Should inflation targeting central banks hold a portfolio of assets that consists only of foreign lottery tickets? No, because if its portfolio of foreign lottery tickets became worthless, and the central bank were unable to get a bailout from the government, it would be unable to buy back the currency it has issued. So if the demand for its currency happened by sheer chance to fall at the same time, it would be unable to buy back that currency and unable to prevent inflation rising above target.
Should inflation targeting central banks hold government bonds? No. Government bonds would be even worse than foreign lottery tickets. At least the value of a portfolio of foreign lottery tickets would be uncorrelated with the central bank's need for assets. The value of a portfolio of government bonds would be negatively correlated with the central bank's need for assets. If expected inflation increased (or if the natural rate of interest increased), the (real and nominal) value of the government bonds would fall, and the (real and nominal) demand for the central bank's currency would fall at the same time. So the central bank would find itself short of assets in exactly those circumstances where it needed those assets the most.
Only an idiot would advise an inflation targeting central bank to invest 100% of its portfolio in government bonds that promise to deliver fixed amounts of the same currency that the central bank issues. It's like advising the owner of an orchard to invest 100% of his pension plan in apple futures. If the price of apples falls, the value of his orchard falls, and so does the value of his pension plan.
[Update: An inflation targeting central bank is writing butterfly CPI call and put options on the liability side of its balance sheet, so should not be holding inverse CPI futures on the asset side.(I probably said that wrong. Sod finance-speak.)]
What is a risky asset for one person can be a very safe asset for another person. Apple futures would be a very safe asset for the pension plan of a banana producer who likes to eat apples. Owning a bet that my house will burn down is a very safe asset for me, but a risky asset for anyone else. I call that bet "insurance". Similarly, what is a safe asset for a central bank to own could be a very risky asset for someone else.
What we are looking for is an asset that has exactly the right sort of risk for a central bank to own. We want an asset with uncertain returns, where those returns are positively correlated with the central bank's need for assets to buy back the currency it has issued.
And the answer to that question depends on the central bank's monetary policy target. For example, gold is a risky asset whose value fluctuates a lot. But it is a very safe asset for a central bank on the gold standard, that targets a fixed price of gold.
But targeting a fixed price of gold is not a sensible monetary policy. Gold is not a safe asset for a sensible central bank that targets inflation, or NGDP.
The best asset for an inflation/NGDP targeting central bank to hold would be a risky asset whose value is strongly positively correlated with deviations of inflation/NGDP from target. The ideal asset would becomes worthless whenever expected inflation/NGDP falls below target. So if the government committed not to bail out the central bank, the central bank would be unable to buy back currency it had issued, unless expected inflation/NGDP subsequently rose above target and raised the value of the central bank's risky asset. [Update: what I am looking for is a commitment device, like burning your boats so everyone knows you can't retreat even if you broke your promise to fight.] Because permanent changes in the stock of money have a much bigger effect on inflation and NGDP than temporary changes. But what we want are permanent changes that are conditional on whether inflation/NGDP is permanently above or below target.
Some sort of lottery ticket or bet, where the payoff is zero if inflation/NGDP falls below target, and big if inflation/NGDP rises above target, would be the ideal risky asset for central banks to own. If you made the central bank truly independent, with a no-bailout clause. (Though I wonder who would take the other side of that bet?) Update: maybe central banks should be writing options on inflation/NGDP, with the target as the strike price, so they would be forced to print and pay big money if inflation/NGDP fell below target? (Thanks louis.)
But government bonds are the worst possible risky asset for central banks that target something sensible to own. They have exactly the wrong sort of risk.
Worthwhile Canadian Initiative 
I’m all for the creation of NGDP futures, but I wonder if we should actually be all that worried about central bank asset risk. They are part of the Federal government (in the US and many other countries) and thus a loss due to a fall in the price of T-bonds is precisely offset by a gain to the issuer (the Treasury.) For the government as a whole, it nets out to zero.
And if bankrupt they would be bailed out just as FDIC, Fannie Mae, etc were bailed out.
