The recent surge in interest in Nominal GDP Targeting, as an alternative to money targeting or inflation targeting if the central bank is to commit to a nominal target of some sort, has prompted some pushback.   This is not surprising.  But one of the responses is most peculiar.  This is the allegation (1) that the surge comes from liberals opportunistically adopting an idea that was originally proposed by conservatives, and (2) that they will not stick with this “fad” in the longer run because it is only designed to fit current circumstances of high unemployment and low output.   Remarkably, every component of this argument is wrong.

 I have in mind, especially, the views of Benn Steil and Dinah Walker of the Council on Foreign Relations, as expressed in “Why  Nominal GDP Targeting is a Fad“:  
 ”NGDP targeting having once been the intellectual stomping ground of economists on the right (notably Scott Sumner), its newest supporters come overwhelmingly from the left (such as Christy Romer)…. We think the rage will be short-lived. The reason is that NGDP targeting’s newest supporters are bad-weather fans. That is, they like it now, when NGDP is well below its 2007 “trend” line, meaning that the policy implies extended and more aggressive monetary loosening. But what happens when NGDP goes above its target, as it eventually will? NGDP targeting then requires tightening….”

Let’s consider the analytics first, and hold off awhile on the less edifying political labels.   The nominal GDP proposal was originally studied and supported by many prominent economists in the 1980s.  The problem at the time was a need for monetary discipline, anchoring expectations, and reducing inflation.   Nominal income targeting was not designed as a way of getting easier monetary policy, but rather the opposite.   It is equally good for either purpose:  the target can be set high or low, depending on the times.

Originally, the leading competitor for the role of monetary anchor was money supply targeting (monetarism).  This was the regime that was adopted in the early 1980s by the central banks of the largest economies. But they were forced to abandon it subsequently.  Later on, the leading competitor became Inflation Targeting;  but it too ran into difficulties in the 2000s.   The general argument for nominal GDP throughout has been that it is robust to a variety of shocks, positive and negative.   It dominates money targeting in that it is robust with respect to velocity shocks.  It dominates inflation targeting in that it is robust to supply shocks. 

In other words, Nominal GDP Targeting is not a short-term expedient but is fit precisely for the long run.

It is true that a major reason why the nominal GDP proposal has been revived over the last two years is that it could help deliver easy monetary policy in the short run, which is what the economy has needed recently.  Some supporters may indeed view it as a short-term expedient, to be jettisoned when the economic recovery has become better established.   And I can see the attraction of the proposal that the Economist magazine has made for the UK: that the Bank of England commit to keeping interest rates low until nominal GDP has re-attained a level 10% higher than today’s level.  But I personally favor keeping it as the framework in the longer term, with loose nominal GDP targets set annually at a horizon of two years.  The width of the bands and the degree of commitment could be similar to whatever it would be under the alternative of inflation targeting.

The targeted nominal GDP growth rate would not be the same every year, let alone every decade.    If the US were to adopt the framework now, 4 ½ % would not be a bad number for the center of the target range.  (A lower number would be appropriate for some, like Japan, and a higher number for others, especially emerging market countries.)

Steil and Walker support their argument that the proposal is not fit for the long run with an attractive graph.  It shows that in many of the years since 1981 when the rate of growth of nominal GDP was above 4 ½ %, which they claim would imply monetary tightening under the proposed regime, unemployment was above 5 ½ %, prompting the Fed to loosen (wisely, in the authors’ view, if I understand them right).

The problem with this argument is that of those eight years when the Fed is shown loosening  in response to unemployment above 5 ½ % (by my count), seven of the years came during the first part of the sample: 1983, 1985, 1986, 1987, 1990, 1992, 1993.   (The only year from the more recent half of the sample is 2003.)  Why is this a problem for the argument?  In the 1980s and even the 1990s, it seems to me that nobody would have set a target so aggressive as to require monetary tightening when nominal GDP reached 4 ½ %.   Back then we were coming down from high levels of inertial inflation and this process was understood to be gradual.   Furthermore, the rate of growth of potential output was higher than today as well.   Thus the numbers chosen for the nominal GDP target would have been higher than today.  They would not have forced the Fed to tighten when unemployment was 7%.

Now to the political labels.  Recall that Steil-Walker claim that the nominal GDP proposal was originally put out by economists on the right and has recently been adopted opportunistically by economists on the left as a short-term fad.   But the originator of the nominal GDP proposal in the UK was Sir James Meade (1978, 1982), who (it turns out) was an “interventionist” and member of the Social Democratic Party.  The earliest proponent in the US was James Tobin (1980, 1983), also a Nobel Prize winner and also on the left.   (I am trying to avoid the confusing word “liberal” which in the US usually means on the left but in the UK continues usually to mean pro-free-market.) 

The recent revival of Nominal GDP Targeting came from a group of bloggers who describe themselves as conservatives (Scott Sumner, Lars Christensen and David Beckworth,)   Even those now proposing a one-time threshold for the level of nominal GDP are not noticeably  clustered on the left of the political spectrum.  The current British chancellor is, of course, a Conservative.   Perhaps what is confusing some observers is the reflexive, but wrong, assumption that Labor/Democrats always favor more expansionary policy than Conservatives/Republicans.

In other words, it would be more correct to say that the idea was a proposal of the left picked up by the right than the other way around, as Steil and Walker claim.   But there are plenty of nominal GDP proponents from each side of the political spectrum, currently as in there were in the 1980s, as well as many whose political views are not immediately apparent.  That is all to the good.   This proposal is neither liberal nor conservative.  Nor is it one that I, personally, will be abandoning as soon as the economy returns to full employment.   With money targeting and inflation targeting discredited, Nominal GDP Targeting is left.  Right?

[Notice to readers:  Starting today, my blogposts will also appear at On Deck, the blog space of Project Syndicate.   Some are elaborated versions of Project Syndicate op-eds.  Others, like this one, stand alone.]

      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.