Ramesh Ponnuru Responds to the FOMC's NGDP Discussion

Ramesh Ponnuru has a new Bloomberg article where he responds to the FOMC's discussion on nominal GDP Targeting.  Some excerpts:

NGDP targeting seeks to stabilize expectations about the future path of the economy, making it easier for people to make long-term plans. Keeping nominal spending, and thus nominal income, on a relatively predictable path is especially important because most debts, such as mortgages, are contracted in nominal terms. If nominal incomes swing wildly, so does the ability to service those debts.

[...]

From the standpoint of macroeconomic stability, then, NGDP targeting is superior because it allows inflation to accelerate and slow to counteract fluctuations in productivity. It moves the money supply only in response to changes in the demand for money balances, and not to supply shocks that mimic the effect of these changes on prices but call for a different monetary response.

If only the Fed would listen to Ramesh Ponnuru and start targeting some pre-crisis trend path for nominal GDP.  Not only would it be good for the U.S. economy, it would also do wonders for the Eurozone economy. 

Maybe He Should Try the ECB Tranquilizer Gun

The Fateful Decision to Tighten ECB Monetary Policy

Paul Krugman notes that the Eurozone crisis began rearing its ugly head again back in April, the very time  the ECB decided to tighten monetary policy.  Krugman thinks these two developments are probably related:

By itself, that rate hike — although it was obviously, obviously a big mistake — should not have mattered that much. But maybe it acted as a signal of the ECB’s bloody-mindedness, and that’s what set off the panic.

I agree.  The market saw this interest rate hike as indicating the ECB would allow further weakening of aggregate demand in the Eurozone.  Consequently, the market lowered its forecast of nominal spending and, as a result, expected inflation started declining, the Euro began weakening, and sovereign spreads started increasing.  Here is the 10-year breakeven inflation expectation series for the Eurozone:    

Here is the nominal effective exchange rate for the Euro:

Finally, from Rebecca Wilder here are the surging spreads:

These figures show that these asset prices all took a marked change in trajectory at about the time the ECB tightened in April.  And all these asset price changes have been indicating tight monetary policy since that time, but no one at the ECB seems to be listening.  No one at the ECB seems to appreciate that by allowing aggregate demand to continue to weaken they are passively tightening monetary policy.  The Europeans seem to be repeating monetary history.

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.

If the Germans Were Serious About Stabilizing Aggregate Demand

Then they would be doing exactly what they are doing now, if their only concern were Germany.  Last week the Federal Statistics Office of Germany released third quarter nominal GDP data where we find relatively robust growth in aggregate demand:

This above-trend growth is entirely consistent with the reluctance of the Germans to open up the ECB monetary spigot.  Doing so would only serve to further raise aggregate demand above trend growth.  The Germans are probably concerned that the additional nominal spending stimulus would raise inflation uncomfortably high and create a positive output gap.  Maybe the Germans are hardcore nominal GDP targeters.  

But are the Germans really focusing on just their own aggregate demand growth?  It is a strange argument to make since the ongoing collapse in Eurozone aggregate demand (see figure below) will ultimately affect the German economy too.  Nonetheless, it is hard not to wonder these thoughts given the Eurozone seems to have been serving German interests all along and the recent reluctance of the Germans to meaningfully address the Eurozone crisis.  It is also not hard to think these thoughts when one comes across statements such as the rather cheery press release accompanying the third quarter GDP numbers (my bold):

Gross domestic product in 3^rd quarter of 2011: upswing continues

WIESBADEN – The German economy continues its growth: In the third quarter of 2011, the gross domestic product (GDP) rose 0.5% – upon price, seasonal and calendar adjustment – on the second quarter. In addition, the result for the second quarter of 2011 has been corrected upwards to +0.3%, as reported by the Federal Statistical Office (Destatis). This means that, following the strong growth at the beginning of the year (+1.3% in the first quarter), the upswing of the German economy continued in the course of 2011, with the growth rate slightly increasing in the reference quarter compared with the previous quarter.

In a year-on-year comparison, too, the GDP grew strongly, although not as strongly as in the first half of the year: In the third quarter of 2011, the price-adjusted GDP was up 2.5% on a year earlier (calendar-adjusted: +2.6%).

And lest you think this is an isolated case, below is a recent AP story on consumer confidence in Germany:

BERLIN (AP) — A survey finds that consumer confidence in Germany, Europe's biggest economy, is holding up despite increasing worries about the economic outlook.  The GfK research institute said Tuesday that its forward-looking consumer confidence indicator for November stands at 5.3 points — up from 5.2 points in October.  GfK says that consumers "remain very optimistic" about income expectations and that their willingness to buy also is being helped by low unemployment and rising salaries.

Really?  German consumers remain very optimistic about income expectations and future spending despite the onward march to Eurogeddon?  Do they know something we do not know?  Or, are they so caught up in the relative successes of the German economy that they fail to fully appreciate what is happening in the rest of the Eurozone?  

