The time is right for the world’s major central banks to reconsider the framework they use in conducting monetary policy. The US Federal Reserve and the European Central Bank are grappling with sustained economic weakness, despite years of low interest rates. In Japan, Shinzō Abe of the Liberal Democratic Party’s (LDP) was elected prime minister December 16 on a platform of switching to a new, more expansionary, monetary policy. Mark Carney, the incoming governor of the Bank of England, has made clear that he is open to new thinking.
Monetary policymakers would do well to consider a shift toward targeting nominal GDP. (Carney is evidently contemplating precisely this.) The switch could be phased in via two steps, without abandoning the established inflation anchor.
A number of monetary economists pointed out the robustness of nominal GDP targeting after monetarist rules broke down in the 1980s. (Meade and other references are given below.) “Robustness” refers to the target’s ability to hold up in the long term under various shocks. The context at that time was the need in the US and other advanced countries for an explicit anchor to help bring expected inflation rates down. The status quo regime to achieve this, during the heyday of monetarism, had been a money growth rule. Relative to the money growth rule, the advantage of nominal GDP targeting was robustness with respect to velocity shocks in particular.
These days the presumptive nominal anchor and cyclical context are both very different than they were in the 1980s. The popular regime is Inflation Targeting. The advantage of a nominal GDP target relative to a CPI target is robustness, in particular, with respect to supply shocks and terms of trade shocks. For example, a nominal GDP target for the European Central Bank could have avoided the mistake of July 2008: the ECB responded to a spike in world oil prices by raising interest rates to fight consumer price inflation — just as the economy was going into recession. A nominal GDP target for the US Federal Reserve might have avoided the mistake of excessively easy monetary policy during 2004-06, a period when nominal GDP growth exceeded 6 per cent.
Why have proposals for nominal GDP targeting been revived at this particular juncture, after two decades of living in obscurity? The motive, in large part, is to deliver monetary stimulus and higher growth — needed in the US, Japan, UK and Euroland — while still maintaining a credible nominal anchor. For an economy on the fence between recovery and recession, such as Euroland, a target for nominal GDP that constituted 4% increase over the coming year would in effect supply as much monetary ease as a 4% inflation target. (The new proponents show up on the left, the right, and the center of the political spectrum: Romer, 2011, and Krugman, 2011 on the Left; Scott Sumner, Lars Christensen and David Beckworth, on the Right; and Goldman Sachs, 2011, and Woodford, 2012, in the center.)
There are at least three reasons why central bankers are wary of the proposals for nominal GDP targeting. First, a longstanding concern is that the public doesn’t know the difference between nominal GDP, real GDP and inflation. But communications clarity is not a reason to go with a complicated function of inflation and real growth (as in the ubiquitous Taylor rule) in place of the simpler nominal income target. Furthermore, the financial markets do understand the differences among these variables.
Secondly, central bankers also worry they may not be able to achieve the nominal GDP target. Needless to say, the margin around the target could and should be wide, though there is no reason why it has to be wider than the bands around the old M1 targets or the more recent inflation targets and there are reasons to think the width of a nominal GDP band could be a bit less. Moreover, under current conditions, the shift in policy need be nothing more than a commitment to keep monetary policy easy so long as nominal GDP falls short of the target. It would thus serve a purpose similar to the Fed’s December 12, 2012, announcement that it would keep interest rates low so long as the unemployment rate remains above 6.5% – but it would not suffer the imperfections of the unemployment number (particularly its inverse relationship with the labor force participation rate and its tendency to lag other measures of expansion).
Third, in the current context, central bankers fear that it would undermine their long-term inflation anchor.
Some economists, such as Paul Krugman (2012) and the IMF’s chief economist Olivier Blanchard (2010) have proposed responding to recent high unemployment by explicitly setting a target for expected inflation above the traditional 2% — say, 4% — as a way of reducing real interest rates in the presence of the Zero Lower Bound on nominal interest rates. They like to remind Fed Chairman Ben Bernanke of similar recommendations that he made to Japan in the past.
But there is little support for the proposal to set a high inflation target. Many central bankers are strongly averse to countenancing inflation rate targets of 4% or even 3%. They do not want to abandon the hard-won 2% number that has succeeded in keeping inflation expectations well-anchored for so many years. The economists can say that the upward change in the inflation target would be made explicitly temporary; but the central bankers worry that to target a higher number even temporarily would do permanent damage to the credibility of the long-term anchor.
Central bankers worry that to set a target for nominal GDP growth of 5% or more in the coming year would inevitably be interpreted as setting an inflation target in excess of 2%, and thus again would damage the credibility of the anchor permanently. They don’t want to give up on the 2% number. Their view on this is unlikely to change. But it doesn’t have to.
