A James Alexander post
We have already posted 0n the growing debate in the Euro Area on NGDP Targeting. The first of three papers was leaked in September and Scott Sumner commented on its positive case for NGDP Targeting. The other two papers presented to the European Parliament argued against. The first was from a French team that we have already dealt with, the second is by Andrew Hughes Hallet (AHH) of the University of St Andrews.
The case for NGDP Targeting
AHH first sets out some weak arguments for NGDP Targeting and then criticises each one in turn. It may just be me but I got the feeling Hughes Hallett’s heart was not in the game. It seemed to consist mostly of arguing that Inflation Targeting or a revised version of the Taylor Rule was superior. So the case “for” starts with this not so open-minded assumption:
“It is undeniable that nominal income targets will deliver worse inflation outcomes on average than a single (inflation) target regime or an inflation focussed Taylor rule.”
It is unclear why this should be so when you consider the actual, even if unintended, consequences of IT or an IT-focused Taylor Rule. Theory may be one thing, but practice delivers something else. IT targets have become rigid ceilings delivering very poor outcomes for inflation, on the low side. Where has Hughes Hallett been for the last few years?
More from the case “for”:
“So, to say that nominal income targeting is suitable is not to say that better rules cannot be found, especially when some flexibility is needed.”
Well, you could adopt flexible NGDP Targeting too. All he is really saying is that flexible rules are flexible, and this may be a good thing.
But what exactly is a flexible rule? Flexibility risks huge discretionary mistakes, as when “inflation nutters” (arguably Trichet) or “macropru nutters” (arguably Mervyn King, or even Ben Bernanke’s Fed) are at the monetary controls. The phrase actually comes from a (gated) Meryvn King paper arguing most central banks weren’t “inflation nutters” quoted favourably by the French team.
Hughes Hallett is a classic example of the strange and strong desire of the mainstream macroeconomics profession to not even consider the possibility of gross errors by central banks in recent times. I suppose it is still much more than their jobs are worth to challenge openly central bank authority.
“A positive demand shock for example will raise both incomes and prices. Higher interest rates, the response of inflation targeting, is the right response for both problems. A nominal income targeting rule will react the same way, although possibly more vigorously because it is acting against both excess prices and greater output. This raises the possibility of overcompensation and induced instability.”
But what is this “positive demand shock”? It’s hard to think of one except perhaps a fiscal policy expansion, but these need to be seen as permanent and not likely to be offset by monetary policy tightening as usually happens. In any case it’s unclear why higher (presumably real) income is seen as a “problem”. It’s a good thing, isn’t it?
It’s hard to bring about a permanent overshoot in nominal income that needs correcting that is not caused by some previously easy monetary policy. Real events don’t cause permanent inflation or excessive nominal growth, only monetary authorities can achieve this outcome.
“Nominal income targeting can be expected to help limit asset price bubbles.”
I’ve never heard this claim made by advocates of NGDP Targeting. However, this is a good thing for Hughes Hallett.
The case against NGDP Targeting
Having turned a weak case “for” NGDP Targeting into the case against and thus not really given a fair hearing to NGDP Targeting Hughes Hallett moved to its drawbacks. There seems to be only one as far as I can judge:
[paraphrasing] Real output data is late and subject to heavy revision versus CPI data that comes out up to one year earlier and is not subject to revision. The output gap is equally hard to measure.
Well, this is just a bit silly, as we have shown before, CPI data is not proper macro data precisely because it is not revised. It is simply not credible to use these figures for steering an economy, real time or looking forward. The GDP deflator is a high quality number and is, obviously, revised, like all quality macro data. CPI is not revised due to politics and other factors related to linkages to financial contracts, pensions etc.
In any case, NGDP Targeters favour targeting the forecast, expectations, just like most mainstream Inflation Targeters including, supposedly, the Bank of England. The question of data reliability of NGDP Targeting misses this really important point.
