Tuesday, November 22, 2011

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.

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