Ramesh Ponnuru Responds to the FOMC's NGDP Discussion

Ramesh Ponnuru has a new Bloomberg article where he responds to the FOMC's discussion on nominal GDP Targeting.  Some excerpts:

NGDP targeting seeks to stabilize expectations about the future path of the economy, making it easier for people to make long-term plans. Keeping nominal spending, and thus nominal income, on a relatively predictable path is especially important because most debts, such as mortgages, are contracted in nominal terms. If nominal incomes swing wildly, so does the ability to service those debts.

[...]

From the standpoint of macroeconomic stability, then, NGDP targeting is superior because it allows inflation to accelerate and slow to counteract fluctuations in productivity. It moves the money supply only in response to changes in the demand for money balances, and not to supply shocks that mimic the effect of these changes on prices but call for a different monetary response.

If only the Fed would listen to Ramesh Ponnuru and start targeting some pre-crisis trend path for nominal GDP.  Not only would it be good for the U.S. economy, it would also do wonders for the Eurozone economy. 

Maybe He Should Try the ECB Tranquilizer Gun

The Fateful Decision to Tighten ECB Monetary Policy

Paul Krugman notes that the Eurozone crisis began rearing its ugly head again back in April, the very time  the ECB decided to tighten monetary policy.  Krugman thinks these two developments are probably related:

By itself, that rate hike — although it was obviously, obviously a big mistake — should not have mattered that much. But maybe it acted as a signal of the ECB’s bloody-mindedness, and that’s what set off the panic.

I agree.  The market saw this interest rate hike as indicating the ECB would allow further weakening of aggregate demand in the Eurozone.  Consequently, the market lowered its forecast of nominal spending and, as a result, expected inflation started declining, the Euro began weakening, and sovereign spreads started increasing.  Here is the 10-year breakeven inflation expectation series for the Eurozone:    

Here is the nominal effective exchange rate for the Euro:

Finally, from Rebecca Wilder here are the surging spreads:

These figures show that these asset prices all took a marked change in trajectory at about the time the ECB tightened in April.  And all these asset price changes have been indicating tight monetary policy since that time, but no one at the ECB seems to be listening.  No one at the ECB seems to appreciate that by allowing aggregate demand to continue to weaken they are passively tightening monetary policy.  The Europeans seem to be repeating monetary history.

We Now Know What "Interesting Conversation" Means

Ben Bernanke said in his last post-FOMC press conference that the committee had an "interesting discussion" on nominal GDP targeting.  The FOMC minutes released today shed some light on this discussion:

The Committee also considered policy strategies that would involve the use of an intermediate target such as nominal gross domestic product (GDP) or the price level. The staff presented model simulations that suggested that nominal GDP targeting could, in principle, be helpful in promoting a stronger economic recovery in a context of longer-run price stability. Other simulations suggested that the single-minded pursuit of a price-level target would not be very effective in fostering maximum sustainable employment; it was noted, however, that price-level targeting where the central bank maintained flexibility to stabilize economic activity over the short term could generate economic outcomes that would be more consistent with the dual mandate. More broadly, a number of participants expressed concern that switching to a new policy framework could heighten uncertainty about future monetary policy, risk unmooring longer-term inflation expectations, or fail to address risks to financial stability. Several participants observed that the efficacy of nominal GDP targeting depended crucially on some strong assumptions, including the premise that the Committee could make a credible commitment to maintaining such a strategy over a long time horizon and that policymakers would continue adhering to that strategy even in the face of a significant increase in inflation. In addition, some participants noted that such an approach would involve substantial operational hurdles, including the difficulty of specifying an appropriate target level. In light of the significant challenges associated with the adoption of such frameworks, participants agreed that it would not be advisable to make such a change under present circumstances.

So there was a substantive discussion on nominal GDP targeting.  And it appears the staff and FOMC recognized the fatal flaw with price level targeting is supply shocks.  Good.

Still, some members of the FOMC remained concerned that such an approach may unmoor long-run inflation expectations and not be flexible enough to handle financial crisis.  A nominal GDP level target, however, would anchor long-run inflation expectations given a stable long-run real growth rate, something that has happened in the United States over the past century. That is, over the long-run real GDP growth has averaged around 3%.   Thus, a 5% nominal GDP target growth rate would lead over the long-run to 2% inflation.  There may be deviations in the short-run--for example, when a positive technology shock temporarily lowers inflation and increases real GDP growth--and maybe the optimal target nominal GDP growth rate is different than 5%. But a truly credible nominal GDP level target presents no problems for long-run inflation expectations.  

