Reply to Jerry O'Driscoll
By Scott Sumner
Marcus Nunes directed me to a post by Jerry O’Driscoll, which asked the following questions:
The specific question I pose for advocates of NGDP targeting is how today will anything the Federal Reserve does to its balance sheet alter the growth rate of NGDP in a predictable fashion? The answer to such a question could be that the central bank should do more. How much more? And what, then, becomes of the rule? It sounds like a recipe for discretion. In any case, central banks have been unable to get either component of NGDP to grow in a normal or predictable manner.
Before answering this question, let’s take a look at NGDP growth in the US:
Notice that NGDP growth became more stable after the mid-1980s. There are many possible explanations, but I believe one factor was the Fed’s adoption of something close to the Taylor Rule. Then NGDP plunged sharply in 2008-09, and the recovery was rather disappointing. So how can we do better?
1. Make policy more effective when the economy is not at the zero bound.
2. Address the zero bound problem. Most economists believe that at least part of the problem since 2008 is that the Fed becomes less effective at the zero bound.
Let’s consider the zero bound problem first. There are two basic approaches to dealing with the zero bound:
1. Dramatically increase the supply of base money.
2. Reduce the demand for base money.
A reduction in base money demand can be done in one of two ways:
1. Raise the trend rate of growth in NGDP/inflation and/or adopt level targeting.
2. Adopt the sort of negative interest rate policy recommended by Miles Kimball.
So there are clearly lots of ways of addressing the zero bound problem, but not surprisingly they are all a bit controversial. Ideally, Congress should instruct the Fed on which approaches are better, but at this point Congress does not understand the problem. Thus Janet Yellen needs to go to Congress and say that the Fed will have to adopt one of those three policies during the next recession, or else monetary policy will fail. I suppose we can consider failure an option, and hence the Fed has 4 options. Yellen should tell Congress that in a perfect world Congress would instruct the Fed as to which option or options it prefers, but if they do not do so then the Fed will be forced to choose on its own. In that case, the Fed should do what it thinks best.
In my view, the best option is something like a 4% NGDP target path, level targeting, maintained by a “whatever it takes” adjustment in the Fed’s balance sheet. But the other options (an even faster NGDP growth rate and/or negative interest rates), are also clearly preferable to failure.
So once we solve the zero bound problem, how do we address the discretion issue that Jerry worries about?
1. I prefer using NGDP futures to guide monetary policy. This removes discretion. There are intermediate (hybrid) policies that could also be considered, as when NGDP futures provide guardrails, and the Fed has discretion within those guardrails. Perhaps discretion within 3% and 5% expected NGDP growth.
2. A switch to level targeting would automatically tend to reduce discretion somewhat, as under level targeting there could no longer be hawks and doves at the Fed. The concept would be meaningless.
3. If the Fed insists on continuing to do what it did in the period 1984-2007, then policy will not be optimal, but I do think that this policy regime was reasonably effective at producing fairly stable NGDP growth. And even under discretion, it’s possible to improve policy through level targeting, the ending of interest rate smoothing, and the adoption of Lars Svensson’s proposal to “targeting the forecast”, which means always maintaining equality between the goal of policy and the Fed’s own forecast of future NGDP. In late 2008, that criterion would have required buying enough assets to insure that expected mid-2010 NGDP exceeded mid-2008 NGDP by the policy target (say 8% or 10%, if the NGDP target growth rate had been 4% or 5% per year.)