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.

In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT), much as the currency crises of the 1990s dramatized the vulnerability of exchange rate targeting and the velocity shocks of the 1980s killed money supply targeting.   But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations?

The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting.  It has gained popularity rather suddenly, over the last year.  But the idea is not new.  It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to shifts in money demand.  Under certain conditions, it dominates not only a money target (due to velocity shocks) but also an exchange rate target  (if exchange rate shocks are large) and a price level target (if supply shocks are large).   First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean (1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein & Jim Stock (1994), Bob Hall & Greg Mankiw (1994), Ben McCallum (1987, 1999), and others.

Nominal GDP targeting was not adopted by any country in the 1980s.  Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy.  (They ended up with a “two pillar approach,” of which one pillar was supposedly the money supply.) 

But now nominal GDP targeting is back, thanks to enthusiastic blogging by Scott Sumner (at Money Illusion), Lars Christensen (at Market Monetarist), David Beckworth (at Macromarket Musings), Marcus Nunes (at Historinhas) and others.  Indeed, the Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere.  Economists at Goldman Sachs have also come out in favor. 

Fans of nominal GDP targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks.    Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy.  An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.

In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target).   But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity?  Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world:  Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.

Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential.  It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent.   (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap.)  But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s.  Of course one could declare that the shift from a 2 % target to 4 % would be temporary.  But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number.   An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year - which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target - and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor.

Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.

 
            The Fed has come in for a surprising amount of criticism since its decision in the fall of 2010 to launch a new round of monetary easing — Quantitative Easing 2.  Ben Bernanke and his colleagues are right not to give in to these attacks.

            Critiques seem to be of four sorts. (Some are mutually exclusive.)

            1)  “QE is weird.”    Quantitative Easing entails the central bank buying a somewhat wider range of securities than the traditional short-term Treasury bills that are the usual focus of the Fed’s open market operations.    This has been a bold strategy, which nobody would have predicted 3 or 4 years ago.   But it has been appropriate to the equally unexpected financial crisis and recession.    Some who find QE alarmingly non-standard may not realize that other central banks do this sort of thing, and that the US authorities themselves did it in the more distant past.    It is amusing to recall that when Ben Bernanke was first appointed Chairman, some reacted “He is a fine economist, but he doesn’t have the market experience of a Wall Street type.”  The irony is that nobody who had spent his or her career on Wall Street would have had the relevant experience to deal with the shocks of the last three years, since none of them were there in the 1930s.  But as an economic historian, Bernanke had just the broader perspective that was needed.   Thank heaven he did.

            2)   “Monetary easing under current circumstances has no effect.”  It is true that, with short-term interest rates already near zero for the last two years, further monetary expansion is likely to be of less help than in a normal recession.  (The classic “liquidity trap” has been re-born as the “zero lower bound.”)    But monetary policy can work through other channels besides short-term interest rates.  Seven such mechanisms are: long-term interest rates, expected inflation, the exchange rate, equity prices, real estate prices, commodity prices, and the credit channel.   QE is worth a try, given that the economy is still weak and given the constraints that keep fiscal policy sub-optimal.

            3)  “Monetary ease will lead to inflation.   What we need now, if anything, is monetary tightening.”   This is the view, for example, expressed recently by some conservative economists, including John Taylor.   It seems to me way off base.  With unemployment far above the natural rate, GDP well below potential, and inflation (slightly) below target, it is clear that the Fed’s November 3 decision to ease further  was appropriate.

            4)  “The Fed is firing a volley in a destructive international currency war.”   This is the criticism that has come from some of our trading partners:  in particular, China, Germany and Brazil.   I don’t generally do “My country, right or wrong.”   But my country is right on this one.    Monetary easing is not a beggar-thy-neighbor policy.  The colorful phrase “currency wars“ seems to have confused some people.  The current situation is precisely the point of floating exchange rates:    when some countries feel that their high unemployment calls for monetary expansion (US) at the same time that others feel that their overheating calls for monetary tightening (Brazil, India, Korea, China…), an appreciation of the latter currencies against the former is precisely the way that floating rates accommodate the differences.    This is why Milton Friedman favored floating rates, so that each country could pursue its own desired policies independently.   I realize that the pressure which US monetary easing puts on countries like China to allow appreciation is unwelcome. China is finding it increasingly difficult to cling to its exchange rate target by means of controls on capital inflows and sterilized foreign exchange intervention.   But capital flows are a far more legitimate way to let China feel the pressure than the alternative:  Congressional threats to impose WTO-inconsistent tariffs on Chinese imports if it won’t allow faster appreciation of the yuan.

            I was glad to see that today’s decision by the Federal Open Market Committee to stay the course was unanimous.   The Fed is right not to give in to misguided criticisms.   This is what we have central bank independence for.

Click here for a TV interview on today’s FOMC decision, and inflation & TIPs.

[Comments can be posted on the Belfer site.]

Everyone is looking for someone to blame for high prices of oil and other mineral and agricultural commodities. Speculators (among others) are high on the list, followed by the Federal Reserve. While I don’t think blame is necessarily the right concept here, I have been arguing that low real interest rates have worked to raise real commodity prices through a number of channels. Each of these channels could be called “speculation,” if speculation is defined as behavior based on expectations of future prices.

A number of commentators, including Don Kohn and Paul Krugman, have argued that low interest rates and speculation cannot be the sources of the problem, because oil inventories are low. It is true that low interest rates, other things equal, should in theory increase firms’ desire to hold inventories.

US crude oil inventories do not appear to be especially low in the graph above, showing June 1998-June 2008 (from Bloomberg). But it is true that they are not especially high either.

We are talking about relatively integrated world markets, however, so it is world inventories that should matter most. According to the International Energy Agency’s Oil Market Report, oil inventories held in developed countries have been above average during most of the last year, as the next graph shows. They rose sharply in January 2008, which happens to be the month when the very aggressive cuts in US interest rates took place. These numbers are far from conclusive, but still…

The theory is meant to explain the mystery why prices of virtually all mineral and agricultural prices are high, not just oil, and in some ways fits others better. Inventories of some commodities are indeed high now. The price of gold, the last graph shown, is a good example. Here the evidence supports the theory (1) that easy monetary policy has driven up the price, and (2) that one channel is low interest rates making it more attractive to stockpile the yellow metal. But, as with oil, the biggest inventory is the one underground.

[Thanks to Pravin Chandrasekaran.]

Dear readers: If you wish to comment on this post, please go to:
http://www.rgemonitor.com/us-monitor/252799
or http://www.rgemonitor.com/us-monitor/bio/660/jeffrey_frankel .
I am turning off the comment function on my own site, because I am tired of sorting through 35 spam posts on my blog every night.