But Scott, the reason why QE has so little effect bang for buck is that people expect it to be temporary. If it were expected to be permanent, conditional on NGDP being permanently below target, it would be much more effective. And the way to make QE permanent under those conditions is if the central bank writes NGDP futures, and it’s a truly independent central bank with a no-bailout clause. We want the central bank to have the (right kind of) asset risk. We want to turn asset risk into a feature, not a minor bug. (Sorry for the cliche.)
Scott:
If the government went broke, and T-bonds lost value, and if those T-bonds backed the dollar, then the dollar would lose value. A fiscal crisis would become a monetary crisis too. That’s bad.
As the dollar loses value, the bonds (denominated in dollars) would lose more value, which would make the dollars fall more, etc. In this stage you’re right: Losses to the central bank would be offset by (probably bigger) gains to the government.
Nick:
The central bank can always cause the dollar to fall by throwing away its assets. No need for it to deliberately hold assets that force it to lose assets. (And when did you start caring about central bank assets, anyway?)
“It’s like advising the owner of an orchard to invest 100% of his pension plan in apple futures.”
In the US at least, there are many groups advocating for exactly that: http://www.separatinghyperplanes.com/2014/08/profit-sharing-is-not-solution-to.html
Mike: I figured this post would be right up your street! I pretended I was you, when writing it.
“(And when did you start caring about central bank assets, anyway?)”
The reason your perspective (backing theory) is normally wrong is that central banks give their positive profits to the government, and the government can always bail out the central bank if it makes negative profits. But suppose there were no bailouts, and the central bank really is fully independent of government. And suppose the demand for central bank currency fluctuates, so the central bank needs assets to buy back currency when the demand for currency falls. And suppose we tried to turn the no bailout clause into a feature, not a bug. What sort of assets would we want an inflation or NGDP targeting central bank to own?
If it throws away assets it loses profits. Plus, it might need those assets again in future. Much better to find some bet, where you lose the bet when you want to throw away assets, and win big when you really need extra assets.
Options and futures are not really assets per se, so the CB would need to hold some sort of bond or other security. That security could have an embedded payout that is correlated with inflation (say TIPS, or equities). Or the CB could overlay its asset portfolio with derivatives to accentuate this exposure. So trade in gov’t bonds as before, but also write swaps on realized inflation, implied inflation breakevens (my preference), NGDP, whatever.
As the CB increases its balance sheet, it would increase the overlay proportionately, so that it becomes more long inflation/NGDP. Should inflation overshoot its target, the CB’s asset base is of sufficient size to mop up the excess liquidity (couldn’t they just raise reserve requirements, or pay interest on reserves, or create a term facility that encourages people to lend to the CB for some period? I’m rolling with the premise).
My question is what this does to the market. If you suddenly have a major natural buyer of inflation futures, it will be cheaper for someone to bet on falling inflation and more expensive to bet on rising inflation. This will make assets that are positively correlated to inflation cheaper and those negatively correlated more expensive. You have to think that will have macro effects, though my brain can’t think them through at the moment. Also, when the CB is shrinking its balance sheet, this effect will be reversed. If the CB is tightening, one would want to buy fixed-nominal-income assets (I guess that’s always true).
PS Thanks for the acknowledgement, but I was suggesting the CB write options not as a way of hedging its balance sheet, but as a way to reduce the market return on risk and so encourage more risk-taking in the economy.
Matthew: I totally agree. A defined benefit pension plan, where the employer is liable for the benefits, is like investing the pension plan 100% in the employer’s corporate bonds. If the company goes bust, you lose your job, and your pension. It happened here with Nortel. Profit sharing pensions are even worse, because it’s like investing your pension 100% in your company’s shares. (Though it does mean the workers care about the long-term future of the company, and are less likely to go on strike if it would harm the company’s future. Maybe.)
Also, this all seems to be more pertinent for a small open economy with its own currency. Holding large amounts of foreign-denominated assets would ensure that the CB has sufficient capacity to fight inflation caused by a drop in the exchange rate. Are there any lessons to be learned from that literature?
louis: “My question is what this does to the market. If you suddenly have a major natural buyer of inflation futures, it will be cheaper for someone to bet on falling inflation and more expensive to bet on rising inflation.”
That’s what I’m trying to figure out too. Who is taking the other side of these bets? It would be best to figure out some bet where there is a major natural seller.