Also, if a nominal GDP level target is explicit and widely understood it would actually serve to mitigate the effects of financial shocks.  If the public understood the Fed would always return nominal GDP to its trend path, public expectations would be better anchored and thus be less susceptible to wide swings.  That means velocity (i.e. real money demand) would be more stable.  For these reasons, it is reasonable to conclude that had the Fed been targeting nominal GDP during the 2008-2009 financial crisis, the outcome would have been far milder.  And for the same reasons, the Fed should be targeting nominal GDP now given the looming financial threat coming from the Eurozone crisis.

Update:  See Scott Sumner for a more thorough assessment of the FOMC's discussion of nominal GDP level targeting.

If the Germans Were Serious About Stabilizing Aggregate Demand

Then they would be doing exactly what they are doing now, if their only concern were Germany.  Last week the Federal Statistics Office of Germany released third quarter nominal GDP data where we find relatively robust growth in aggregate demand:

This above-trend growth is entirely consistent with the reluctance of the Germans to open up the ECB monetary spigot.  Doing so would only serve to further raise aggregate demand above trend growth.  The Germans are probably concerned that the additional nominal spending stimulus would raise inflation uncomfortably high and create a positive output gap.  Maybe the Germans are hardcore nominal GDP targeters.  

But are the Germans really focusing on just their own aggregate demand growth?  It is a strange argument to make since the ongoing collapse in Eurozone aggregate demand (see figure below) will ultimately affect the German economy too.  Nonetheless, it is hard not to wonder these thoughts given the Eurozone seems to have been serving German interests all along and the recent reluctance of the Germans to meaningfully address the Eurozone crisis.  It is also not hard to think these thoughts when one comes across statements such as the rather cheery press release accompanying the third quarter GDP numbers (my bold):

Gross domestic product in 3^rd quarter of 2011: upswing continues

WIESBADEN – The German economy continues its growth: In the third quarter of 2011, the gross domestic product (GDP) rose 0.5% – upon price, seasonal and calendar adjustment – on the second quarter. In addition, the result for the second quarter of 2011 has been corrected upwards to +0.3%, as reported by the Federal Statistical Office (Destatis). This means that, following the strong growth at the beginning of the year (+1.3% in the first quarter), the upswing of the German economy continued in the course of 2011, with the growth rate slightly increasing in the reference quarter compared with the previous quarter.

In a year-on-year comparison, too, the GDP grew strongly, although not as strongly as in the first half of the year: In the third quarter of 2011, the price-adjusted GDP was up 2.5% on a year earlier (calendar-adjusted: +2.6%).

And lest you think this is an isolated case, below is a recent AP story on consumer confidence in Germany:

BERLIN (AP) — A survey finds that consumer confidence in Germany, Europe's biggest economy, is holding up despite increasing worries about the economic outlook.  The GfK research institute said Tuesday that its forward-looking consumer confidence indicator for November stands at 5.3 points — up from 5.2 points in October.  GfK says that consumers "remain very optimistic" about income expectations and that their willingness to buy also is being helped by low unemployment and rising salaries.

Really?  German consumers remain very optimistic about income expectations and future spending despite the onward march to Eurogeddon?  Do they know something we do not know?  Or, are they so caught up in the relative successes of the German economy that they fail to fully appreciate what is happening in the rest of the Eurozone?  

In case there were any questions, what has happened to aggregate demand in the rest of the Eurozone can be seen below.  First, nominal spending has never recovered from its collapse in 2008 and 2009: 

Moreover, nominal spending has actually fallen over the past two quarters:

Now maybe the German public does appreciate what is going on in the Eurozone, but simply are not fazed by it.  One reason for this might be their belief that they can force the rest of the Eurozone to become more German-like as this "we have them by the balls" comment indicates.  A second reason is that in a worst-case scenario the Eurozone breaks up and they return to their beloved Deutsche Mark with a relatively resilient German economy.  Whatever the motivation may be, what we do know is that the Germans are doing a fine job stabilizing aggregate demand in Germany.  

