Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 1 June 2013

My verdict on NGDP Targets

At the beginning of the year I decided I needed to firm up my views on nominal GDP (NGDP) targets, and when I thought it was interesting track that process through blog posts. I think I have now done enough to reach a tentative conclusion. I also gave a policy talk at the Bank of England yesterday, which was a useful incentive to get my thoughts in order.

Here is a link to the slides from my presentation. What I first do is compare targeting the level of NGDP to an ideal discretionary monetary policy. That is a demanding standard of comparison, but I argue that NGDP targets have the potential advantage over discretion that they may allow central banks to pursue a time inconsistent policy after inflation shocks that would otherwise be politically difficult (see this post). More speculatively, the uncertainty for borrowers of NGDP variation may be more costly than uncertainty over inflation, as Sheedy argues (see this post).

Against these advantages, I see two major negatives. First, following a shock to inflation, I think NGDP targets would hit output more than is optimal (see here and here). Second, if there is inflation inertia (inflation depends on past inflation rather than expected inflation), then targeting the level of NGDP is welfare reducing, because it is better in that case to let bygones be bygones. (There is a related point about ignoring welfare irrelevant movements in non-core inflation, but that probably needs an additional post to develop.)

So far, so typical two handed economist. But now let’s shift the comparison to actual monetary policy, rather than some ideal. Or in other words, how does actual policy as practiced in the UK, US and Eurozone compare to an ideal policy? While NGDP targets may well hit output too hard following inflation shocks (and more generally gets the short run output inflation trade off wrong), current policy seems even worse. One interpretation of this is that policymakers are obsessed with fighting what they see as the last war. Outside the US this is often institutionalised by having inflation targets (even if they are flexible) rather than a dual mandate, locking in the error Friedman complained of during the Great Depression.  As attitudes or institutional frameworks are unlikely to change soon, moving to NGDP targets represent a move towards optimality.

This bias in policy is particularly unfortunate when we are at the zero lower bound (ZLB), because unconventional monetary policy is far less predictable and efficient. Although fiscal stimulus is likely to be less costly as a way of raising output at the ZLB than committing to higher future inflation, monetary policy has to work with fiscal policy as it is. (However policymakers have a responsibility to let the public know when inappropriate fiscal policy is making it difficult for monetary policy to meet its objectives, as Bernanke is now doing, but the Bank of England has not. As for the actions of the ECB in encouraging austerity at the ZLB, I have described the gravest macroeconomic policy errors as those that are both wrong and contradict the textbooks.)

With perverse fiscal policy and uncertain unconventional monetary policy, we need to raise inflation expectations as a means of overcoming the ZLB and raising demand. Here I agree with Christina Romer: we need to indicate something rather more fundamental than the kind of marginal change implied by the forward guidance we currently have in the US and are likely to have soon in the UK. My proposal is therefore the adoption of a target path for the level of NGDP that monetary policy can use as a guide to efficiently achieving either the dual mandate, or the inflation target if we are stuck with that. NGDP would not replace the ultimate objectives of monetary policy, and policymakers would not be obliged to try and hit that reference path come what may, but this path for NGDP would become their starting point for judging policy, and if policy did not move in the way indicated by that path they would have to explain why.

To some supporters of NGDP targets this advocacy may seem a little wimpish. Why limit NGDP to an intermediate target that can be overridden? Given the problems with NGDP targets that I mention above, it would I believe be foolish to force monetary policymakers to follow them regardless. In general I think intermediate targets should never supplant ultimate objectives, and NGDP is an intermediate target. The analogy I would draw is with monetary targets as adopted by the Bundesbank, and as briefly adopted in the UK. As I wrote here, most readings of Bundesbank policy suggest that they treated money targets pretty flexibly. Following the oil price shocks of the mid 70s and early 80s, inflation did rise substantially, but the target ensured that inflation came back down again. In contrast the UK adoption of money targets was far less flexible, so we had inflation overkill in the early 80s, and these targets were quickly dropped.

How was this proposal received by my audience at the Bank? Did my reasoning stand up to their criticism? Well at least one of the slides I would change in hindsight, but perhaps all that is best left for a separate post tomorrow.


