Contrasting Inflation Targeting with NGDP Level Targeting

Given the recent increase in the number of articles or blog posts on NGDP level targeting (see, for example, here, here, here or here), I thought it would be useful to post an essay I wrote at the end of 2014 that compared NGDP-LT to inflation targeting. The piece is empirical, but I think the visual evidence is compelling,

Which is more reliable-1

Independent Fiat-Money Central Banks and ITs: A Toxic Combination

A Benjamin Cole post

The woeful record of independent fiat-money central banks and inflation targets is one of nearly universal economic asphyxiation. Everywhere on the globe where a central bank has an IT, one sees inflation below targets, deflation and anemic growth.

Right to it:

  • The Reserve Bank of Australia has an inflation target of 2% to 3%, but with inflation at 1% the RBA is below target. Growth is subpar—and this is the best of the lot.
  • Thailand has a1.5% inflation band around 2.5% IT, and has no inflation and subpar growth.
  • The People’s Bank of China has a 4% IT, and a 1.8% inflation rate. The nation is about at half of real growth rates when inflation was close to target.
  • The ECB has a 2% IT, and is in deflation perma-gloom
  • Japan has a 2% IT, and is in deflation perma-gloom.
  • The Bank of England has a 2% IT, and a 0.3% inflation rate. Growth is subpar.
  • Singapore has exchange-rate target on currencies that are ruled by ITs. The city-state nation most recently posted 0.3% QoQ growth and is in deflation.

Calling Inspector Clouseau

I see a pattern!

For that matter the Fed has a 2% IT on the PCE, often misperceived as a 2% ceiling on the CPI (perhaps even by FOMC officials). The Fed is below target and real growth in the U.S. microscopic. What a surprise!

Should not the macroeconomic topic of the day be,  “Why are global central banks nearly universally falling below their ITs while mired in slow growth?”

At this late date, why does anyone think an IT is a good idea? Where has an IT worked (with the possible exception of the RBA’s IT-band, a slightly less worse idea than an strict IT).

The sooner fiat-money central banks kill off ITs the better. They have not worked. Is that not reason enough?

Yes, NGDPLT’s would be better.

The oddity: For decades, there has been long-winded sermons on the risks of fiat-money central banks, one reason they were made independent. The premise, even in present-day literature, is that central banks have been loose, are loose, and want to be loose, to serve sinister statist-inflationist goals and populist madmen.

The reality? Independent fiat-money central banks have universally asphyxiated commerce through tight money.

How else to explain gathering global deflation and slow growth?

When will macroeconomic orthodoxy accept the reality?

Appearances can be deceiving

To many, the economy is strong enough to sustain a jolt of higher rates. Richmond´s Jeff Lacker is a case in point:

The U.S. economy appears strong enough to warrant significantly higher interest rates, Richmond Federal Reserve Bank President Jeffrey Lacker said on Friday.

Lacker, who is not a voting member of the U.S. central bank’s rate-setting committee this year, said he still favors raising rates sooner than later and that the Fed’s last policy meeting in July would have been a “good time” to tighten policy.

Speaking to a group of economists in Richmond, Lacker argued that a range of economic analysis suggests the Fed’s benchmark overnight interest rate – the federal funds rate – is currently too low.

“It appears that the funds rate should be significantly higher than it is now,” he said in the speech.

As the chart shows, for the past 23 years, inflation (PCE-Core) has been ‘cornered’.

Appearances Deceiving_1

What we dearly miss is some of the robust growth the economy experienced during the Greenspan years (1987 – 2005)

Appearances Deceiving_2

If 2% is not enough, don´t double it

According to the Economist:

…How might these problems be fixed? One possibility is simply to raise the inflation target to, say, 4%. Credibly enacted, that ought to alleviate the risk of impotence. If investors and consumers believe inflation will reach 4%, nominal interest rates should eventually rise to 5% or so even if real rates stay low. But rich-world central banks have undershot their targets for so long they may struggle to persuade the public to expect higher inflation. And a higher target would still leave central banks with a dilemma when economic growth and inflation diverge. Neither would it make up for big misses.

A more radical option is to move away from targeting inflation altogether. Many economists (and this newspaper) see advantages in targeting the level of nominal GDP, the total amount of spending in the economy before adjusting for inflation. A nominal-GDP target would allow for temporary variations in inflation. Downturns would be tempered by an expectation of protracted stimulus later on to make up lost ground. In better times, a rise in real GDP would provide the lion’s share of the required nominal-GDP growth and inflation could drift lower.