The ECB Needs the Fed Now More Than Ever

And it is not because the ECB needs more currency swaps.  It is because the ECB needs the Fed for cover.  Here is why.  The Fed is a monetary superpower.  It manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. As a result, its monetary policy gets exported to much of the emerging world. This means that the other two monetary powers, the ECB and Japan, have to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. So, to some extent U.S. monetary policy also gets exported to the Eurozone and Japan too.  

This exporting of Fed policy to the Eurozone can be seen in the figures below.  The first figure shows the targeted policy interest rates for both the Fed and the ECB since the Euro's inception in 1999.  The figure shows that the ECB adjusted its target interest rate in a manner that seems to follow movements in the targeted federal funds rate, a response consistent with the Fed being a monetary superpower.  Even the ECB's attempt to break away and tighten in 2011 appears to be conforming to the irresistible pull of the Fed's power. 

The next figure shows the year-on-year growth rate for NGDP across the two regions.  The arrows highlight what appear here too to be a leading relationship for the USA: nominal spending first takes off in the USA then in Europe and then slows down in that order too.  

As a robustness check, the figure below shows the effect across both regions' NGDP growth rates of an unexpected change or shock to the US NGDP growth rate.*  The figure reveals that the typical shock to US NGDP during the 1999-2011 period created similar responses across both regions. 

 

Again, an easy way to explain these relationships is that the Fed is a monetary superpower and influences monetary policy in both the United States and the Eurozone.  Thus, when the Fed was too easy in the early-to-mid 2000s it fueled rapid nominal spending growth in both regions.  Likewise, when the Fed became passively too tight in 2008 it stalled nominal spending growth in both places too.  

The Fed, therefore, should be able to help spur nominal spending growth in the Eurozone by do something radical, like adopting a NGDP level target that would return U.S. NGDP to its pre-crisis trend.  This would imply aggressive monetary easing by the Fed that, in turn, would put downward pressure on the dollar.  This would create the incentive for the reluctant Germans--who seem to care as much about their exports as they do about inflation--and the ECB to get serious about opening their monetary spigots.  In other words, a sufficiently aggressive Fed would provide the cover for the ECB to do what it needs to have done all along.  

Of course, a more efficient way to do this would be a coordinated effort, such as the plan suggested by Lars Christensen, where the major central banks of the world work together to raise their nominal spending to pre-crisis trend levels.  But since this type of coordination does not seem likely anytime soon, it seems natural for the reigning monetary superpower to take the lead and start a global nominal spending recovery.

*These impulse response functions come from a VAR with just the two NGDP growth rates and a constant.  Five lags are used along with a Cholesky decompostion.

Conservatives for NGDP Targeting

Goldman Sachs has another research note out on NGDP  targeting and, among other things, has this to say:

NGDP target[ing] enjoys growing support from economists on both sides of the political aisle. Several prominent economists who have recently advocated NGDP targeting, including Paul Krugman, Christina Romer, and Bradford DeLong, lean toward the Democratic side. However, many of the long-standing “market monetarist” supporters of NGDP targeting such as Scott Sumner and David Beckworth identify themselves as political conservatives. Beckworth recently wrote an article advocating NGDP targeting with political journalist Ramesh Ponnuru in the conservative National Review. Gregory Mankiw, an adviser to Republican presidential candidate Mitt Romney, has in the past also published research favorable to NGDP targeting, although he has to our knowledge not weighed in on the current debate.

Actually, Greg Mankiw in a recent Brookings Paper argued for macroeconomic policy that amounts to a NGDP target.  In his own words: 

This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth.

Other long-time, right-of-center proponents include Tyler Cowen and Alex Tabarrok--their Modern Principles of Macroeconomics textbook has an innovative AD-AS model that is conducive to making the case for a NGDP target--as well as the recently deceased William Niskanen  of Cato Institute.  National Review Senior Editor Ramesh Ponurru could also be considered a long-time advocate since he has supported George Selgin's NGDP target for some time. More recently, though, he has become very vocal in his calls for the loosening of monetary policy via a NGDP target (see here, here, here, and here) and has opened the pages of the National Review to us Market Monetarists (see here, here, here, and here).  More recent endorsements for a NGDP target come the CATO Institute's Tim Lee.  Bruce Bartlett and the folks at FrumForum are also in favor of something like a nominal GDP target.  And then there is all the blogging by the Market Monetarists who tend to be right-of-center.  So yes, there is growing political support from both sides. The problem, though, is that on the right we have a uphill battle against the hard-money view.  

