History shows that an explicit NGDP level target is much better than IT

David Beckworth has a very good article “Inflation Targeting – A monetary regime whose time has come and gone.”  A very short summary of the argument is given here:

What, then, would characterize a robust monetary-policy regime? Based on the discussion above, it would be one that does not respond to supply shocks, but does vigorously respond to demand shocks. The problem with an inflation targeting central bank is that it has a hard time ignoring supply shocks because they move inflation. The central bank should only respond to inflation caused by demand shocks, but it is hard to distinguish the source of inflation movements in real time. One way to get around this problem is to directly target demand itself. That is, the Federal Reserve could aim to stabilize the growth of total dollar spending. This way the Federal Reserve would not have to worry about divining the sources of movements in inflation.

Note that the price level times real GDP is equal to total dollar spending. That is, the dollar price of everything produced and sold equals, by definition, the total number of times money is spent. This relationship implies, then, that if the Federal Reserve directly targeted the growth of total dollar spending it would by default be allowing the price level to move inversely with productivity-driven changes in real GDP. This would amount to a monetary-policy regime that ignores supply shocks.

To be clear, ignoring supply shocks means allowing such shocks to be reflected in relative price changes. No attempt is made to offset them or their effect on the price level. Ignoring supply shocks also means allowing market interest rates to more closely track the market-clearing or natural-interest-rate level. Doing so reduces financial instability.

To see this, recall that a positive productivity shock pushes up the natural interest rate. A central bank that targeted the growth of total dollar spending would have to raise its interest-rate target to keep spending stable. This is because the higher productivity growth would raise expected profitability for firms and expected income for households, and thus encourage them to spend more. Raising the interest rate target to its new natural rate level would ensure their spending did not get too excessive. An inflation-targeting central bank, on the other hand, would be tempted to lower its interest-rate target because of the disinflationary pressures created by the productivity shock. This is, arguably, what the Federal Reserve did between 2002 and 2004. As discussed earlier, pushing market interest rates below their natural interest rate level will lead to unwarranted capital accumulation, excessive reaching for yield, too much leverage, soaring asset prices, and a buildup of financial imbalances. A total dollar spending target would avoid this temptation because it would focus on stabilizing expenditures, not the price level. It therefore would better promote financial stability.

David was terribly smart! He has convincingly brought “financial stability” under the umbrella of NGDP level targeting. Now that central banks in general and the Fed in particular are worried about the consequences for financial stability flowing from unconventional monetary policies, with the Fed actively discussing if “financial stability” should be an additional mandate, an NGDP level target proposal makes even more sense!

In the last paragraph of the summary above I highlighted the word “arguably” because what I want to do here is tell an alternative story about the 2002-2004 period. This story does not in any way invalidate David´s argument and the implied usefulness of NGDP level targeting for financial stability.

The chart shows the progression of total factor productivity (TFP).

Notice how the period of the “Great Inflation” (1966-82) was a productivity “stopper”. After that TFP rises robustly until 2000 at which point it begins to rise much more gently. It thus appears that the years 2002-04 did not witness a “productivity shock”. It also implies that during a significant part of the “Great Moderation”, the high rate of TFP growth did not complicate the fulfillment of nominal stability by the Fed, since during that time aggregate nominal demand (NGDP) evolved pretty closely to a stable trend level path.

The chart below shows the NGDP gap, the distance of actual NGDP from trend over the period 1992-05.

The takeaway from this chart is that the period 1998-03 was one of nominal instability. First NGDP rises strongly above trend and then drops significantly below trend. At the beginning and end points, NGDP is very close to trend.

So the period of “too low for too long” rates that is supposed to have caused so much havoc doesn´t square with the facts. Interest rates could not have been “too low” because NGDP was falling below trend. In fact, falling rates were not taking NGDP back to trend. That only happened when the FOMC adopted “forward guidance” in its August 2003 meeting.

Why did nominal instability take hold after 1998? To answer that question recall that the Asia crisis of late 1997 was a (worldwide) negative aggregate demand shock. By the end of 1998, for example, the price of oil had dropped to $ 10/barrel (in real terms that price was lower than the price that prevailed before the first oil shock of late 1973!).

Look at what happened to inflation. Inflation was trending down (consistent with the steeper TFP trend). Suddenly inflation “crashes”. That was not due to a productivity shock, but to a strong contraction in worldwide aggregate demand (AD).

At the time, the US was the only large economy in condition to help offset the AD shock. If you look at the US current account (CA) you will see the CA deficit begin to rise strongly at that point, facilitating the adjustment of the Asian economies.

The next chart shows that at the time money velocity falls. But the Fed stepped too hard on the monetary pedal, so that broad money supply more than offset the rise in money demand, resulting in nominal spending rising far above trend. Later, the Fed stepped too hard on the brake so that nominal spending fell far below trend. Forward guidance succeeded in correcting the situation, with nominal spending rising back to trend by the time Greenspan ended his tenure.

If the Fed had an explicit NGDP level target any instability would have been much more contained. It also shows that, after Greenspan, with the FOMC focusing much more narrowly on inflation, and given the supply side nature of the shocks that took place, things have gone very, very badly!

PS Simon Wren-Lewis has a good post: “Why macroeconomists, not bankers, should set interest rates”. But instead of:

To most macroeconomists, the theory of monetary policy is pretty straightforward. Interest rates should be set at a level which closes the output gap, which can be defined as the level of output and unemployment that will keep underlying inflation constant. We can call this real interest rate the Wicksellian natural rate. The difficulty is not in the concept, but in the practice of putting numbers to this concept when inflation is noisy, the output gap is hard to estimate, there are lags in the system etc etc.

I would prefer, as David Beckworth argues:

A total dollar spending target would focus on stabilizing expenditures, not the price level. It therefore would better promote financial stability.