Thursday, April 24, 2014
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Time for Nominal Growth Targets

ZANZIBAR – It is time for the world’s major central banks to reconsider how they conduct 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, the opposition Liberal Democratic Party’s (LDP) candidate for prime minister, campaigned for a more expansionary monetary policy ahead of the general election on December 16. And central banks in both the United Kingdom and China are coming under new leadership, which might entail new thinking.

Monetary policymakers in some countries should contemplate a shift toward targeting nominal GDP – a switch that could be phased in gradually in such a way as to preserve credibility with respect to inflation. Indeed, for many advanced economies, in particular, a nominal-GDP target is clearly superior to the status quo.

Central banks announce rules or targets in terms of some economic variable in order to communicate their intentions to the public, ensure accountability, and anchor expectations. They have fixed the price of gold (under the gold standard); targeted the money supply (during monetarism’s early-1980’s heyday); and targeted the exchange rate (which helped emerging markets to overcome very high inflation in the 1980’s, and was used by European Union members in the 1990’s, during the move toward monetary union). Each of these plans eventually foundered, whether on a shortage of gold, shifts in demand for money, or a decade of speculative attacks that dislodged currencies.

The conventional wisdom for the past decade has been that inflation targeting – that is, announcing a growth target for consumer prices – provides the best framework for monetary policy. But the global financial crisis that began in 2008 revealed some drawbacks to inflation targeting, analogous to the shortcomings of exchange-rate targeting that were exposed by the currency crises of the 1990’s.

A nominal-GDP target’s advantage relative to an inflation target is its robustness, particularly with respect to supply shocks and terms-of-trade shocks. For example, with a nominal-GDP target, the ECB could have avoided its mistake in July 2008, when, just as the economy was going into recession, it responded to a spike in world oil prices by raising interest rates to fight consumer price inflation. Likewise, the Fed might have avoided the mistake of excessively easy monetary policy in 2004-06 (when annual nominal GDP growth exceeded 6%).

The idea of targeting nominal GDP has been around since the 1980’s, when many macroeconomists viewed it as a logical solution to the difficulties of targeting the money supply, particularly with respect to velocity shocks. Such proposals have been revived now partly in order to deliver monetary stimulus and higher growth in the US, Japan, and Europe while still maintaining a credible nominal anchor. In an economy teetering between recovery and recession, a 4-5% target for nominal GDP growth in the coming year would have an effect equivalent to that of a 4% inflation target.

Monetary policymakers in some advanced countries face the problem of the “zero lower bound”: short-term nominal interest rates cannot be pushed any lower than they already are. Some economists have recently proposed responding to high unemployment by increasing the target for annual inflation from the traditional 2% to, say, 4%, thereby reducing the real (inflation-adjusted) interest rate. They like to remind Fed Chairman Ben Bernanke that he made similar recommendationsto the Japanese authorities ten years ago.

But many central bankers are strongly averse to countenancing inflation rate targets of 4% – or even 3%. They have no desire to abandon a hard-won target that has succeeded in keeping inflation expectations well-anchored for so many years. Even if the increase were explicitly temporary, they worry, it might do permanent damage to the credibility of the long-term anchor.

This is also one reason why the same central bankers are wary of proposals for nominal-GDP targeting. They worry that to set a target for nominal GDP growth of 5% or more in the coming year would naturally be interpreted as setting an inflation target in excess of 2%, again damaging the credibility of the anchor permanently.

But the commitment to the 2% target need not be abandoned. The practical solution is to phase in a nominal GDP target gradually. Monetary authorities should start by omitting public projections for near-term real growth and inflation, while keeping longer-run projections and the inflation setting where it is. But they should add a longer-run projection for nominal GDP growth. This would be around 4-4.5% for the United States, implying a long-run real growth rate of 2-2.5%, the same as now. For Japan, lower targets would be needed – perhaps 3% nominal GDP growth, as the LDP recently proposed – owing largely to the absence of population growth. No one could call such moves inflationary.

Shortly thereafter, projections for nominal GDP growth in the coming three years should be added – higher than 4% for the US, UK, and eurozone (perhaps 5% in the first year, rising to 5.5% after that, but with the long-run projection unchanged at 4-4.5%). This would trigger much public speculation about how the 5.5% breaks down between real growth and inflation. The truth is that central banks have no control over that – monetary policy determines the total of real growth and inflation, but not the relative magnitude of each.