There Are Things Worse Than Inflation

Like an economic collapse in Europe, or worse.  Here is Ambrose Evans-Pritchard on the latter possibility:

Chancellor Angela Merkel tells us that peace in Europe can no longer be taken for granted, and she is right. Her own Gothic actions and her inflexible imposition of 1930s Gold Standard contraction and debt-deflation on Southern Europe is itself preparing the ground for Europe’s civil war (hopefully pacific), a rebellion by the South against the North.

His point is that preserving the Eurozone in the way it is currently being done will only lead to a Eurozone rebellion that cannot end well.  In particular, he is appalled at the "great Euro Putsch" rolling over two European democracies:

The Greeks were ordered to drop their referendum on measures that reduce their country to a sort of Manchukuo, with EU commissars "on the ground", installed in each ministry, drawing up lists of state assets to be liquidated to pay foreign creditors. Europe had the monetary and fiscal means to contain the EMU debt crisis long enough for Greeks to give or withhold their crucial assent to this ultimatum in December. It chose - under German-Dutch pressure - not deploy those means. Instead it forced Greece to capitulate by cutting off an agreed loan payment. In Italy, the European Central Bank has engineered the downfall of Silvio Berlusconi by playing the bond markets, switching purchases on and off to enforce compliance with its written dictates ("La Lettera"), and ultimately allowing 10-year yields to spike to 7.45pc to drive him out.

What a sobering interpretation of recent events.  It brings to mind the famous 1997 Martin Feldstein article titled "EMU and International Conflict."  Here is the first paragraph:

To most Americans, European economic and monetary union seems like an obscure financial undertaking of no relevance to the United States. That perception is far from correct. If EMU does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe and confrontations with the United States.

There is an easier and more peaceful way to save the Eurozone.  It is letting loose the true firepower of the ECB.  Doing so would reduce the risk premium on troubled sovereign debt, raise inflation, and restore nominal incomes.  The first of these would give breathing room to sovereigns needing to work out their debt problems, the second would correct the real exchange rate imbalance within the currency union, and the last would reduce the drag of the debt burden.  The problem is that the Germans seem more concerned about inflation than the fallout that will come from staying on the Eurozone's current path.  If only there were a way to incentivize the Germans and the ECB to turn on the monetary spigot.  Actually, I think there is a way, but it will have to wait for another post.

The Fed Needs To Get Ahead of the Eurozone Crisis

Brad DeLong says what I have been thinking for some time:

Where is my fed announcement that it will not let chaos in Europe cause a double dip here?

Exactly.  The Fed needs to be proactive not reactive, otherwise it risks making the same mistakes it made in 2008.  Here is what I said along these same lines earlier this year:

Nick Rowe is concerned that the collapse of the Eurozone could lead to another Lehman-type event for the global financial system.  He is also wondering what central banks should be doing in preparation for such an event.  Nick is not the only one concerned.  Others have expressed concerned that financial contagion could arise from credit default swaps on Greek bonds or U.S. money market funds that are indirectly linked to the Greek economy through investments in the core Eurozone countries.  Even Fed Chairman Ben Bernanke expressed concern in his last press conference about the indirect exposure the U.S. economy has to Greek crisis:

 Answering a question during Wednesday's press conference about the U.S. financial system's exposure to Greece's problems, Bernanke went to great lengths to explain how U.S. institutions had very little "direct exposure" to Greece but considerable "indirect exposure" via their loans to European banks that have loaned to Greece. He drew attention to U.S. money market funds' "very substantial" holdings of European bank-issued commercial paper, which others have estimated to represent a whopping 40% of their assets
 ...
[M]emories of the chaos that followed the demise of Lehman Brothers in 2008 are strong and tend to color how investors, including U.S. money funds, respond to troubling events, such as the Greek crisis...The fear is that a default by Greece or a disorderly restructuring of the nation's debt could create contagion in the bond markets of other troubled sovereigns, thereby doing damage to the balance sheets of banks that have loaned to those governments. This could then raise fears about counterparty credit risks in short-term lending markets and, in a worst-case scenario, the paralysis of this vital source of bank funding. 

So what can the Fed do? Here is a suggestion: the Fed could say if total current dollar spending begins to plummet because concerns about the financial system are causing investors to rapidly buy up safe money-like assets (time and saving accounts, money market accounts, treasuries, etc.) then the Fed would begin buying up less-safe and less-liquid assets until the investors' demand for money-like assets is satiated such that they return total current dollar spending to its previous level. The Fed would need to stress the "until" part means it would purchase as many trillions of dollars of assets as necessary to restore total current dollar spending. Since this  process would take place over time, the Fed would also want to set a target growth rate for where it wanted the level of total current dollar spending to go.    

