Tyler Cowen recently asked o1 Pro the following question.
What is the biggest problem with economist Scott Sumner’s idea that the Fed subsidize the NGDP futures market? Based on theoretical macroeconomics, agency problems, finance theory, etc. Please answer.
Below is part of the response.
One of the most serious challenges to the proposal to subsidize the NGDP (nominal gross domestic product) futures market to the Federal Reserve is its inherent vulnerability to market manipulation and perverse incentives. Although this idea of using the NGDP futures market as a direct feedback loop to monetary policy is theoretically elegant, it raises several interrelated issues.
Market manipulation and gamification of the system:
If the Fed is willing to adjust monetary policy based on NGDP futures prices, traders will have a strong incentive to move those prices in favor of their portfolios. As central banks are forced to respond to signals emanating from futures markets, groups of well-capitalized or strategically coordinated traders can manipulate prices and influence policy actions. . For example, if participants believe the Fed will ease policy in response to a decline in NGDP expectations, they may sell short NGDP futures contracts to force the Fed’s hand and benefit from the subsequent asset price reaction. . Subsidies to markets aimed at increasing liquidity ironically make the trading environment more attractive to those with motives other than informational, reducing the costs of such operations.
Information asymmetry and noise trading:
The presence of subsidies may attract traders who are more motivated by the possibility of subsidy recovery and leveraging the Fed’s response capabilities than by any fundamental view of future NGDP. Under normal circumstances, futures markets aggregate disparate information and reflect true expectations about future economic conditions. But when markets are dominated by participants who react to the Fed’s predictable policy feedback loops, price signals become less about true economic fundamentals and more about the speculators spearheading the central bank. It will be. As a result, the quality of the information content of NGDP futures prices may be significantly reduced.
Because of the efficient market hypothesis, we do not believe this will be a serious problem. If market manipulation were possible, competition among market manipulators would reduce excess returns to near zero. If someone can manipulate monetary policy the “wrong way” to make a profit of $X, someone else can manipulate it in the opposite direction and make an even bigger profit.
A long time ago, I realized that this was a losing battle. Therefore, for the past decade, I have been advocating an NGDP futures targeting approach that is clearly not subject to the risk of market manipulation. I call this the “guardrail approach,” and I explain it in Chapter 5 of my free online book. I once again feel the need to explain this idea so that those who criticize my politics can respond to what I am actually proposing.
Assume that the Fed has a target of 4% NGDP growth next year. (During the COVID-19 outbreak, I think I was recommending temporarily switching to two-year futures contracts.) The Fed has created an unlimited long position in NGDP futures contracts based on 3% growth. All it had to do was announce its intention to take an unlimited short position in the NGDP futures contract based on 3% growth. 5% growth. In that case, the Fed can benefit any time current growth rates are within those two guardrails, i.e. between 3% and 5%.
that’s it. That’s the whole proposal. I guess I’m also suggesting that the Fed needs to respond to the futures market? No, you can ignore it completely when making monetary policy decisions if you wish. No subsidy required.
So let’s consider some counterarguments.
1. What happens if no one trades the contract? I don’t care. In the words of Bob Dylan, “There is no greater success than failure.” If no one trades this contract, it is likely because traders expect NGDP growth to be in the 3% to 5% range.
2. What if no one trades contracts when policy is way off track, such as in 2008 or 2022? In that case, I can trade contracts and get really, really rich. Sho. It was clear to anyone with half a brain in late 2008 that NGDP would soon fall below the Fed’s desired NGDP growth rate. It was clear that NGDP growth would exceed the Fed’s desired growth rate in 2022. That will make me rich.
But didn’t I argue earlier that the EMH suggests that it’s actually very difficult to get rich? Yes, it was. But let’s consider what that fact means. If it’s clear that the Fed is way off course and no one is trading NGDP contracts, that will mean it’s easy to get rich. And that implies that if the Fed clearly goes off track, a whole lot of people will actually be trading those contracts.
And it’s not over yet. The Fed clearly doesn’t want to incur huge losses on NGDP futures. Imagine having to explain to Congress that you lost a lot of money on an obviously stupid deal. To prevent that from happening, the Fed is likely to adjust policy until market expectations for NGDP growth are within the 3% to 5% range.
So why is this guardrail approach immune to market manipulation? It is helpful to consider two scenarios:
Case A. Trading is fairly quiet for a while, but then a large number of traders start lining up on one side of the futures market.
Case B. Trading was fairly quiet until George Soros suddenly made a $1 billion bet on the market.
If you were a Fed official, which of the following two scenarios would you be more likely to change your policy stance? The answer is obvious. The whole point of the NGDP target is to leverage the “wisdom of the crowd,” and the idea is to expand the FOMC voting membership from 12 to 8.2 billion people. George Soros is rich, but it’s still just an opinion.
There are two schools of thought about this proposal.
1. Provide useful information to the Fed.
2. Add constraints to your policy to make it more reliable.
It actually serves both roles, but I think the credibility aspect is much more important than the information aspect. Even the Fed knew that NGDP in 2009 was too low. Even the Fed knew that NGDP in 2022 was too high. Guardrails force the Fed to “do the right thing.”
In this respect, NGDP futures targeting is very similar to level targeting without NGDP futures contracts. Under level targeting, markets also put intense pressure on the Fed to “do the right thing.” Had level-targeting policies been introduced in the second half of 2021, market interest rates would have risen once the market decided that NGDP growth was too high, anticipating future monetary tightening that would be needed to bring NGDP back up. . However, such an increase in interest rates would have caused nominal spending to decline rapidly. Under level targeting, the market moves the wheel (market interest rates) in favor of the Fed whenever the Fed is asleep at the wheel.
Guardrails and level targeting – two ways the market forces the Fed to do the right thing.
Perhaps someday people will respond to my current suggestions. Until then, I feel like this person (painted by Titian).
