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.]

Menzie Chinn, Prof. of Economics at University of Wisconsin, is guest posting this week:

I want to thank Jeff Frankel for the opportunity to be a guest writer on his blog.

A lot of attention has been devoted to how oil price and food price shocks have affected the US economy, both along the output and price dimensions. A general presumption has been that as long as inflation expectations remain well anchored, then one need not worry about 1970’s style stagflation (recession is another matter).

However, there are many places in the world where inflation expectations are not well anchored. Or at least we can’t tell if they’re well anchored or not. Figure 1 presents data for several key groups (using the IMF classifications): Industrial countries, LDCs excluding oil exporters, oil exporters and developing Asia.

Figure 1: Inflation rates defined as 12 month changes in CPIs, in selected groupings: Industrial countries (blue), oil exporters (black), developing countries excluding oil exporters (red) and developing Asia (green). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

It’s clear that inflation is surging in the oil exporting countries. This is occurring as reserves balloon (see Brad Setser has diligently tabulated on a number of occasions; e.g., [1]), often under pegged-to-the-dollar exchange rate regimes, and the monetary authorities are unable to sterilize money base expansion. Here, I can’t resist writing the identity:

Money Base = Foreign Exchange Reserves + Net Domestic Assets

As foreign exchange reserves increase, money base must increase, unless the central bank can (and will) sterilize by making offsetting reductions in net domestic assets.

This is why Feldstein has called for de-pegging from the dollar for oil exporter currencies [2] (for contrasting recommendations, see Paulson’s comments [3]).

Of course, this mechanism does not apply in all instances, there are oil exporting countries not under fixed exchange rates, but reserve accumulation nonetheless is making its way into money base creation. As government revenues increase, spending is also pushing up prices.

So, no surprise that inflation is rising in this group. But what is surprising is how much inflation has risen in the non-oil-exporting LDCs, and in Developing Asia (this group excludes NICs like Korea).

Figure 2: Inflation rates defined as 12 month changes in CPIs, in selected East Asian countries: China (red), Malaysia (blue), Philippines (green), Thailand (black), Vietnam (teal). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

Inflation has risen as food and energy prices have risen. Vietnam is the most striking example. And China, of course, has been in the spotlight, largely because of its economic mass. But note how Thailand and the Phillipines inflation rates have accelerated.

Now one might say this is all obvious - - but in several of these countries (e.g., China), energy prices were heavily subsidized. Raising these subsidized prices will - - in a mechanical fashion - - raise the recorded CPI. If prices were perfectly flexible, higher energy and food prices only represent a higher relative price for these goods. I’ll let the reader determine for him or herself whether that’s a plausible assumption. In any case, the net effect over the longer term is uncertain. Raising the subsidized prices means higher prices on those specific goods (possibly feeding into wages). But the lower government outlays for subsidies means smaller deficits (holding all else constant) and hence lower money base creation.

Is there hope to be derived from the fact that there are more inflation targeters now than there were during the previous episode of inflationary pressures, three decades ago? In a paper written two and a half years ago, Andy Rose documented the fact that inflation targeting has proven to be a relatively durable form of monetary regime. That is, compared to the “fixed” exchange rates, an average duration of an inflation targeting regime is longer. One observation I would make is that most of those inflation targeting regimes were implemented in a relatively benign global economic environment - - at least benign from the inflationary standpoint. While oil prices have been rising since 2002, it appears that the surge in food prices, on top of oil and non-food commodity prices - - is what has changed matters (Figure 3 recaps a graph from this post).

Figure 3: Log indices. NBER defined recession shaded gray. Source:.
(Of course, these oil and food price shocks may end a lot of exchange rate reimges as well).

By the way, Thailand and Philippines are classified as inflation targeters by Rose. Korea, also classified as an inflation targeter, has also experienced accelerating, but nonetheless lower, inflation (at about 4 percent). So, the jury is still out on the question whether the commitment to inflation targeting during this episode will result in a substantive difference in how matters play out.

On a more speculative note, one idea that has struck me is that, as inflation rates rise, it may become more difficult for the East Asian countries to maintain their exchange rates against the dollar at their current levels. Recalling (in logs):

q^j = s – p^j + p ^US

In words, the real exchange rate for country j against the USD (defined as up is weaker) will strengthen as the domestic price level rises, holding all else constant. That may in turn a be a harbinger of the end of the tendency for the East Asian countries to export capital to the US (although the overall US current account balance will tend to remain driven largely by domestically driven by the saving/investment balance in the US, and we know where the current trajectory of the US budget deficit is going…[4]).

Figure 4: Trade weighted broad real currency values, in logs. NBER defined recession shaded gray. Dashed line is at June 2005, the month before the CNY revaluation. Source: BIS accessed June 23, 2008.

So far, this remains speculation. However, over the past couple months, China’s real currency value has appreciated in trade weighted terms, which is remarkable when one keeps in mind the dollar’s depreciation over this same period. It remains to be seen whether the other currencies follow suit. That may hinge upon how these countries respond to inflationary pressures.