Sep 12, 2022

Scott Sumner on Alternative Approaches to Monetary Policy

Segmenting monetary history into phases of ultra-low, very high, or low-and-stable interest rate conditions can help us understand the ever-shifting popularities of alternative approaches to monetary policy.
David Beckworth Senior Research Fellow , Scott Sumner Ralph G. Hawtrey Chair Emeritus of Monetary Policy

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Scott Sumner is the Ralph G. Hawtrey Chair of Monetary Policy at the Mercatus Center. Scott joins David on Macro Musings to look back on his contributions to monetary policy research with the Mercatus Center and elsewhere, as well as discuss his upcoming book, *Alternative Approaches to Monetary Policy.* In particular, Scott and David discuss how the Fed’s monetary policy mistakes in 2008 impacted the direction of Scott’s research, the theory and prospects for a nominal GDP futures contract, the future of monetary policy in the Eurozone and whether the ECB has gotten more hawkish, how changing macroeconomic conditions across history help explain the changing popularity of particular policy models, and much more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Scott, welcome back to the show.

Scott Sumner: Thanks for inviting me, David. Good to be here.

Beckworth: It's always great to have you on. You're a great colleague of mine. It's been a privilege to work with you at the Monetary Policy Program at the Mercatus Center. And we want to get into your upcoming book, titled Alternative Approaches to Monetary Policy. So, that sounds exciting and we want to get into that. Before we do Scott, what's the big announcement you want to share with our listeners?

Sumner: I'll be retiring from Mercatus next week. I'll actually be 67 years old this month. I'll be retiring and taking a break, but I'll continue to be active in promoting these ideas in my own time.

Beckworth: And we will miss you immensely at the program. And I should mention to the listeners, the Monetary Policy Program would not exist without Scott. He's the reason that it first got started. There were interested parties. There was one particular donor in particular who liked Scott's work and helped fund the program initially. This podcast wouldn't be happening if it weren't for Scott. Scott got the program going. A little bit after Scott you joined, you invited me to join and then the podcast became a part of that. What we have going here is due to the efforts you've put out making this program work. And we've done a lot of fun things over these years. So when did you start? Remind the listeners when you actually started at Mercatus.

Sumner: First of all, thanks for the kind introduction. I think I started the program, but you really put it on the map with this podcast and other things you've done. I started around the beginning of 2016. Don't recall the exact date. At that time I was finishing up teaching at Bentley University where I'd been for more than three decades. Since then, I've been working basically out of my house in the program.

Beckworth: Yes, we've both have been traveling to Mercatus as we've done our work for the Monetary Policy Program. We've had a great support team at Mercatus and we've had several scholars added over the years. We had Chris Russo, who's now at the Senate. He's a chief economist for the Senate Republicans on the Senate Banking Committee. We have Pat Horan. Used to be a staff member now he's a scholar with our team. We have Carola Binder visiting fellow. And we've had a lot of other affiliated scholars. Bob Hetzel, Josh Hendrickson, Peter Conti-Brown. People who've written articles for us. So it's been a fun run. In fact, we did a number of conferences together, too, Scott. I was just looking back and thinking about this, getting ready for the show.

Beckworth: I came in 2016 after you did. You and George Selgin had organized a monetary policy conference, a joint Cato Monetary Policy Conference. And I believe it was called “Monetary Policy Rules for a Post-Crisis Economy.” And you had a number of great guests. You had Perry Mehrling, Peter Ireland, David Papell, John Taylor. And that was a real great way for me to at least start off my experience there at Mercatus. We also did the Allan Meltzer conference. In fact, that actually started with the podcast. As you remember, we did a live podcast that some other conference, and Allan Meltzer was still alive. We interviewed him in front of the audience and went well. And then we organized a conference, a bunch of papers written about his life, on the margins of an AEA meeting in 2018. We had a number of great names there. We had Bob Lucas, Jim Bullard was there, Michael Bordo, Charles Plosser. Ed Prescott was in the audience. I don't know if you remember that. He showed up as a fan in the audience. He really appreciated Allan Meltzer as well.

Beckworth: And then we had a conference in 2019 on the Federal Reserve and Don Kohn was our keynote speaker, I don't know if you remember that one, had a number of good speakers. Andy Levin, Joe Gagnon, Peter Conti-Brown, Dennis Lockhart, former President of Atlanta Federal Reserve Bank was there. So we've had a number of conferences. I think we had a few more besides those. And those were always great. You get to meet people and interact. And these are on the margins of some other larger conference. So we did these conferences. We've done papers, podcast, and you've come out with several books. OPne of the books you came out with was right before you got to Mercatus, this was The Midas Paradox, correct? That's the title?

Sumner: Yeah, it should have been the Midas Curse, but the publisher had me change the name.

Beckworth: And that was 2015. And that deals with the interwar gold standard, the Great Depression. And then most recently you had a book out titled The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy. And that came out last year, correct?

Sumner: That's right.

Beckworth: So, you had those two books and you're working on this third one. So you've been a busy person. You've done a lot in this program. For listeners, maybe walk us through this journey. How did you get to Mercatus? What were you doing before? Why did you decide to become a part of a program at a research center like Mercatus?

Sumner: I think it goes back to my decision to start blogging in early 2009. I was frustrated by what I thought were policy mistakes being made during the Great Recession. So I got into blogging and started to get my ideas out there. That got me a little bit of attention during a period where blogging was very popular. This is before the Twitter era. Out of that came some opportunities. I did some speaking, some writing. I wrote some papers for Mercatus, even before I was employed with Mercatus. A donor put up a lot of money to support a program on monetary policy at Mercatus so I thought it was a natural fit. I'd already been teaching for a long time. And it was an opportunity I really enjoyed being able to focus full-time on, something I felt very passionately about at the time, which was monetary policy reform. That was what got me into the position at Mercatus. I've been there since.

