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Updating the case for Nominal GDP Targeting

What’s at stake Nominal GDP targeting – as an alternative to inflation targeting – was first discussed in the early 1990s. Proponents of the idea have, however, been particularly vocal in the different phases of the current recession arguing that monetary policy under NGDP targeting would have better leaned against the increase in imbalances ahead […]

By: Date: April 25, 2011 Topic: Finance & Financial Regulation

What’s at stake

Nominal GDP targeting – as an alternative to inflation targeting – was first discussed in the early 1990s. Proponents of the idea have, however, been particularly vocal in the different phases of the current recession arguing that monetary policy under NGDP targeting would have better leaned against the increase in imbalances ahead of the crisis, provided a stronger and more rapid policy response to the initial phase of the downturn and would make easier to provide an adequate response to the anemic economic recovery despite the current spike in inflation.

What NGDP targeting is: basically a “velocity-corrected” money growth rule

In a 1993 issue of the San Francisco Fed economic review, John Judd and Brian Motley pointed that nominal GDP growth can be thought of as "velocity-corrected" money growth. The Fed has de-emphasized the use of monetary aggregates because their relationships with prices and output have deteriorated in response to financial deregulation and innovation (unstable velocity) but a nominal anchor for monetary policy was useful to the extent that it provided guidance from a nominal quantity variable that is closely linked to inflation in the long run and as a commitment mechanism for policymakers. Since inflation = NGDP growth – RGDP growth and RDGP is determined by real factors in the long run, a target for NGDP growth translates into a long-run objective for inflation. Since MV=NGDP, targeting M was simply a way of targeting NGDP in the absence of unpredictable swings in velocity.

NGDP targeting ahead of the crisis: no over-expansionary monetary policy

Macro market musings argues that rather than targeting inflation, monetary policy should directly target the underlying source of macroeconomic volatility over which it has real influence: aggregate demand (AD). Doing so would have gone a long way in making the U.S. economy more stable during the 2000s: monetary policy would have been accommodated thanks to the disinflationary effect of the favorable productivity shock but to a lower extent. Crucially, the Fed did not only decrease the interest rate to make the economy move only the aggregate demand curve, but decreased it to the extent necessary to bring inflation back up to its 2% target generating an unsustainable increase in aggregate demand. A far better response would have been to do no harm by keeping AD stable at its normal level. Such a response would keep the economy at full employment instead of entering a boom-bust cycle.

NGDP targeting in the crisis: appropriate rapid and strong expansionary monetary policy

Scott Sumner, an economist at Bentley University, came to prominence during the recession and recovery for observing that the Fed was doing far too little to support the economy, and that it had helped precipitate the deep recession by doing too little in 2008, during which time nominal GDP was falling sharply. While markets were flashing warnings in the summer of 2008 that NGDP expectations were sinking fast, the Fed waited until November 2010 to undertake QE2 because inflation only slowly reversed course and began falling. Between mid-2008 and mid-2009, NGDP fell at its fastest rate since 1938 at over 8% below trend (or about 3% in absolute terms) signaling an unambiguous need for further monetary expansion.  If the Fed, for example, had been targeting NGDP along a 5% growth trajectory, it would have been immediately obvious that NGDP was coming in well below target, and would remain below target for many years.  With such a view the QE2 program would then have been adopted much sooner and in larger amounts.

In a recent paper for the Adam Smith institute that comprehensively summarizes his case for NGDP targeting, Scott Sumner broadens this often US-centered debate by pointing out that even though the sub-prime crisis was centered in the US, NGDP in Japan, the eurozone and Britain fell even more sharply. The crash of 2008 was the first postwar recession where NGDP fell in the UK.

Andy Harless points also that NGDP level targeting has an advantage over a Taylor rule in that it never breaks. When the Taylor rule implies an interest rate below zero, the appropriate course of action is unclear, and there is a lot of room for dispute. With NGDP targeting, there is less room for dispute: just look at your forecast; if it says NGDP will be below target, then you need a more aggressive policy.

NGDP targeting in the current recovery: dealing with conflicting implications for policy

Mark Thoma
has an article in the Fiscal Times on the dilemma facing central banks in the current recovery: does it respond to rising inflation or the anemic economic recovery?  On the one hand, the Fed is concerned about maintaining its inflation fighting credibility and its independence from Congress.  Thus, it wants to be seen as vigilant on the inflation front. On the other hand, it does not want to undermine the economic recovery, as sluggish as it is.  Thoma believes the Fed will err on the side of fighting inflation, which Macro market musings considers unfortunate because any honest, fact-based assessment of the economy will show that long-term inflation expectations are well anchored, money demand remains elevated, and there remains much economic slack. Instead, NGDP targeting would make it easy for the Fed to have some higher inflation during the catch-up stage while keeping long-run inflation expectations anchored by providing a more transparent path for its future actions.
In his Adam Smith institute paper, Scott Sumner argues that the U.K. government wouldn’t be in a position where it is reluctant to cut the budget deficit because of fear of the effect on the recovery if the BoE was following a target for NGDP. With NGDP targeting, you have the assurance that any slowdown in nominal GDP due to budget tightening can be offset by monetary policy.

