Arnold Kling  

Nominal GDP Targeting

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Because of a cold, i will be missing an invitation-only event featuring Scott Sumner. In the spirit of sharing my ideas without my germs, let me offer some thoughts on nominal GDP targeting.

1. For the Fed, a target represents a justification for taking action. Some people may be upset with what your action does to the exchange rate or the interest rate. Having a target allows you to justify your action.*

2. I would like to see the Fed use a target to justify its actions.

3. If the Fed were to use a target, then future nominal GDP would be an excellent choice.

4. In the current environment, a target for future nominal GDP could be used to justify expansionary actions.

5. There are plenty of expansionary actions available. The Fed could charge a penalty for holding excess reserves. The Fed could be buy foreign bonds (this might require a change in current law). There still are plenty of long-term Treasuries out there for the Fed to buy.

6. In the best case, the Fed would hit a target for future nominal GDP, unemployment would fall fairly quickly, and we would live happily ever after.

7. In the worst case, we would begin to shift to a regime of high and variable inflation. The Fed would have to undertake strong contractionary measures in order to keep nominal GDP on target, while unemployment remains high.

8. A lot depends on the relative importance of two factors in causing unemployment. One factor is high real wages, due to sticky nominal wages and low prices. The other factor is what I call recalculation or co-ordination failure. If the wage stickiness factor is most important, then nominal GDP targeting will give us the best case. If recalculation is most important, then we are more likely to get the worst case. I put the probabilities at .3 for wage stickiness as most important, .6 for recalculation as most important, and .1 for something else that I have not considered.

9. In spite of these probabilities, I would gamble on nominal GDP targeting. Given how bad the unemployment situation is now, anything that has a shot at helping is worth a shot.

*Why, then, is the Fed so averse to stating a target? I can only come up with cynical possibilities:

(a) They do not want to be embarrassed if they are unable to hit a target
(b) This is what Tyler Cowen would call a Straussian situation, in which the insiders must never reveal their true agenda, or horrible demons will be let loose, leading to social breakdown and bloodshed.
(c) They fear that announcing a target would create "lock-in" and cost flexibility.
(d) A target would make many of the departmental functions and rituals (such as FOMC meetings) long cherished at the Fed seem pointless.
(e) The Fed is institutionally more concerned with the stability and profitability of the banking system than with macroeconomic variables.

These are not mutually exclusive, I tend to put the most weight on (e), but the fact that the Fed does not state this explicitly means that I also have to put a positive weight on (b), even though I think that Cowen's Straussianism owes a great deal to Tyrone.


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CATEGORIES: Monetary Policy



COMMENTS (15 to date)
Lee Kelly writes:

Just as deflation (or disinflation) are desirable during periods of healthy growth, a little inflation may not be such a bad thing when when growth falls (or is negative).

In any case, so long as long run growth expectations are relatively stable, then so will be long run inflation expectations in a nominal income targeting regime. This will in turn help stabilise the supply and demand for money today and make short term inflation volatility due to recalculation unimportant.

Richard A. writes:

I have had the suspicion for the past couple of years that (e) is what's going on--the banking system is more important than the economy. Of course this leads to (b).

fundamentalist writes:

Targeting something, anything, would be better than Fed policy of the past few years. But Sumner's ngdp targeting requires the assumption that drops in ngdp cause depressions, when in reality they are the depression. If Austrian cycle theory is correct, then targeting ngdp will do nothing to prevent depressions.

Sumner believes ngdp falls because the Fed is too tight at some point. However, Fed forecasts of ngdp in the past did not see the massive drop in 2008. That's because mainstream models cannot forecast depressions. So targeting ngdp in the past would not have prevented the latest depression.

Alex J. writes:

fundamentalist,

Sumner may reply to you himself, but I'll give it a go:

Firstly, V dropped a somewhat due to the mortgage crisis, causing a similarly modest drop in NGDP. Then, when it became clear to the markets that the Fed was not going to increase M to maintain NGDP, V plummeted. Then the Fed also did not increase M (enough?) to counteract this drop and that caused the long term unemployment etc. that we've been facing.

My personal spin on this is that when V is constant, holding M constant is ambiguous between the strategies "hold MV constant" and "hold M constant". Thus, a change in V without a change in M revealed their strategy, and revealed it to be inappropriate.

English Professor writes:

Look, I'm not an economist, so I might be missing something here that everyone else sees, but I don't see how the Fed could have hit an NGDP target. Why hasn't QE and QEII stimulated substantial increases in NGDP? There have been huge infusions of cash into the banking system, but (from what I've read) the banks have used the money largely to inflate their balance sheets. Does the Fed have another mechanism besides the banks to get currency into the economy? Is the point that the Fed could take actions that force the banks to give up some of the cash they have been hoarding? I read Sumner's piece in National Review online, and I'm not qualified to judge whether the mechanism he proposes will work, but I'm still doubtful that the Fed really could hit an NGDP target.

My gut feeling (i.e., non-rational response to a subject on which I don't have any real professional training) is that both banks and businesses are filled with uncertainty about the economic future. This keeps both groups hoarding cash, and it also prevents businesses from doing much hiring. I was very much impressed by Russ Roberts' recent interview with Richard Epstein on EconTalk. Epstein sees the current problems largely as a rational response to a threatening political environment. Since I share his response to current politics, my own conclusions may just be an example of confirmation bias.

