The CATO Institute and NGDP Targeting

Guess which think tank gives this advice in its official hand book for policymakers:

The intent of Congress would be better served and monetary policy would be more effective if Congress instructed the Federal Reserve to establish a monetary policy that reflects both their concerns in a single target. The best such target, I suggest, would be the nominal final sales to domestic purchasers—the sum of nominal gross domestic product plus imports minus exports minus the change in private inventories... Congress is best advised (1) to specify a target rate of increase of final sales and (2) to instruct the Federal Reserve to minimize the variance around this target rate. The target rate of increase of final sales may best be about 5 percent a year, sufficient to finance a realistic rate of economic growth of 3 percent and an acceptable rate of inflation of about 2 percent.

So the think tank is advising policymakers to do something like nominal GDP (NGDP) targeting. It may surprise you to learn that it comes from the CATO Institute. But it should not be a surprise. Some of CATO's top monetary experts, like Lawrence H. White and George Selgin, also support versions of a NGDP target. They would prefer a free banking system, but given we have a Fed they would prefer it target NGDP. CATO Senior Fellow Steve Hanke also shares this view as does former CATO scholar Timothy B. Lee. The reason for their support of a NGDP target is because they see it as the most conducive to monetary stability. 

Here is why. A NGDP target aims to stabilize total dollar spending. It is one target that has embedded in it both the supply of and the demand for money (i.e. total dollar spending = money supply x velocity of money). The beauty of a NGDP target is that the Fed does not need to know what is exactly happening to the money supply or money demand. All the Fed only needs to worry about is the product of the two components. There is no need to track the money supply or estimate money demand. By focusing on total dollar spending, the Fed will be fostering a stable monetary environment where movements in money supply and money demand are offsetting each other. 

Another great feature of a NGDP target is that it allows supply shocks to be reflected in relative price changes. No attempt is made to offset them or their effect on the price level. For example, assume there is a technological innovation that raises a firm's productivity. Such productivity gains mean lower per unit production costs that, in turn, should translate into lower output prices given competitive pressures. Here, the increase in a firm’s output from the productivity gains is matched by a decrease in its sales price. For an economy-wide productivity innovation that affects many firms, this response would manifest itself in rising real GDP growth alongside a declining price level and vice versa. But note that the price level times real GDP is simply total dollar spending. Consequently, if the Federal Reserve directly targeted the growth of total dollar spending it would by default be allowing the price level to move inversely with productivity-driven changes in real GDP. This amounts to a monetary policy regime that ignores supply shocks. This feature is conducive to financial stability.

So there are good reason that many folks at CATO support some kind of NGDP target. I bring this up because CATO Senior Fellow Alan Reynolds had a recent article in Investor's Business Daily that bashed NGDP targeting. Unlike his colleagues at CATO, though, Reynolds shows an incredible amount of confusion in his article. So if you are looking to the CATO institute for guidance on monetary policy I recommend you turn to their other experts or its official handbook for policymakers.

Let me detail a few of the many problem with his piece. First, try this:

Prominent economists of all stripes have proposed that the Fed should focus instead on keeping the growth of nominal GDP (NGDP) growing at a steady rate. But growth of NGDP is simply the inflation rate added to the real GDP growth rate.

No, we directly observe NGDP and from it is derived real GDP based one some estimated index of the price level. Reynolds should listen to CATO monetary expert George Selgin on this issue:

The occasional, if tacit, treatment of NGDP as a value that is “derived” by taking the product of two directly observable magnitudes, real output (y) and the price level (P), is as mischievous as it is wrong. We must understand the behavior of both P and y to depend, the first in the long run and the second in the short run, on that of Py, rather than the other way around. That is why it is also important to insist that stabilizing NGDP is not just a rough-and-ready way of minimizing a loss function in which fluctuations of P and Y are separable components. No and no again: if the natural rate of y plummets (natural disaster or war, say), what is desirable is not that we should minimize both P and y movements subject to the supply-shock “constraint. It is rather than we should see P move the opposite way from y, which is done by stabilizing Py.

Here Reynolds esposuses an atheoretical model of inflation, something akin to trend analysis:

[T]he trouble with basing future policy on past inflation news is that inflation is always lower before it moves higher. PCE inflation rates of 0.8% in 1998 and 1.3% in 2002, for example, were followed by 2% inflation in 2003, 2.4% in 2004, and 2.9% in 2005.

What? Inflation is inherently an oscillating process? So the very thing Reynolds is criticizing, Fed policy, is not at all responsible for the path of inflation?

This is just a sample of the confusion in the article. So again if you are conservative and looking for guidance on monetary policy I encourage to look at the actual monetary experts at CATO.

P.S. You could also look to the monetary experts at the Mercatus Center like Scott Sumner. He has several articles there worth exploring.