In case there were any questions, what has happened to aggregate demand in the rest of the Eurozone can be seen below.  First, nominal spending has never recovered from its collapse in 2008 and 2009: 

Moreover, nominal spending has actually fallen over the past two quarters:

Now maybe the German public does appreciate what is going on in the Eurozone, but simply are not fazed by it.  One reason for this might be their belief that they can force the rest of the Eurozone to become more German-like as this "we have them by the balls" comment indicates.  A second reason is that in a worst-case scenario the Eurozone breaks up and they return to their beloved Deutsche Mark with a relatively resilient German economy.  Whatever the motivation may be, what we do know is that the Germans are doing a fine job stabilizing aggregate demand in Germany.  

The ECB Needs the Fed Now More Than Ever

And it is not because the ECB needs more currency swaps.  It is because the ECB needs the Fed for cover.  Here is why.  The Fed is a monetary superpower.  It manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. As a result, its monetary policy gets exported to much of the emerging world. This means that the other two monetary powers, the ECB and Japan, have to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. So, to some extent U.S. monetary policy also gets exported to the Eurozone and Japan too.  

This exporting of Fed policy to the Eurozone can be seen in the figures below.  The first figure shows the targeted policy interest rates for both the Fed and the ECB since the Euro's inception in 1999.  The figure shows that the ECB adjusted its target interest rate in a manner that seems to follow movements in the targeted federal funds rate, a response consistent with the Fed being a monetary superpower.  Even the ECB's attempt to break away and tighten in 2011 appears to be conforming to the irresistible pull of the Fed's power. 

The next figure shows the year-on-year growth rate for NGDP across the two regions.  The arrows highlight what appear here too to be a leading relationship for the USA: nominal spending first takes off in the USA then in Europe and then slows down in that order too.  

As a robustness check, the figure below shows the effect across both regions' NGDP growth rates of an unexpected change or shock to the US NGDP growth rate.*  The figure reveals that the typical shock to US NGDP during the 1999-2011 period created similar responses across both regions. 

 

Again, an easy way to explain these relationships is that the Fed is a monetary superpower and influences monetary policy in both the United States and the Eurozone.  Thus, when the Fed was too easy in the early-to-mid 2000s it fueled rapid nominal spending growth in both regions.  Likewise, when the Fed became passively too tight in 2008 it stalled nominal spending growth in both places too.  

The Fed, therefore, should be able to help spur nominal spending growth in the Eurozone by do something radical, like adopting a NGDP level target that would return U.S. NGDP to its pre-crisis trend.  This would imply aggressive monetary easing by the Fed that, in turn, would put downward pressure on the dollar.  This would create the incentive for the reluctant Germans--who seem to care as much about their exports as they do about inflation--and the ECB to get serious about opening their monetary spigots.  In other words, a sufficiently aggressive Fed would provide the cover for the ECB to do what it needs to have done all along.  

Of course, a more efficient way to do this would be a coordinated effort, such as the plan suggested by Lars Christensen, where the major central banks of the world work together to raise their nominal spending to pre-crisis trend levels.  But since this type of coordination does not seem likely anytime soon, it seems natural for the reigning monetary superpower to take the lead and start a global nominal spending recovery.

*These impulse response functions come from a VAR with just the two NGDP growth rates and a constant.  Five lags are used along with a Cholesky decompostion.

Conservatives for NGDP Targeting

Goldman Sachs has another research note out on NGDP  targeting and, among other things, has this to say:

NGDP target[ing] enjoys growing support from economists on both sides of the political aisle. Several prominent economists who have recently advocated NGDP targeting, including Paul Krugman, Christina Romer, and Bradford DeLong, lean toward the Democratic side. However, many of the long-standing “market monetarist” supporters of NGDP targeting such as Scott Sumner and David Beckworth identify themselves as political conservatives. Beckworth recently wrote an article advocating NGDP targeting with political journalist Ramesh Ponnuru in the conservative National Review. Gregory Mankiw, an adviser to Republican presidential candidate Mitt Romney, has in the past also published research favorable to NGDP targeting, although he has to our knowledge not weighed in on the current debate.

Actually, Greg Mankiw in a recent Brookings Paper argued for macroeconomic policy that amounts to a NGDP target.  In his own words: 

This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth.

Other long-time, right-of-center proponents include Tyler Cowen and Alex Tabarrok--their Modern Principles of Macroeconomics textbook has an innovative AD-AS model that is conducive to making the case for a NGDP target--as well as the recently deceased William Niskanen  of Cato Institute.  National Review Senior Editor Ramesh Ponurru could also be considered a long-time advocate since he has supported George Selgin's NGDP target for some time. More recently, though, he has become very vocal in his calls for the loosening of monetary policy via a NGDP target (see here, here, here, and here) and has opened the pages of the National Review to us Market Monetarists (see here, here, here, and here).  More recent endorsements for a NGDP target come the CATO Institute's Tim Lee.  Bruce Bartlett and the folks at FrumForum are also in favor of something like a nominal GDP target.  And then there is all the blogging by the Market Monetarists who tend to be right-of-center.  So yes, there is growing political support from both sides. The problem, though, is that on the right we have a uphill battle against the hard-money view.