Over at TheMoneyIllusion I did a post discussing Steve Ambler’s presentation on NGDP targeting, and Nick Rowe’s subsequent discussion. Now I’d like to address some concerns expressed by Stephen Williamson.
One concern is that NGDPLT (or average inflation targeting) might be rather complicated to communicate. I believe that’s true of average inflation targeting, but not NGDPLT. Williamson mentioned that each year there would be a different NGDP target growth rate, depending on whether current NGDP was above or below the target path. But I believe it’s a mistake to think in terms of growth rates when evaluating a level targeting regime.
Consider the analogy of exchange rates under the Bretton Woods regime. The British pound was targeted at $2.80, plus or minus 1%. In my view that’s a very simple and easy to understand system. But if you consider the exchange rate in terms of growth rates, it might seem very complicated. Thus if the current exchange rate is $2.82, (i.e. slightly overvalued) then the Bank of England might be said to “target a negative growth rate of the exchange rate” until the pound returns to $2.80. The opposite would be true if the exchange rate were currently $2.78. And how long would it take to return the exchange rate to the target?
I favor a system where the Fed targets 12-month forward NGDP at exactly the rate implied by a predetermined target path, growing at 4% per year. The focus should not be on current NGDP, or the expected growth rate over the next 12 months, rather the focus should always be on the expected level of NGDP in 12 months. And that expected value should always be equal to the target value. In other words, monetary policymakers should “target the forecast”. Over time, I believe that people would begin to think in level terms, just as with they did with exchange rates under Bretton Woods.
If 12 months is too short (arguably true in the special case of Covid-19) then use a 24-month forward target. But even with inflation targeting there will be special cases, as with severe supply shocks.
Williamson also argued that NGDPLT might lead central banks to adopt a “lower for longer” policy after an event like 2008, as both RGDP and inflation would be below trend. In contrast, with an inflation target the central bank need not make up for depressed RGDP. (Actually, with the Fed’s dual mandate that distinction is less clear, but I’d like to focus on some other issues.)
I have two responses to the questions raised by Williamson:
1. I believe it’s incorrect to treat the severe NGDP gap of 2008-09 as a given. In my view, the big drop in NGDP was mostly caused by the Fed’s unwillingness to adopt a policy of 5% NGDP level targeting in 2007. Had such a policy been in place, the drop in NGDP during 2008-09 would have been far smaller. This is consistent with models developed by Michael Woodford and others, where current levels of aggregate demand (NGDP) are heavily dependent on expected future aggregate demand, i.e. expected future path of monetary policy. In 1933, FDR raised current gold prices by promising to raise future gold prices. Then in 1934, FDR did raise the price of gold from $20.67 to $35/oz. If the Fed promises to quickly push NGDP back to the 5% growth trend line, then NGDP will fall less sharply below the trend line in the short run. (Of course that’s not to say there wouldn’t be a recession in 2008-09, but it would have been considerably milder.)
2. I believe it is a mistake to assume that if a central bank did X and fell short of its inflation and/or NGDP goal, it would have had to do 2X or 3X to have hit the goal. My claim sounds counterintuitive, but in fact my argument has an affinity to NeoFisherian ideas that have been developed by Williamson. The very low interest rates of 2009-15 to some extent reflected the low levels and growth rates of nominal GDP during this period. With higher NGDP and/or faster expected growth in NGDP, the equilibrium (natural) interest rate would have been higher in nominal terms, perhaps allowing the central bank to hit its policy target with a higher policy interest rate.
In 2001, Lars Svensson proposed a “foolproof” method for Japan to escape its liquidity trap. Svensson’s proposal called for a one-time depreciation of the yen, but the most important part of the proposal was that the yen would subsequently be pegged to the US dollar. In the long run, this would raise Japan’s inflation close to US levels, due to purchasing power parity. But due to interest parity it would also raise Japan’s nominal interest rates up to US levels, which were still well above zero back in 2001. I believe Williamson would recognize Svensson’s proposal as being NeoFisherian in spirit, even though Svensson himself is a New Keynesian. Svensson reassured his readers that the policy would be expansionary “in spite of” of higher Japanese nominal interest rates, but a NeoFisherian would say there’s no need to say “in spite of”.
Monetary policy affects interest rates in two ways. First, policy can target a short-term interest rate. Second, a change in the policy regime can impact the equilibrium or natural rate of interest. In monetary policy models, the policy stance is often described as the difference between the policy interest rate and the equilibrium rate. My argument is that a shift to a 5% NGDPLT target path in 2007 would have radically boosted NGDP growth expectations during 2008. Actual NGDP expectations fell sharply in the second half of 2008, even for 2009 and 2010. With NGDPLT, expectations for future NGDP would have held up better during 2008, and thus the equilibrium interest rate would have been higher.
This does not mean that the Fed could have gotten by with a higher target interest rate. We know that the actual target rate was too high to maintain adequate NGDP growth (or even 2% inflation) in 2009. So we needed a lower interest rate relative to the equilibrium rate. Whether we needed a lower interest rate in absolute terms is uncertain. If a switch to NGDP level targeting had raised the equilibrium interest rate in 2008, then the effect on the actual short-term interest rate would be ambiguous. It depends on whether the Keynesian effect or the NeoFisherian effect was dominant.
