When is nominal GDP targeting optimal?
Commenter Felipe sent me to an interesting Jeffrey Frankel post on NGDP targeting:
There are good reasons to think that NGDP targeting is better suited to emerging and developing economies than to industrialized countries. These economies are more frequently subject to adverse terms-of-trade shocks, such as increases in world oil prices or declines in prices for their commodity exports. Their economies also tend to suffer larger supply shocks from natural disasters, other weather events, social unrest, and unexpected productivity changes.
The advantage of a nominal GDP target is that adverse shocks of these sorts are reflected equally in output and inflation, rather than imposing the entire burden in the form of a loss in output. This provides the sort of response that one would want anyway, while still retaining the advantages of a rule (communicating the central bank’s plans in such a way that it can live with what it has promised to do).
There’s clearly some truth to this, but on balance I believe that the case for NGDP targeting in emerging economies is actually weaker than in developed economies. Let’s take an extreme example of a terms of trade shock for a commodity exporter. Suppose the price of oil doubles, and the quantity of oil exports is unchanged. Under NGDP targeting a country like Saudi Arabia would have to sharply contract the non-oil sector of the economy. At first glance that might not seem so bad, one sector is booming while the other contracts. But note that oil production is far less labor intensive than other sectors such as services. Indeed even if we relaxed the constant output assumption for oil, and allowed Saudi oil output to increase, it is quite likely that NGDP targeting would lead to sharply lower total employment if Saudi Arabia was hit by a positive oil price shock.
For emerging markets with large and volatile commodity export sectors, I have suggested targeting total domestic nominal labor compensation, which is the largest component of NGDP. This will smooth out employment fluctuations and also keep inflation low in the long run. Indeed I think a good argument can also be made for targeting nominal compensation in developed countries like the US, but the advantages over the much for familiar and easy to explain NGDP targeting are less clear.
Patrick Sullivan directed me to a post that is mildly critical of NGDP level targeting, by Stephen Cecchetti and Kermit Schoenholtz:
The large gap highlights an important aspect of nominal GDP targeting: when the trend rate of real economic growth rises or falls, the implicit inflation objective also changes (in the opposite direction). The policy question is whether that is desirable. Would the Fed reduce systematic (undiversifiable) risk in the economy by stabilizing nominal GDP if doing so raises uncertainty about future inflation and the price level? Doing so conceivably protects debtors who anticipated a certain level of future income, but it also complicates decisions for households and firms who must distinguish relative price changes from inflation surprises in order to make efficient choices.
All of this leads us to conclude that returning to the price path implied by the pre-crisis trend is a realistic possibility. Returning to the earlier nominal GDP path is not. That said, the inflation overshoot that our rough calculations suggest is moderate, so the benefits are likely to be limited. But the costs could include a loss of credibility in the inflation-targeting framework. Would that really be worth it?
Let’s start with the idea of returning to the pre-2007 trend line. Given the amount of wage and debt contracts that have been negotiated since 2007, I’ve argued that it would now be destabilizing to go all the way back to the pre-2007 trend line. Of course if NGDP targeting, level targeting, had been in effect in 2008 the recession would probably have been much milder. But that raises another problem, implicit in the Cecchetti and Schoenholtz quote—trend growth has slowed since 2007, and hence a 5% path of NGDP which would have led to roughly 3% real growth and 2% inflation over the previous 100 years, might well lead to 1% to 2% RGDP growth and 3% to 4% inflation over the next few decades. Would that be undesirable?
Put aside the question of whether 5% is too high. A number of economists have argued that a stable path of NGDP is more likely to produce economic stability and debtor/lender fairness than a stable price level path. George Selgin’s “Less than Zero” is perhaps the best study of this subject. Because most debts are nominal, borrowers and lenders are more concerned about nominal income shocks than price level shocks, a point acknowledged by Cecchetti and Schoenholtz. However labor markets are also better stabilized with NGDP targeting than with price level targeting.
Consider the following example. From mid-1963 to mid-1968, inflation rose from a 1% to 2% range up to a 4% to 5% range. The same thing occurred from mid-2003 to mid-2008. But surely the public should have treated these two cases very differently. The first example was a powerful demand shock, which caused NGDP growth to accelerate. In the second case it was mostly an adverse supply shock, and by mid-2008 NGDP growth was slowing sharply even as inflation peaked at nearly 5%. Not surprisingly, workers responded to the first shock by increasing their pay demands sharply (with a lag), whereas in the second case wage growth remained fairly modest. In the long run wages follow NGDP more closely than the price level.
Of course wages are only one of many relative prices in the economy. But I’d argue they are the most important, largely responsible for the business cycles. If inflation is unstable then consumers will have a difficult time ascertaining relative price changes for toothpaste and cars. But is this actually a big problem? On the other hand if NGDP growth is unstable then the relative aggregate wage level will move to a suboptimal position—which really is a big deal.
Over at TheMoneyIllusion I just did a post showing that Keynes favored thinking in terms of NGDP and employment, not inflation and real growth. Back in the 1970s I also studied the models of inflation shocks, and I do understand the underlying assumptions that led most New Keynesians to favor inflation targeting. But I fear those assumptions are wrong, and I believe the events since 2008 have exposed a serious weakness in the inflation targeting approach. Some of those flaws could be fixed if we moved to price level targeting, as discussed by Cecchetti and Schoenholtz, but not all.