If the above sounds reasonable to you, then you should be a fan of nominal GDP level targeting.  It is exactly what the U.S. economy needed in early 2008 when inflation expectations and velocity started falling.  And it is exactly what the  U.S. economy needs now. 

We now have two good reasons for the Fed to adopt a nominal GDP level target: one, it would restore robust nominal spending growth to the U.S. economy and two, it would better insulate the U.S. economy from the Eurozone crisis.  Time is of the essence, act now!

Scott Sumner Is Live At the WSJ

Supply Shocks and Nominal GDP Targeting

Adam P is a bit irritated with all the attention being given to nominal GDP targeting and has been tossing some "volatility critique" and "optimality critique" grenades our way.  Fortunately, the volatility critique grenade was a dud, though I am still am holding and sizing up the optimality one.  Hopefully, it doesn't blow up. Where is the love Adam P?

His latest bombardment on the nominal GDP camp comes in an attempt to critique what I think is one of the biggest benefits of nominal GDP targeting: how it deals with supply shocks.  This latest bombardment, however, is not a dud but ironically ends up blowing apart inflation targeting rather nominal GDP targeting.

Here is why.  Inflation is the result or symptom of underlying shocks to aggregate demand (AD) and aggregate supply (AS).  Monetary policy, however, can only meaningfully influence AD so that is where its focus should be.  This cannot happen with strict inflation targeting because it requires the central bank to respond to any change in inflation, regardless of whether it is caused by AD or AS shocks.  In other words, inflation targeting causes the central bank to respond to AS shocks when it should only be responding to AD shocks.  A nominal GDP target acknowledges this distinction and appropriately focuses monetary policy on the cause (AD shock) not the symptom (inflation).

Adam P., therefore, is therefore right to claim that monetary policy cannot "fix" a supply shock, but he has it completely backward when he claims that this does not happen with inflation targeting:

[T]he thing about supply shocks is that there really isn't anything monetary policy can do to "fix" the problem, one of the reasons that inflation or price level targeting is better [than nominal GDP targeting] is exactly because there is no attempt to fix a problem that is not amenable to a monetary solution.

On the contrary, a strict inflation-targeting central bank is forced to respond to AS shocks when they occur.   For example, assume a new technology makes computers significantly faster.  All else equal, this productivity-enhancing AS shock would create disinflation and put upward pressure on the natural (i.e. equilibrium) interest rate. A central bank adhering to a strict inflation target would be forced to respond to the disinflation by lowering its target interest rate.  This response, however, would push the target interest rate down just as the natural interest rate was increasing, a destabilizing development.  Stated differently, this response would add unwarranted monetary stimulus to an existing boom.  A nominal GDP target, on the other hand, would allow the inflation rate to fall and the target interest rate to rise with the natural interest rate. 

To make this example concrete, assume a nominal-GDP growth-rate target of 5 percent. This technology shock might temporarily result in 5 percent real economic growth and 0 percent inflation under this regime. In contrast, a rigid inflation target of say 2 percent in conjunction with the 5 percent real economic growth would require 7 percent nominal-GDP growth, or a potentially destabilizing surge in spending. Better to ignore the supply shock and allow the temporary disinflation than to have an unsustainable boom in spending. 

Now consider a negative AS shock caused by a super-virus that temporarily shuts down most computer systems. This negative shock would decrease productivity and increase prices. This might, for example, result in 0 percent real economic growth and 5 percent inflation. Here, a 2 percent inflation target would require a tightening of monetary policy that would further constrict an already weakened economy. A Federal Reserve that was targeting nominal GDP would not face this dilemma. It would simply keep total current-dollar spending stable at 5 percent growth and allow the supply shock to work itself out.  Yes, there would still be a recession and rise in unemployment, but nowhere near as pronounced as a central banking choosing to further strangle an economy just to maintain an inflation target.

Though not explicitly arguing for nominal GDP targeting, Lawrence Christiano, Roberto Motto, and Massimo Rostagno in this NBER paper raise the same criticism of inflation targeting.  They formally show that focusing "too narrowly on inflation may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles can be generated. The authors explain that in

the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy.