Beckworth: So Scott, walk us through this research that you did on this journey.

Monetary Policy During the Great Recession

Sumner: I'd done research in three areas that all helped me, I think, see things more effectively during the Great Recession. My biggest research area was the Great Depression and there's certainly some parallels in terms of the financial crisis and the deep downturn. I also did research on liquidity traps, the situation in Japan. And the third area was using markets as a guide to policy. So, setting policy at a position where the markets expected you to succeed. Ideas like nominal GDP futures targeting. During the Great Recession, I saw a lot of the same mistakes being made as in the thirties, not nearly as badly, but still in my view, an excessively contractionary monetary policy, a misreading of the stance of policy, too much of a fatalistic attitude towards money due to the Zero Lower Bound. And so I wanted to push back against some of these ideas based on the research I'd been doing in those three areas.

I'd done research in three areas that all helped me, I think, see things more effectively during the Great Recession. My biggest research area was the Great Depression and there's certainly some parallels in terms of the financial crisis and the deep downturn. I also did research on liquidity traps, the situation in Japan. And the third area was using markets as a guide to policy. So, setting policy at a position where the markets expected you to succeed. Ideas like nominal GDP futures targeting.

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Sumner: So more specifically, in late 2008, I saw that monetary policy was being set at a level where the markets were forecasting a recession and below target inflation going forward. So the Fed was not likely to fulfill its dual mandate and there was this sense of fatalism. People thought this was all due to the banking crisis and there's nothing the Fed could do. But in fact, the Fed could have done a lot more stimulus in 2008. And indeed we weren't even at the Zero Bound at that time. That would've been very helpful to the economy. I was very frustrated over that situation and the lack of focus or emphasis on monetary policy, not just within the Fed, but within the broader profession. And so I wanted to push these ideas that there's a lot more that Fed could be doing. And that's really what got me involved in this whole program.

Beckworth: So one of the defining characteristics of your work is that the Fed should look at asset prices, also rules-based, predictable, but you really stress looking at asset prices. So how could the Fed have used asset prices in 2008 to have done better monetary policy?

Sumner: So ideally we'd have a liquid nominal GDP futures market, but lacking that, you look at what asset prices you have. In late 2008, all of the asset markets were signaling a contractionary mistake. Inflation expectations, and the TIPS spread were falling dramatically. Commodity prices were crashing. Stock prices were crashing. The dollar was appreciating strongly in the foreign exchange market. Commercial real estate was going down. So it wasn't just residential real estate. Virtually any signal that you looked at was signaling that we were going into a deep recession and inflation was going well below the Fed's target. This is in the second half of 2008, by the way. That's really what I think the Fed was missing. So again, ideally we'd have a nominal GDP futures market. But even without that market, there was enough market indicators suggesting that monetary policy was too tight. At least it was pretty clear to me that was the case.

Beckworth: And as you said, the second half of 2008. So if you look at break-evens that begin, I believe, to go down in June. There was plenty of time, at least for the second half, for the Fed to see things. What about the first half though? One of the critiques that you and I have made over the years is that the Fed, it cut rates through April and then parked them at 2%. Set on 2% through October. And for many people that's like, "Well, what's the big deal. It's two percentage points, more they could have cut." And we've argued it wasn't just those that cut but the expectation of rate hikes. The Fed was talking up rate hikes during this period because commodity prices were surging, inflation was high. In fact, the ECB, very similar situation, did raise interest rates. But what could the Fed have seen maybe in earlier 2000? Any signals there that would've told them, "Hey, keep on loosening and don't talk up rate hikes"?.

Sumner: In retrospect, policy was a little bit too tight in early 2008. Although I would say that I think the mistake there was much smaller and more understandable. We did have high headline inflation due to the oil price surge, they are supposed to look past that. But overall I think the situation was a little bit hard to read because some of the data, like on GDP growth, comes out with a lag. I'm willing to cut the Fed slack on that period. But I would also emphasize that they had a regime in place, which was growth rate targeting rather than level targeting, which made it harder to avoid mistakes. So if you have a level targeting regime where you promise to come back to the previous trend line, it's easier to avoid a major mistake such as occurred in late 2008, because the markets will understand that the future policy will tend to push the economy back on track. Especially true that it gives policy more traction at the Zero Lower Bound, which we eventually did hit in December of 2008. I think with monetary policy, sometimes people put too much weight on the day to day decisions the Fed makes, and whether they misjudge a meeting or a rate cut here or there, and not enough on the regime and the need for a level targeting regime, which really imposes some discipline on monetary policy and creates stabilizing expectations so that if you do make a mistake, it doesn't have the repercussions that a mistake would have if you're not doing level targeting.

I think with monetary policy, sometimes people put too much weight on the day to day decisions the Fed makes, and whether they misjudge a meeting or a rate cut here or there, and not enough on the regime and the need for a level targeting regime, which really imposes some discipline on monetary policy and creates stabilizing expectations so that if you do make a mistake, it doesn't have the repercussions that a mistake would have if you're not doing level targeting.

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Beckworth: And just to be clear, when you say level targeting, do you mean a nominal GDP level target or would a price-level target be okay as well?