@ssumner:
The way I imagine it, central bank operations act on the monetary base in two separate periods. The first period is when an asset is purchased or shorted, and the second period is when the asset matures.
Central banks such as the Fed seem to generally act only through the first period. When the Fed wishes to expand the monetary base, it purchases bonds, which it sells to shrink the base. When the bonds mature, the profits would ordinarily act with the inverse effect, except that the central bank remits them as seigniorage revenue.
Instead, I think we want the central bank to trade on the spread between its target and the real rate of interest. The problem is that it’s easy to imagine instruments that increase the monetary base, but it’s more difficult to imagine instruments to shrink it.
Imagine the Fed offered to freely exchange real-return bonds for nominal bonds paying its inflation target + the real return rate. If I believed inflation would be below-target, then I would purchase said real-return bonds (acting to reduce the risk-free real interest rate), make the exchange, and as long as I’m still right I would make a spendable profit. If I’m wrong and inflation is above-target, then the Fed has made a profit that it can eat to reduce the monetary base.
But to go the other way is trickier. If I expect inflation to be above-target, then the above deal is unattractive — and the Fed can’t force me to take it. Instead, I have to be induced to loan money to the Fed. So the Fed should itself issue real-return bonds (raising the real risk-free rate), and use those to purchase any nominal bond of acceptable quality that is yielding more than the real-rate + inflation target. “Nominal bond of acceptable quality” would include government bonds at minimum, but this could work in that the yields are free to float.
For level targeting, the first part is still easy since it’s the Fed writing the nominal instrument (to pay out $x at the end of term based on the announced level), but the second part is more difficult unless the fiscal authority cooperates with its own debt issues. A robust futures market could perhaps provide a sufficient bridge.
Nick:
“If it throws away assets it loses profits.”
Sorry, that came out wrong. I should have said that the central bank keeps its assets, but just declares that in certain cases it will not use those assets to support the dollar. Then if it ever needs those assets again, it still has them. If the central bank’s assets are worth far more than the money it has issued, then it has no problem keeping the value of its money anywhere it wants.
If the government stands ready to bail out the central bank, then the backing theory says that the value of the dollar is determined by the combined assets of the central bank and the government. If, for example, the central bank lost assets, and if we expected the value of the dollar to fall as a result, but then the government bailed out the central bank, then the backing theory wasn’t wrong. We were the ones who were wrong, for not seeing that the dollar was backed by the assets of both the central bank and the government.
But in the case you’re supposing, with no bailouts, then the value of the dollar is determined by the central bank’s assets. As to what sort of assets such a bank should own, well, I’m not brave enough to answer that. I’d just go with what bankers have always done: issued their money in the discount of good bills, at not more than 60 days’ date. I know it seems better to hold assets that are not denominated in your own currency, but for some reason that’s not the historical norm.
Face it gentlemen. A representative from the Central Bank and a representative from the Government can meet and exchange products.
The representative from the Central Bank can return to the office bearing Government Bonds. The representative from the Government can return to the office bearing green Federal Reserve Notes (United States) in either a brief case or electronic versions.
Now the Central Bank can sit for a long time happily holding Government Bonds, and Government can pay it’s bills.
It’s that simple.
Mike: “I should have said that the central bank keeps its assets, but just declares that in certain cases it will not use those assets to support the dollar.”
Paul Krugman says that the central bank would not be credible if it said that. It needs to burn its boats, so it can’t retreat, and everyone knows it can’t retreat. I’m looking for a contingent boat, that only floats if NGDP rises above target, and will sink otherwise.
“If the government stands ready to bail out the central bank, then the backing theory says that the value of the dollar is determined by the combined assets [and liabilities NR] of the central bank and the government.”
Which is FTPL. But you can’t add currency and bonds, because they don’t pay the same rate of return. And currency typically pays a negative yield, so the PV of primary surpluses discounted at a negative rate is (probably) negative.
“I’d just go with what bankers have always done: issued their money in the discount of good bills, at not more than 60 days’ date. I know it seems better to hold assets that are not denominated in your own currency, but for some reason that’s not the historical norm.”