English Professor writes:

That last sentence might not make sense. I may have approved of Epstein's comments because they reflected my own gut feelings about the current situation.

Dan writes:

can I have your invitation?

Philo writes:

You write: "For the Fed, a target represents a justification for taking action." But Sumner is proposing not *a* target but *the* target. And it would be not a *justification* for Fed actions, but their *objective*.

"Having a target allows you to justify your action" only if the target is the *right* one, and only if your means were well chosen to hit the target.

"In the worst case, . . . [t]he Fed would have to undertake strong contractionary measures in order to keep [expectations of future] nominal GDP on target, while unemployment remains high." This seems extraordinarily unlikely, unless the government were somehow promoting high unemployment through its non-monetary policies. Anyway, Sumner is not saying that, if only the Fed targets future NGDP, *nothing bad can ever happen*. (By the way, your scenario of low but positive inflation together with high unemployment is not *the worst*; for example, it is not as bad as a similar scenario with *even higher unemployment*. The worst scenario is something like: we all die painful, lingering deaths from an epidemic of a new infectious disease.)

"If recalculation is most important, then we are more likely to get the worst case." You make it sound like Sumnerism would make recalculation *harder*. But, really, recalculation can (and would) take place at least as well if the Fed were targeting future NGDP as if it were pursuing some other objective.

English Professor,

You aren't missing something. The economic interactions of literally millions of individuals result in NGDP. The notion that the Fed can do something with monetary policy to target NGDP with even marginal reliability and precision is enormously optimistic.

But it is clear that the Fed can confound and confuse millions of individuals all at the same time. It is also clear that the Fed can generate sufficiently distorted price signals to cause or promote gross malinvestment (a.k.a., bubbles).

I believe it was Milton Friedman who taught us about the folly of the Fed "targeting" anything. Prof. Friedman was right.

Simon K writes:

@fundamentalist - I think Scott would agree that drops in NGDP just are depressions, rather than causing them. The Fed doesn't need to forecast drops in NGDP - the NGDP futures market is meant to do that, and if it fails Scott's scheme is a level targetting scheme. If NGDP falls of fails to rise at the targetted rate, the Fed simply creates money until it reaches the level it would have reached given the targetted rate.

@English Professor - The idea is that its always possible to hit and *nominal* GDP target by printing or burning more money. Nominal GDP is totally different from real GDP - its just amount of money times the number of times it gets spent and nothing to do with the amount of value being produced. Banks may hold on to cash, but unless they hold on to all of it, eventually nominal GDP will rise.

I'm becoming fascinated with the "hostile political environment" explanation for the recession as a phenomenon. People of right wing or libertarian inclinations keep asserting that regulation is excessive or uncertain but I can't get a straight answer from anyone as to what exactly is so awful now, or expected to be so awful in the near future, that wasn't also wrong in 2006 when everything seemed just fine, economic growth wise, that could account of 10% unemployment.

Jeff writes:

Arnold: The long history of the Fed refusing to ever commit to any target makes (a) and (d) seem more likely. The first law of bureaucracy has always been to avoid accountability.

Alex J. writes:

Simon K, the health insurance minimum wage is new, and its future impact is uncertain. It may be repealed, or it may be avoidable or it may be strengthened if many companies cease to offer health insurance.

English Professor writes:

@Simon K

Listen to the podcast I mentioned in which Roberts interviews Epstein. He goes into detail about how things are different and why he thinks we have reached a tipping point.

Also, I got the difference between real and nominal GDP, but it still seems to me that the Fed is having trouble getting money into circulation. Am I defending the idea of a liquidity trap?

Simon K writes:

@Alex J. - I suspect most employers will simply pay the penalty and let their employees get insurance on the exchange, right? So the cost is fixed and not large, though obviously it does exist. I just can't see it accounting for 10% unemployment.

@English Professor - Yes, you're defending the idea of a liquidity trap. If every dollar the Fed creates is simply stashed away by someone, that's a liqudity trap. Or to put it another way, every increase in the supply of money creates and equal and opposite drop in spending. Its hard to see how this can really happen - even if banks just use the new money to buy short term treasury debt, its still gone somewhere.

I think you're right to say the Fed is having trouble getting new money "out into the economy". That because they're sending mixed messages - their policy actions are expansionary, but expanding the money supply only raises the price level and thus lowers real interest rates if the increase is expected to be permanent. There's widespread worry that the Fed will imitate the Bank of Japan and yank the new money out of the system too soon and keep inflation at zero. Having a target - especially an NGDP level target, but really even an explicit CPI rate target would help - would change these expectations.

I'll listen to the Epstein thing when I'm not at work. I hate audio - its slow and hard to multitask.

effem writes:

I think there is another reason the Fed wouldn't try targeting...it knows there is no credible way to hit an NGDP target because the Fed's entire mandate could quickly be changed by an act of Congress. And with Fed approval so low among the public, this is not far-fetched.

Let's say the Fed commits to an NGDP target tomorrow. My guess is that markets would immediately run stocks higher and the oil price to $150ish. The average person has little wealth in stocks and would have to pay $4 at the pump while waiting for the lags associated with hiring to kick in (assuming hiring would even happen). In that scenario I think there is a high risk of mass public agitation resulting in an act of Congress.

The ultimate worst possible outcome for Bernanke would be a change in the Fed's mandate. He is covering-his-butt just like any other executive would.

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