NGDP Targeting is about ensuring nominal stability, it claims nothing about the “output gap”. This is a concept that can happily be left to economic historians. If NGDP turns out to have been 5% inflation and 0% real no great harm is done, if it turns out to be 5% real and 0% inflation, then whoopee! What is seriously dangerous is too low NGDP growth because of the risks of negative demand shocks causing horrific recessions and unemployment.
The weakness of Hughes Hallett’s argument is shown by his sympathetic summing up of the case against:
… it is not difficult to agree that nominal income targeting makes a great deal of sense as a policy regime. It is simple and intuitive. But the practical difficulties involved in measuring the output term in real time, defining the output target accurately, explaining the necessary revisions, make it a difficult and risky rule to maintain in practice.
The next major section (3.1) of Hughes Hallett’s report is hard to follow. He seems to claim that NGDP Targeting is optimal when labour supply is totally inelastic, and most effective when it is highly inelastic. Then he also claims that it becomes progressively less effective “as the elasticity of labour supply responses diminishes”. Perhaps there are some typos here.
Section 3.2 acknowledges the role of markets in targeting, but says the Bank of England already does this by targeting inflation two years out. One of the current Deputy Governors of the Bank of England has recently shown that the BoE in its actual interest rate decisions targets real output and not inflation. This is a confusing situation at the very least.
Hughes Hallet then dismisses level targeting as an objective by quoting a 2013 ex-BoE MPC member Charles Bean speech that argued there would have to have been a 15% extra growth in 2008-12 to make up for losses in the recession. Maybe. But the real argument is that a clearly signalled level target in place from before the recession would probably have meant no recession, or at least a very quick recovery. And Bean was a key member of the now discredited team at the BoE operating under the “marcopru nutter” Meryvn King.
Section 3.3 appears to take issue with a claim that NGDP Targeting would promote more discipline. It is a rather obscure discussion and not a claim with which I am familiar. Discipline, to what end?
Section 3.4 frets about dual mandates and how to prioritise them. NGDP Targeters urge monetary policymakers not to fret and just target NGDP and let the long run and/or markets and/or governments sort out the balance. It is not the role of central banks to be the arbiter in this debate about the shares of inflation and real growth in nominal growth. Central banks should merely maintain nominal stability to prevent low nominal income (or GDP) expectations, given sticky wages, being the problem they so often are. All else is noise.
Section 4 sets up a model that shows how precisely executed inflation targeting or a modified Taylor rule work, not only well, but perfectly. Just like the French contribution to the debate that we have already highlighted, but they are far from being precisely executed. Discretion ruins the theory in practice.
NGDP expectations targeting is far more likely to work well and not get hijacked by inflation or macropru “nutters”, using their discretion to follow their own, unintentionally anti-prosperity, ends.
The summary is fairly balanced:
From the ECB’s point of view, nominal income targeting is a feasible regime, but probably with as many drawbacks as advantages. On the positive side: it is easily understood, it accommodates beneficial supply shocks, provides stronger responses in bad times, and is a more efficient rule when supply responses are limited or structural reform is needed.
The “on the other hand” bit that follows is quite weak, as we have just shown.
The drawbacks are: inflexibility, problematic policy responses when prices and output react at different speeds, it may overreact or destabilise, and is robust to real time measurement errors. In addition, it appears to be less effective than the flexible form of Taylor rule that the ECB now uses. Nominal income targeting may be feasible, but probably not desirable.
The idea that “it appears to be less effective than the flexible form of Taylor rule that the ECB now uses” is just so remarkably optimistic, idealistic even. The evidence is primarily in the appalling track record of the ECB with its two bouts of disastrous rate rises in 2008 and 2011. Further evidence is the potential tragedy being played out in real time due to the ECB being so trapped by its rigid, and completely inflexible, ceiling of its “close to, but not above, 2%” inflation target. Draghi struggles heroically to offset the trap with huge amounts of QE and we and the markets watch with dread fascination how it will play out.
While it is really welcome to see the French team and Hughes Hallett taking an interest in NGDP Targeting, even if a somewhat critical one, these issues are just too important to be left to ivory tower academics alone.