Commercial banks are on the Bank of Canada standard, and the Bank of Canada is on the CPI standard. So what would be a safe asset for a commercial bank is not a safe asset for the Bank of Canada.
“It would be best to figure out some bet where there is a major natural seller.”
A major natural seller of inflation futures would be someone who benefits from higher than expected inflation and/or someone who is hurt by low inflation.
Pension funds have real future liabilities. To the extent they hold bonds as part of their portfolio, they would be naturally short inflation. No good.
Debtors are generally considered beneficiaries of unexpected inflation, but its hard to picture a world where corporate treasuries and mortgaged home owners sell inflation protection to the CB. I suppose financial intermediaries could short inflation risk to the Fed and roll that exposure into loans that are indexed to the price level.
In that case, the debt burden would be constant in real terms in a deflationary environment. Richard Koo would like that.
Of course, if this change makes the inflation target more credible, people should be less inclined to hedge against changes in inflation expectations.
Roger: “Now the Central Bank can sit for a long time happily holding Government Bonds, and Government can pay it’s bills. It’s that simple.”
Nope. That’s simply wrong. Because if inflation is above target the last thing the central bank wants to do is to give the government more money to spend. It wants those bonds so it can reduce the stock of money in circulation, not increase it.
“The reason your perspective (backing theory) is normally wrong is that central banks give their positive profits to the government, and the government can always bail out the central bank if it makes negative profits.”
Think about the negative profits/insolvent/negative equity case.
If that happens, the federal gov’t (majority owner) could shut it down.
How about good old bank stocks?
BMO and co.
Commercial bankers don’t like the zero lower bound because of margin compression.
So the initial interest rate lift gives them some juice. Similar for insurance companies.
Also, NGDP growth is consistent with healthier banks and higher stock prices.
The problem is the inflection point where serious money tightening creams banks stocks because of the discount rate factor.
That’s when the CB governor gets fired and the next guy is back to buying bonds.
I think you need to go over the case where the central bank only owns mortgages.
JKH, what does a central bank do if a solvent (emphasis) commercial bank experiences a bank run?
“Commercial banks are on the Bank of Canada standard, and the Bank of Canada is on the CPI standard.”
Is that a CPI standard or a CPI target?
TMF: STOP. Your comments are random, off-topic, red herrings. As usual.
“Should inflation targeting central banks hold a portfolio of assets that consists only of foreign lottery tickets? No, because if its portfolio of foreign lottery tickets became worthless, and the central bank were unable to get a bailout from the government, it would be unable to buy back the currency it has issued. So if the demand for its currency happened by sheer chance to fall at the same time, it would be unable to buy back that currency and unable to prevent inflation rising above target.”
And how might the gov’t hypothetically bail out the CB? Not by giving it currency with which to buy back the currency that it has issued. 😉 Not by giving it, say, gov’t land to sell, which is selling your birthright for a mess of pottage. Perhaps the gov’t should tax the excess currency away.
“Owning a bet that my house will burn down is a very safe asset for me, but a risky asset for anyone else.”
Arsonists excepted, OC. 😉 And maybe neighbors. If your house burned down that would not be so good for the neighborhood, eh?
Min: “And how might the gov’t hypothetically bail out the CB?”
By giving it bonds. Or land. Or any asset it can sell. By selling future generations’ birthright, one way or another.
Nick:
“Which is FTPL. But you can’t add currency and bonds, because they don’t pay the same rate of return. And currency typically pays a negative yield, so the PV of primary surpluses discounted at a negative rate is (probably) negative.”
OK, you lost me there. If we combine the central bank and the government, then the government’s balance sheet will show taxes receivable as its main asset, while currency and government bonds both show up on the liability side. No accountant has any trouble adding these things together. Also, currency has a senior claim over all other government liabilities, so even if the government is broke, the currency can hold its value.
“Paul Krugman says that the central bank would not be credible if it said that. ”
A bank with huge assets can easily set the value of its liabilities at any level it wants. It’s when the bank’s liabilities outrun its assets that its promises lose credibility.
“Roger: “Now the Central Bank can sit for a long time happily holding Government Bonds, and Government can pay it’s bills. It’s that simple.”