In other words, these authors are arguing that by forcing monetary authorities to respond to changes in inflation that come from AS shocks, inflation targeting becomes destabilizing.  Now these authors say nothing about nominal GDP targeting, but their point above that the price level should be allowed to fall in response to a positive AS shock implies nominal GDP targeting--which allows for this very thing--would be better.  

This flaw with inflation targeting--treating all changes in inflation the same--is a big reason why the Fed added too much stimulus in the early-to-mid 2000s.  It misread the disinflationary pressures then as indicating weak AD rather than rapid productivity gains. This flaw also explains why the Fed failed to add monetary stimulus at its September, 2008 FOMC even when all signs where indicating a sharp collapse in AD.  As I said before, it is better to target the cause than to target the symptom.  

A Win-Win for Conservatives and Liberals

Ramesh Ponnuru and I have a new article in The New Republic where we argue that conservatives should embrace more aggressive monetary policy while liberals should not fear budget tightening.  Our point is that the Fed could be doing far more to restore robust nominal spending and if it did so, it would be possible to do fiscal consolidation without harming the economy. For example, if the Fed were targeting nominal GDP and government spending cuts proved to be contractionary, then the Fed would offset them so as to maintain a stable nominal GDP growth rate.  It is a win-win situation.  Conservatives get fiscal consolidation and liberals get a meaningful boost to aggregate demand.

Joe Weisenthall objects by arguing the following:

The biggest problem facing the economy is that the private sector is in too much debt. Americans are trapped in their homes, where they owe huge mortgages, and are generally paying off the big credit boom from the last few decades...If you can accept that this needs to come down, it seems ludicrous to think that the answer to the debt crisis is: cheaper loans!

Two responses.  First, nowhere have we argued that indebted households should take on additional borrowing.  Rather, monetary easing via a nominal GDP level target would make its biggest impact, in our view, via changes in expectations that would cause households to rebalance their portfolios in a way that would stimulate spending.  Bank lending and borrowing are not key to this story.  And yes, there is ample evidence that expectations do affect spending decisions. 

Second, while the buildup of household debt is a drag for debtors it does not have to be for the economy as a whole.  If the monetary authority is able to maintain stable nominal spending expectations--that is minimize uncertainty about future nominal income growth--then the creditors should provide a boost to spending that offsets the debtors' reduction in spending.  The "balance sheet recession" view ignores this possibility and ignores the historical examples where this actually happened.  Moreover, a closer look at household balance sheets reveals that the real problem constraining aggregate demand is on the asset side, not the liability side. That is, what best explains in a systematic manner spending changes is the household share of liquid assets not its debt to income ratio.  But even so, a rise in nominal income from adopting a nominal GDP target would make it easier for indebted households to service their liabilities.

Finally, Joe Wiesenthall is troubled with our claim that the fiscal policy multiplier is zero.  Let me explain this claim using this analogy I made in the past:

Scott Sumner once compared arm wrestling with his daughter to the relationship between monetary and fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how hard fiscal policy may attempt to stimulate aggregate spending the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  In other words, the size of the fiscal multiplier ultimately depends on the stance of monetary policy.

Since the Fed could do more by its own admission and yet seems content doing nothing at the moment, it stands to reason that a fiscal policy stimulus that lead to enough rapid nominal spending growth to close the output gap would be quickly arrested by the Fed.  The problem, then, is with the Fed.  A nominal GDP level target would change the Fed's perspective so that it would allow enough nominal spending growth to return  nominal GDP to some pre-crisis trend.  Fiscal policy in such a setting would be more effective, but then it wouldn't be needed because the Fed itself would be pushing nominal GDP to its target growth path.  

For further comments on our article see Rameh Ponnuru's comments here and here. 

The Fed Gets Schooled Again: Swiss Central Bank Edition

I once argued that all incoming Fed officials should spend six months interning at the Swedish central bank given their relative success in stabilizing nominal GDP.  I was wrong.  What I should have said is that all incoming Fed officials should spend six months interning at the Swiss central bank.  Lars Christensen explains why:

Here is from The Street Light:

“You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?

It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September — most of which was after the announcement of the exchange rate minimum — the SNB’s foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB’s foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB’s purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.”

This is a very strong demonstration of the power of monetary policy when the central bank is credible. This is the Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target. (Nick Rowe and I like this sort of thing…) And now to the (not so) crazy idea – if the SNB can ease monetary policy by announcing a devaluation why can’t the Federal Reserve and the ECB do it?

