Federal Reserve vice chairwoman Janet Yellen seems poised to receive the White House’s nomination to replace Fed chairman Ben Bernanke in the top spot at the central bank when his term expires in January.
Her fiercest competition for the nomination, former Treasury Secretary Larry Summers, withdrew his name from contention last week. Before that, though, the debate over which candidate was better-suited for the job was unusually intense, especially for a Fed nomination.
The debate raised the question for a few observers like Lars Christensen, head of emerging markets research and cross asset allocation at Danske Bank: why choose either?
“I have another candidate,” wrote Christensen on his blog in July. “Chuck Norris! Or rather I strongly believe that monetary policy needs to be strictly rule-based, and if you have a rule-based monetary policy, who is Fed chairman isn’t really important.”
At the moment, U.S. monetary policy can hardly be described as rule-based.
Last week, the Federal Open Market Committee (FOMC) — the Fed’s monetary policymaking body — shocked markets with its decision to refrain from tapering quantitative easing. The taper was a policy move widely expected on Wall Street, based on the strong signal Bernanke was said to have sent to market participants at the press conference following the FOMC’s June 19 policy meeting.
“Why bother with transparency when you can and do change your minds?” asked ED&F Man Capital managing director and bond market veteran Tom di Galoma, saying what it seemed like everyone was thinking following last week’s FOMC decision.
The dissonance here is a result of the Fed’s drive over the past year or so to introduce greater transparency into its decision-making process, something that won’t change for Yellen or whoever else takes over at the helm of the central bank when Bernanke exits his post in January.
Of course, that’s only the most fashionable criticism of Federal Reserve monetary policy at this particular moment. Some have argued that policy has been too loose in recent years, laying the foundation for dangerous asset bubbles that will have to be dealt with down the road. Others have contended that policy has been too tight, failing to adequately stimulate the economy and provide it sufficient aid in returning to sustainable levels of growth.
So why not take the power to set monetary policy out of the hands of the chairman of the Federal Reserve and the small committee of bankers and economists who sit on the FOMC and just let the markets decide what the Fed should do?
That’s essentially what Christensen has in mind when he suggests nominating Chuck Norris to replace Bernanke.
In his blog post, he pointed to a recent paper by Bentley University economist Scott Sumner, a leading advocate of this type of approach.
“Under a strict monetary policy rule, monetary policy will be fully ‘automatic’, especially if you introduce ‘
A Market-Driven Nominal GDP Targeting Regime‘,” wrote Christensen. “This is, of course, what we call the
Chuck Norris Effect— that the markets are implementing monetary policy.”
Sumner explains in the paper how setting up a nominal GDP futures market and letting traders place their bets would make monetary policy “fully automatic,” as Christensen describes it, using a hypothetical example in which the Fed is targeting a 3.65% nominal growth rate for the American economy:
In most futures markets, a change in investor sentiment affects the price of the futures contract. This proposed market would be very different. The Fed would peg the price of NGDP futures at $US1.0365, but only during the period where it was the target of monetary policy. During this period, changes in investor sentiment would affect the quantity of money, not the price of NGDP futures.
For market expectations to determine monetary policy, there must be a link between NGDP futures purchases and sales, and the quantity of money. This link can be achieved by requiring parallel open-market operations for each NGDP contract purchase or sale. Because investors buying NGDP futures are expecting above-target growth in NGDP, the Fed should automatically reduce the monetary base each time an investor buys an NGDP futures contract, and it should automatically expand the base each time an investor sells an NGDP contract short.
For instance, each $US1 purchase of a long position in an NGDP futures contract might trigger a $US1,000 open-market sale by the Fed. A purchase of a $US1 short position would trigger a $US1,000 open-market purchase by the Fed. In that case, investors would be effectively determining the size of the monetary base.
Traders would continue buying and selling NGDP futures until the money supply had adjusted to the point where the market expected NGDP growth to be right on target.
“Recall that after the central bank stops pegging a particular contract (and starts pegging the next contract), its price can rise or fall,” writes Sumner. “Thus, people would trade NGDP contracts for exactly the same reason they trade any other asset: in the hope that the price will move in the direction they anticipate (after the Fed is no longer targeting the price).”
Sumner goes on to argue that if an NGDP futures market were in place in 2008, when the financial crisis hit, the experience would have been vastly different:
Under the monetary regime described here, the United States would never face the situation that occurred in the latter part of 2008. By late 2008, it was obvious to market participants that NGDP growth during 2008-9 would be far lower than the Fed would have liked. Indeed, NGDP fell by 4 per cent between mid-2008 and mid-2009 — the steepest decline since the Great Depression. Asset prices were falling sharply as investors reduced forecasts of future nominal growth and future asset prices. Yet, even though financial-market participants saw what was happening, investors had no way to profit from that information. Markets were unable to correct the Fed’s monetary policy errors.
If an NGDP futures market had existed in 2008, investors would have sold NGDP futures until the money supply had increased sharply enough to produce on-target expected NGDP growth. That does not mean actual NGDP growth would have been exactly on target; no monetary regime can guarantee that result. But if even expected NGDP growth had been on target, it would have been a vast improvement over actual monetary policy, which was far off course in late 2008. On-target expected NGDP growth would have helped to stabilise asset markets.
The nominal GDP targeting idea has been kicked around elsewhere on Wall Street for a while. Goldman Sachs Japan chief economist Naohiko Baba endorsed it in a November 2011 note to clients, asserting that “a move to a nominal GDP (NGDP) target would stand a better chance [than an inflation target] of helping the Fed achieve both parts of its dual mandate over time.”
“It would provide a way to strengthen the employment side of the mandate, while allowing for errors in the estimation of potential output,” wrote Baba. “If combined with a commitment to use the remaining tools of monetary policy aggressively, our analysis suggests that it could potentially give a significant boost to growth and employment.”
So, is it time for a nonhuman Fed chairman and just have monetary policy be set automatically?
“There is no reason why the FOMC should be limited to 12 members, or indeed why there should be any limit at all,” says Sumner.
And given the state of the global economy, monetary policy may well be headed in that direction.
“Nominal activity continues to be extremely low globally in spite of 4-5 years of zero-interest rate policies (ZIRP) and QE,” says Deutsche Bank head of fundamental strategy Jim Reid. “So do we need to fundamentally change the way monetary policy is enacted? And if so, how? We would argue there should be more debate around the idea of a Nominal GDP Target (NGDPT). This could be the next big theme if nominal activity remains as stubbornly low as it has been so far post-crisis.”
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