shift to a different NGDP trajectory. And the second is the much less serious problem of convincing the markets that they intend to keep targeted NGDP on roughly the same growth track as had persisted for several decades. The later problem doesn’t requite changing peoples’ minds, but rather reassuring them that any near term shortfall will be made up as soon a reasonably possible. If such an assurance is provided, it will greatly reduce the near term fall in NGDP, even if there are real shocks such as a dysfunctional banking system. At worst you would get a bit of stagflation, but that is appropriate in the face of supply shocks under either flexible inflation targets like the Taylor Rule, or my preferred NGDP targeting regime.

I simply don’t see any examples of severe demand-side recessions that were not accompanied by equally sharp declines in one and two year forward-looking NGDP expectations. This happened in 1920-21, 1929-30, 1937-38, 1981-82, and 2008-09. I can’t say it’s impossible; it is theoretically possible that unemployment might soar to 9.7 percent in an environment where the public continued to expect on-target NGDP growth over the next year or two. But until I see something remotely close to that scenario, I will continue to believe that the odds of it occurring are vanishingly small, and not a consideration for policy formation.

As an aside, yesterday Hamilton’s blog ( ran a guest post by David Papell that clearly shows the importance of targeting price level or NGDP expectations. Papell points out that throughout almost all of the 1970s the public continued to lag behind reality in their inflation forecasts. Let’s suppose they consistently missed by two percent or three percent. In that case, a Fed policy of targeting inflation expectations would lead to persistently high inflation. In contrast, a price level target that was consistently underestimated by two percent or three percent would result in roughly on-target inflation, except at the very beginning. And since wage contracts are generally linked to expected inflation, any short term price level movements would have little effect on wage growth, and thus would make it relatively easy to get back on target without a major change in employment. We need to stabilize expectations; but not inflation expectations, rather price level or, even better yet, NGDP expectations.

Perhaps this is just wishful thinking, but I continue to believe Hamilton and I aren’t that far apart. But we need to get beyond hypotheticals like hyperinflation that neither of us favor. Consider this statement by Hamilton:

Given a longer time frame (and I think 12 months is still too short), I believe a target average for the nominal growth rate becomes more credible. But that’s because I believe in long and variable lags, with much that can happen that is beyond the Fed’s control that matters for output and prices. The Fed influences, but does not control, nominal GDP growth.

Let’s say 12 months is too short. Let’s suppose Hamilton thinks the Fed should be looking 24 months down the road. My response would be “fine, let’s target 24 month forward NGDP at a level about 10 percent above current levels.” (I.e. five percent per annum.) Suppose he prefers four percent per annum. Fine. I’d prefer using market forecasts, but if Hamilton doesn’t think that would work, then let’s use Fed discretion. I claim even that policy would have made the near-term recession far less severe; Hamilton is more skeptical. But what is the worst that could happen? We’d still be implementing Hamilton’s preferred policy. In contrast, the Fed is going to deliver mid-2010 NGDP at a level roughly equal to mid-2008 levels. That’s 10 percent below trend, and eight percent below a hypothetical goal I gave Hamilton. I don’t know exactly what target he favors, but from his blog it is clear he thinks it would have been better if AD had not fallen so sharply late last year.

Also from this issue

Lead Essay

  • In this month’s sure-to-be controversial lead essay, Bentley University economist Scott Sumner argues that almost everything economists and economic policymakers thought they knew about the role of monetary policy in the recent recession and financial collapse is wrong. Sumner contends that the resources of monetary policy were not exhausted, as many economists believed, but were barely used. Flying in the face of conventional wisdom, Sumner maintains that monetary policy in the run-up to the finacial crisis was not highly expansionary, but was in fact disastrously contractionary. Sumner offers a short history of monetary economics to put into historical perspective the role of allegedly failed monetary policy in the financial crisis and recession. He proposes a strategy for central bankers — targeting forecasts of nominal GDP — that might help avert future crises. In conclusion, Sumner warns of the political dangers of misdiagnosing the crisis: unless the record is set straight, free markets will once again take the fall for a failure of monetary policy.

Response Essays

  • University of California, San Diego economist James D. Hamilton disputes Scott Sumner’s claim that the sub-prime crisis was a fluke with few lessons for macroeconomics. According to Hamilton, the booming U.S. housing market represented a “huge misdirection of capital,” and the overexposure of key financial institution to the housing market’s downward correction crippled lending and sent the economy into a nosedive. Hamilton agrees that the Fed might have limited the damage had it kept the growth rate for nominal GDP higher, but he disagrees with Sumner about the tools available to the Fed to achieve this. Hamilton notes that tools available to the Fed depend on which of the possible specifications of the money supply and its velocity actually determine nominal GDP. Hamilton says unconventional paths to monetary stimulus were open the Fed in late 2008 and that “the preferred policy … would have been to acknowledge more aggressively the losses financial institutions had absorbed on existing loans, impose those losses on stockholders, creditors, and taxpayers, and retain as the Fed’s first priority the stimulus of nominal GDP rather than trying to lend to everybody.” Hamilton concludes with some worries about Sumner’s favored tool for targeting nominal GDP growth.

  • University of Georgia economist George Selgin agrees with Scott Sumner that “tight money was the proximate cause of the post-September 2008 recession” and that “a policy of nominal income growth targeting might have prevented the recession.” Selgin encourages Sumner to acknowledge the role easy money played in the subprime crisis, and argues that Sumner’s five-percent nominal income growth target is “unnecessarily and perhaps dangerously high.” Selgin favors a two or three percent target, which he contends would be less likely to perpetuate boom-bust cycles.

  • San Joses State’s Jeffrey Rogers Hummel begins with a brief history of economic thought about the causes of the business cycle, which leads to a call for “a measure of epistemic humility.” Hummel signs on to much of Sumner’s story about the Fed behavior in 2008, and accepts his criticism of the widespread use of interest rates as the main indicator of monetary policy. But Hummel departs sharply from Sumner’s prescription for better monetary policy — a rule to target the forecast of nominal GDP growth. “The … critical defect of Sumner’s Rule,” Hummel argues, “is its blithe assumption that money, unlike any other good or service, requires not merely government provision but detailed, sophisticated, and flexible government management.” Hummel raises doubts that even the best such rule would be well-applied, and calls for the “abolition of the Fed, elimination of government fiat money, and complete deregulation of banks.”