Nope. That’s simply wrong. Because if inflation is above target the last thing the central bank wants to do is to give the government more money to spend. It wants those bonds so it can reduce the stock of money in circulation, not increase it.”
Is is correct to attribute an inflationary bias to a CB/Government money supply increasing event. The CB would realize that the bond from Government is very risky and would be willing to sell it to the private economy. That would improve the position of the CB because the CB would hold fewer risky government bonds.
Now why would the CB want to buy a security or any asset from the private sector? The cost to the CB is identical whether it is buying Government Bonds or private securities or assets. The cost is NOTHING.
If the CB wants to buy something from the private sector, it must be because the CB wants to favor some aspect of the private economy.
I agree with louis: the CB needs to hold a positive-value asset to balance its liabilities. And if you want a positively valued security whose price is smoothly and positively correlated with inflation and has minimal credit risk (minimizing the lottery ticket aspect), you can’t do better than inflation-indexed bonds issued by your own government (a government is naturally long inflation via its tax revenues.) In theory, the CB could hold nominal assets and buy unfunded inflation via futures or swaps, but the existing market would not support the desired volume and I don’t see where a new large seller would come from unless the government were willing to take that role anyway.
There is also a potential political problem with perceived moral hazard. When the CB holds assets that decline in value with increasing inflation, it is making a credible signal that it does intend to allow inflation to increase. When it holds assets that increase in value with increasing inflation, it is signalling the opposite.
Holding NGDP-linked bonds is one good option, however they do not help to manage the risk of changes in the natural rate of interest. That’s why it is better to hold assets that pay policy rate plus spread instead.
Call up the provinces directly. Purchase non-callable, inflation protected bonds issued by them for purchase by the central bank. As Roger Sparks intimates in this thread you should purchase those that finance something that makes policy sense to the central bank.
Nick,
A little confused here:
“The best asset for an inflation/NGDP targeting central bank to hold would be a risky asset whose value is strongly positively correlated with deviations of inflation/NGDP from target. The ideal asset would becomes worthless whenever expected inflation/NGDP falls below target.”
Presumably the central bank is a buyer of these assets when NGDP is below trend (adding liquidity during recession) and a seller of these assets when NGDP is above trend (remove liquidity during boom). Meaning the central bank is acting as a profit center buying low and selling high.
If I am a producer / grower of NGDP, why would I take the opposite side of the central bank’s trade? During a recession, I am selling less NGDP and I may be taking a loss of the NGDP contracts the central bank is buying from me.
“it would be unable to buy back the currency it has issued”
The central bank could issue securities to draw out money.
CMA: true, but those securities could only be backed by the revenue from printing more money in future.
I dont understand what you mean. The central bank doesn’t need revenue. It can print to make interest pmts on those securities it issued.
Nick, Yes, I sort of ignored that part of your post. I suppose it would work, but it seems like overkill. The reason people didn’t believe the monetary injections were permanent, is that they were told the injections were not permanent. That doesn’t seem to be a hard problem to fix—decide to do the right thing, then do it. Whatever CBs actually decide to do, is very likely what the markets will expect them to do (notwithstanding the recent exception of Switzerland.)
Mike, Yes, but I was assuming there is little danger of the US government going broke (obviously not true of other governments, especially those lacking an independent monetary policy.) In the US context, it’s much easier for me to envision the Fed being technically insolvent, than the Treasury being insolvent.
BTW, if I understand your proposal correctly, it’s similar to a proposal I made (regarding inflation targeting) in my 1995 JMCB paper. The Fed buys and sells long term CPI futures at the target price on demand, but not for monetary policy control purposes. Rather it’s to assume enough risk that the central bank would not do the mistake the market expected them to do (assuming most people feared an over- or undershoot, and most of the market was either short or long.)
They would target near-term CPI futures for monetary control purposes.
CMA: But the central bank might not want to print, if inflation is above target. It wants to buy back currency.
Scott: If we are trying to increase expected inflation/NGDP, I would tend to agree, though a bit of extra enforced credibility never hurts. But just suppose the hyperinflationistas’ fears come true, in a year or two, and expected inflation and nominal interest rates jump up, and a central bank has made big losses on its long term nominal bonds, and lacks the assets to reduce base money by a large amount. And Bitcoin really takes off, and all drugs get legalised so people stop using much currency. Sort of worst case scenario.
