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.]

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.

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.]