Sumner: That's a complicated question. So nominal GDP level targeting is ideal. And maybe this would be a good time to pivot to the current situation because this is very much involved with what's going on now. Price-level targeting is acceptable if it's part of a dual mandate approach where you don't put all the weight on the price level. The reason I prefer nominal GDP targeting is it does a better job of handling supply shocks and so on. If you're doing price-level targeting, you have to look past temporary price spikes caused by energy shortages, food shortages, and so on and focus on the part of inflation that's demand-driven. So if we take the current case, part of the increases in inflation in 2021, last year, were things the Fed should have allowed because they reflected supply problems. So it was appropriate for inflation to go well above target. The only part that they should apply the level targeting to is the demand side part of inflation.

Sumner: Now, in the very long run demand shocks will balance out and you should get roughly on-target inflation, even headline inflation. But over the medium term, you don't want to artificially push the price level back to a particular point when there are severe supply shocks going on. In this case, they might want to focus more on core inflation or something like that. Even core inflation has some problems built in. And this is why nominal GDP targeting is so much better than price-level targeting. Is it automatically directs the Fed's attention to the appropriate variable, which is preventing instability and aggregate demand and nominal spending and letting there be transitory changes in the price level due to supply shocks. Yes, you can do price-level targeting, but it has to be done in a flexible way, cognizant of the need to allow some fluctuation due to supply shocks.

Beckworth: That's why Michael Woodford, who has called for a price-level target actually prefers what he calls an output-gap adjusted-price-level target. I know that's a mouthful. But he says, "Look, a nominal GDP level target approximates that, so I'm going to call it a nominal GDP level target. I'm going to go for a nominal GDP level target." I asked that question though, Scott, because going back to 2008, a price-level target, depending on how one interpreted it, a strict price-level target may have led the more tightening in 2008. As the headline inflation number went up, they may have had to tighten to get back onto the price-level path, whereas a nominal GDP level target would've made it easier for the Fed to be accommodative during 2008. Now, I know, again, the big challenge critics will bring up about 2008 is "Well, the GDP data initially didn't come out signaling that." And that's where you would say, "Okay, well, give me my nominal GDP futures contracts, they would've fixed that problem." Maybe before we move on, let's touch on, in more detail, the nominal GDP futures contract idea. So tell the listeners. I know they've heard before, but it's good to hear it again. What is this type of contract and how would it operate?

The Nominal GDP Futures Contract

Sumner: It's a futures contract where the maturity value depends on the actual outcome of nominal GDP growth. Let me give an example of the core or system I had proposed. The Fed could stand willing to take a short position on any nominal GDP futures contract for 5% nominal GDP growth. In that particular case, if nominal GDP growth comes in under 5%, the Fed profits, if it's over 5%, the person buying the contract profits. And then the Fed would take a long position at, say, 3% nominal GDP growth. So if nominal GDP growth is above 3%, the Fed profits on the contract, if it's below 3%, the bearish forecaster profits. And in that case, the Fed would be essentially committing to keeping nominal GDP growth within a 3 to 5% range, would still give the Fed a little bit of discretion for unforeseen circumstances. There's also the question of how far out do you want to go with these contracts, should be a year, two years. You can make good arguments both ways.

Sumner: But the basic idea is that these contracts would represent a warning system for the Fed. I analogize it to the beeping noise a truck makes backing up when it's about to hit something. If suddenly everybody is taking a long position in the NGDP market, as they would've been late last year, the Fed knows that the market thinks NGDP growth is going to go well above target. And the Fed would have two choices. They could either tighten monetary policy until that was no longer the market's expectation, or they could decide they're smarter than the market and take a risk. But I think over time, the Fed would've learned that it wouldn't want to get too far out of line with market expectations. And it wouldn't want to go before Congress having lost a lot of money in a market, by thinking it was smarter than the market. The Fed would adjust monetary policy to try to keep market expectations of nominal GDP growth within that 3 to 5% range. That's the basic idea.

Beckworth: Now this contract does not yet exist. And if there's anyone out there who wants to pursue it, you can get in touch with Scott. He can talk to you more about it. But we have had some fun with the idea. We had this Hypermind market set up while you were here at the Mercatus Center, which was an approximation. It wasn't really a futures contract, but people could bet on where the nominal GDP numbers were going to go in the future. And there's been a few other places that have picked up this idea and ran with it in terms of a betting market. But what you would like to see is an actual financial asset that's traded in the markets and would be providing useful information to the Fed going forward.

Sumner: That's right. All these prediction markets are interesting, but they almost never involve any real money or any significant real money. I'm talking about something where the Fed would provide unlimited liquidity in a sense. People could take as strong, long or short position as they wished. That would make it a much more serious market price. Now, sometimes people say to me, "Well, what if nobody traded this contract?" Well, that would be fine. Then that would be an indication that the market thinks NGDP growth will be on target. A lot of people, in analyzing my proposal, I think, think about it in the wrong way. They think about it this way, “well, suppose we set up a NGDP futures market at the Chicago Mercantile Exchange or something, and there was very little trading on it because traders weren't interested in NGDP. Then it wouldn't be very useful as an indicator to the Fed.” And that's right, but that's actually not what I'm proposing.

Sumner: I'm actually proposing that the Fed make the offer to take an unlimited long or short position at these two price points. Then you'd automatically have essentially as much liquidity as you wanted, if you wanted to trade that contract and it would represent a meaningful constraint on the Fed. Now, hopefully there would never be much trading because that would mean the Fed's policies are roughly on target, but if they got well off target, as they were clearly late last year, there would obviously be enormous trading because it would be an easy way to earn large profits for people. In the case of late 2021, for people taking the long position.

