Scott Sumner Is Live At the WSJ

Supply Shocks and Nominal GDP Targeting

Adam P is a bit irritated with all the attention being given to nominal GDP targeting and has been tossing some "volatility critique" and "optimality critique" grenades our way.  Fortunately, the volatility critique grenade was a dud, though I am still am holding and sizing up the optimality one.  Hopefully, it doesn't blow up. Where is the love Adam P?

His latest bombardment on the nominal GDP camp comes in an attempt to critique what I think is one of the biggest benefits of nominal GDP targeting: how it deals with supply shocks.  This latest bombardment, however, is not a dud but ironically ends up blowing apart inflation targeting rather nominal GDP targeting.

Here is why.  Inflation is the result or symptom of underlying shocks to aggregate demand (AD) and aggregate supply (AS).  Monetary policy, however, can only meaningfully influence AD so that is where its focus should be.  This cannot happen with strict inflation targeting because it requires the central bank to respond to any change in inflation, regardless of whether it is caused by AD or AS shocks.  In other words, inflation targeting causes the central bank to respond to AS shocks when it should only be responding to AD shocks.  A nominal GDP target acknowledges this distinction and appropriately focuses monetary policy on the cause (AD shock) not the symptom (inflation).

Adam P., therefore, is therefore right to claim that monetary policy cannot "fix" a supply shock, but he has it completely backward when he claims that this does not happen with inflation targeting:

[T]he thing about supply shocks is that there really isn't anything monetary policy can do to "fix" the problem, one of the reasons that inflation or price level targeting is better [than nominal GDP targeting] is exactly because there is no attempt to fix a problem that is not amenable to a monetary solution.

On the contrary, a strict inflation-targeting central bank is forced to respond to AS shocks when they occur.   For example, assume a new technology makes computers significantly faster.  All else equal, this productivity-enhancing AS shock would create disinflation and put upward pressure on the natural (i.e. equilibrium) interest rate. A central bank adhering to a strict inflation target would be forced to respond to the disinflation by lowering its target interest rate.  This response, however, would push the target interest rate down just as the natural interest rate was increasing, a destabilizing development.  Stated differently, this response would add unwarranted monetary stimulus to an existing boom.  A nominal GDP target, on the other hand, would allow the inflation rate to fall and the target interest rate to rise with the natural interest rate. 

To make this example concrete, assume a nominal-GDP growth-rate target of 5 percent. This technology shock might temporarily result in 5 percent real economic growth and 0 percent inflation under this regime. In contrast, a rigid inflation target of say 2 percent in conjunction with the 5 percent real economic growth would require 7 percent nominal-GDP growth, or a potentially destabilizing surge in spending. Better to ignore the supply shock and allow the temporary disinflation than to have an unsustainable boom in spending. 

Now consider a negative AS shock caused by a super-virus that temporarily shuts down most computer systems. This negative shock would decrease productivity and increase prices. This might, for example, result in 0 percent real economic growth and 5 percent inflation. Here, a 2 percent inflation target would require a tightening of monetary policy that would further constrict an already weakened economy. A Federal Reserve that was targeting nominal GDP would not face this dilemma. It would simply keep total current-dollar spending stable at 5 percent growth and allow the supply shock to work itself out.  Yes, there would still be a recession and rise in unemployment, but nowhere near as pronounced as a central banking choosing to further strangle an economy just to maintain an inflation target.

Though not explicitly arguing for nominal GDP targeting, Lawrence Christiano, Roberto Motto, and Massimo Rostagno in this NBER paper raise the same criticism of inflation targeting.  They formally show that focusing "too narrowly on inflation may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles can be generated. The authors explain that in

the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy.

In other words, these authors are arguing that by forcing monetary authorities to respond to changes in inflation that come from AS shocks, inflation targeting becomes destabilizing.  Now these authors say nothing about nominal GDP targeting, but their point above that the price level should be allowed to fall in response to a positive AS shock implies nominal GDP targeting--which allows for this very thing--would be better.  

This flaw with inflation targeting--treating all changes in inflation the same--is a big reason why the Fed added too much stimulus in the early-to-mid 2000s.  It misread the disinflationary pressures then as indicating weak AD rather than rapid productivity gains. This flaw also explains why the Fed failed to add monetary stimulus at its September, 2008 FOMC even when all signs where indicating a sharp collapse in AD.  As I said before, it is better to target the cause than to target the symptom.  