If interest rates “disappear”, Central Banks lose their relevance!

In Central Bankers’ Main Challenge: Staying Relevant – Decline in the natural interest rate gives authorities less ammunition to counteract economic shocks, Grep Ip writes:

When central bankers gather this week in Jackson Hole, Wyo., they will be consumed not with some pressing crisis in the global economy but by an existential threat to their relevance.

The threat stems from the realization that the sluggish economic growth that has prevailed since 2009 may be here to stay. If so, then so are today’s low interest rates.

For more than 8 years they´ve been shooting themselves in the foot, refusing to abandon their inflation target framework and the associated interest rate targeting (which now they desperately want to “normalize”).


Unwittingly, Conor Sen demolishes inflation targeting

Conor Sen discusses inflation:

Those who argue that the U.S. Federal Reserve should keep interest rates low typically point to the same piece of evidence: The central bank’s preferred measure of inflation remains below its 2 percent target, suggesting that the economy still needs stimulus.

What they ignore is that during the dot-com and housing booms of the 1990s and 2000s, this logic would have led to bigger bubbles — and bigger busts.

Stop right there.

That´s the best argument against inflation targeting!

In the late 1990s and early 2000s, the economy was buffeted by (positive) productivity shocks. That increases RGDP growth and reduces inflation. If the fall in inflation induces the Fed to adopt a more expansionary monetary policy, the result will be nominal instability.

But those were not straightforward times. Other relevant shocks were taking place. There was the Russia/LTCM shock of 1998, the oil shock of 1999 and Y2K (1999), terrorist attack (9/11/2001), the Eron et al also in 2001. In 2003-08 there were also back to back significant negative oil shocks.

Instead of gauging the stance of monetary policy by the up´s and down´s of the Fed Funds rate, you should look at the behavior of NGDP relative to trend.

The chart puts the NGDP Gap (the behavior of NGDP relative to its trend path) and PCE Core inflation.

C Sen_1

It seems that in its reactions to those shocks, the Fed initially “oversupplied” money between 1998 and 2000 and then, “undersupplied” money between 2001 and 2003. During most of that period, inflation remained below “target” because the positive supply shock was preponderant.

Then Conor Sen writes:

The bursting of the subprime bubble was particularly disastrous, forcing the Fed and Congress to take extraordinary measures to keep the financial system afloat and contain the economic damage. One can only wonder how much worse the episode would have been — and whether Congress would have found the political will to pay for even bigger bailouts — if the Fed had further fueled the boom by conducting even looser monetary policy. We should be glad the bubble got no bigger than it did.

He couldn´t be more wrong. What happened is that with the end of the productivity boom and the reemergence of a strong negative supply (oil) shock, core inflation ticked above the then implicit inflation target between 2005 and 2007.

But that was enough to bring on the inflation paranoia, which is quite evident in the 2008 FOMC Transcripts.

The result was that in 2008 monetary policy was severely tightened, with NGDP taking a deep and prolonged dive.

Now, you could ask: Why didn’t inflation become deflation? It certainly was on the way to that, but in 2009 the Fed reversed course and put NGDP growth back into positive territory. The chart illustrates.

C Sen_2

Something interesting to note: Since the crisis, core inflation has not behaved differently from what it did during 1997-2004, remaining mostly below target.

The difference is that now, instead of a productivity boom, we´re having a productivity slump. Inflation should be higher. It isn´t because NGDP growth has remained on a much lower path than before.

However, likely because the NGDP level path has been so much lower, opportunities for productivity enhancement investments have been rare. This has important feed-back effects and may be the main reason for the appearance of “feelings” of “Great Stagnation”.

At the end, Conor Sen confirms “inflation” as the proper target. But one that should be complemented by other indicators

Of course the Fed has to focus on inflation in making its monetary policy decisions. But officials should keep in mind that core PCE is not the only measure, and factor in other indicators such as employment and the behavior of asset markets. If they do so, the case for removing stimulus in the near future will look a lot stronger.

Life for the Fed and for the market would be much simpler if, instead of an elusive “inflation target”, the Fed targeted a trend level path for NGDP, much like it implicitly did from 1987 to 2007.