Sumner: Now I should say that my proposal on level targeting is similar in this respect. It also provides market discipline in this way. Suppose the Fed had been doing level targeting of nominal GDP late last year, and it became clear that nominal GDP was running well above the 4% trend line. Markets would've anticipated a sharp increase in interest rates as the Fed had to tighten up to get back onto that trend line. And those increases would've occurred immediately in the credit markets, automatically tightening monetary policy at a time when the Fed was slow to see the problem. So in a sense, level targeting has markets work towards the process of stabilizing monetary policy in much the same way as an NGDP futures market would. Maybe not quite as effectively, but still in my view, relatively effectively, if the Fed's commitment is sincere.

Beckworth: Now, Scott, just to flesh this out a little bit more, if the Fed were using nominal GDP futures contracts, and let's say the economy was expected to be heating up, growing too fast, then what would happen effectively is money would flow from the public back into the Fed and vice versa, is that right, through these contracts?

Sumner: The original proposal I made was one where it was an automatic system where the money supply adjusted automatically to these purchases, maybe like the gold standard or something. But over time, I developed a more flexible approach to corridor system. I call it guardrails, where the Fed agrees to take these long or short positions, but the Fed still has the discretion to do monetary policy as it wishes. The constraint is really more on the Fed not wanting to take large losses. That's what disciplines the Fed. It doesn't really control the money supply in an automatic way any longer. Now, the Fed could still, if it wished, do money supply targeting, interest rate targeting, exchange rate targeting. It could use any policy instrument it wanted to control aggregate demand with a proviso that if aggregate demand got very far off course, and the public saw this and took either very strong, short or long positions, the Fed could lose a lot of money. It would be a way to use financial markets to nudge the Fed towards a policy that the financial markets themselves felt would be consistent with the Fed's goal, say 4% NGDP growth.

Beckworth: This instrument would actually provide a means to adjust the amount of dollars in circulation, though with the guardrails, it would be less blunt, or it'd only be used in extreme situations when you hit the guardrails. It would provide though automatic mechanism of some sort. Now, my question would be then, would monetary policy work because of that or because of the expectation management this futures contract made or would it be both?

Sumner: I would combine it with level targeting. I think both tend to stabilize monetary policy. How well it works, there's trade-offs here. You can make the guardrails narrower. Instead of 3% and 5%, you can go 3.9 and 4.1%. And the Fed has less discretion in that case. I was trying to propose something in my more recent proposal that would be more pragmatic, more likely to be acceptable. But if you want to be a real hardcore rules proponent and take away all discretion from the Fed, you could set up a system where essentially these nominal GDP futures contract trades automatically adjust the monetary base until the base is at a level and implicitly interest rates are at a level, where the market expects NGDP growth to be right on target.

Sumner: There's also issues of possible risk premium and so on. That's another reason why I thought it made sense to have a corridor system or guardrails where there's some flexibility there in case something was distorted in the trading in that market. If you had one major player that was taking a short position or a long position, but nobody else, the Fed could ignore that and say, "Well, that's just one person. Maybe they're trying to manipulate the market. We won't dramatically change monetary policy on that basis," for instance. So there's a lot of issues that would have to be fleshed out, but that's the basic approach that I would favor.

Beckworth: And we'll provide a link to your articles on nominal GDP futures targeting in the show notes.

Alternative Approaches to Monetary Policy

Beckworth: Let's move on to your upcoming book. And again, that title of your book is Alternative Approaches to Monetary Policy. And you have a number of chapters in there. Some of the chapters are previous articles you've written. Some of them are new chapters. And I want to focus in on a few chapters that look at schools of thought. And the reason I asked this, Scott, is because we've talked about this before, but there seems to be fads in monetary policy, different ideas that become popular. Over the past decade, when inflation was running really low and it looked like the US government had lots of fiscal space, without jeopardizing inflation, the Fed could continue to have it easy. Schools of thought like MMT emerge. MMT may not have been the justification that was used, say, in the pandemic for the fiscal packages. That line of reasoning became more common, more widespread. I suspect, and my impression is, that it's died down now. You don't see as much coverage. I just get the sense, there's a lack of momentum for MMT given we now have high inflation. Do you see something like that happening throughout your career? You think that's normal to see this happen or is this unique?

Sumner: No, not just my career, but looking back over monetary history in general, I think you can identify three phases that we go through. There's the ultra-low interest rate phase often associated with deflation. There's the very high inflation rate phase. And then there's the relatively low and stable inflation like the so-called Great Moderation of the 1990s and early 2000s. Each of these phases is associated with different models being popular. When interest rates are stuck, close to zero, monetary policy is often seen as ineffective. Various types of old Keynesian type models are very popular and MMT is a variation on that theme.

Looking back over monetary history in general, I think you can identify three phases that we go through. There's the ultra-low interest rate phase often associated with deflation. There's the very high inflation rate phase. And then there's the relatively low and stable inflation like the so-called Great Moderation of the 1990s and early 2000s. Each of these phases is associated with different models being popular.

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Sumner: When inflation is very high, persistently high, monetarist models that focus on money supply growth, tend to dominate because interest rates become a very unreliable indicator of the stance of monetary policy. And this has been true, by the way, throughout history, not just say the 1960s and 70s, when Friedman's ideas got more popular. You can go back to the early 20s when there was a lot of inflation and economists that had previously focused on interest rates like Wicksell and Keynes suddenly started talking about money supply growth as the key problem. The German Hyperinflation, for instance and other European post-war inflations. So, we go through these cycles over and over again.

Sumner: And then during the intermediate period, let's say the 1990s, early 2000s, you have a situation where inflation's high enough where nominal interest rates are positive, but nevertheless, Keynesian models seem to work relatively effectively because the inflation rate is still fairly low and stable, so you don't have to worry as much about the Fisher Effect. And so you get what are called New Keynesian models. And I think even going back to the 1920s, to some extent, this approach was relatively popular. Having a central bank adjust interest rates, try to keep the economy stable and keep inflation relatively low and stable.