The practical solution for overcoming these worries entails phasing in a nominal GDP target in two steps. Here is how to do it.
One of the main communications devices currently used by the US Federal Reserve is the Summary of Economic Projections. The governors and regional presidents give their forecasts of real growth rate and inflation rates for each of the next three years and for the long run. (Also for interest rates.) The press interprets these as policy statements, even if they are only labelled projections.
My proposal is to start, in Phase I, by omitting near term projections for real growth and inflation. Do keep the longer run projections, and keep the inflation setting where it is, 2% [formerly 1 ½ -2% for the US]. But add a longer run projection for nominal GDP growth as well. It should be around 4-4 ½ % to avoid any discontinuous jumps: That number would imply a long-run real growth rate of 2-2 ½ %, the same as now. Nobody could call such a move inflationary. For Japan, the targets for nominal and real GDP growth would have to be set at lower levels, due in part to the absence of population growth.
A few months later, in Phase II, add projections for nominal GDP growth for the next three years. These numbers should be greater than 4 % — perhaps 5 ½ % — but with the long run projection unchanged at 4 or 4 ½ %. Much public speculation would ensue, as to how the 5 ½ % breaks down between real growth and inflation. The truth is that the central bank has no control over that – monetary policy determines the total but not the breakdown – and thus doesn’t know what the answer is any more than anyone else does. But the nominal GDP target would insure that either (i) real growth will accelerate, as we hope, or else, (ii) if real growth falls short, there will be an automatic decline in the real interest rate which will push up demand, which again is what is desired. The targets for nominal GDP growth could be chosen so as to put the level of nominal GDP on an accelerated path back to its pre-recession trend. In the long run, when nominal GDP is back on its path of 4-4 ½ %, real growth will be back at its potential, say 2 ½ %, and inflation back at 1 ½ % – 2%.
This way of phasing in nominal GDP targeting delivers the advantage of some stimulus now, when it is needed – while satisfying the central bankers’ reluctance to abandon their cherished low inflation target.
References
Bean, Charles (1983), “Targeting Nominal Income: An Appraisal”, The Economic Journal, 93:806-819.
Bernanke, Ben (2000), “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” Chapter 7 in Ryoichi Mikitani and Adam S. Posen, eds., Japan’s Financial Crisis and Its Parallels to U.S. Experience (Institute for International Economics), pp. 149-166.
Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro (2010), “Rethinking Macroeconomic Policy,” IMF Staff Position Note, 12 Feb.
Feldstein, Martin and Jim Stock (1994), “The Use of a Monetary Aggregate to Target Nominal GDP”, in N. Gregory Mankiw, ed., Monetary Policy, NBER (University of Chicago Press).
Frankel, Jeffrey (1995), “The Stabilizing Properties of a Nominal GNP Rule,” Journal of Money, Credit and Banking 27, no. 2, May, 318-334. Reprinted in Financial Markets and Monetary Policy (MIT Press. 1997).
Frankel, Jeffrey (2012), “Inflation Targeting is Dead. Long Live Nominal GDP Targeting,” VoxEU, June 19.
Hall, Robert and N. Gregory Mankiw (1994), “Nominal Income Targeting,” in N. Gregory Mankiw, ed., Monetary Policy (University of Chicago Press), 71-93.
Hatzius, John (2011), “The Case for a Nominal GDP Level Target,” US Economics Analyst, issue 11/41,Goldman Sachs, Oct.
Krugman, Paul (2011) “A Volcker Moment Indeed (Slightly Wonkish),” Oct. 30.
Krugman, Paul (2012a), “Two per cent is not enough”, The New York Times, 26 January.
Krugman, Paul (2012b), “Earth to Bernanke”, The New York Times, 24 April.
McCallum, Bennett and Edward Nelson (1998), “Nominal Income Targeting in an Open-Economy Optimizing Model,” Journal of Monetary Economics, 43(3):553-578.
Meade, James (1978), “The Meaning of Internal Balance,” The Economic Journal, 88:423-435.
Romer, Christina (2011), “Dear Ben: It’s Time for Your Volcker Moment,” New York Times, Oct. 29.
Tobin, James (1983) “Monetary policy: Rules, Targets and Shocks,” Journal of Money Credit and Banking, 15, 506-518.
Woodford, Michael (2012) “Methods of Policy Accommodation at the Interest-Rate Lower Bound,” presented at the Jackson Hole symposium, August (Federal Reserve Bank of Kansas City).
A short version of this post appeared at Project Syndicate; comments can be posted there. A version also appears at VoxEU.