“CMA: But the central bank might not want to print, if inflation is above target. It wants to buy back currency.”
The interest pmts on securities issued expand money supply. The securities issued contract it. If the CB contracts the money supply by 10% through securities and those securities pay 5% interest they are expanding the money supply be 0.5% when paying interest over a year. The money supply still contracts by 9.5%. Securities issuance is really effective for temporary contractions of M.
CMA: “Securities issuance is really effective for temporary contractions of M.”
Yes, but not for permanent, which might sometimes be needed.
I’m not aware that a permanent contraction of money has ever occurred under any monetary regime. MB always has a trend growth rate to offset the deflationary force of productivity increases. BTW CB’s could also incorporate very effective permanent contractionary tools that don’t involve asset sales if necessary.
Nick……. and Scott
Why do you guys refuse to listen to a person…… Mike Sankowski over at Monetary Realism….. who has done work in futures markets, designed futures contracts, is genuinely interested in getting the US and world economies back on sound footing, is NOT some raving ideologue and has pretty much concluded that NGDP futures are a DEAD END! Is it simply because you want to put your fingers in your ears and shout La La La La La or do you have a valid criticism of his work?
He’s looked at this. He wishes it would work. Its the type of solution he, as a finance guy, could really get behind…. but he has pointed out precisely how it not only could but WOULD be gamed…… and therefore be totally ineffective.
I don’t get it.
Nick, you have always seemed to be an earnest guy looking for answers to complex problems and you seem to be open about what you know little about. Why do you dismiss Sankowskis efforts out of hand?
Scott on the other hand I understand. He’s is a pure ideologue and completely closed to idea outside his bubble. He wants to be remembered for something other than the guy who really knew how Paul Krugmans ankles tasted, and thinks NGDP targeting is his chance to be forever lionized in the annals of economics.
Sad really.
Gizzard:
I am far more (what you would call) “ideological” than Scott.
This post is not about the central bank’s monetary policy instrument, or Scott’s plan for targeting NGDP by having the central bank target the price of NGDP futures. It’s about what assets the central bank should hold, both for “safety” and as a commitment device (like burning your boats so you can’t retreat even if you wanted to). As far as this post goes, it doesn’t matter whether the central bank sets a rate of interest, or adjusts the money base, or the price of NGDP futures, to fine-tune hitting its target.
I did read Mike’s post. I tried to understand his argument. I failed. I strongly suspect that his argument is wrong. But as in all cases, there is always the possibility that he simply did not explain it clearly enough, or I am too thick to understand it, or it got lost in translation from finance-speak to macro-speak (or a mixture of the three).
Put it this way (by analogy): there is a very big difference between: the Bank of Canada trying to peg the exchange rate between the Euro and Pound; the Bank of Canada trying to peg the exchange rate between the Canadian dollar and the Pound. And as far as I could understand it, Mike’s argument seemed to treat those two things the same. If the Bank of Canada tried to do the first, it would eventually fail, making big losses.
Finance guys can be very smart, and very good at finance, but sometimes not get money/macro at all. And the central bank targeting the price of NGDP futures is money/macro, not finance. If anyone else tried to do it, it would be finance, and Mike would be right.
CMA: with a positive real GDP growth rate, and a positive inflation target, it is unlikely that there will ever need to be a literally permanent fall in M. But it is still possible, if V is rising faster than the growth rates of Y plus P. Plus, the discounted present value of future seigniorage (which is what the central bank can borrow against) is still finite, and may be smaller than the desired reduction in current M under some circumstances.
@Nick
@Scott
What is the benefit of choosing a better asset portfolio for the central bank? I see two options:
#1. It allows you to have a better choice of nominal anchor
#2. It allows you to increase real quantity of money, moving you closer to the optimum of Friedman rule
I see Scott is concerned only with #1 and Nick is arguing something else, maybe #2 (?).
Thanks for the response Nick
I am assuming that NGDP futures would qualify as an asset for CBs to own, if they were made available and that you have these types of things in mind when you are discussing these matters….. maybe I’m mistaken….. maybe not. Your last paragraph of your post and Scotts first words in his comment make me dubious that this was NOT a post that is somehow related to the NGDP futures concept as a monetary policy instrument.
