Something interesting is happening in the United Kingdom. Some government officials there are pushing for the Bank of England to adopt an NGDP target. From the Independent:
Officials in the UK Treasury are “probably” considering whether to change the Bank of England’s inflation-targeting mandate due to the massive economic shock imparted by the coronavirus crisis, according to a former minister.
Lord Jim O’Neill, who was commercial secretary to the Treasury in 2015, wants the central bank to shift from its current target of keeping inflation at 2 per cent to targeting a steadily rising trend of nominal UK GDP growth instead.
Since the U.K. Treasury determines the monetary policy target for the Bank of England, these rumblings are more than noise. The U.K. Treasury's increased interest in an NGDP target is driven, in part, by the efforts of Jim O'Neil. He has written articles, done interviews, and made a forceful case for this approach to monetary policy. Another prominent voice is Sajid Javid who was recently the Chancellor of the Exchequer. He also has called for NGDP targeting in a new study. They are not alone, as other members of Parliament also talking about an NGDP target and several UK think tanks are promoting it as well. There seems to be, in short, some real momentum for NGDP targeting in the Boris Johnson government.
If the Bank of England were to get an NGDP target, it would be the first central bank to explicitly do so. The Bank of England was an early adopter of inflation targeting, so it would be fitting for it also to be an early adopter of NGDP targeting. Moreover, moving to this monetary policy framework should not be too hard for the British central bank since it already does something that looks a lot like an NGDP target.
Still, this would be seen as a big change for the central bank and many observers are unsettled by its prospects. Again, from the Independent:
Lord O’Neill conceded that the idea of moving to nominal GDP targeting would “scare” many people in the Treasury and the Bank who regard the current inflation-targeting regime as a proven success.
To those observers who are worried, I would encourage you to check out my paper from late last year that summarizes the facts and fears of NGDP targeting. It was written with the Fed in mind, but its lessons are applicable to any central bank. Here, I want to make three points that are specifically directed toward the Bank of England adopting an NGDP target.
Changes in Potential Real GDP: Much Ado About Nothing
My first point is that changes in potential real GDP should not be a practical concern if the Bank of England were to adopt an NGDP target. Changes to potential real GDP is a common objection to NGDP targeting and in principle a legitimate concern. In practice, however, the magnitudes involved make this a moot concern.
To illustrate this point, imagine that the Bank of England had been credibly targeting NGDP at 4% a year since the mid-1960s. Also assume that the potential real GDP (y*) evolved as it actually did over this period. The difference between this imagined NGDP target and the actual growth rate of y*, would be the counterfactual trend inflation experienced during this time. The figure below shows the outcome. It reveals that trend inflation in the UK would have ranged from about 1% to 3%. The average inflation rate over the whole period would have been just under 2%. Not a lot to see here. Even if we tweaked the NGDP target up a bit, there would still no runaway inflation. Instead, we end up in a world with longrun inflation well-anchored and a stable growth path for nominal income.
Now to the extent that changes in potential real GDP do matter, it actually favors NGDP targeting over flexible inflation targeting (FIT). Josh Hendrickson and I show this outcome in a JMCB paper (ungated version) last year. The punchline is that a central bank doing FIT needs to know both potential real GDP (y*) and real GDP (y) in realtime to avoid making mistakes. A central bank doing NGDP targeting does not need to know y* or y in realtime. In fact, it intentionally remains agnostic about them over the shortrun and simply aims to stabilize nominal income. As a result, it is less likely to accidentally make matters worse. This is not just a theoretical argument. Athanasios Orphanides, for example, shows that one reason for the Fed's tepid response to rising inflation in the in the 1970s was bad realtime data on the output gap. In more recent times, one see the Fed's talking up of rate hikes in the fist half of 2008 or the ECB's outright tightening of policy in 2008 and 2011 as manifestations of this problem.
Concerns about changes in potential real GDP, then, are much ado about nothing under an NGDP target and only meaningfully matter for a FIT.
NGDP Targeting Would Not Be a Radical Change
My second point is that the Bank of England adopting an NGDP target would not be a radical change. For it is already producing outcomes that closely mimic an NGDP target. This can be seen in the figure below.
This chart shows that prior to the COVID-19 crisis, the Bank of England had grown NGDP about 4% a year along a stable path. This is exactly what an NGDP level target would look like. Interestingly, former Governor Mark Carney actually wanted the Bank of England to follow an NGDP target when he first arrived. The idea was quickly shot down, but nonetheless he got the outcome he was calling for back in 2012. It is almost as if the Bank of England had a stealth NGDP target under his stewardship.
Prior to the Great Recession, NGDP was also on a relatively stable path, though during this time it was growing closer to 5%. This too looks similar to an NGDP level target. Both of these NGDP targeting-like experiences, however, end in a sustained trend path drop that is not made up. In other words, the Bank of England's implicit NGDP target is actually a version of a growth rate target rather than a level target. And that is where the recent calls for an NGDP level target are different from what the central bank has been doing.
The Real Change Would Be an Explicit Make-Up Policy
My final point is that the real change being called for is the adoption of a level target. That is, the goal is to move the Bank of England from an implicit NGDP growth rate target to an explicit NGDP level target. This would require the central bank to make up for past misses from its target. Put differently, an NGDP level target would empower the central bank to temporarily run the economy hot until NGDP got back up to its trend growth path. In the case of the United Kingdom, that means growing NGDP faster than the trend 4% growth rate. This faster-than-normal catch-up growth is sometimes called 'make-up' policy and is illustrated below:
What an NGDP Level Target Might Look Like in the United Kingdom
If the UK Treasury were to announce an NGDP level target for the Bank of England, it could be as simple as restoring NGDP to its trend growth path that existed under Mark Carney. That is, temporarily run NGDP hot to make up for shortfalls below its trend path that occurred during the COVID-19 crisis. After that, simply grow NGDP at 4%. As seen in the first figure, a 4% level target would probably be fine given likely changes in potential real GDP in the United Kingdom. More complicated versions of an NGDP level target are possible, but I would start simple.
In closing, it is worth noting that NGDP targeting is not a new idea. It was highly talked about in the 1980s, but gave way to inflation targeting in the 1990s. The United Kingdom's adoption of an NGDP level target would simply put monetary policy in advanced economies back on its original journey. Bon voyage to the Bank of England!
NGDP Targeting in the United Kingdom - Scott Sumner