A Win-Win for Conservatives and Liberals

Ramesh Ponnuru and I have a new article in The New Republic where we argue that conservatives should embrace more aggressive monetary policy while liberals should not fear budget tightening.  Our point is that the Fed could be doing far more to restore robust nominal spending and if it did so, it would be possible to do fiscal consolidation without harming the economy. For example, if the Fed were targeting nominal GDP and government spending cuts proved to be contractionary, then the Fed would offset them so as to maintain a stable nominal GDP growth rate.  It is a win-win situation.  Conservatives get fiscal consolidation and liberals get a meaningful boost to aggregate demand.

Joe Weisenthall objects by arguing the following:

The biggest problem facing the economy is that the private sector is in too much debt. Americans are trapped in their homes, where they owe huge mortgages, and are generally paying off the big credit boom from the last few decades...If you can accept that this needs to come down, it seems ludicrous to think that the answer to the debt crisis is: cheaper loans!

Two responses.  First, nowhere have we argued that indebted households should take on additional borrowing.  Rather, monetary easing via a nominal GDP level target would make its biggest impact, in our view, via changes in expectations that would cause households to rebalance their portfolios in a way that would stimulate spending.  Bank lending and borrowing are not key to this story.  And yes, there is ample evidence that expectations do affect spending decisions. 

Second, while the buildup of household debt is a drag for debtors it does not have to be for the economy as a whole.  If the monetary authority is able to maintain stable nominal spending expectations--that is minimize uncertainty about future nominal income growth--then the creditors should provide a boost to spending that offsets the debtors' reduction in spending.  The "balance sheet recession" view ignores this possibility and ignores the historical examples where this actually happened.  Moreover, a closer look at household balance sheets reveals that the real problem constraining aggregate demand is on the asset side, not the liability side. That is, what best explains in a systematic manner spending changes is the household share of liquid assets not its debt to income ratio.  But even so, a rise in nominal income from adopting a nominal GDP target would make it easier for indebted households to service their liabilities.

Finally, Joe Wiesenthall is troubled with our claim that the fiscal policy multiplier is zero.  Let me explain this claim using this analogy I made in the past:

Scott Sumner once compared arm wrestling with his daughter to the relationship between monetary and fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how hard fiscal policy may attempt to stimulate aggregate spending the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  In other words, the size of the fiscal multiplier ultimately depends on the stance of monetary policy.

Since the Fed could do more by its own admission and yet seems content doing nothing at the moment, it stands to reason that a fiscal policy stimulus that lead to enough rapid nominal spending growth to close the output gap would be quickly arrested by the Fed.  The problem, then, is with the Fed.  A nominal GDP level target would change the Fed's perspective so that it would allow enough nominal spending growth to return  nominal GDP to some pre-crisis trend.  Fiscal policy in such a setting would be more effective, but then it wouldn't be needed because the Fed itself would be pushing nominal GDP to its target growth path.  

For further comments on our article see Rameh Ponnuru's comments here and here. 

The Fed Gets Schooled Again: Swiss Central Bank Edition

I once argued that all incoming Fed officials should spend six months interning at the Swedish central bank given their relative success in stabilizing nominal GDP.  I was wrong.  What I should have said is that all incoming Fed officials should spend six months interning at the Swiss central bank.  Lars Christensen explains why:

Here is from The Street Light:

“You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?

It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September — most of which was after the announcement of the exchange rate minimum — the SNB’s foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB’s foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB’s purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.”

This is a very strong demonstration of the power of monetary policy when the central bank is credible. This is the Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target. (Nick Rowe and I like this sort of thing…) And now to the (not so) crazy idea – if the SNB can ease monetary policy by announcing a devaluation why can’t the Federal Reserve and the ECB do it?

Exactly. Instead of having a central bank that sets an explicit target and commits to doing whatever is necessary to hit it, we have a central bank that at best has a fuzzy inflation target and operates in a manner that does little to create certainty about the future path of monetary policy.  This lack of clarity was on display yesterday at the post-FOMC news conference when journalist pointed out to Bernanke that the Fed's forecast is worsening yet the Fed wants to wait for further information before acting.  These journalists wanted to know what would trigger the Fed to act and Bernanke could not give a clear answer.  This is because he is simply unable to make a conditional forecast of future monetary policy with no explicit target.  This is crazy.  Here we have the most powerful central bank in the world stumbling, tripping, and occasionally getting lost as it moves forward because it chooses not to set a clear, explicit path of where it wants to go.  If only we could learn from the Swiss...

Greg Ip Takes on Nominal GDP Targeting

Greg Ip has a long post criticizing nominal GDP targeting.  This is not the first time he has expressed skepticism about nominal GDP targeting so his response is not entirely surprising.  What is surprising is some of the arguments he makes.  Ip does not seem to understand the theory or evidence for nominal GDP targeting.  Fortunately, Ryan Avent, Nick Rowe, Scott Sumner, and Bill Woosley provide replies to many of Ip's criticisms.  I hope Ip reads them.  

