Tuesday, 12 June 2012

Rate Expectations: NGDPLT and Uncertainty

Market Monetarism has been one of the most interesting developments in macroeconomic thought coming out of this crisis, led by Scott Sumner. What he essentially advocates is the Federal Reserve targeting the trend level of nominal GDP. I’m no expert on monetary economics, which is a fiendishly complicated subject, but stabilising the path of nominal incomes seems like a good idea. It would allow for what would amount to a temporary raising of the inflation target during times of depressed output, and a lower inflation target during times of high output. Doubtless Sumner would denounce me for thinking of monetary policy in terms of inflation at all, but it is a way to frame the concept in conventional terms.

So far, so good. But the central question is whether central banks could credibly hit an NDGP level target. This is particularly pertinent at a time when, with interest rates hard up against the zero lower bound, many doubt how much traction further attempts at monetary easing would actually have. Sumner responds to this line of argument by contending that the very act of announcing the new targeting system would change the stance of monetary policy, and would go a long way towards hitting the target with limited actual intervention. Given that monetary policy, especially at the zero lower bound, revolves around expectations, that’s a reasonable point. After all, who would bet against the Fed achieving its target, when it has promised to use all of its prodigious powers to hit that target?

It’s a similar situation to a central bank fixing the exchange rate of its currency. If there is the expectation that the central bank is willing and able to hold the currency at that level, it doesn’t have to utilise its foreign reserves to push up or hold down the value of the currency. Markets are expecting the exchange rate to hit the central bank’s target – and because foreign exchange markets are so reliant on expectations, that’s exactly what happens, even though the central bank hasn’t actually intervened. The target becomes self-fulfilling.

The problem comes when markets start wondering if the central bank is really willing and able to hold its stated exchange rate value. Speculative attacks start, and the same self-reinforcing effect happens, but in reverse – because people don’t think the central bank can hit its target, it becomes unable to do so. The British ERM fiasco in 1992 was an example of this.

The same thing applies to central bank targets. If enough people think that the central bank is limited in its ability to affect the economy, then the NGDP target would become meaningless. Whether or not a sufficient number of relevant individuals believe in the Keynesian-style liquidity trap is another matter.

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