Is the 20-Year Inflation Targeting Detour About to End?

Harvard's Jeffrey Frankel says nominal GDP targeting's time has finally come:

It is time for the world’s major central banks to reconsider how they conduct monetary policy... 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...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.

Frankel reminds us that NGDP was first widely discussed in the 1980s, but then fell out of vogue with the advent of inflation targeting in the early 1990s.  Recent developments indicate that this almost 20-year detour into inflation targeting may now be ending as noted  by Matt O'Brien over at the Atlantic:

It's okay if you have that Animal Farm feeling. There's been a revolution, but nothing has changed. The Fed still thinks it's first rate hike will come in 2015-ish, and it's still buying $85 billion of bonds a month. This is a true fact. But it undersells the intellectual shift at the Fed. It's gone from mostly thinking about inflation to creating a framework to guide its thinking about inflation and unemployment. And it's done that in just a year. This framework, the Evans rule, is really just a quasi-NGDP target. It's not exactly the catchiest of phrases, but NGDP, or nominal GDP, targeting would be a real revolution in central banking. In plain English, it's the idea that central banks should target the size of the economy, unadjusted for inflation, and make up for any past over-or-undershooting. In theory, a flexible enough inflation target should mimic an NGDP target, which is why the Evans rule is so historic. It's an incremental step on the way to regime change at the Fed.

That doesn't mean we should expect the Fed to move towards NGDP targeting anytime soon. A risk-averse institution like the Fed will want to see another country try it first -- and it might get that chance soon. Incoming Bank of England chief Mark Carney, who currently heads the Bank of Canada, endorsed the idea in a recent speech, and British Treasury officials indicated they might be open to it too -- which is significant because the British Treasury can unilaterally change its central bank's mandate. It might not be long till NGDP targeting comes to Britain, and from there, the world. If it does, you can be sure that Charles Evans will be figuring out how to make it work here.

Big changes are afoot in the central banking world.  My guess is that by 2020 most large, advanced economies will be doing some kind of NGDP targeting. 

Latest Article in the Atlantic

Ramesh Ponnuru and I have a new article in the Atlantic where we argue concerns about the fiscal cliff are exaggerated if the Fed continues to stabilize nominal spending.  We note two experiences that support this notion:

The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was "no basis in economic theory or supporting evidence" for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.

Something similar happened in Canada in the mid-1990s. After running several decades of budget deficits that had led to a debt-to-GDP ratio of 70 percent in 1995, then-Finance Minister Paul Martin introduced a budget plan that began a half decade of reducing the federal budget, largely through cuts in spending. This fiscal tightening led to budget surpluses by the early 2000s. As in the British case, the Bank of Canada eased monetary policy over the same time, offsetting any fiscal drag. The economy performed nicely.

The same outcome is possible for the U.S. fiscal cliff, but would require the Fed to adopt a NGDP level target.  Reihan Salam provides a smart follow-up discussion here.

P.S. This 2010 IMF article lends further support to our claim.  It shows that countries undertaking fiscal consolidation do much better when monetary policy accommodates it.

Historic Times for Monetary Policy

This past summer Ramesh Ponnuru and I wrote that it is time for monetary regime change:

Twice in the last century, economic turmoil revealed the failure of a monetary regime and forced the West to abandon it for another. During the Great Depression of the 1930s one country after another abandoned the gold standard—a decision vindicated when they recovered in the same order. The inflation of the late 1960s and 1970s, meanwhile, persuaded most of the developed world’s central bankers to quit trying to “fine-tune” the real growth rate of the economy and instead concentrate on
achieving price stability.

It is once again time for regime change. The crisis in Europe and our stagnation at home both have primarily monetary causes, and a solution will require a new approach to monetary policy that learns from both the successes and the failures of the past.

We argued that NGDP level targeting is the new monetary regime needed. Since we wrote this piece, there have been some major changes in Fed policy that have increased the likelihood of this approach becoming reality.  First, the Fed decided at its September FOMC meeting to start a new large-scale asset purchase program, QE3, conditional on the state of the economy, rather than tie it to a specific dollar amount up front. This conditionality approach was a vast improvement over previous QE programs in that it better tied expectations of future monetary policy to economic outcomes, similar to NGDP level target.  QE3, however, was linked to the vague objectives of "labor market improvements...in the context of price stability."  More clarity was needed to for this program to fully utilize the power of expectations management.