Exactly. Instead of having a central bank that sets an explicit target and commits to doing whatever is necessary to hit it, we have a central bank that at best has a fuzzy inflation target and operates in a manner that does little to create certainty about the future path of monetary policy.  This lack of clarity was on display yesterday at the post-FOMC news conference when journalist pointed out to Bernanke that the Fed's forecast is worsening yet the Fed wants to wait for further information before acting.  These journalists wanted to know what would trigger the Fed to act and Bernanke could not give a clear answer.  This is because he is simply unable to make a conditional forecast of future monetary policy with no explicit target.  This is crazy.  Here we have the most powerful central bank in the world stumbling, tripping, and occasionally getting lost as it moves forward because it chooses not to set a clear, explicit path of where it wants to go.  If only we could learn from the Swiss...

Greg Ip Takes on Nominal GDP Targeting

Greg Ip has a long post criticizing nominal GDP targeting.  This is not the first time he has expressed skepticism about nominal GDP targeting so his response is not entirely surprising.  What is surprising is some of the arguments he makes.  Ip does not seem to understand the theory or evidence for nominal GDP targeting.  Fortunately, Ryan Avent, Nick Rowe, Scott Sumner, and Bill Woosley provide replies to many of Ip's criticisms.  I hope Ip reads them.  

Now let me add a few more points to the discussion.  One thing Greg Ip asks for is "evidence linking NGDP targeting to the behavior of private actors."  Now there have not been any explicit nominal GDP targeters from which to draw lessons, but we do have evidence on the importance of nominal GDP expectations and actual nominal GDP performance.  Based on this evidence it seems likely that Fed would pack quite a punch if it adopted a nominal GDP level target.

Greg Ip also claims that since "2007 the Fed has worked overtime to push employment higher and keep inflation from falling."  If the Fed has been working overtime then why did total current dollar  spending take its biggest postwar fall in late 2008, early 2009? The data clearly show that the Fed failed to fully respond to the fall in velocity starting in 2008. And it has failed to restored robust nominal spending ever since.  What Ip fails to appreciate here is the notion of a passive tightening of monetary policy.  Fed chairman Ben Bernanke takes it seriously.  Ip should too.

Finally, Greg Ip cites one study by Laurence Ball (1999) that theoretically finds problems with NGDP targeting. What he failed to mention is that the results of this study have been shown to be fragile.  Here is what I wrote before about this paper: 

Laurence Ball (1999) demonstrated theoretically in a widely-cited paper that nominal GDP targeting can lead to increased volatility of output and inflation.  Lars Svenson (1999) later reconfirmed Ball's findings. This made some observers questions whether nominal GDP had any future.  Bennett McCallum (1999), however, said not so fast.  He showed that their conclusions were based on special backward-looking IS and Phillip curve relations that are "theoretically unattractive" (because they are backward looking)  and whose results fail to hold up with more general specifications.  Richard Dennis (2001) later confirmed that Ball and Svenson's results were fragile.  Finally, Kaushik Mitra (2003) showed that even with adaptive learning, nominal GDP targeting remains a desirable objective for monetary policy.  Thus, there have been no robust studies that show nominal GDP targeting increases volatility.   

I hope Greg Ip wrestles with these points and those made by the other commentators replying to him.  If he does, I think he will better appreciate why more and more folks are becoming enamored with nominal GDP targeting.  Who knows, maybe he too will catch the nominal GDP targeting bug!

Some Evidence on the Importance of Expectations

Modern macroeconomics tells us that expectations are crucial to economic decision making.  It is not hard to see why.  Imagine someone is going to get a big pay raise next year and it will be permanent going forward.  It is highly likely that as a result of this change the person will increase his spending today, all else equal. I see this scenario every year with college students who have landed a job, but have yet to start working and get a paycheck. They feel more financially secure and start making bigger purchases such as a new car.

Now think about all those households that are being financially cautious because they are uncertain about their investments and job prospects in the future. If suddenly they feel more secure about their future incomes, they too will start spending more. Same thing for firms sitting on cash. Improve their forecast of sales and they will start hiring more workers and building more plants to meet that expected rise in demand for their goods.  

