A better Modern Monetary Theory

A new movement by the name of Modern Monetary Theory (MMT), which holds that governments should be more open to creating money to cover their spending, is attracting a great deal of attention.

Some proponents of the Green New Deal and "Medicare for all" argue that MMT is the key to financing ambitious (and expensive) new policies. 

Despite its name, however, MMT offers little guidance to the Federal Reserve. Indeed, its proponents typically argue that controlling inflation is the responsibility of Congress and the president, not the Fed.

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Ironically, recent developments in Fed policymaking adhere much more closely to a very different “modern monetary theory”: market monetarism. Market monetarists believe that any targeting of inflation should be done by the Fed. 

Although market monetarists are best known for advocating nominal GDP targeting, the specific “market” part of “market monetarism” refers to the belief that Fed policy should be guided by market forecasts, not highly technical computer models of the economy. There are signs that the Fed is moving in this direction. 

The computer models of the economy no longer appear to be adequate. For example, Fed models of inflation are traditionally based on the idea that pushing the economy to full employment leads to inflation, thanks to upward pressure on wages and prices.

As the labor market has strengthened, fear of higher inflation has led the Fed to boost its interest rate target nine times since late 2015. Yet, as unemployment has fallen below 4 percent, inflation remains slightly below the Fed’s 2-percent target. 

In response, Fed Chairman Jerome Powell announced that this June the Fed will host a major conference in Chicago aimed at exploring alternative approaches to policymaking. The Fed’s approach may already be changing ahead of this meeting. 

This past December, stock prices and bond yields fell sharply on worries that economic growth was slowing. In response, the Fed adjusted its 2019 plans, scrapping plans for two expected interest-rate increases.

This shift was not based on macroeconomic models of the economy, but rather market signals. With “output gap” models no longer producing reliable policy guidance, the Fed is now almost forced to rely on market forecasts.

Currently, the Fed seems to rely especially heavily on signals from the stock and bond markets. There are, however, several downsides with this specific approach. If the Fed appears to be trying to prop up the stock market, it opens itself up to attacks from populist politicians, even if its ultimate motive is preventing a recession.

Furthermore, the stock market is a somewhat crude tool for forecasting the business cycle. One famous economist quipped that it had predicted nine of the past five recessions. A good example occurred in 1987, when a major stock crash was not followed by a recession. 

So while enthusiastic about market-based Fed policy, market monetarists advocate for more effective guideposts than the stock market can provide. 

One was established in 1997, when the government began issuing Treasury bonds that are indexed to the rate of inflation. The spread between the interest rate on conventional bonds and the interest rate on indexed bonds —both reflecting market expectations — provides a rough-but-useful market inflation forecast.

An even better approach would be to create and subsidize trading in futures markets that forecast nominal GDP growth. Nominal GDP growth is important because it is closely linked to both sides of the Fed’s dual mandate: stable prices and high employment. 

A nominal GDP futures market would provide a minute-by-minute indicator of the expected growth rate in nominal spending over the following 12 months. 

As some of the Fed’s traditional tools continue to fall short, market forecasts will continue to become more important. Our complex economy changes too rapidly and unpredictably to rely on any fixed mathematical forecasting model. Policy approaches that are appropriate for one decade may be completely inappropriate for the next. 

While market forecasts are far from perfect, they reflect the consensus views of thousands of traders who have money on the line. That means we need the best possible market forecasts, even if it requires putting resources into creating useful market indicators.

Scott Sumner is the Ralph G. Hawtrey chair of Monetary Policy with the Mercatus Center (@mercatus on Twitter) at George Mason University.