Sumner: So in this intermediate, what we call New Keynesian approach, they agree with old Keynesians in the sense that they favor using interest rates rather than money supply to control monetary policy. And they agree with the monetarists that ultimately it's monetary policy that drives aggregate demand and inflation, not fiscal policy. So you can think of the New Keynesian model as a hybrid of the old Keynesian and the monetarist approach. And the old Keynesian and the monetarist approach are ones that are popular at the extremes, either near zero interest rate for old Keynesian or very high inflation for monetarists models being popular.

Beckworth: That is so fascinating. Being able to map out US economic history with these different views of how things should be run. Keynesian, monetarists, New Keynesian, the extremes, the more moderate case. So where do you think we're going in the US over the next, say, decade? Are we going to go back to a New Keynesian world or a world where New Keynesian policies are embraced, or what do you see?

Sumner: I'm not very good at predicting these things, so I guess that would be my default prediction. I have this phrase, I like. "Good economists don't forecast, they infer market forecast." As you know, the markets are forecasting slightly above 2% inflation for the next decade. And in that kind of world, I do think policy tends to move in a New Keynesian direction. I don't see any obvious reasons why that approach would not remain relatively popular. Probably the most interesting question is what have we learned from most recent events? And that's still to be determined because we don't yet know how this is going to play out. We don't know whether we're going to have a soft landing or a recession. And how that plays out will determine to some extent what lessons we learned.

Sumner: If you go back to the Great Recession, we learned that we should have been more aggressive in trying to stimulate the economy during the 2010s. That led the Fed to adopt average inflation targeting. And I think, appropriately, my only disappointment with that is that the policy was not made symmetrical. The Fed did a very good job of promoting a rapid recovery. The policy did what it was supposed to do in the first year of the recovery from COVID recession. Brought unemployment down very, very quickly. They did overshoot, and I attribute that overshooting to the fact that the policy wasn't symmetrical and the Fed became... The Fed should always be neutral. It should never be dovish or hawkish. It should always be trying to hit its targets. But inevitably with human beings, biases creep in. And because the lesson of the 2010s was we were too hawkish, the Fed became too dovish in its orientation, and didn't really worry about inflation becoming a problem and ended up stimulating too much.

Sumner: Now, that wasn't the whole mistake. The supply shocks were a good bit of the inflation, but part of the inflation of the last year has been excessive demand stimulus. How this plays out, I would say if we get a soft landing, the Fed will feel better about average inflation targeting, even though I do think it was misused. Unfortunately, if we get a hard landing, I think that's going to make it harder to do this aggressive stimulus in the next recession, because people will say, "Look, remember, you overstimulated." And so we may be always like the general fighting the last war. We understimulated in the 2010s, overstimulated in 2021. And that's why I emphasize we need to avoid an attitude of dovishness or hawkishness and really focus like a laser on what numbers are we trying to hit? Have a level target where we commit to come back to that trend line. And that's the kind of discipline that will avoid these wild swings going forward.

If we get a soft landing, the Fed will feel better about average inflation targeting, even though I do think it was misused. Unfortunately, if we get a hard landing, I think that's going to make it harder to do this aggressive stimulus in the next recession, because people will say, "Look, remember, you overstimulated." And so we may be always like the general fighting the last war. We understimulated in the 2010s, overstimulated in 2021. And that's why I emphasize we need to avoid an attitude of dovishness or hawkishness and really focus like a laser on what numbers are we trying to hit? Have a level target where we commit to come back to that trend line.

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Beckworth: I agree with that. I just wonder if moving forward, even if we have a soft landing, that monetary policy across the advanced economies will be more hawkish in general. Because we went through these 2021, 2022 period of really high and sustained. It's lasted for about a year now or over a year now. That has really affected what's important. Politically, if you look at polls, inflation's number one in the US, it's rising in other countries. I just wonder if there's going to be a permanent scar, like there was a permanent scar for many policy-makers who cut their teeth in the Great Inflation. For them, that was a defining moment. And so they were always very careful, very cautious. I just wonder if some of that will follow policy-makers through this experience, even in the case of a soft landing. What do you think?

Sumner: It's hard to say. I think it depends how much inflation we have going forward. A lot of people think inflation's reached a peak, but it matters a lot whether inflation a year from now is 6% or 3%, for instance.

Beckworth: Yeah, that's a good point.

Sumner: As far as I can tell the markets seem to be relatively optimistic if you believe the TIPS spreads. That will be closer to three than six. But if it turns out that inflation is stubborn and difficult to get down, and this is the problem we had in the 70s, of course, is that the policy makers were too optimistic and to some degree of the markets as well. The more that goes on, the more that makes people hawkish in their orientation. And it makes it harder to do a dovish policy where it's appropriate. And again, this is why something like level targeting is so crucial. It disciplines. I've argued that basically if you have a level targeting regime in place, it no longer even makes any sense to talk about Fed officials as being dovish or hawkish. They would all try to do the same thing, get back to that trend line because if a dovish person got higher inflation, that's just going to lead to a recession, as you get back to the trend line.

Sumner: But if you don't have level targeting and you just have an inflation rate that drifts around, then although you have this official 2% inflation target, it really allows for hawks and doves to quietly push for a little more than 2% inflation or a little less than 2% inflation, if that's their preference. There's no price to be paid for cheating on the 2% inflation target when you don't have a level targeting regime in place. Because of the dual mandate, again, I think it really needs to be nominal GDP level targeting. But if you did level targeting of maybe the core inflation rate over a fairly long period of time, that might be workable as well.