A nominal-GDP target would ensure either that real growth accelerates or, if not, that the real interest rate declines automatically, pushing up demand. The targets for nominal GDP growth could be chosen in a way that puts the level of nominal GDP on an accelerated path back to its pre-recession trend. In the long run, when nominal GDP growth is back on its annual path of 4-4.5%, real growth will return to its potential, say 2-2.5%, with inflation back at 1.5-2%.

Phasing in nominal-GDP targeting delivers the advantage of some stimulus now, when it is needed, while respecting central bankers’ reluctance to abandon their cherished inflation target.

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  1. Portrait of Jeffrey Frankel

    CommentedJeffrey Frankel

    To Ross Clem: Yes, it is difficult to overcome inflation caused by supply shocks, such as oil shocks or adverse weather events. Yet CPI targeting, interpreted narrowly, tries to do precisely that. The result is an unnecesarily severe recession. (I would cite teh ECB's decision to raise interest rates in mid-2008 as an example.) This is why nominal GDP targeting is better. It allows some temporary inflation in response to an adverse supply shock.

  2. CommentedRoss Clem

    It it possible to target nominal GDP and at the same time preserve credibility with respect to inflation?

    1. Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      To Ross Clem:
      Yes, it is possible to target nominanl GDP and at the same time preserve credibilty with respect to inflation (which was the main point of my op-ed). It is long-run inflation credibility that really matters. A nominal GDP target that is set equal to the long-run inflation target plus the estimated expected real GDP path in theory has the same implications for inflation credibility as setting the target for inflation directly. In inflation were the only goal of policy, it might make sense to target it directly, to make it easier to hold the central bank accountable for failures to meet the target. But a nominal GDP target is more credible in the long run, both because it is probably easier to hit and so in fact makes it easier to hold the central bank accountable (because monetary policy works via aggregate demand; the split between inflation and real growth is determined by supply, over which the central bank has no control) and because it is more robust in the sense that it is less likely that an adverse shock will make it regret its choice of target.

      Thanks for your comments,
      JF

  3. CommentedJonathan Lam

    Gamesmith94134: Time for Nominal Growth Targets

    It had been years after EQI and II, there are little change in the economical development in the developed countries, especially in EU and Japan. Perhaps, it is time to reexamine the model that many monetarists has used, it is the global finance that regions like the emerging market nations and the BRICS toke on the currency war of the 1990s, and it is now again if the developed nations are taking their threat seriously. It is because the global market shares changed.

    The displacement of the exchange currencies and goods made many developed nations separated their course in balanced trade or fiscal budget in leveraging debts; and some like, the PIIGS stood in the inundated debts even in lower rates; and insolvency caused the banking industries to fail even after the effects of the Quantitative Easing. It is because the micro formula did not catching on with the macro projects, even in US. We have 1.6 trillion deficits.
    Unemployment and capital goods like real estate became the issue of the current debate; whether disinflation should omitted deflation in national finances. In the way I feel, deflation is the natural process for the micro-economic and those who did not catch on with the price and cost, in which, contraction on expenses can save money. Afterward, saving can be utilized as capital for rebuilding the economy even for employment. But, some thought deflation would have caused another problem for the erosion of revenues and invasion of foreigner’s funds. So, bicycle is good at a distance, but with a bad knee could be a disaster.

    I would think some monetarists are short-sighted in remanding the economy, some would rather expand the cost of living to gain a surreal recovery; since austerity program in appliance to the balanced budgets may not curb the further trade deficit. In a way, the quantitative Easing would have deepen its suffering for those having the conflict of value and price; they may have distant to recovery, even in unemployment if the level of wages did not come down enough through the liquidity or benefit of the low interest rate. Therefore, in using the nominal growth targets may cause another escalation in debts for the user; and the downfall of saving under the current low interest rate environment could erode further. Secondly, the capital goods and real estate are the first in line to bloat if the community or economy is not developing the sufficient productivity to grow. Gradually, it would come through inflation, then polarization of the rich and the poor could made goods less consumable. More inequality for the community could make anemic growth.