Today the FOMC unexpectedly did just that. It tied QE3--or more accurately QE Flex since it now includes both MBS and treasury purchases--to the specific targets of 6.5% unemployment rate and 2.5% inflation. This is huge. It makes very clear to the public that the Fed will not stop until these targets are hit. Markets, in turn, should respond in anticipation of these goals being hit.  That is, the elevated demand for liquid assets should start declining as households and firms start moving their funds into higher yielding assets. This rebalancing should raise asset prices, help repair balance sheets, and ultimately spur nominal spending.  In other words, by better managing expectations, the Fed should cause the public to do the heavy lifting--and they already have started.  If all goes according to plan, the Fed may not have to actually purchase that many additional assets.  Ironically, this means that had the Fed been doing this all along its balance sheet would be much smaller now.

So this announcement is big news and fundamentally changes how U.S. monetary policy gets conducted.  Matt Yglesias sums it nicely up as only he can:

With today's policy announcement, the Federal Reserve's Open Market Committee has stopped screwing around and started doing real expectations-based monetary easing.

Indeed.  But the transformation is not complete. The Fed needs to take the final step and adopt an explicit NGDP level target.  The new unemployment rate and inflation targets get us closer to this ideal, but as Michael Woodford notes they are not the same. The Fed can only target nominal variables in the long-run and that is where it emphasis should ultimately be. A NGDP level target would do just that.

Interestingly, the Fed's actions today were not the only winds of change bearing down on monetary policy this week. Current Bank of Canada governor and future Bank of England governor Mark Carney came out and endorsed NGDP level targeting in a speech. Wow! It was not so long ago he was against it. These ongoing developments all point to a sea change in how monetary policy gets conducted. These truly are historic changes.

Update: Let me clear that I am not a proponent of targeting real variables, especially the unemployment rate.  But let's keep things in perspective.  First, if high unemployment is structural then the new asset purchases will cause inflation to hits its target and the Fed will be forced to tighten.  Second, given the Fed already embarked on this path with QE3, these explicit thresholds make the Fed more accountable and transparent. Finally, these thresholds are presumably just a halfway step to a full NGDPLT.

Marco Rubio, the GOP, and NGDP Level Targeting

One of the hardest points to make to my fellow conservatives is that Fed policy actually has not been easy over the past four years. Yes, monetary policy has been ad-hoc, unpredictable, and appears to have been hyperactive with its large-scale asset purchases. Despite these actions, the Fed has failed to reduce the elevated demand for liquid assets. This is evident in the seemingly insatiable appetite for treasuries that is keeping yields at historic lows and in the latest Flow of Funds data that shows households are still holding an inordinate share of liquid assets in their portfolios.¹ As Bernanke notes, though, the Fed is actually capable of addressing this problem in a systematic, rule-based fashion but has failed to do so. This failure amounts to a passive tightening of monetary policy.  

One reason for this failure is the political pressure the GOP has placed on the Fed.  Most in the GOP think the Fed has been too easy and want it to do less.  Specifically, many in the GOP want to narrow the Fed's mandate to just inflation targeting.  Senator Marco Rubio is the latest to push this view.  Matt O'brien agrees with Rubio that the Fed's mandate needs to be narrowed, but in a different way:

But Rubio is right that the Fed needs a better, clearer monetary rule nowadays... Imagine the Fed had a single mandate, but not for inflation. Imagine instead the Fed had a single mandate for the total size of the economy, which goes by the unwieldy name of nominal GDP (NGDP). During the Great Moderation, NGDP grew about 5 percent a year, but it's only grown about 2.85 percent a year since 2008. If the Fed had an NGDP target of 5 percent a year, and was supposed to make up for any over-or-undershooting, it would have been aggressively easing the entire time since 2008. It's a dual mandate that doesn't get confused by low inflation and low growth. 

O'brien is correct that a NGDP level target is a superior way to narrow the Fed's mandate.  Unlike an inflation target, it is not susceptible to misinterpreting supply shocks and systematically accounts for past policy mistakes.  NGDP level targeting also increases the transparency of the Fed, makes its actions more predictable, and reduces the need for countercyclical fiscal policy. It is a GOP dream.  Republicans should be out in front of this idea, promoting it vigorously. They could start by reading this paper.

