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Alternatives to interest rate targeting

Summary:
[Over at Econlog, I have a post explaining 3 MMT fallacies.] In my recent Mercatus paper I criticized interest rate targeting and also suggested an alternative. One problem with interest rate targeting is that it doesn’t work well when nominal rates fall to zero, or slightly below zero. Fortunately, there are many possible alternatives. One famous alternative is money supply targeting, as proposed by Milton Friedman. But even Friedman moved away from this idea late in his career. Here I’d like to focus on alternative asset price targets. After all, if you target short-term interest rate then you are also implicitly targeting the price of assets such as one-month T-bills. Here are some better options: 1. Exchange rates: This is the system that Singapore uses:

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[Over at Econlog, I have a post explaining 3 MMT fallacies

In my recent Mercatus paper I criticized interest rate targeting and also suggested an alternative. One problem with interest rate targeting is that it doesn’t work well when nominal rates fall to zero, or slightly below zero. Fortunately, there are many possible alternatives.

One famous alternative is money supply targeting, as proposed by Milton Friedman. But even Friedman moved away from this idea late in his career. Here I’d like to focus on alternative asset price targets. After all, if you target short-term interest rate then you are also implicitly targeting the price of assets such as one-month T-bills. Here are some better options:

1. Exchange rates: This is the system that Singapore uses:

Fourth, the choice of the exchange rate as the intermediate target of monetary policy implies that MAS gives up control over domestic interest rates (and money supply). In the context of free capital movements, interest rates in Singapore are largely determined by foreign interest rates and investor expectations of the future movements in the Singapore dollar.

The downside of the policy is that it probably doesn’t work for big economies—the trading partners would object.

2. A stock price index: This is the system that Roger Farmer advocates. The downside is that stocks can move for reasons unrelated to changes in NGDP, such as a corporate tax cut that increases the share of after-tax GDP going to corporations.

3. A gold price target: This was the method used by FDR during November 1933. The problem is that it worked because markets understood that movements in gold prices were an indicator of the future path of monetary policy, once convertibility was restored (in February 1934). That’s not the case today.

4. A commodity price basket: Supply siders used to occasionally advocate targeting the price of a basket of actively traded commodities. The problem is that even a diversified basket of commodities can have a very unstable relative price.

5. The TIPS spread: First proposed in 1989 by Robert Hetzel, this idea was recently revived by John Cochrane. One problem is that there might be a time varying risk premium on TIPS spreads. Another is that it doesn’t address the Fed’s dual mandate.

6. NGDP futures targeting, guardrails version: This is my preferred policy, with no IOER and OMOs used as the policy instrument. It doesn’t really have any downsides (as you’d expect of a policy that I favor) except that central banks are reluctant to adopt such a radical policy.

7. Hybrid model/market-based policy; The central bank targets the NGDP forecast, with 50% weight given to a prediction of NGDP based on basket of asset prices and 50% weight given to a prediction of NGDP from Fed models and private forecasters. Once the non-asset price part of the forecast is established, policy targets the basket of asset prices at a level expected to produce on-target NGDP, when averaged in with the non-asset price NGDP forecast.

All these approaches should use level targeting.

For some reason, MMTers often seem to think that the Fed can’t target anything but interest rates. Singapore shows that’s not the case. In Singapore, both money and interest rates can be viewed as endogenous, as it should be.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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