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.

It is with regret that we announce the death of Inflation Targeting.    The monetary regime, known affectionately as “IT” to its friends, evidently passed away in September 2008.   That the demise of IT has not been officially announced until now testifies to the esteem in which it was widely held, its usefulness as a figurehead for central banks, and fears that there might be no good candidates to assume its position as preferred anchor for monetary policy.

Inflation Targeting was born in New Zealand in March 1990.   Admired for its transparency and accountability, it achieved success there, and soon also in Canada, Australia, the UK, Sweden and Israel.  It subsequently became popular as well in Latin America (Brazil, Chile, Mexico, Colombia, and Peru) and in other developing countries (South Africa, South Korea, Indonesia, Thailand and Turkey, among others).   

One reason that IT gained such wide acceptance as the champion nominal anchor was the failure of its predecessor, exchange rate targeting, in the currency crises of the 1990s.   Pegged exchange rates had succumbed to fatal speculative attacks in many of these countries.  The authorities needed something new to anchor the public’s expectations of monetary policy.  IT was in the right place at the right time.

Before the reign of exchange rate targeting, in turn, the fashion in the early 1980s had been money supply targeting, the brainchild of monetarist Milton Friedman.   The money supply rule had succumbed to violent money demand shocks rather quickly.  Friedman’s general argument for rules over discretion, in order to make a commitment to low inflation credible, however, is still very influential.

Inflation Targeting was best known as a rule that told central banks to set a target range for the yearly rate of change of the Consumer Price Index (CPI) and to try their best to attain it.    Close cousins included targeting the price level (instead of the inflation rate) and targeting the core inflation rate (that is, excluding the volatile food and energy components of prices) instead of the headline number.    

There were also proponents of Flexible Inflation Targeting, who held that it was fine to put some weight on real GDP growth in the short run, so long as there was a clear target for CPI inflation in the longer term.     But some felt that if the definition of IT were stretched too far, it would lose its meaning.

Regardless, Inflation Targeting has taken some heavy blows over the last four years, analogous to the crises that hit exchange rate targets in the 1990s.   Perhaps the biggest setback came in September 2008, when it became clear that central banks that had been relying on IT had not paid enough attention to asset bubbles. 

Central bankers had told themselves that they were giving asset markets all the attention they deserved, by specifying that housing prices and equity prices could be taken into account to the extent that they carried information regarding goods inflation.  But this escape clause proved insufficient:  When the global financial crisis hit, suggesting at least in retrospect that monetary policy had been too loose during the years 2003-06, it was neither preceded nor followed by an upsurge in inflation.  

That the boom-bust cycle could take place without inflation should not have come as a surprise.  The same thing had happened when asset market bubbles ended in crashes in the United States in 1929, Japan in 1990, and Thailand and Korea in 1997.  And the Greenspan hope that monetary easing could clean up the mess in the aftermath of such a crash proved wrong in the great recession of 2008-09.

While the lack of response to asset market bubbles was probably the biggest failing of Inflation Targeting, another major setback was inappropriate responses to supply shocks and terms of trade shocks.  An economy is healthier if monetary policy responds to an increase in the world prices of its exported commodities by tightening enough to appreciate the currency.   But CPI targeting instead tells the central bank to appreciate in response to an increase in the world price of the imported commodities — exactly the opposite of accommodating the adverse shift in the terms of trade.  For example, it is widely suspected that the reason for the otherwise-puzzling decision of the European Central Bank to raise interest rates in July 2008, as the world was sliding into the worst recession since the 1930s, was that oil prices were just then reaching an all-time high.  Oil prices get a substantial weight in the CPI, so stabilizing the CPI when dollar oil prices go up requires appreciating versus the dollar.

One promising candidate to take the position of preferred nominal anchor has lately received some enthusiastic support in the blogs:  Nominal GDP Targeting.   The idea is not new.  It had been a candidate to succeed money targeting in the 1980s, since it did not share the latter’s vulnerability to velocity shocks. 

Nominal GDP Targeting was never adopted at that time.  But now it is back.  Its fans point 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.)

A dark horse candidate is Product Price Targeting.  It would focus on stabilizing an index of producer prices rather than an index of consumer prices, and so would not like IT have the problem of responding perversely to terms of trade shocks.  The supporters of both Nominal GDP targeting and Product Price Targeting claim that IT sometimes gave the public the misleading impression that it would stabilize the cost of living even in the face of supply shocks or terms of trade shocks, over which central banks have no control.

IT is survived by the gold standard, an elderly distant relative.   Although some eccentrics favor a return to gold as the monetary anchor, most would prefer to leave this relic of another age to its peaceful retirement, reminiscing over burnished fables of its long lost youth.

[This post originally appeared as an op-ed in Project Syndicate.]