¹Don't even think of blaming the Fed for the low yields on treasury yields.  

The Deeper Secrets of the NFIB

Much ado is being made about the drop in the NFIB small business optimism index.  While interesting, this index is just one part of the larger NFIB Small Business Economic Trends survey that contains a trove of other information.  In fact, a little digging into this survey can shed some light on the nature of the ongoing economic slump. This is because the survey asks firms what specific developments they see as the "single most important problem" they face. This question, in my view, is the more important than the news-making small business optimism index because it tells us why firms feel more or less optimistic. Knowing this information better informs what the appropriate policy response should be to the ongoing slump.  Unfortunately, it rarely makes the headlines.  This post is an attempt to correct this shortcoming.

So what does this survey show for this question? There are a number of answers from which firms can chose.  Below is a graph that shows some of their responses.  

Money Still Matters: Part XIV

Several recent articles have made the case that monetary policy should not ignore information about the stance of monetary policy found in a properly specified measure of the money supply.  Properly specified means (1) appropriately grouping monetary assets into aggregates based on how money-like they are and (2) recognizing that there are both retail and institutional money assets. Standard measures of money like M2 ignore both issues.  The graph above shows monetary aggregates from the Center for Financial Stability that do account for both.  

Peter Ireland made the case for these measures at the most recent Shadow Open Market Committee while Doug Irwin did so on the pages of the Financial Times.  Steve Hanke, meanwhile, invokes them to warn that the Fed may be undermining their growth by imposing stricter bank capital requirements.  My own thoughts on properly measuring money can be found to right under the "Safe Assets, Money, and the Great Recession" header.

Update I: Just to be clear, I am not advocating money supply targeting.  I still prefer a NGDP level target.

Update II:  Michael Belongia reminds me that the targeting the money supply--an intermediate target--should not be confused with the ultimate goal of monetary policy, stable NGDP growth. Point taken. See his paper with Peter Ireland where they show how the Fed could implement NGDP targeting by stabilizing a Divisia measure of the money supply.

Paul Krugman Will Not Like These Figures

[See update below]
See if you can figure out why:

Source 

This first figure shows that aggregate demand growth has not been affected by a tightening of fiscal policy since 2010.  Specifically, it shows that nominal GDP (NGDP) growth has been remarkably stable since about mid-2010 despite a contraction in federal government expenditures. The same story emerges if we look at the budget deficit relative to NGDP growth:

Source

Both figures seriously undermine the argument for coutercyclical fiscal policy and suggest a very a low fiscal multiplier.  They also indicate that the Fed has been doing a remarkable job keeping NGDP growth stable around 4.5%. Monetary policy, in other words, appears to be dominating fiscal policy in terms of stabilizing aggregate demand growth.  This in turn implies that the Fiscal Cliff should not be a big deal if the Fed continues to stabilize NGDP growth around 4.5%. Yes, there would still be distributional and incentive changes if fiscal consolidation occurs, but the fiscal tightening itself should have no bearing on aggregate demand if the Fed continues to do its job. As I noted before, the Fed is the other solution to the Fiscal Cliff.  Lars Christensen agrees.

P.S. Though the Fed has been doing a remarkable job keeping NGDP growth stable since mid-2010, it has yet to allow a period of catch-up nominal spending growth that would return NGDP to its pre-crisis trend. So the Fed's work is not complete.

Update: Noah Smith and Daniel Kuehn provide some pushback to this post. Noah invokes Nick Rowe's thermostat reasoning to conclude the graphs could be consistent with a large fiscal multiplier.  That is a possibility, but given what we know about fiscal policy and the last two years his alternative story does not fit.  The economy has been hit by multiple negative shocks--Eurozone crisis, 2011 debt cliff talks, concerns about China slowdown--over the past few years that have kept demand for safe assets elevated and thus the economy below full employment.  For Noah's interpretation to work fiscal policy must be nimble enough to counter these shocks as they happen. That hasn't happened; fiscal policy is clumsy and has been winding down despite these shocks and despite the consternation of Paul Krugman who has endlessly complained that it hasn't been enough.

Daniel, on the other hand, thinks if we put the variables on the same scale all is well.  No, here are total federal expenditures and NGDP in the same growth rate form and in dollar levels. In both cases, total federal expenditures have been trending down since 2010.