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Central Banks Can Phase in Nominal GDP Targets without Losing the Inflation Anchor

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 otherreferences 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.