  1. 1. Monetary and fiscal policy are at the end of the day not 2 more or less equals. At the end of the day fiscal policy is the by far dominant one. As it is closely connected to the basis of power in any democracy: via a parliament (most of the time) the voter.
    2. Monetary policy has become this important in this crisis mainly for 2 reasons: fiscal policy have clearly shown that it is completely incompetent on this issue. It simply doesnot oversee it.
    The other main reason is that this way rescue/stimulus measures can be undertaken out of the sight of democratic control. This has de facto been acceptable for the general public. But eg the EU example shows that there is clearly a border in how far that is possible. That border is basically constantly moving and with the EU has turned itself against politics. Iso an easy excuse as the EU was, now simply the voter has turned the game 180 degrees. When something happens that they donot like they simply blame general politics and let them sort it out even it is a Brussels decision.
    As long as you can keep flying under the radar it will likely work. When you get into the general headlines (like now) you will get a problem somewhere down the line.
    3. This could very easily happen with CBanking as well. The main reason a lot of power was transferred to the CBs was basically because markets didnot trust politics. It is not a 'natural' thing to do.
    4. In other words (from 2 and 3) if the present rescue attempts end in disaster. Very likely the following is to happen. Politics will blame the CBs and the public will demand that powers are reversed. If it goes well it is up till the next larger crisis. With the risk CBs are taken now at one point something must go wrong.
    5. If we see in practice a double mandate it is probably more like now with the EU. Brussels basically determining (at least legally) how big the deficit can be and everybody subsequently ignoring that. Another 'independent' agency on stimulus or more general debt control.
    Hardly encouraging.
    6. The US is an exception, historically grown. Hard to see that arrive in Europe and the UK.
    7. Some loose remarks:
    -hard to see politics transfer more powers to CBs, at this time, as they get the blame when something goes wrong.
    -when you start to involve politics like you do (taking stuff that have direct consequences fior the distribution of income and wealth into consideration), you simply reduce the chance that a double mandate will happen even further. You basically need a wide consensus on it and you donot have that if you either favour even indirectly left of right policies.

  2. How do you include unit labor costs into your analysis? Using the following equation...

    unit labor costs = labor share x price level

    If price level rises, and you contain unit labor costs, labor share continues to drop, further weakening aggregate demand. If you hold labor share constant, unit labor costs will rise. And I believe that we are nearing the LRAS curve, at which point rising unit labor costs can cause inflation with no growth. This dynamic is already being seen in parts of the UK.
    I would like to hear your thoughts on how NGDP targeting affects unit labor costs, because businesses are quite sensitive to it.

    Another issue is the potential real GDP target. If you use the bubble trend line, you will recreate the bubble economy. I say the potential real GDP trend line has lowered to a new equilibrium dynamic that is now below real GDP. If this is true, NGDP targeting will be delusional and dangerous. Do you take into account the possibility of an equilibrium shift?

  3. The best argument for NGDP level targeting (or, better still, nominal labour income level targeting), has always been about its effects on the indexation of labour contracts. Indexing contracts is far easier with a level target, than a rate one, since with a level target the forecast error remains bounded far into the future. (To get something similar with a rate target, contracts would have to be indexed to reported inflation, which is far more tricky than just indexing to a fixed path.) The optimal thing to index a labour contract to is the nominal labour income level, (which grows both because of productivity improvements and because of inflation), so targeting this is likely to be near optimal. (And of course NGDP is a pretty close proxy for nominal labour income.)

    With fully indexed labour contracts, the impact of wage dispersion is completely neutralised. If you think that the distortions caused by wage rigidity are large relative to those caused by price rigidity, then this is going to be pretty close to first best. (But if you are more concerned with price rigidity, then price level targeting is preferable.)

  4. "Against these advantages, I see two major negatives. First, following a shock to inflation, I think NGDP targets would hit output more than is optimal (see here and here)."

    And then Simon Wren-Lewis links to a blog post where he solves for optimal monetary policy assuming a quadratic welfare loss function in inflation and output gaps and a phillips curve as a constraint.

    The problem with this approach is that you are essentially assuming the conclusion (i.e. that an NGDP target is not optimal). The assumed objective is to minimize the sum of the squares of the inflation and output gaps. There is absolutely no combination of values for the parameters that will result in an NGDP target being optimal in all events.

    Now, Simon Wren-Lewis also says:

    "More speculatively, the uncertainty for borrowers of NGDP variation may be more costly than uncertainty over inflation, as Sheedy argues (see this post)."

    And while this may be provocative to him, in my opinion the argument is, and always has been, about stable aggregate demand (or AD, which by definition is NGDP). Economists saw inflation variability leading to output instability and decided stable inflation was the best way to stabilize AD, and hence output.

    If instead one assumes a quadratic welfare loss function of the NGDP gaps and output gaps (Warning, this is wonkish. For simplicity sake I'm leaving out the subscripts as they add absolutely nothing):

    (y+pi)^2 + cy^2

    Then using the Phillips curve constraint and doing the usual Lagrangian manipulations one comes up with the following equation:

    (1 + c + a)y + (1 + a)pi = 0

    Assuming that there is no cost to an output gap then c is zero. In this case the optimal solution is offset output gaps and inflation gaps one for one, which is essentially an NGDP target. This is true regardless of the value of the slope of the Phillips Curve (a).

    Now instead assume that c is greater than zero. Then one would want to give some weight to output gaps and the result is essentially a flexible NGDP target which sounds terribly close in concept to Michael Woodford's prefered target of an Output Gap Adjusted Price Level Target (OGAPLT).

    Still, I'm skeptical for two reasons.

    One is that an NGDP target is already effectively giving weight to the output gap which inflation and price level targeting most certainly are not. An argument can also be made that an NGDP target is giving more weight to the output gap than variable inflation rate targeting.

    The other is empirical. It seems to me that almost all large output gaps have involved large NGDP gaps. Realistically I cannot imagine the conditions that would result in an NGDP level target producing a loss of output anywhere near to any of the recessions experienced in any of the past century or more.


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