As far as CB targeting NGDP futures not being a “finance” thing but simply a “money/macro” thing…… thats funny.
The problem with your example with Canadian CB targets is that its not about whether a CB targets an exchange rate between its own currency and someone else or whether it targets exchange rates between two completely foreign currencies its about whether it is targeting quantity and letting price float or targeting price and letting quantity float. If a monopolist tries to target both there is no market.
Vaidas: Neither of those. I’m arguing:
3. Greater “safety”, so it is less likely the central bank will need a bailout from the government to be able to hit its target.
4. Greater credibility. The right portfolio, plus a commitment from the government not to bail it out, acts as a commitment device to make it more credible that the central bank will stick to its target. Like burning your boats, or Ulysses’ tying himself to the mast.
Gizzard: yep, the two ideas got a bit mixed in comments between me and Scott above.
A monopolist who produces apples cannot target both Pa and Qa, true. But he can target the ratio of Qa to Pa (target Qa/Pa). And, if Qb is the quantity of bananas, he can also target Qb/Pa (he sets a price of apples proportionate to the quantity of bananas that banana producers are producing). And if we measure the price of bananas in terms of apples, and so define Pb=1/Pa, then targeting Qb/Pa is equivalent to targeting QbxPb. Which is NGDP, if apples are money, and bananas are real GDP.
#2. vs #3 is a choice. If you optimize your portfolio, NPV of future seigniorage increases. #2 is reversing it by increasing the ratio of base money to GDP. #3 is taking the extra money and transferring it to treasury.
#4. “The right portfolio” – yes, right portfolio helps you run the optimal policy. “a commitment from the government not to bail it out” – this is not credible. Benefits of central banking are enormous, and it is a good idea to bail out the central bank at a certain point to prevent Zimbabwean situation.
Vaidas: you might be right that the “no bailout” promise would add little extra credibility to a “target level path NGDP” promise. But it would help promote central bank independence, if it held the right assets and so knew it would never need to ask for a bailout.
Nick, all assets are risky. Right assets reduce the risk, but not eliminate it. It is important to have bail-out backstop for a central bank that does the optimal thing but loses the game of risk.
Vaidas: gold is risky but a perfectly safe asset for a gold price targeting central bank. (OK, it could be stolen, or fake, or get lost I suppose.) What we are looking for is the equivalent of gold, for an inflation/NGDP targeting central bank.
Nick, suppose you have a NGDPLT targeting central bank which decides to hold only ultra-safe NGDP-linked instruments. There are three problems.
First, you have the Taylor Rule natural rate interest constant problem. Unless you are central bank willing to copy some members of US Congress who are planning to enshrine the 2% natural interest in the legislation, you have a problem – when your NGDP-linked instruments mature, you lose money if you revise your estimate of natural interest upwards.
Second, NGDP expectations derived from ultra-safe assets may not be the most relevant ones. During credit crunch, NGDP expectations of safe and risky players may diverge, and it makes sense to target some sort of average.
Third, by limiting the range of assets you invest in to ultra-safe ones, you can pay only very low IOR which is not optimal from the perspective of Friedman Rule.
Nick / Scott,
Don’t you want the central bank buying and selling output gap futures instead of nominal GDP futures?
With nominal GDP futures the central bank buys the futures when their value is low and sells the futures when their value is high. In the short term, it is a pro cyclical move – adding liquidity during a boom and removing liquidity during a recession. Over the long term (multiple recessions / booms), the central bank (as a profit center) is removing liquidity.
With output gap futures the central bank buys the futures when their value is high (during a recession) and sells the futures when their value is low (during a boom). In the short term, this is a counter cyclical move – adding liquidity during a recession and removing liquidity during a boom. Over the long term (multiple recessions / booms), the central bank (as an insurer) is adding liquidity.
Presumably the futures are not liabilities of the central bank and so they are a finance instrument of some other enterprise? And so it remains an open question – whose liability is a NGDP / output gap future. If they are fixed term liabilities – who is the redemption agent when the liability reaches full term?