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.