Beckworth: We recently had Jeff Lacker on the show and he talked about using a range for the inflation target, like your guardrails, but a range. And he mentioned anything from 1 to 3%. And his preference was for a little bit smaller 1.5 to 2.5 but something that you'd have some flexibility and you wouldn't be viewed as hawkish or dovish if you deviated a little bit above or below 2%. But going back to the current situation, Scott, and what I at least see in monetary officials, and in the US in particular, I see this incredible newfound focus on fighting inflation. Some of the most dovish people, I hate to use the term, but most dovish Fed officials are now Hawks. Neel Kashkari, Mary Daly, people in the past you would've labeled as a very strong dove, you could label as a strong hawk now.

Beckworth: And so it's interesting to see this transformation. I think it's true across most of the FOMC members. They're very much focused on getting inflation down in a way that I haven't seen in a long time. It just makes me wonder how easy it will be to lose that focus moving forward. Maybe they'll begin to relax slowly over time.

Has the ECB Gotten More Hawkish?

Beckworth: But let's move across the Atlantic to the ECB. They seem to be tightening into a supply side recession. In the case of the US, we both agree nominal GDP aggregate demand growth has been too strong. It's above where it should be. The Fed should have tightened sooner. But I look at the ECB and I don't know what the forecast are for nominal GDP growth rates going forward, but at least through the second quarter, it's just about where it was pre-pandemic. And now the ECBs talking up further rate hikes. And I understand they're worried about inflation expectations becoming unanchored. But from where I sit it sure looks like they're tightening into a real recession, a supply-side driven recession, and they're doing this because of this, again, this laser-like newfound focus on inflation. I know Europeans, Germans in particular, have always had this, but it just seems to me at least, there's a new hawkishness pervading central banking and advanced economies. Maybe I'm being too dramatic here, Scott, and you can correct me but don't you get some sense of that change that's going on?

Sumner: I have trouble interpreting Europe. First of all, I didn't even see the second quarter GDP figures. Are the nominal figures out? Two weeks ago they weren't even out yet.

Beckworth: Well, I had to infer. Real GDP is out. And you can look at real GDP, you can look at inflation numbers. Even the deflator doesn't come out immediately so you have to estimate a relationship between inflation and the deflator. And you can come up with a good proxy for it. And if you do that, you look at where nominal GDP is, it's right about on trend. So it hasn't shot above. And that’s through the second quarter. Now, again, I haven't looked at forecasts. If you were to say, "Well, Beckworth nominal GDP's going to be 5% above trend or some massive number, okay, that's a different story. But it sure looks like, if anything, nominal GDP's going to decline going forward with the Russia-Ukraine war energy crisis. Truly a supply shock if we've ever seen one, a really large one is occurring and unfolding now in Europe.

Beckworth: It just strikes me that they're tightening into that. And that's not something you would do. Even under standard flexible inflation targeting, you're supposed to see through things, unless, again, the key is if you are going to worry about inflation expectations being unanchored, which I don't think is going to be a case going into a recession. But maybe that's just me, and I'm sure there'll be some listeners who will let me know I'm wrong and there's other complicating factors. I've had people tell me, "Well, they're worried about the Euro falling too low. They have to move because the Fed's moving." But they're doing so, at least in my view, at a pace that seems to be imposing more damage than good. Again, that's my take from over here on the other side of the Atlantic and I may be off.

Sumner: A few months ago, I argued that the ECB had done a really good job up until that point of not overshooting or undershooting in terms of demand stimulus. I don't know enough about the last few months figures to have a strong view, either way. I would say this. I don't think policy has been very far off course here to now, but it wouldn't surprise me if what you're saying is correct. Given the ECBs hawkish bias, the sort of mistake they're likely to make going forward is what they did in 2008, which is tightened in a supply shock and drive the eurozone into recession.

Sumner: They're not doing that right now. If you look at the most recent unemployment data out of the eurozone, it's really strong, really low unemployment. All this is provisional on what they do next. There's still time for the ECB to adjust policy properly, and avoid a deep downturn, at least a deep demand side downturn. Inevitably, the supply problems will cause economic distress in Europe, but there doesn't need to be a severe demand side downturn given what they've done so far, but given their bias and the focus on headline inflation there, it wouldn't surprise me at all if they tighten too much and push eurozone into a recession.

Beckworth: I have an article up here from September 4th in the Financial Times. And the title of the article is “ECB makes hawkish shift as inflation surge shreds faith in the models.” And the first two paragraphs here, I'll read them. The European Central Bank's sense of urgency in tackling inflation has overtaken concerns over the damage an aggressive rate increase would inflict to the eurozone economy ahead of policy meeting this week. Several ECB rate-setters have said they are focusing more on current record levels of inflation to decide policy, moving away from an earlier, more dovish approach that hinged mostly on where they expected prices to be two years from now.

Beckworth: So people are forecasting a potential 75 basis point increase there. And that, I guess, is what I find interesting and surprising. And again, going back to my bigger point here is this hawkish shift, this maybe a new world where central bankers have rediscovered their old hawkish religion. Let's move on from this discussion that's fascinating. We can spend more time here, but we want to get back to your book. Again, the title of your book and it's upcoming, it will be released at some point in the later day. In fact, Scott, when do you expect it to be released?

More Details on Scott’s Upcoming Book

Sumner: Probably later this year. Perhaps I should say a little about the nature... It's not a traditional book. There will be no physical book. It'll be published online in installments. It will be free. It will be an ongoing project where I will occasionally add to it, revise. It will also be interactive. What I hope to do, and this is an experiment, is to get reactions from readers and sharpen my argument based on those reactions. Maybe there'll be a version 1.0, version 2.0 and so on.

Beckworth: A living document.