HT David Beckworth

Inflation targeting as voodoo economics

A James Alexander post

My last post was on the need to change the 2% inflation target to higher one or, better still, switch to  NGDP growth targeting. However, by even talking about inflation I feel it is easy to get sucked into a black hole of nonsense chatter about a concept so hard to practically measure.

Nominal GDP (as measured by the value of output, total income or total expenditure) is the reality. Real GDP is a highly artificial construct. And inflation is also a highly artificial construct, the mere residual between the reality of actual Nominal GDP and the artificial Real GDP. It is necessary to calculate some version of inflation to get from real Nominal GDP to artificial Real GDP.

To create a Real GDP figure the statisticians are meant to collect a huge number of price indices for each product, and then deflate the real or actual nominal value of output (ie sales) to derive a supposedly inflation-free “real” but artificial output figure.

Although they collect all these price indices they don’t create indices for the changing quality of each product. They should do. The price indices are thought of as “inflation”, but that is because of the assumption that the inflationary element of prices changes more quickly than quality or nature of the goods and services change. But how do we know? Has it been tested? Has it even been thought about in any methodical manner. I don’t think so. Occasionally, hedonistic or quality changes are incorporated into the price indices, but in a highly haphazard way. Statisticians do track changes in the basket of goods and services via surveys or by observing actual patterns of expenditure but can’t track changes in the nature of service – like a switch from learning on the job to learning at college, or a switch from spending on alcohol to spending on a gym, vice to virtue.

Of course, any quality or nature indices would create huge debates. But the price indices are largely meaningless without them. How can price inflation be observed without as much monthly effort going in to assessing the quality and nature of the product or service being tested.

Entertainment is the classic example, 15% of the CPI basket. The switches from street entertainers, to theatres, to movie theatres, to black and white television, to colour television, to broadband internet all involved major changes in product quality and very often the fundamental nature of the service. The pure inflation element may be able to be measured from one week to the next, but quality and nature also move ahead rapidly.  Transport, another 15%, is the same as walking gave way to horse drawn transport, to railways, to motor vehicles, to aircraft, to not travelling but having people and products brought to you virtually. The cost is not then transport but the cost of the broadband connection. Restaurants and hotels, 10% of the basket, change in quality all the time. Housing provokes similar questions.

I am not denying it is quite hard to compile NGDP as it has one or two theoretical issues itself: the final vs intermediate consumption issue, the issue of how to value self-owned housing or the scale of the informal economy. But RGDP has the exact same issues, plus the massive issue of divining pure inflation from changes in quality and nature.

Paul Krugman likes to throw the “voodoo economics” tag around when non-mainstream economists come up with ideas, but what should be done when mainstream economics has formed a consensus   around a very silly idea like inflation targeting.

The 2% target is voodoo upon voodoo

On top of the targeting of inflation, seemingly out of thin air a 2% target was created. It was possibly invented because the long run real growth has often been calculated as around 3%. So a 2% inflation seemed a nice balance. Not more than real growth, but not too close to zero and risking deflation. Not too high as to upset the current bunch of Republicans, the Germans, the famous Japanese housewives, or …? William Dudley of the NY Fed recently gave as a reason that it meant most people in their 30 year working lives would see a doubling of prices. Assuming inflation can be so precisely calculated, so what? Why not no change or quadrupling? What difference can it make?

Why has inflation targeting appeared to have worked?

There is much discussion about the “divine coincidence” that while targeting inflation, central bankers actually targeted the output gap. And during the Great Moderation got monetary policy more or less right. The “output gap” is an even more tricky theoretical concept.

NGDP Targeting is so sensible, so simple. It does not rely on any theoretical concepts to target like inflation, RGDP or another voodoo upon voodoo concept like the gap between artificially-created RGDP and where the artificial RGDP should be, theoretically speaking.

Some have suggested that central bankers were implicitly targeting NGDP growth. Well, maybe. If they were, it came very unstuck in 2007-08 when they seemed blinded by high headline inflation, and were very slow to react to falling actual NGDP growth and crashing NGDP growth expectations.

“If you can’t hit the 2% target why introduce a harder one? Because …”

A James Alexander post

I was pleased to report some traction in the Market Monetarist campaign to see inflation targets substituted by, or added to, an NGDP growth target.

One common pushback I’ve received recently is if the central bank can’t hit a 2% target how can it hit a tougher target? It’s a reasonable question.

