This post is pretty nerdy. If you’re a normal person you might consider skipping it….
It’s been a while since I talked about monetary policy, but the old debate about NGDP Futures Targeting kicked up again last week with a number of very smart people criticizing the mechanics of the idea. Here’s economist Noah Smith on the subject, quant trader Zachary David and bond trader Brian Romanchuk. And here’s structured product wizard Mike Sankowski on the matter back in 2013 before anyone else realized it was cool to explain the deficiencies in this idea. I wrote a lot about this several years ago and my thinking basically hasn’t changed – NGDP futures won’t be a functional market and even if the contracts could be structured to work it still has no viable mechanism through which it can achieve its goals.
If you’ve been too busy to be a huge nerd then the basic idea with NGDP Futures Targeting is this – the Fed would set a target rate for Nominal GDP growth (say, 5%) and the market would be able to gauge any deviations in the futures contracts to decipher economic growth. If the price rose to $1.06, for instance, the Fed would push the price back to $1.05 by tightening monetary policy and the economy would respond accordingly. If the price fell to $1.04 the Fed would loosen monetary policy and presto-changeo there’s your economic growth! All of this would steer the economy back to a target rate of growth. I am simplifying the idea, but that’s the basic gist of it (you can get deep in the weeds with Sumner’s actual paper if you’d like).
This idea won’t work for two main reasons:
- The market structure of the contracts will be prone to failure. As Mike and Zachary both note, an NGDP Futures market will be ripe with manipulation. There’s two main reasons for this. First, traders know the supply reaction of the monetary base to everything they do so the market can be targeted via spread trades that would be designed to take advantage of the Fed’s reactions. This would either result in a windfall profit for the traders or, more likely, traders would learn that this is outright manipulation and the Fed’s reaction would actually lead to a muted market reaction in other prices. In other words, the blatant manipulation of the pricing mechanism would make the market dysfunctional. In this case, the market becomes nearly impossible to manage risk within and the contract fails because there is a lack of viable spread product to hedge risk against. This is the primary reason why futures contracts fail in the first place.¹
- There is no viable transmission mechanism to the real economy. As the ECB notes extensively in their concerns over NGDP Targeting, the mechanism through which it impacts the real economy does not appear reliable.² An NGDP Futures market is a lot like setting the price of a stock. So, let’s say the Fed wanted to set the price of Apple stock at a growth rate of 5% per year. The Fed could become the price setter of this stock and manipulate its price so that it always reflects a 5% annual increase. This sounds fine in theory, but the Fed needs a counterparty in this market. A market maker is just that, a market maker. And no one would be a viable counterparty to such a farce. After all, the Fed has no viable transmission mechanism through which it can force Apple’s employees to innovate products that would result in 5% annual growth. The same exact point is true for the economy as a whole. And it’s why QE failed (as I predicted back in 2010) – it had no viable transmission mechanism relating to the real economy. And once traders realized that the price of Apple was a farce there would be no counterparty for the Fed to trade against and the market would fail. Now, someone smart might respond that the Fed could force a counterparty (like the Treasury, Primary Dealers, etc), but this is silly. It’s the equivalent of a hyperinflation when a Central Bank monetizes the debt and essentially trades debt between the Central Bank and the Treasury – yeah, you have a buyer and a “market”, meanwhile the private sector is experiencing a catastrophic loss in purchasing power all while the Treasury “sells” its bonds. The market always fails in a hyperinflation, but the government usually doesn’t realize it until after the fact. The same would be true for a NGDP Futures market structure.
The bottom line is, NGDP Futures won’t work. Even if you can get the contract to somehow function it still won’t create the results that the Fed desires because the Fed doesn’t have an Archimedean Lever over the private sector.
¹ – Why Do Some Futures Contracts Succeed and Others Fail? by Hilary Till