We should never assume that if low rates and lots of QE failed, then even lower rates and even more QE would have been needed to hit the target. That’s one option, but regime change is another. The Australian central bank did not cut rates to zero, and didn’t do any QE, and yet completely avoided recession in 2008-09. A credible and successful policy of maintaining adequate NGDP growth expectations in the long run is the best way of keeping equilibrium interest rates above zero, and avoiding the need to do QE.
READER COMMENTS
Garrett
Sep 28 2020 at 3:52pm
I’ve been taking an Econometrics class so here’s another way I think about NGDP level targeting: The path of NGDP is currently non-stationary, which means that shocks (recessions) have a permanent impact on the mean. This makes business forecasting and planning difficult, as it’s not clear e.g. for a 30 year fixed mortgage what income levels will be 10/20/30 years from now.
If the Fed targeted the level of NGDP, then NGDP would become log-linear trend-stationary. This would allow the public to much more easily forecast future nominal incomes for better planning. So even if there were a recession in the future, businesses could still hire because they would know that future incomes would still be higher.
With discretionary growth rate targeting, whenever there is a shock it’s unclear to the public if a mean shift has occurred. This uncertainty leads to volatility and conservatism in investment and hiring.
Rajat
Sep 28 2020 at 4:29pm
I watched that session with Ambler and Nick and listened to Steve Williamson’s questions. I agree with you on the approach Williamson took to evaluating NGDP targeting – taking the fall in NGDP in 2008-09 as a given and then lamenting the fact that it would mean staying at zero rates for longer and ‘never getting off the ZLB’ or words to that effect. I think the main problem faced by NGDP proponents is that many critics simply don’t engage with your arguments. Williamson couldn’t make those criticisms if he had read one of your or Nick’s many posts on how having a level target and open-ended asset purchases would stabilise expectations and avoid the fall in NGDP in the first place and then lead to a faster rise in nominal rates afterwards. In fact, Nick made that very point as discussant before the questions began. So many people, from brilliant macroeconomists to fund managers to economic journalists seem willing to dismiss MM without proper engagement.
Ike Coffman
Sep 28 2020 at 4:34pm
My understanding of NGDP targeting is rudimentary, and I would admit that it is likely to be too complicated for my feeble mind to comprehend. But I do have a couple of concerns.
First, I understand that to apply NGDP targeting you have to kind of let interest rates float, which I understand would lead to much greater volatility, and likely large swings in interest rates. I think that would make planning involving debt (think mortgages) uncertain and risky. Timing would be key, to say nothing of the effect on national debt. I don’t see that as much of a positive.
Second, I understand the 2008 recession was due in large part to bundling risky, poor quality assets and pricing those bundles as if they were high quality, with brokers and dealers making huge profits on those deals (skimming profits off the top, so to speak, like in a banana republic). If the recession would not have occurred I would expect that practice to continue, and even to grow. It is claimed that NGDP targeting would have reduced the severity of that downturn, so I am wondering if that would have the effect of encouraging those questionable and risky practices. How can that be good?
My last concern is the increasing wealth gap, which seems to be accelerating under the COVID pandemic. Is there anything structural in NGDP targeting that would prevent the rich from getting richer and widening inequality?
Perhaps my concerns are easily countered due to my ignorance and stupidity. Scott is particularly good at exposing those, so I await his response.
Scott Sumner
Sep 29 2020 at 12:12pm
Ike, I believe that NGDPLT would result in less volatile interest rates, as interest rates tend to be correlated with NGDP growth rates (and levels).
NGDPLT would not affect wealth inequality, as that’s an issue that monetary policy is not capable of addressing.
I don’t believe that recessions are a useful way to discourage excessive risk taking, but that’s obviously a debatable point.
Scott Sumner
Sep 29 2020 at 12:12pm
Garrett and Rajat, Good points.
Iskander
Sep 29 2020 at 3:22pm
I don’t see how NGDP targeting is that difficult to communicate. And even if it is I don’t think it would be that costly for businesses to learn about it.
The gold standard was easy to communicate, but gold/silver bimetallism was not. Give me the latter over the former any day if it was necessary to involve lumps of metal in our monetary system.
Ivan Tcholakov
Sep 30 2020 at 5:40pm
1. NGDPLT might bring some stability, not so deep crises (I don’t see in this article a word about the self-stabilization feature of this kind of targeting), but I doubt that it will be used for solving the problem about the inflation “tax”. Targeting would be high. It seems to me, the benefit would be not enough to attract public enthusiasm.
2. Changing targets after 36-months would be better, don’t give the opportunity to any President to tweet too often about this matter. 🙂 The longer period seems like a rule-based targeting. One-year period for targeting is, well, discretionary policy.
3. The economy of the US Dollar is bigger than the economy of USA. This circumstance brings complications. I trully, radically love the idea for hard money, but initially NGDPLT should be watched for not tightening money-supply sharply.
Eventually, NGDPLT might be a useful idea for a transitional regime towards a gold standard.
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