    Would nominal growth Target is another license to free credit? I would not know; but, the present deficit is telling me that we are not recovering and under the delusion of strong sales and lower profit margin. At present, I sense the deflation is coming back in real time, if the scheme may lose it impetus to grow. Nominal growth target may be valuable to the stronger economy, but it seems more problem like foreigner’s investment if it is not profitable.

    Will the stabilized real estate continue to be valued perpetually? In the coming season will some see default his house is more profitable as the price rises? What goes up must comes down? Apple to a thousand that many dreamed about, I was not and I am not.

    May the Buddha bless you?

  4. CommentedProcyon Mukherjee

    Wage-Price stickiness have moved more towards rigidity, while some asset classes have been bloated by the fund flow; monetary transmission during the zero lower bound phase is less atypical of shadow banks and private equity to make hay when the sun shines, as we see mounting leverage as the money from the bonds must be invested somewhere and while there is little scope for investing in one’s own business, there is crowding out by the S&P 500 to other classes of assets that is doing precious little to the cause of jobs. So when the cash pile mounts (S&P 500 has crossed $1.5 Trillion), there is more in the coming which must find new havens; the usual ones are the obvious, the new M&A deals for example that would see leverage grow again, while at best there would be no change in job growth.

    Procyon Mukherjee

  5. CommentedDanny Cooper

    In order to create growth through monetary policy you need an effective and efficient method of implementation. Under the current monetary system this is not being done because the monetary transmission channel between the central bank and the economy is blocked. So instead of depending on banks to pass on lending just modify the central bank so it deals directly with the public. Heres an explanation of how such a proposal could work: internationalmonetary.wordpress.com

  6. CommentedGulzar Natarajan

    Two comments on the use of NGDP
    1. It does not address the major failing with an IT approach - the failure to take into account asset price inflation. We cannot assume that both - asset price growth and GDP growth - are directly related. For example, the DJIA has nearly doubled since 3/09 and equities in general have done really well without it reflecting anyway in the general GDP growth. Or does this mean that we de-link macroeconomic stability in the real economy from the financial markets and rely on separate counter-cyclical measures to address asset inflation?

    2. Like horses for courses, there may be a case that NGDP may be an appropriate target now, when economies face disinflationary environments and liquidity trap. But does that also mean it is appropriate for normal times? After all NGDP targets price stability through the nominal GDP, but not inflation directly. If tomorrow, the US economy grows at 6% with 2% inflation and we have an NGDP target of 4%, wouldn't that call for monetary tightening? Will the government and popular opinion concur? If we revise NGDP target then, what is it that prevents central banks from revising inflation target itself in an IT regime? After all both could have the same adverse effect of undermining the hard won inflation fighting credibility of the Fed.

    1. Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      To Gulzar Natarajan:
      (1) It is true that Nominal GDP targeting is not designed to address one of the major shortcomings of Inflation Targeting: the failure to address financial market conditions, particularly asset price bubbles. It is possible that accelerated growth of nominal GDP is a better predictor of asset price peaks and crashes than is accelerated inflation; it would be interesting to test this proposition. But I agree that one probably needs something else to address the asset price problem. A partial answer is regulatory tools, including good old-fashioned requirements for down-payments on home purchases and margin requirements for stock market speculation. Beyond that, if asset prices are nevertheless moving further and further into what looks like bubble territory, I think it is legitimate for the central bank to respond: first with speeches from the chairman or board members, then with hints of possible monetary tightening and then, if still necessary, with actual tightening. But it's a different topic. than the choice of nominal anchor.
      (2) I hope that people don't forget that nominal GDP targeting was originally proposed in the 1980s, when the task was providing an anchor to REDUCE inflation. I think the NGDP horse works on different courses. To answer the specific example of 6% growth in real GDP: If it happened just for a quarter, that would not carry any major implications. If it happened for a year, that might indicate excessive demand growth and the need for tightening, as the target for the nominal GDP growth would tell us. (If we were still far below potential GDP, as under current circumstances, that helps illustrate the virtue of proposals to set the nominal GDP target as a level, aimed to get back to the pre-recession path, rather than just as a growth rate relative to the current position.) If it (6% real growth) persisted year-after-year, it would call for re-estimating the estimate of long-run growth in potential output, and therefore re-setting the long-run target for nominal GDP.
      JF

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