This is why expectations is such a big part of modern macroeconomics. And it is why the Fed could pack more of punch if it did a better job managing expectations about future nominal spending (and by implication inflation) via a nominal GDP level target.  Now the Fed would probably need to back up its announcement for higher nominal spending with additional asset purchases, but if taken seriously the public would do much of the heavy lifting. That is, households and firms would start rebalancing their portfolios away from safe, liquid assets toward riskier, higher yielding ones that would create positive balance sheet and wealth effects for spending.  Some of the portfolio rebalancing would go toward capital assets that would directly affect spending.  These developments would improve the economic outlook and that, in turn, would further reinforce the decision to spend more today.

But some folks are not convinced.  They want more than stories.  They want evidence that by changing expectations the Fed can change current nominal spending.   Here is my attempt to provide some evidence on this question.  It is brief and much more could be done, but I think it should be sufficient to give the skeptics pause.

First, many observers have documented that FDR changed nominal expectations at the depths of the Great Depression by talking up a price level target and backing it up by devaluing the gold content of the dollar.   Gautti Eggertson probably has the best known piece on how expectations were crucial to this experience, but also see here for how the change in expectations influenced nominal spending.  What is remarkable about this experience is that FDR was able to turn around expectations despite almost three and half years of deflation and economic collapse.  That FDR could do this in such dire circumstances suggests it could be done today.

Second, it is fairly straightforward to empirically demonstrate that both inflation expectations and nominal spending expectations have been important to current nominal spending.  This can be done using the quarterly Survey of Professional Forecasters from the Philadelphia Fed.  This survey has inflation and nominal GDP forecasts for the next five quarters that go back to 1968:Q4.  The next two figures show that if one takes the average forecast for the next four quarters and plots it against the actual subsequent nominal GDP growth that occurred over the next year there is a systematic relationship:

Now the relationship is not perfect--you wouldn't expect it to be because subsequent shocks could come along over the next year--but it is strong enough to suggest expectations about the future do influence current spending decisions.  Plotting the forecasts against just the current quarter (whose value is unknown at the time of forecast) yields similar results. 

Now since the above data is in growth rate form, we don't have to worry about spurious relationships emerging from trends.  We might, however, wonder if these figures are picking up some kind of serial correlation coming from an omitted variable.  In order to address this question, I ran ran a vector autoregression (VAR) that had as variables the forecasted nominal GDP growth rate for the next year (same as above) and the current quarter nominal GDP growth rate (annualized).  Five lags were used since this many is sufficient to whiten the residuals and get rid of any serial correlation.  The VAR also allows me to answer this important question: what happens to the current nominal GDP growth rate when there is an unexpected change in its forecasted growth rate over the next year?  (These unexpected changes or shocks to the nominal GDP forecasts are those movements in the forecast that could not have been predicted by changes in its own past values or by changes in the past values of actual nominal GDP.)  

The next two graphs answer this question.  The first one shows what happens to the forecasted nominal GDP  growth rate for the next year following a typical (i.e. one standard deviation) shock to the forecast.  It reveals that, on average over the 1968:Q4-2011:Q3 period, such shocks cause the forecasted nominal GDP growth rate to increase about 0.73 percentage points upon impact and then slowly decline after that. 

Now the above figure is not what we are really after.  What we want to see is the response of actual nominal GDP.  But the above figure is important because it provides a way for us to compare the size of the change in the forecasted nominal GDP growth rate to the size of the change in the actual nominal GDP growth rate following such a shock.  So what does the typical, actual nominal GDP growth rate response look like?  Here is the answer:

This figure shows that the typical forecast shock of 0.73 percentage points causes the actual nominal GDP growth rate to increase about 1.50 percentage points upon impact.  In other words, current nominal spending is very sensitive to changes in forecasted nominal GDP.  The actual nominal GDP growth rate response remains elevated for about two quarters after the shock and then gradually declines.  The VAR was rerun with the GDP deflator inflation forecast instead of the nominal GDP forecast.  Upon impact, the  typical forecast shock caused expected inflation to increase 0.35 percent while the nominal GDP growth rate response increased 0.68 percentage points.  Here to current nominal spending is very sensitive to changes in expected inflation.  

To summarize, the evidence from the scatterplots and the vector autoregressions indicates that current dollar spending is very sensitive to changes in both expected inflation and expected nominal spending.  These findings suggest, then, that if the Fed did adopt a nominal GDP level target--something that would definitely jolt expectations--it is likely that nominal spending would respond quickly and meaningfully.