James Pethokoukis has a new article in Commentary that examines nominal GDP (NGDP) targeting and its potential to spark a recovery. The piece starts out fine, but then gets gets confused because it fails to distinguish between a NGDP growth rate target and a NGDP level target. A NGDP growth rate target, like an inflation target, lets bygones be bygones. A NGDP level target, on the other hand, corrects for past mistakes. Under a NGDP level target a central bank would commit to reigning in aggregate nominal spending if it overshot and vice versa. Such a rule would therefore actually anchor long-run inflation expectations while allowing for aggressive catch-up growth (or contraction) in aggregate nominal spending so that NGDP returned to its trend path. The following figure illustrates these important differences:
Note that with a NGDP growth rate target (the blue line) NGDP can be growing on target and yet the big collapse in aggregate demand that precedes it is never corrected. With those points made, let's turn to Pethokoukis' piece:
And there’s the rub. The idea of nominal GDP-targeting would threaten the Fed’s hard-fought credibility as an inflation-killer and raise expectations of future inflation simply to jimmy the unemployment rate a point or so lower than it would be five years from now.
No. There might be higher inflation in the short-run, but over the long-run a NGDP level target would anchor (see the red line) nominal expectations. But even then, some higher inflation over the short run is actually justified. For it would restore nominal incomes to where they were expected to be when debtors and creditors agreed to nominal contracts and similarly it would return debt burdens to the path expected when the contracts were signed.
And then there is the Glenn Hubbard adding to the confusion:
[M]arkets [may] begin to worry that the Fed won’t be able to unwind its positions in a timely manner to prevent an uncontrolled inflation surge...That concern is well justified, according to R. Glenn Hubbard, dean of Columbia’s business school and potential Fed chairman if a Republican wins the White House in 2012. As he told me recently: “In the near term, it’s hard for me to imagine that [NGDP-targeting] would work much differently than what the Fed is currently doing, which isn’t exactly a booming success. And then in the longer term, I would worry about inflationary expectations becoming unhinged….
No. Hubbard is thinking of a NGDP growth rate target (the blue line.) Advocates of NGDP targeting are thinking of a level target (the red line) which implies more aggressive but systematic monetary stimulus. And no, the inflation expectations would not get unhinged because this is a level target. As we learned from FDR's experience with level targeting in 1933-1936, such an approach can do wonders for the real economy and still maintain a nominal anchor. Ben Bernanke knows all this and advocated something like it for Japan. Consequently, I do not think he is worried about unmooring inflation expectations, but is concerned about the politics of adopting such a new rule. If Republican leadership would give NGDP level targeting a fair hearing they might actually like it.