NGDP Targeting: An Introduction with Market Applications

Theoretical UnderpinningsMarket Applications

Summary

NGDP TargetingAn Introduction with Market Applications

Yichuan Wang

Michigan Interactive InvestmentsUniversity of Michigan

October 10, 2012

Yichuan Wang NGDP Targeting

Summary

Outline

1 Theoretical UnderpinningsEffects of Money Supply ChangesThinking about Monetary Policy

2 Market ApplicationsThe Great RecessionEvidence from the Financial MarketsOutlook for Gold

SummaryEffects of Money Supply ChangesThinking about Monetary Policy

Outline

Equation of Exchange

GDP equation: Y = C + I +G +NX

Very misleading for monetary policy - you end up needing to “tellstories” for why monetary policy affects GDP

MV = PYM = Money Supply, V = Money Velocity, P = Price Level, Y =“Real” GDP

%∆M + %∆V = %∆P + %∆Y“Percent growth in the money supply plus percent growth in moneyvelocity equals percent growth in Nominal GDP”

Long run monetary neutrality - but large effects in the short run

Economic Frictions - Sticky Wages

“We’re not in Econ 101 anymore”

Focus on two things that don’t adjust well: wages and debt

Wages - Money IllusionWould prefer 5% wage growth and 7% inflation over -1% wagegrowth and 0% inflation

Source: San Francisco Fed Economic Letters, “Why Has WageGrowth Stayed Strong?”

Economic Frictions - Sticky Debt

Debt - contracts don’t adjustEven if real income rises, if nominal income doesn’t rise you struggleto pay back debt

Major issue in current recession

Source: Evan Soltas, “Safety Dance”

“Nominal shocks have real effects” - if we can stabilize the nominalside of the economy, it will improve the real side

Outline

Monetary Policy: A RethinkIt’s all about the money

Monetary policy is about money – The “M”Interest rate as a secondary thought - we can discuss later

Most importantly, it’s about expectations.E{M}V = E{PY }

If we expect the Fed to burn the money that they printed today,we’re not going to spend it

Expectations of future feed back into presentIf I expect business activity (NGDP) to be low tomorrow, I might aswell not invest today.

Expectations get priced into current conditions

Transmission of Monetary Policy

Portfolio Balance

“Hot potato” - electricity analogy

Expectations“Long and variable lags” → “Long and variable leads”

Expectations of the future money supply change NGDP today

Note I ignored interest ratesNot reliable for monetary policy - Friedman

If the economy is strong, people want to borrow, which raisesinterest rates

But raising interest rates 6= make the economy stronger

Portfolio Balance

Mandate for Monetary Policy

Stabilize level nominal GDPLevels, not rates

Adjust M with respect to V

Stabilizes expectations of future nominal GDP

QE3 – a step in the right direction, but too discretionary and toovague

Better than gold standard or inflation targetingAttacks the root of the market frictions better

The Best Free Market Solution?

Note what I’m not advocating:Central planning

Failed loans to zombie companies

Zimbabwe

Borrowing or leverage

Discretionary policy

Actually, NGDP targeting emulates Hayek’s solution for monetarypolicy

Zimbabwe

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The Great RecessionEvidence from the Financial MarketsOutlook for Gold

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NGDP Output Gap

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A Historical Comparison

The biggest annual drop in NGDP since the Great Depression

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TIPS and Stocks

TIPS = measure of market expectation of inflation, reasonable proxyfor NGDP expectations

Incredible positive correlation since after 08 crisis - First found byDavid Glasner, “Uneasy Money”, data from FRED

Summary

TIPS and Stocks

TIPS = measure of market expectation of inflation, reasonable proxyfor NGDP expectations

Incredible positive correlation since after 08 crisis - First found byDavid Glasner, “Uneasy Money”, data from FRED

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A Closer Look

Without looking, which one is which?

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TIPS and Stocks

Why is there this connection?

Two types of inflation:Supply side - OPEC decides to raise oil prices - always badDemand side - result of NGDP expansion - maybe good

Connection between inflation and stocks is strongly suggestive oflack of demand: lack of NGDP

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TIPS and Stocks

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TIPS and Stocks

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TIPS and Stocks

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TIPS and Stocks

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QEI and QEII

Source: Marcus Nunes, Historinhas

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QE3 - Similar Effects

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Interest Rates

High NGDP expectations predict higher rates - First identified byDavid Beckworth, data from Survey of Professional Forecasters andFRED

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Interest Rates

Suggests that “borrowing” channel is insufficient

Simple explanation from market monetarism - QE improved theeconomy, built increased expectations into interest rates

We see this in the effect of QE on the 10 yr/1yr Treasury Spread:

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Interest Rates

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Interest Rates

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A Contrarian Perspective

Real growth seems to be bigger driver of stock/gold differenceReal PCE:

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A Contrarian Perspective

CPI Headline Inflation:

I see NGDP as central barrier to real growth, so even if gold pricesrise in response to QE, they are unlikely to rise more than theSP&500

Summary

Nominal shocks have real effects – therefore a monetary policy thatstabilizes nominal GDP is critical for growth

This type of monetary policy enhances rather than detracts from afree market

Given what evidence we have, QE3 should have a highly beneficialeffect on the stock market

Summary

NGDP Targeting: An Introduction with Market Applications

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