Sumner: Right. And because being online and not being a paper version, I can adjust as much as I want. I'm not interested in making money off of it. And I'd like to have the largest readership possible. That's my approach. So it's not going to be just a fixed project. Who knows, maybe I'll even have someone else write a chapter and add it on. Right now, provisionally has five chapters and three appendices. It's not real long. If you don't read the appendices especially, it's just five chapters. That's what I'm trying to do. And basically my motivation for this was to address issues that came out of my previous book. My previous book, even people that were somewhat sympathetic to the book overall, almost never really bought into what I thought was my core argument, which was that tight money had caused the Great Recession in 2008. That was just a bridge too far for most economists, even economists that support nominal GDP targeting.

Sumner: I think that there were really two issues there, that I met resistance on. One is that it didn't look like money was tight. The Fed was cutting interest rates in 2008. And second, it looked like the Fed was doing all it could, or there wasn't much more they could do, given the banking problems and real estate problems. So I wanted to address those two issues head on with a book that explains why I think about monetary policy in a different way from most other mainstream economists. And so that's what I set out to do. A little more philosophical approach to the subject than my previous book.

I think that there were really two issues there, that I met resistance on. One is that it didn't look like money was tight. The Fed was cutting interest rates in 2008. And second, it looked like the Fed was doing all it could, or there wasn't much more they could do, given the banking problems and real estate problems. So I wanted to address those two issues head on with a book that explains why I think about monetary policy in a different way from most other mainstream economists.

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Beckworth: And the title again is Alternative Approaches to Monetary Policy. Let me just quickly read the titles of the chapters and then maybe we can come back and touch on a few of them. But chapter one is “Introduction: What is Monetary Policy?” Chapter two is “Five Years of Bold and Persistent Experimentation, 1929-1934.” Chapter three is “The Princeton School and the Zero Lower Bound.” Chapter four is “Which Approach to Monetary Policy Works Best?” Five, “The Advantage of Targeting the Price of Money.” Then you have three appendix. Appendix A is “A Critique of Interest Rate Orientated Monetary Policy.” Appendix B, “A Critique of Modern Monetary Theory.” And Appendix C, “A Critique of Libertarian Monetary Theory.” So you want to touch on any of those and maybe shed a little more light on what you're saying?

Sumner: By the way, an anecdote just popped into my head. A few weeks ago on the internet, there was some survey that somebody published of economists about fiscal policy. Is it contractionary or expansionary right now? And I believe economists are almost equally split on that question. I could have asked "What is fiscal policy?" If economists don't even agree right now whether it's expansionary or contractionary, then they, at some level, must not even agree on what fiscal policy is. Because if you had a precise definition, it should be clear. Well, with monetary policy, this is even worse. Because fiscal policy, you can orient around the deficit and deficit spending and so on. But with monetary policy, we have three indicators that I focused on in chapter one, the interest rate approach, the money supply approach, and the price of money approach.

Sumner: Probably your listeners are familiar with the idea of high and low interest rates as an indicator or more or less money printing as an indicator. By the price of money approach, I'm really referring to a grab bag of methods of thinking about monetary policy in terms of the price of money, in terms of some other asset. Under the gold standard, they used the price of gold as a tool for implementing monetary policy. Under Bretton Wood, they used exchange rates. Those are two famous price of money approaches. I favor using the price of nominal GDP contracts as the indicator and maybe even instrument of monetary policy. TIPS spreads are essentially a price of money approach. You've got, I think, three approaches. You could call the interest rate, the rental cost of money or the price of credit, but the actual price of money has to be measured in terms of some type of good or other type of money, like an exchange rate.

Sumner: And in addition to that, we have the question of "What do you mean by target? What do you mean by instrument? What do you mean by tool?" Let me give you an example. People will say "The Fed is targeting interest rates." People will say "The Fed is targeting inflation." But do you notice they're using the word target in a completely different way in those two things. The Fed might actually be targeting interest rates as a method of targeting inflation, but it might be more accurate to say the interest rate is the instrument of policy and inflation is the goal, 2% inflation is the goal. So we have a lot of fuzziness about various concepts. If we talk about the money supply, well, is that a good indicator or instrument? I know this is all a little bit vague so what I did in the book is in the second chapter, I wrote a chapter that summarizes a lot of key points from my Great Depression book, because it turns out that the early 1930s were an unusually rich period in monetary experimentation. And all three of these basic approaches, interest rate, money supply and price of money approach, were used in very important ways in monetary policy experiments or initiatives.

Sumner: This period also illustrates the difficulty of ascertaining the stance of monetary policy by looking at these indicators. Do low interest rates indicate tight money or easy money? What about money supply growth? What about the monetary base? What about the M2 money supply? What about changes in the price of gold? There's a bunch of different policy indicators that can be used. And the 1930s is a perfect illustration of how you really need to be careful when you're talking about what monetary policy is doing. You have to be careful of whether you're actually correctly ascertain the stance of monetary policy. And even you need to figure out what do you mean by the stance of monetary policy? I know that's a lot.

This period also illustrates the difficulty of ascertaining the stance of monetary policy by looking at these indicators. Do low interest rates indicate tight money or easy money? What about money supply growth? What about the monetary base? What about the M2 money supply? What about changes in the price of gold? There's a bunch of different policy indicators that can be used. And the 1930s is a perfect illustration of how you really need to be careful when you're talking about what monetary policy is doing.

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Beckworth: No, that's great. And this book will be available for people to check out and to digest, give comments back to you and it'll be a living document. And maybe at some point after you've had lots of feedback, Scott, you will publish a physical version, who knows.