Now let me add a few more points to the discussion.  One thing Greg Ip asks for is "evidence linking NGDP targeting to the behavior of private actors."  Now there have not been any explicit nominal GDP targeters from which to draw lessons, but we do have evidence on the importance of nominal GDP expectations and actual nominal GDP performance.  Based on this evidence it seems likely that Fed would pack quite a punch if it adopted a nominal GDP level target.

Greg Ip also claims that since "2007 the Fed has worked overtime to push employment higher and keep inflation from falling."  If the Fed has been working overtime then why did total current dollar  spending take its biggest postwar fall in late 2008, early 2009? The data clearly show that the Fed failed to fully respond to the fall in velocity starting in 2008. And it has failed to restored robust nominal spending ever since.  What Ip fails to appreciate here is the notion of a passive tightening of monetary policy.  Fed chairman Ben Bernanke takes it seriously.  Ip should too.

Finally, Greg Ip cites one study by Laurence Ball (1999) that theoretically finds problems with NGDP targeting. What he failed to mention is that the results of this study have been shown to be fragile.  Here is what I wrote before about this paper: 

Laurence Ball (1999) demonstrated theoretically in a widely-cited paper that nominal GDP targeting can lead to increased volatility of output and inflation.  Lars Svenson (1999) later reconfirmed Ball's findings. This made some observers questions whether nominal GDP had any future.  Bennett McCallum (1999), however, said not so fast.  He showed that their conclusions were based on special backward-looking IS and Phillip curve relations that are "theoretically unattractive" (because they are backward looking)  and whose results fail to hold up with more general specifications.  Richard Dennis (2001) later confirmed that Ball and Svenson's results were fragile.  Finally, Kaushik Mitra (2003) showed that even with adaptive learning, nominal GDP targeting remains a desirable objective for monetary policy.  Thus, there have been no robust studies that show nominal GDP targeting increases volatility.   

I hope Greg Ip wrestles with these points and those made by the other commentators replying to him.  If he does, I think he will better appreciate why more and more folks are becoming enamored with nominal GDP targeting.  Who knows, maybe he too will catch the nominal GDP targeting bug!

Some Evidence on the Importance of Expectations

Modern macroeconomics tells us that expectations are crucial to economic decision making.  It is not hard to see why.  Imagine someone is going to get a big pay raise next year and it will be permanent going forward.  It is highly likely that as a result of this change the person will increase his spending today, all else equal. I see this scenario every year with college students who have landed a job, but have yet to start working and get a paycheck. They feel more financially secure and start making bigger purchases such as a new car.

Now think about all those households that are being financially cautious because they are uncertain about their investments and job prospects in the future. If suddenly they feel more secure about their future incomes, they too will start spending more. Same thing for firms sitting on cash. Improve their forecast of sales and they will start hiring more workers and building more plants to meet that expected rise in demand for their goods.  

This is why expectations is such a big part of modern macroeconomics. And it is why the Fed could pack more of punch if it did a better job managing expectations about future nominal spending (and by implication inflation) via a nominal GDP level target.  Now the Fed would probably need to back up its announcement for higher nominal spending with additional asset purchases, but if taken seriously the public would do much of the heavy lifting. That is, households and firms would start rebalancing their portfolios away from safe, liquid assets toward riskier, higher yielding ones that would create positive balance sheet and wealth effects for spending.  Some of the portfolio rebalancing would go toward capital assets that would directly affect spending.  These developments would improve the economic outlook and that, in turn, would further reinforce the decision to spend more today.

But some folks are not convinced.  They want more than stories.  They want evidence that by changing expectations the Fed can change current nominal spending.   Here is my attempt to provide some evidence on this question.  It is brief and much more could be done, but I think it should be sufficient to give the skeptics pause.

First, many observers have documented that FDR changed nominal expectations at the depths of the Great Depression by talking up a price level target and backing it up by devaluing the gold content of the dollar.   Gautti Eggertson probably has the best known piece on how expectations were crucial to this experience, but also see here for how the change in expectations influenced nominal spending.  What is remarkable about this experience is that FDR was able to turn around expectations despite almost three and half years of deflation and economic collapse.  That FDR could do this in such dire circumstances suggests it could be done today.

Second, it is fairly straightforward to empirically demonstrate that both inflation expectations and nominal spending expectations have been important to current nominal spending.  This can be done using the quarterly Survey of Professional Forecasters from the Philadelphia Fed.  This survey has inflation and nominal GDP forecasts for the next five quarters that go back to 1968:Q4.  The next two figures show that if one takes the average forecast for the next four quarters and plots it against the actual subsequent nominal GDP growth that occurred over the next year there is a systematic relationship:

Now the relationship is not perfect--you wouldn't expect it to be because subsequent shocks could come along over the next year--but it is strong enough to suggest expectations about the future do influence current spending decisions.  Plotting the forecasts against just the current quarter (whose value is unknown at the time of forecast) yields similar results. 

