John Cochrane: “A Big Stick for the Fed” (close to NGDP-Level-Targeting?)

In my previous post on prof. Cochrane and NGDP-Level-Targeting I puzzled that John said:

(…)I don’t think the Fed controls NGDP. If it did, it certainly would not have stood for what just happened. I think the Fed’s basically at its limit.

I was under the impression that Dr. Cochrane was one of those proposing a new Fed policy based upon CPI futures targeting. This policy is very close to the operation of the NGDP futures targeting proposed by Scott Sumner and others. The latter policy is superior, not least because NGDP is simple – we all know what it is. CPI is anything but simple, and worse doesn’t incorporate the growth of the economy and employment in the target. 

This is what Dr. Cochrane wrote in a note responding to the Fed’s September 21, 2011 FOMC statement:

The Fed needs something new. Here’s what I think works best. In every theory, governments easily cut off inflation or deflation by switching to a commodity standard. If the Fed commits to exchanging one dollar bill for a bushel of wheat, or an ounce of gold, those commodities cannot inflate or deflate. If the government is buying at a fixed price, you would never sell privately for less, and vice versa. In many theories, this “big stick” contingency plan helps to prevent inflation or deflation from breaking out in the first place.

But a commodity standard is impractical for a modern economy. If gold can double in value relative to other goods in the CPI, as it has done recently, then other goods can deflate to half their value if the government fixes the price of gold.

Instead, the Fed can target the thing it cares about – expected CPI inflation – rather than the price of gold. To do it, the Fed can target the spread between TIPS (Treasury Inflation Protected Securities) and regular Treasurys, or target CPI futures prices. Here’s a simple example. Investors buy a CPI-linked security from the Fed for $10. If inflation comes out to the Fed’s target, they get their money back with interest, $10.10 at 1% interest. If inflation is 2 percent below target, the Fed pays $2 extra — $12.10. This pumps new money into the economy, with no offsetting decline in government debt, just like the helicopter drop. If inflation is 2 percent above target, investors only get back $8.10 – the Fed sucks $2 out of the economy at the end of the year. If investors think inflation will be below the Fed’s target, they buy a lot of these securities, and the Fed will print up a lot of money, and vice versa.

(…) This note draws on a more detailed paper, “Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic.” 

I’ll post a query on John’s recent post – perhaps he will be willing to expand on this.