Prospects for Nominal GDP Targeting

Beckworth: Well, Scott, in the time we have left, going forward, do you have any hope that nominal GDP-level targeting will ever be adopted as a monetary policy regime? As of now we have a new prime minister in the United Kingdom, Liz Truss, and she has supported nominal GDP-level targeting at some point in her past and has said favorable things about them. And there were some articles that were written a few weeks ago that she may ask the Bank of England to switch over. Now we don't know if that's going to happen, but you could imagine if the Bank of England did so and they tried it. Of course this would be a very turbulent time to be doing that, and who knows it could actually make things look bad for nominal GDP targeting if it doesn't work out well. But it's also possible it could be tried and be successful and also encourage other central banks to follow. As you know, Scott, central bank first adopted inflation target in the early 1990s, New Zealand, United Kingdom, Bank of Canada. They all began to do it together. And those early movers set in motion and help set the example for other countries to adopt 2% inflation. It might be the case the UK does this and it puts in motion a broader movement towards nominal GDP level targeting, or it may not. But do you have any thoughts about the prospects of this one day being a fairly regular part of monetary policy?

Sumner: First of all, let me mention my fear. My fear is that a central bank will adopt nominal GDP growth rate targeting because I think that's more acceptable to central bankers. And that has many of the same weaknesses as the current regime. If that doesn't work, it makes it a lot harder to move on to nominal GDP level targeting because, even though nominal GDP level targeting is very different from nominal GDP growth rate targeting, they sound similar. So, in people's mind, they're going to be connected inevitably. I really hope that the first attempt is nominal GDP level targeting. If it's growth rate targeting, that's going to be very unfortunate. I don't have any inside knowledge on what's going on in Britain, but I do think that in the very long term, we are trending in that direction. And by the way, it doesn't have to be exactly nominal GDP, that's the aggregate being targeted. It could be something slightly different, but it should be something roughly along those lines. You could target total nominal aggregate income, labor income, for instance, that might actually work better for some countries.

The areas that I'm most enthusiastic about are basically three principles of monetary policy: level targeting, which we've talked about; using market forecast to guide policy; and what I call a “whatever-it-takes” approach, that is, the Fed commits to do whatever it takes so that it expects to hit its target, it buys as many assets as necessary. Those are the principles that to me are the most valuable.

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Sumner: But I think that the problems of inflation targeting are becoming more and more clear. Fortunately, nominal GDP was again an accurate indicator this time around just as in the Great Recession. Recalling the Great Recession, nominal GDP fell in 2008. That was a correct warning that policy was too tight. And we saw in late 2021 that NGDP growth rose well above the previous trend line indicating that money was too easy. It continues to perform well as a policy indicator and that leads me to believe that eventually it'll play some role as an explicit target or goal of monetary policy, but we'll have to wait and see on Britain.

Beckworth: Let me put a plug in for nominal GDP targeting in 2008. Because some might say, "Oh, but GDP was revised." And one way around that, and I have a paper coming out with my colleague, Pat Horan, called “The Fate of FAIT,” we show that if you'd looked at forecast of nominal GDP, monthly forecast that come out from the Blue Chip Economic Indicators, it would've told you that nominal GDP was going to fall relative to expectations in 2008. Same thing in 2021, it would've told you that the economy was going to overheat. In fact, I was talking to Evan Koenig from the Dallas Fed, I believe he's retired now, but he mentioned that they were doing similar exercises down there in 2021 and were worried that nominal GDP forecast was going too high. Even if GDP gets revised, you can still turn to the existing forecasts and get fairly reliable predictions. You're not going to be perfect, but you're getting the right ballpark. I think there is a practical way to use this. And of course the ultimate solution would be your nominal GDP futures contracts.

Sumner: I should also say as a mea culpa on my part that I don't think I was as quick to recognize the inflation problem as a lot of people last year. One reason for that is I assumed in 2021 that the average inflation targeting was symmetrical. So I thought the market would push up interest rates as appropriate to slow inflation down because of that commitment to keep average inflation near 2% over the course of the decade. In sometime around early January, I think of this year, the Fed made it clear that it wasn't symmetrical, they weren't going to try to achieve an average inflation rate of 2%. That's the point where I realized that monetary policy had gone off course, but some of our colleagues – Bob Hetzel, who's done papers for Mercatus and others – were, to their credit, quicker to understand what the Fed was actually doing and that they had developed a strong dovish bias and were off course even in 2021. So I was behind the curve on that particular mistake.

Beckworth: Scott, as I noted on a recent podcast, I was also behind even more so than you. I had a column written where I argued along with a friend that we shouldn't worry about inflation as of February 2021. I too got it wrong along with most forecasters during this time. So Scott, as our time is winding down and as you are sailing off into the sunset of retirement, my parting question for you is where do you want to see the Monetary Policy Program at Mercatus go?

Sumner: I could answer that in two ways. The areas that I'm most enthusiastic about are basically three principles of monetary policy: level targeting, which we've talked about; using market forecast to guide policy; and what I call a “whatever-it-takes” approach, that is, the Fed commits to do whatever it takes so that it expects to hit its target, it buys as many assets as necessary. Those are the principles that to me are the most valuable. But in terms of the program going forward, obviously you're going to bring in younger people with new ideas and I would encourage them not to slavishly follow what I've been doing, but look at the situation. Obviously, as things change over time, new ideas will probably be appropriate and try to come up with their own answers as to what works best and not stick to any given dogma.

Beckworth: Scott, we appreciate your work and your contribution to the Monetary Policy Program and you will be missed. Our guest today has been Scott Sumner. Scott, thank you for coming back on the show.

Sumner: Thank you very much, David. Appreciate it.

Photo by Chip Somodevilla via Getty Images

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