Noah Smith wrote a critique of Scott Sumner's proposal to use futures contracts on nominal GDP to target the growth path of nominal GDP. Unfortunately, his understanding of the proposal came from Williamson's brief description. Smith discusses a proposal to control monetary policy according to changes in the price of a futures contract. The central bank would observe the price at which private investors trade a futures contract, and then use that to gauge appropriate changes in monetary policy.
Smith argues that monetary policy would be very volatile--the central bank would have to tighten or loosen large amounts. He makes this judgement based upon the volatility of stock prices relative to the discounted value of dividends. Since stock prices vary much more than discounted dividends, then futures contracts on nominal GDP would vary more than nominal GDP. He then notes that nominal GDP has been very volatile (though using Williamson's peculiar measure.) And so, the futures prices would be extremely volatile.
It is certainly good to see more outside criticism of futures targeting. Unfortunately, it is important to review what the proponents have said rather than just riffing off what other critics have said. Sumner proposes having the central bank buy and sell the futures contract at a target price. There would be zero volatility in the price of the futures contract.
I believe that Sumner has in mind a system where the target price increases at a 5% annual rate. However, it would also be possible to define an index by dividing the actual value of nominal GDP by the target, which would mean that the price of the future contract would never change.
Of course, what this means is that the central bank always takes a position opposite to the net position of market traders. If there are more bulls than bears on the market, the Fed must be a bear too. If there are more bears than bulls, the Fed must be a bull. Smith's argument would then be that because stock prices vary more than actual dividends, the Fed's position on the futures contracts would vary more than actual fluctuations of nominal GDP. Since nominal GDP varies so much, then the Fed's position on the contracts would vary a tremendous amount.
There are several problems with his argument.
Estimates of nominal GDP volatility from periods when the central bank was targeting some combination of inflation and the output gap, targeting the unemployment rate and allowing accelerating nominal GDP growth, and targeting some combination of inflation and interest rates (explicitly to help the Treasury fund deficits, no less,) are not likely to help predict actual nominal GDP volatility under a monetary regime that solely targets the growth path of nominal GDP.
To the degree that stock volatility is generated by momentum trading (foolish investors buying stock because it provided capital gains in the past,) or some kind of "greater fool" process, (clever investors buying over-valued stock planning to unload it to really foolish investors,) or even clever people playing some zero sum "musical chairs" game, none of that applies to an index futures contract with a fixed price. The contracts only provide a payoff if nominal GDP actually deviates from target in the direction predicted by the trader. If it goes the other way, there are losses and with no change, there is no gain, just wasted transactions costs.
I would think that comparing the volatility of stocks to the volatility of dividends is not just looking at excessive volatility in stocks, but also at the theory that stock only has value if profits are paid out to the stockholders in the form of dividends. The notion that stockholders accept that profits are retained forever and any one stockholder can only cash in by selling shares, is also being tested. Suppose that certain blue chip companies pay out regular dividends, hoping to attract investors who see the stock as providing stable income, almost like a bond. Other companies keep just about all profits and reinvest them. Dividends are remarkably stable (perhaps more so than earnings.) Stock values vary depend ing on expected earnings. (Of course, maybe Smith misspoke and he meant that stock prices are remarkably more volatile than earnings .rather than dividends.)
Also, discounting observed dividends by a variety of discount rates, and comparing that to stock price volatility seems to assume that discount rates are stable. Isn't the hypthosesis that there is a discount rate being tested? I would think that one of the things that impact stock price volatility is changes in expected future discount rates.
Most importantly, stocks form an important store of wealth for many people. They have a long record of providing positive returns one way or another. People storing wealth in this way have any number of personal reasons to buy or sell. Further, the prices do change, and trying the beat the market is always a temptation. Nominal GDP futures are a bet on whether nominal GDP will be on target or not. If the system works perfectly, the expected return would be zero. It is hard to see why these contracts would form an important store of wealth.
All of the proposals for futures targeting involve having the central bank change current monetary policy according to changes in its position on the futures contract. If the market is long, and the central bank is short, then it should tighten. If the market is short, and the central bank is long, then it should loosen. The problem that concerns Smith is that the market position on the contract can be expected to vary more than the true expected value of nominal GDP away from target, (which means more than the expected payoffs) and so the central bank will be loosening and tightening more than necessary. And even if nominal GDP stays on target, this offsetting loosening and tightening seems scary. Well, let's change "scary" to "might be disruptive to real economic activity," or "somewhat or substantially reduce human welfare."
Smith suggests that this volatility in central bank policy would be quarter by quarter. There would be a quarter of tight monetary policy followed by a quarter of loose monetary policy. Most proposals for futures targeting involve continuous adjustment. The central bank trades the future all during the quarter and makes open market operations according to its position on the contract. In other words, rather than the trades last quarter determining whether policy is tight this quarter, trades early today are determining monetary conditions later in the day. Trades late in the day determine monetary conditions tomorrow morning.
Sumner has proposed discrete trading, but on a daily basis. The central bank announces a tentative daily target for base money, the contracts are traded, and then the Fed adjusts the tentative target by the net position on the contract. Perhaps the futures contract trades in the morning, and then open market operations in bonds occur in the afternoon.
This doesn't mean that there would be no volatility. On the contrary, my point is that all of these proposals would allow for volatility to occur during each quarter, each month, and each week. And with the more continuous proposals--during each day.
To some degree, this high frequency volatility is even more "scary," but not necessarily. Wouldn't such fluctuations would be over before there was much chance for it to do harm? Still, I believe that the quantity of base money should adjust to the demand to hold it, conditional on the nominal anchor. And the least bad nominal anchor is slow steady growth of spending on output--a nominal GDP target. To the degree trades of the future contract causes an excess supply of base money for the first part of the week, even if there is an offsetting excess demand at the end of the week, it would be undesirable.
These shortages and surpluses of base money would certainly cause liquidity effects on interest rates, and so there would be undesirable volatility in short term interest rates. Now, I don't think that stable short term interest rates are necessarily desirable. I think that short term interest rates should fluctuate due to short term changes in the supply and demand for credit. If many people want to borrow this week, and few want to lend, having interest rates a bit higher this week, so some of those wanting to borrow wait a bit, and who were going to lend next week, bring forward their lending to this week, is desirable.
Still, it is hard to see how significant volatility would be introduced into short term interest rates, much less long term rates, by high frequency changes in the monetary base. It would rather be expectations of persistent changes in the monetary base due to persistent shifts in the market position on the contract that would have have persistent effects on financial markets and then spending on output.
Of course, most criticisms of the proposal have been that no one will be motivated to trade the contract, not that they will do a lot of trading for reasons that have nothing to do with expectations of nominal GDP relative to target.
Anyway, my own view is that the central bank should be free to adjust monetary conditions as it sees fit, subject to the constraint that it trade the futures contract at the target price. If it turned out that a short position by the market today was likely to be followed by a long position by the market tomorrow, then making open market purchases today just to sell them tomorrow would be pointless. (Part of my mindset continues to be consideration of a purely privatized version of index futures convertibility, where all the competing issuers of money are free to choose their positions on the contract just like anyone else.)
Finally, if futures targeting worked, wouldn't the variation of the central bank's position on the contract vary more than nominal GDP? It is supposed to provide a negative feedback mechanism. Monetary conditions today are adjusted according to market expectations of future nominal GDP as revealed by the market position on the futures contract. If it works, nominal GDP must actually have less volatility than the the market position on the contract. Suppose nominal GDP varied, but the central bank's position on the contract always stayed zero. Would that be a good thing?
Noahpinion: Excess volatility and NGDP futures targeting