Killing two birds with one stone
By Scott Sumner
Over the past 10 years, there’s been increasing support for NGDP targeting in academia, the media, and among policymakers in DC. But there seem to be two sticking points that prevent it from being adopted as the Fed’s new policy target:
1. What if trend GDP growth changes? Won’t inflation become unanchored?
2. Isn’t inflation targeting much easier to communicate? Most people don’t even know what NGDP is.
It turns out that both of these objections can be easily addressed with a slight tweak of the NGDP targeting regime. This tweak might reduce the effectiveness of the policy very slightly, but it would still be a substantial improvement over the current regime.
I’ve previously suggested a fixed NGDP target growth path, say 4%/year. Instead, the Fed could adjust the target path every few years to reflect changes in the estimated rate of trend
NGDP real GDP growth. The target growth path would be estimated trend real GDP growth plus 2%. This would keep long run inflation quite close to 2%, while allowing inflation to move up and down in the short run to help stabilize the economy when there are supply shocks. Fortunately, the trend rate of growth tends to evolve gradually over time. Thus you might have a 4.0% NGDP target for 5 years, then a 4.2% for the next 5 years, and then a 3.9% target path for the next 5 years. Those modest adjustments would not create large business cycles, but would keep long run inflation close to 2%.
Here’s how the Fed should sell its new policy regime in January 2020, when their current policy review is completed:
1. We will continue to have a 2% long run PCE inflation target.
2. We will continue to allow short run deviations from the 2% inflation target as needed to address the other side of the dual mandate, high employment.
3. However, we will no longer use “output gap” models to determine our short run deviations from 2% inflation. Rather we will stabilize NGDP growth at roughly 4% as the preferred method for achieving the employment side of our mandate.
4. While the target rate of NGDP growth will initially be set at 4%, the target growth rate path will be adjusted periodically, as needed to keep long run inflation close to 2%.
This is no harder to communicate than the current regime. Consider the fact that the current regime has a simple and understandable 2% long run inflation target and a complex method for addressing the employment side of the dual mandate, which most people don’t understand. The new system would have a simple and understandable 2% long run inflation target and a slightly less complex method for addressing the employment side of the mandate, which many people still won’t understand. The all-important financial markets can understand either target, but NGDP is simpler.
How can they be so similar? It’s simple. Even under a non-NGDP targeting regime, a successful implementation of policy, i.e. success on the dual mandate, will as a side effect produce a stable path of NGDP. So the advantage of NGDP level targeting is not so much that you are trying to achieve a radically different outcome, rather it’s primarily a method for better achieving what you are already trying to do. (It is substantially different from a simple inflation target, but the Fed now treats employment as equally important in the dual mandate.)
Yes, my modified proposal is not ideal. But it’s less far from ideal than you might assume. George Selgin has persuasively argued that the optimal NGDP growth rate should vary with changes in the growth rate of the labor force–but not productivity. But much of the recent slowdown in trend GDP growth in the US is due to a sharp slowdown in the growth rate of the working age population. So it’s quite possible that this modified regime, which appropriately responds to changes in the labor force growth rate and inappropriately responds to changes in productivity growth, is actually superior to a simple NGDP targeting regime that appropriately does not respond to productivity changes but inappropriately does not respond to changes in the labor force.
Also keep in mind that only long run changes in trend productivity would change the target path, not short run (cyclical) changes such as an oil shock. So it really is almost as good as a simple NGDP growth rate level target.
Over time, as people became comfortable with the new system it could be tweaked again, closer to what Selgin (correctly) argues is the optimal regime. Changes in the NGDP target could be made only on the basis of changes in the growth rate of the labor force, not productivity.
I understand that the Fed may be reluctant to leap into a radically new regime like NGDP targeting. But if they actually believe it’s as good a system as David Beckworth and I think it is, there are ways of putting their toe in the water and getting there in stages. One needs to think about what sort of gradual steps in that direction can be most easily communicated. In this post I’ve tried to show that there are very useful steps that would both substantially improve monetary policy and yet be easy to communicate, even if they fall a bit short of the ideal regime.
Don’t let the perfect be the enemy of the good.
PS. And I didn’t even mention another problem with inflation targeting, it’s much harder to communicate than most people assume. The public thinks it’s about keeping inflation low, and doesn’t understand the “symmetrical” nature of the target. Hence Bernanke faced a firestorm of criticism in 2010 when he announced the intention of trying to raise core inflation from 1% to 2%.