Rebuttal 1: Inflation targeting is already flexible enough to deal with supply shocks

Stanley Fischer
argued in an 1995 AER paper that the better automatic response of monetary policy to supply shocks under NGDP targeting is offset to the extent that inflation-targeting makes special provision for supply shocks: for instance, the New Zealand inflation target is adjusted for terms of trade shocks.

Even without specific provisions for supply shocks, Ben Bernanke and Frederic Mishkin argued in a 1997 JEP paper inflation targeting should be viewed as a as a flexible policy framework rather than a rule. Viewed as such, inflation targeting is able to achieve greater transparency, better discipline and accountability for policymakers without entirely giving up the benefits of discretionary policies in the short run. For this reason, they doubt that there is much practical difference in the degree to which inflation targeting and NGDP targeting would allow accommodation of short-run stabilization objectives.

Macro market musings however respond that in practice the Fed seems to have deviated from a Taylor Rule – that is a rule that puts weight on both RGDP and inflation – and appears to be more of a pure inflation targeter in times of aggregate supply shocks.  It goes without saying that this argument would resonate to the ears of ECB watchers who complained both about the rate increase in July 2007 and the latest one.

Rebuttal 2: NGDP targeting would increase instability

Modeled behavior argues that NGDP targeting can induce a permanent instability because prices and output do not respond at the same time to a single action by the Fed. Suppose that we enter a credit bubble where nominal spending expands rapidly as credit risk is underpriced. Such a bubble would show up as a rise in Nominal GDP. The Fed would respond by tightening the money supply. Tightening would have the immediate impact of raising unemployment and bringing real GDP down. Nominal GDP would fall as well and the Fed will meet its target. Over the next 18 months, however, the rate of inflation would trend down in response to tightening. This would lead the Fed to loosen money. Unemployment would fall, Nominal GDP would expand and the Fed would hit its target. This process could in theory continue indefinitely. The Fed is hitting its target every time but because the same policy instrument affects the different parts of Nominal GDP at different times a permanent instability is induced. Both unemployment and inflation are high in one period. Both unemployment and inflation are low in the next. Nominal GDP is stable but the variables of interest are not.

Mark Thoma argues that the particular form of the NGDP targeting rule matters, and some rules can perform very badly. Kaushik Mitra showed that a rule where the interest rate is adjusted so as to keep NGDP growth as close as possible to a constant value is locally unique (essentially, the rule satisfies the Taylor principle of moving the nominal interest rate more than one-to-one with expected inflation). But some people define NGDP targeting as setting expected NGDP growth one period ahead equal to a fixed value. This version of nominal interest rate targeting does not satisfy the Taylor principle (i.e. indeterminacy is a problem) and it is not stable under learning.

Practical considerations: communication and implementation

Scott Sumner
argues that in the current crisis we’ve seen just how difficult it is to communicate the need for higher inflation. In contrast, NGDP is essentially nominal income.  The Fed can tell the public they are trying to raise nominal growth to 5%, because a healthy economy requires the incomes of Americans to grow by about 5% per year.  That’s much less negative sounding that trying to raise the cost of living. Similarly, it would be easy to explain to the public that an excessively rapid growth in nominal incomes could be inflationary, and raise rates when needed. 

Macro market musings
points that NGDP targeting does not require knowledge of the proper inflation measure, inflation target, output gap measure, the neutral FFR, coefficient weights, and other elusive information that are required for inflation targeting and the Taylor Rule. For example, NGDP is robust to whether the Fed go with the CPI or PCE, the headline inflation measure or the core, the CBO’s output gap or their own internal estimate, the original Taylor Rule or the Glenn Rudebush version, etc. NGDP targeting would also be easier to implement because it is easy to understand, as the public can comprehend the notion of stabilizing total current dollar spending.

In contrast, Stanley Fischer argued in an 1995 AER paper that the case for inflation-targeting rather than nominal-income targeting is that the inflation rate is of direct concern to economic agents, and that inflation performance is easier to monitor than nominal-income performance.

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