First, central banks in the US, UK, Euro Area and Japan, don’t want to hit their 2% targets. An odd claim, I know. But on closer inspection they now actually operate a 2% medium term target, crucially based on their own forecasts of inflation. Any time their medium term forecast approaches 2%, or worse moves above it, the noise level about interest rate paths gets very loud. The Fed even raised rates!

This targeting a target has been discussed before here, and is very depressing to economic activity, real and nominal. It ends up with actual inflation consistently below the 2% target. It is rather like most people’s two year out plans, they never seem to quite come off.

Shoot higher, achieve more

Second, moving to a 4% inflation target and missing it by 1-2% is far less damaging than missing a 2% target by 1-2%. Modest 2-3% inflation is consistent with 5% nominal growth, i.e. trend nominal growth. Stable nominal growth is the proper target for central banks, agreed by most people, even central banks.

Central banks wouldn’t have to hit 4% but turning it into a target would enable the market to believe the central banks were happy with 2-3% inflation now. Even four percent inflation, if achieved, would not be terribly damaging either. Market Monetarists are not crazy inflationists, just dull-sounding moderate inflationists, and very hostile to missing lowflation targets. The truth of the matter is that they don´t like the word “inflation”.

Third, simply moving the target obviates the need for the sort of oxymoronic “responsibly promise to do something irresponsible” thing Paul Krugman again suggests in a response to a Tony Yates blog post. No one in markets takes such nonsense seriously.

Central banks do not operate like that, and if they did markets would be worried about other stuff pretty quickly. Just change the target to something more ambitious, but still credible and responsible. It would also end the ridiculously unnecessary, frankly idle, chatter about helicopter drops.

Last an NGDP growth target is a different animal to an inflation target. NGDP is simply aggregate demand or aggregate income. It is what the central banks have almost exact control over. Inflation is a terrifically hard to calculate residual of the difference between easy to calculate nominal demand and terrifically hard to calculate real demand.

The exact balance of any nominal growth between real and inflationary growth is very difficult to divine in real time. It is, nevertheless, very important to understand and to fix if the balance is too much inflation and not enough real. That debate is no concern of the central bank. Inflation is simply the wrong target for them. They control money and therefore the other half of all economic transactions, not output. It’s a powerful tool, use it!

Tony Yates on Kocherlakota

In his further comments on Stan Fischer´s presentation at the AEA meeting, Kocherlakota writes:

Why has r* fallen so much and stayed so low, despite signs of improvement in the economy?  One reason is the diminished credibility of central bank objectives.

The Fed (and other central banks) have fallen short of their inflation and employment goals for many years, and are expected to do so for several more years to come.  The public’s beliefs about Fed long-run capabilities and objectives are evolving in response to these misses.  It should not be surprising that the Fed’s extended misses with respect to its objectives are fueling expectations of similar future extended misses – and are one factor that is pushing down on r*.

This analysis seems like yet another argument against the plan to continue to tighten monetary policy.  Doing so only serves to prolong the Fed’s long undershoot with respect to inflation and (more arguably) with respect to employmentThe additional erosion of credibility will create still more downward pressure on r*. (Note: r*   stands for the neutral rate of interest).

To which Tony Yates responds:

On Twitter last night, commenting on Stanley Fischer’s contribution to a panel at the American Economic Association meetings in San Francisco, outgoing FOMC member Kocherlakota expressed his scepticism about the wisdom of raising the inflation target.

However, credibility worriers also need to remember [and here I don’t finger Prof Kocherlakota for failing to] that in some respects raising the inflation target may improve the credibility of monetary policy and reduce inflation uncertainty.

By persisting with the current 2 per cent target, the Fed and other central banks risk further long episodes at the zero bound, and further protracted periods in which inflation is substantially below target [in the UK headline inflation has been about 0 for a year now], and corresponding uncertainty about whether the central bank can ever regain control over inflation.  If setting a higher target means reduced time at the zero bound, then it most surely means better inflation control, and enhanced ‘credibility’, in the sense of the reputation for competence and inflation forecasts that would follow from inflation turning out to be closer to the new, higher objective.

Nowhere does Kocherlakota mention a higher inflation target. That´s TY´s pet project. In any case, if the Fed does not seem to be able to hit the 2% target, how can we presume a 4% target is not only achievable but also enhances credibility!

Inflation is determined by monetary policy. If instead of associating monetary policy with interest rate policy (which becomes “ineffectual” at the ZLB) you associate monetary policy with NGDP growth relative to a stable trend path, you get nominal stability. In that case you not only avoid the ZLB but you get stable (and credible) inflation and stable RGDP growth.

