Almost 20 years ago Stanley Fischer gave his views on Central Banking in “Central Bank Independence Revisited” American Economic Review, 1995:
“In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run–albeit with long-run targets and consequences in mind. Nominal- income-targeting provides an automatic answer to the question of how to combine real income and inflation targets, namely, they should be traded off one-for-one…Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to imply a better automatic response of monetary policy to supply shocks…I judge that inflation-targeting is preferable to nominal-income-targeting, provided the target is adjusted for supply shocks” [not easy or even “practical”].
Fast forward: In a speech in April 2013, just before stepping down from Governor of the Bank of Israel, Fischer said:
In the past 20 years, an approach to monetary policy has developed in which the central bank must strive for a flexible inflation target. Over time, this belief has become an almost religious imperative. However, in the US, the law defines a dual mandate for the central bank, according to which it must give equal weight to real activity and inflation. The Federal Reserve recently surprised observers when it announced that it would continue its quantitative easing until the unemployment rate reaches 6.5 percent, on condition that inflation does not reach 2.5 percent. They did this despite the natural tendency of every central banker to try not to give quantitative targets to his policy. I was surprised by the fact that the Fed was ready to give a forecast to monetary policy with a range of more than 2 years, since in general it is very hard for us to forecast developments at such ranges.
The world with which we must deal is the world of the next quarter, not just the world of after the storm is past. The central banks tend to focus on the inflation target since it is easier to forecast that in the long term we will stand at the target inflation rate, and it is harder to forecast developments in (real) GDP or unemployment.
I believe that the fact that the most respected central bank in the world set itself a quantitative target for real activity without being asked to do so by the government will lead other central banks to set such goals. This will confuse the life of the central bankers, but that is what they pay us for.
There are those who support setting a nominal GDP target. I think that this is very impractical. The data that we receive on nominal GDP are very unstable. There are changes of whole percentage points between the various estimates of GDP. For this reason, I think that there is no reason to use nominal GDP as a target.
Interesting to observe that for “most respected central bank in the world set itself a quantitative target for real activity without being asked to do so by the government”, is “fine and practical”; but to set a target for a nominal variable isn´t! [although he thinks adjusting the inflation target for supply shocks is]
Ironically, as Governor of the Bank of Israel from 2005 to 2013, Stanley Fischer (managed) to keep NGDP growing at a stable rate along a level path!
As he wrote in 1995: “Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to imply a better automatic response of monetary policy to supply shocks”.
And that perfectly explains the difference between what happened in Israel and what came about in the US as the charts indicate. While in the US the rise in oil prices led the Fed, (for fear of inflation) to “tighten” (constrain aggregate nominal spending (NGDP or Aggregate Demand (AD)), in Israel NGDP remained “on trend”. The result was a deep recession in the US while Israel experienced only a real growth slowdown.
And it´s not like Bernanke was not aware of the effects of supply shocks. In 1997 he had written:
The results are reasonable, with all variables exhibiting their expected qualitative behaviors. In particular, the absence of an endogenously restrictive monetary policy results in higher output and prices, as one would anticipate. Quantitatively, the effects are large, in that a nonresponsive monetary policy suffices to eliminate most of the output effect of an oil price shock, particularly after the first eight to ten months. The conclusion that a substantial part of the real effects of oil price shocks is due to the monetary policy response helps to explain why the effects of these shocks seems larger than can easily be explained in neoclassical (flexible price) models.
Bottom Line: When the time comes, knowledge has to be used.