Tuesday, November 2, 2010

Why a NGDP Level Target Trumps a Price Level Target

Two recent articles speak to the advantages of a nominal GDP level target over a price level target.  The first article is from The Economist which actually discusses a price level target but in so doing actually builds the case for a NGDP level target. The Economist article first describes the benefits of a price level target:
Assume that inflation of 2%, on average, is ideal. This implies that if the price level is 100 this year, it will be 102 next year and 104 (or more precisely, 104.04) in the second year. If inflation is only 1% in one year, a conventional inflation-targeting central bank would aim only to return inflation to a rate of 2% the next. This would leave the price level at 103, lower than its original implied path. In contrast, a central bank that targets the price level wants to make up any lost ground on prices. It would seek to raise inflation to 3% in the second year to get to a target of 104.

In theory price-level targeting is superior to inflation-targeting because it provides more certainty about the long-term purchasing power of money. Central banks always target inflation flexibly. The Bank of Canada and the Bank of England, for example, target a rate of 2% but permit a range of 1% to 3%. That means someone making a 30-year investment must plan for cumulative inflation of as much as 143% or as little as 35%. A credible price-level target eliminates that uncertainty.
 So a price level target trumps an inflation target, but it has one glaring problem: it doesn't handle aggregate supply shocks very well. Here is The Economist:
There are questions, too, about how central bankers would deal with a one-time rise in the price level because of a new value-added tax, say, or higher oil prices. The boost to inflation would be temporary, but to the price level, permanent. In theory a central bank would have to wrestle all other prices lower no matter what the cost. It could make an exception, but too many exceptions would dent the bank’s credibility. Conversely, a positive shock such as lower oil prices or higher productivity that pushes prices lower would require the central bank to raise future inflation, driving down real interest rates and maybe risking an asset bubble.
Implicit to this discussion is that a price level target does great if the business cycle is dominated by aggregate demand (AD) shocks. But if aggregate supply(AS) shocks matter at all then a price level target can actually be destabilizing. Would we really want the Fed to tighten because a negative AS shock pushed up prices? This would require the Fed to further constrict an already weakened economy.  On the other hand, if there were a productivity boom that implied a higher neutral interest rate and lower inflation rate, would we really want the Fed pushing interest rates below the neutral rate and raising AD above trend growth just to keep the price level stable?

What then is left? Ramesh Ponnuru provides an answer in a National Review article titled "Hard Money" (sorry, no link):
Economists Scott Sumner of Bentley University and David Beckworth of Texas State University are among those who have suggested that the Fed should move gradually toward a new, more rule-bound and predictable monetary policy. The first step would be to signal to the markets that the Fed is willing to do whatever it takes to reach 2 percent average inflation. Over time the Fed would move to stabilize and then slow the growth of nominal GDP, which is the size of the economy as measured in a given year’s dollars. If the nominal GDP target was for 3 percent growth and the economy grew by 2 percent, there would be 1 percent inflation.

That policy would bind the Fed to a rule, thus reducing the uncertainty that recent policy has generated, including the risk that we will get galloping inflation at some point in the future. But it is superior to simply targeting the inflation rate, Beckworth argues, because it incorporates two worthwhile types of flexibility. It allows the price level to move in response to supply shocks: An oil embargo would cause prices to rise, a technological advance would have the opposite effect. And it allows the money supply to move up and down in response to the demand for cash: In periods such as late 2008, when people were holding on to their money, the Fed would have loosened more than it did. But since the rule would have required tighter money during the boom years, the financial crisis might not have been as severe in the first place.
So the answer is a NGDP level target.  There is some disagreement on exactly how fast NGDP should be growing and thus targeted.  However, supporters of a NGDP level target agree that the beauty of a NGDP level target is that it forces Fed to focus on stabilizing AD while ignoring potentially misleading signals coming from changes in the price level. In short, such a rule would force the Fed to focus on a cause of the business cycles, not a symptom of it


  1. From 1921-1929 NGDP growth in the U.S. averaged something like 3.7%. There was a big increase in Y and the price level fell slightly over the period.

    Friedman argues that Fed policy was too tight during that period. Austrians argue that it was too loose (the price level should have fallen further than it did).

    I see the 1920's boom similar to the 2003-2007 boom. As you've pointed out, the Fed improperly responded to an increase in productivity because they were too concerned about disinflation.

    Do you see the 1920's boom the same way (which would put you at odds with Friedman)?

    I would think that if we wanted a 3% NGDP target, the Fed did a decent job of hitting it in the 1920s. Thoughts?

  2. JDTapp,

    I am familiar with that argument and have been sympathetic to it in the past. But I would want to go back and look closely at the data before being certain. Any sources you recommend that make this argument?

  3. No. The idea occurred to me reading the Lawrence White paper contrasting the Fed's "real bills" doctrine and the Hayek-Robbins preference (that you linked to long ago) and reading a Sumner post on Friedman's view of that 1920s boom.

    I find your view on the Fed in the 2003-2006 boom to be very similar to Hayek's view on the 1920s (Fed shouldn't have responded to a positive productivity shock) and wonder why Friedman & Schwartz argued that the Fed should have been more expansionary. Or maybe Friedman later changed his mind about that?