Over more than 20 years prior to 2008, the Fed succeeded in obtaining nominal stability. That comes out clearly in the chart below where, particularly between 1993 and 2007 NGDP growth is quite stable (low growth dispersion). That stability (around a trend growth path) was lost in 2008 and the appropriate level path has not been regained.


Core inflation, which particularly during the 1993 – 2007 period had remained close to 2%, fluctuating due to real (productivity) shocks, since 2008 has mostly been below the 2% target.


Just like the 1970s showed that a rising NGDP growth path is inflationary, the last several years have shown that too little inflation results from too low NGDP growth (at a low trend path).

What that tells me is that it is high time to stop talking and worry about inflation and try to regain the lost nominal stability that the US economy enjoyed prior to 2008. Best way to achieve that is for the Fed to set an NGDP Level Target.

Central bankers on target with their targets

A James Alexander post

There has been an illuminating exchange between Scott Sumner and Nick Rowe with John Handley who has been defending bravely New Keynesian models. New Keynesians wonder why QE at the ZLB hasn’t been effective in raising inflation. To me the best the reply is: central banks don’t want to raise inflation.

The central banks seem to define inflation as inflation two years out, that is expected inflation, based on their own “official” expectations. And, therefore, central bankers are on target with their own targets.

The evidence is clear in the charts and tables below, unanimously modelling a return of inflation.

So they just patiently, or often impatiently, wait for near term inflation to behave as their models predict so they can move rates as they plan: up in the US and the UK, hold flat in Japan and the EuroZone.  And the central bankers are slaves to these models.

The markets understand all this: that it is the two-year out inflation outlooks that drive monetary policy. For the Fed and the BoE monetary policy may even be a little too loose, certainly if they don’t raise rates in line with their guidance. The Bank of Japan seems to think it can just stand pat. And that maybe the EZ is a little worried that its two year out projection is a bit too low, and so is muttering about using some more tools.

All four central banks use mainstream New Keynesian models. So what is wrong? Inflation never seems to rise to the two-year out expectations. We have been there many times over the last several years as “inflation” keeps disappointing these determinedly mainstream models. So the market is really asking: at what point will the mainstream economics realise there is something wrong with their models? While the markets wait to find out, nominal growth will continue stalling, fearing that these New Keynesian slaves wont’ change their models but find a reason to raise rates – see our very last chart from the Bank of England desperately searching for an inflation pickup.

Market Monetarists understand that it is the two year out inflation targets that keep depressing near term inflation, and depressing nominal and real growth as a result. The answer is to target nominal growth expectations not strict inflation targets.

Flexible inflation targets would be better, but inflation is a poor economic measure. No one really knows when overall prices rise or fall, it is too difficult to observe. And there is total confusion about individual or particular baskets of goods and services price changes being due to quality changes or not, to mix changes or not.

Just target total nominal incomes, spending or output and forget about inflation. Five percent nominal growth will give enough flexibility for economies to ride the real economy cycles and not cause real economy mayhem due to downwardly sticky wages.

The Federal Reserve Board of Governors forecast in September 2015: PCE “inflation” will be at 2% in late 2016, assuming it raises rates in line with its guidance.


Federal Reserve “guidance” on rates from the same report


The ECB staff projection in September 2015 forecast  HICP “inflation” will be at 2% in late 2016, assuming it raises rates in line with its guidance.


ECB “guidance” on rates from the same report.


The Bank of Japan’s macroeconomic model in October 2015 forecast  (All Items Less Fresh Food) “inflation” will be at 2% in late 2016, assuming it raises rates in line with its guidance.


The Bank of England’s macroeconomic model in August 2015 forecast CPI “inflation” will be at 2% in late 2016, assuming it raises rates in line with its guidance.


Bank of England interest rate “guidance” from the same report.


Evidence of just how watchful central banks are about inflationary pressures coming up on the blind side and biting in the back is the chart from the same BoE August 2015 inflation report. The chart heading reveals a lot about the thinking at the BoE. A “slight pickup in consumer goods inflation” is evidenced by a “rise” from an actual negative rate of 0.25% to a positive 0.05%. Whereby the official CPI projection has some appropriately wide fan charts to show the degree of error, when it comes to spotting future pressures the error charts disappear.