Now since the above data is in growth rate form, we don't have to worry about spurious relationships emerging from trends.  We might, however, wonder if these figures are picking up some kind of serial correlation coming from an omitted variable.  In order to address this question, I ran ran a vector autoregression (VAR) that had as variables the forecasted nominal GDP growth rate for the next year (same as above) and the current quarter nominal GDP growth rate (annualized).  Five lags were used since this many is sufficient to whiten the residuals and get rid of any serial correlation.  The VAR also allows me to answer this important question: what happens to the current nominal GDP growth rate when there is an unexpected change in its forecasted growth rate over the next year?  (These unexpected changes or shocks to the nominal GDP forecasts are those movements in the forecast that could not have been predicted by changes in its own past values or by changes in the past values of actual nominal GDP.)  

The next two graphs answer this question.  The first one shows what happens to the forecasted nominal GDP  growth rate for the next year following a typical (i.e. one standard deviation) shock to the forecast.  It reveals that, on average over the 1968:Q4-2011:Q3 period, such shocks cause the forecasted nominal GDP growth rate to increase about 0.73 percentage points upon impact and then slowly decline after that. 

Now the above figure is not what we are really after.  What we want to see is the response of actual nominal GDP.  But the above figure is important because it provides a way for us to compare the size of the change in the forecasted nominal GDP growth rate to the size of the change in the actual nominal GDP growth rate following such a shock.  So what does the typical, actual nominal GDP growth rate response look like?  Here is the answer:

This figure shows that the typical forecast shock of 0.73 percentage points causes the actual nominal GDP growth rate to increase about 1.50 percentage points upon impact.  In other words, current nominal spending is very sensitive to changes in forecasted nominal GDP.  The actual nominal GDP growth rate response remains elevated for about two quarters after the shock and then gradually declines.  The VAR was rerun with the GDP deflator inflation forecast instead of the nominal GDP forecast.  Upon impact, the  typical forecast shock caused expected inflation to increase 0.35 percent while the nominal GDP growth rate response increased 0.68 percentage points.  Here to current nominal spending is very sensitive to changes in expected inflation.  

To summarize, the evidence from the scatterplots and the vector autoregressions indicates that current dollar spending is very sensitive to changes in both expected inflation and expected nominal spending.  These findings suggest, then, that if the Fed did adopt a nominal GDP level target--something that would definitely jolt expectations--it is likely that nominal spending would respond quickly and meaningfully.   

Who Said This?

The following are some excerpts from a paper on the problems Japan faced in the 1990s. If one were to replace Japan with the United States you might think you were reading a Market Monetarist article.  Consider first, this paragraph:

As already suggested, I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.

Sounds very Scott Sumnerian.  But it gets better.  The author also makes the Market Monetarist claim that low interest rates can actually be a sign of tight monetary policy:

The argument that current monetary policy in Japan is in fact quite accommodative rests largely on the observation that interest rates are at a very low level. I do hope that readers who have gotten this far will be sufficiently familiar with monetary history not to take seriously any such claim based on the level of the nominalinterest rate. One need only recall that nominal interest rates remained close to zero in many countries throughout the Great Depression, a period of massive monetary contraction and deflationary pressure. In short, low nominal interest rates may just as well be a sign of expected deflation and monetary tightness as of monetary ease.

 And there is this flippant dismissal of liquidity traps like there are a walk in the park:

It is true that current monetary conditions in Japan limit the effectiveness of standard open-market operations. However, as I will argue in the remainder of the paper, liquidity trap or no, monetary policy retains considerable power to expand nominal aggregate demand. Our diagnosis of what ails the Japanese economy implies that these actions could do a great deal to end the ten-year slump.

 Finally, this critique of the uncertainty created by the vagueness of the Bank of Japan's policy objective seems almost eerily similar to the Market Monetarists' critique that the Fed lacks a clear policy objective and that in turn creates more macroeconomic uncertainty:

A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns subside”? Krugman (1999) and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.

In other words, the author is saying here that the Bank of Japan needs do price-level targeting to restore aggregate demand.  In such circumstances, that also amounts to an argument for nominal GDP targeting. But the author is no Market Monetarist. No, he just happens to be Federal Reserve Chairman Ben Bernanke, back when he was an academic.  If Chairman Bernanke ever needed a reason to adopt a nominal GDP level target it is his own work in this paper.  I encourage him to sit down, replace all the Japan references with United States in the above paper, and then ponder its implications for the Fed today.