The Fed Can Suffocate The Economy Under NGDPLT Too

A Benjamin Cole post

Recently there has been a hubbub in Market Monetarist circles that prominent Democratic economist Larry Summers, generally a Keynesian type, tipped his hat to nominal GDP level targeting, or NGDPLT.

Well, at least in preference to inflation targeting or IT.

Said Summers at latest report, “I didn’t quite endorse NGDP targeting. I said that I would prefer a shift to NGDP targeting to a shift up in inflation targets.”

Why The Summerian Reservation?

That Summers endorsement of NGDPLT was hesitant and oblique may not be surprising. He is, after all, a Keynesian, and believes in federal deficit-spending.

But Summers may also have entirely human and sensible reason for his backhanded support of NDGPLT—that is, a central bank can just as well suffocate an economy under NGDPLT as under IT.

Indeed, the U.S. Federal Reserve has kept the U.S. economy growing at a fairly steady nominal rate since 2008. The problem is, the economy is blue in the face from monetary asphyxiation.

Remembering Milton

Forgotten today is the Milton Friedman of October 1992, when CPI inflation was 3.2%, and real GDP was expanding at about 4.0%.

Yet the title of Friedman’s October 1992 op-ed in The Wall Street Journal, after the Fed had dropped interest rates from 10% to 3%? It was: Too Tight For A Strong Recovery

That 1992 Friedman op-ed speaks worlds about the inflation-obsessed state of modern economists.

Market Monetarists of 2015

Yet some Market Monetarists recommend straitjacket nominal growth rates, succumbing to the present-day peevish fixation that inflation—even moderate inflation—cannot be endured.

We can hope someone will further flesh-out Summers’ sentiments regarding NGDPLT. But whatever Summers’ take, I hope Market Monetarists  do not mimic the inflation-nutters.

It doesn’t really matter if inflation is 1% or 4%.

What matters is robust real growth.

A “solution” to DeLong´s “back-propagation induction-unraveling” problem

Brad DeLong has a (way too) long post. But the end gives the gist of his argument:

The problem is that the macroeconomics that Paul Krugman learned at Jim Tobin’s knee wasn’t just 1930s-style Hicks-Hansen Keynesianism. It was the 1970s adaptive-expectations Phillips Curve neoclassical synthesis–nearly the same stuff that I first learned at Marty Feldstein and Olivier Blanchard’s knees in the spring of 1980.

That is the framework that Marty is using now, and that generates his puzzlement. That framework had a short run of 1-2 years, a medium-run transition-dynamics phase of 2-5 years, and a long run of 5 years or more baked into it. You cannot–or at least I cannot–just throw away the medium run transition dynamics* and the declaration that the long run Omega Point is five years out, and say that mainstream economics does well. You need to explain why the back-propagation induction-unraveling worked at its proper time scale in the 1970s and the 1980s, but is nowhere to be found now.

And so I am much less confident that I have solid theoretical ground under my feet than Paul Krugman does.

The “solution” (or “explanation” for the absence of the “back-propagation induction-unraveling”), towards which even Brad´s pal Larry Summers is warming up to is….NGDP-Level Targeting. In fact, the Fed has (implicitly) established a much lower level target for NGDP, a level that is consistent with Summers´ “Great Stagnation” thesis.

So I hope that when Summers says “I didn’t quite endorse NGdp targeting. I said that I would prefer a shift to NGdp targeting to a shift up in inflation targets”, I also hope he has a level target at the back of his mind!

HT Scott Sumner

The Depression´s “Great Moderation”

It´s always interesting to see that not many perceive the low growth of this ‘recovery’ as clear evidence that the economy is in a depression (not a “Great” one, but one nevertheless).

The chart provides an illustration:

Depressions´ Great Moderation_1

At the WSJ Jon Hilsenrath writes about his (and the markets´) befuddlement in Why the Economy—and the Fed—Keeps Getting Knocked Off Track:

The peril of a slow-growing economy is that even small disturbances can knock it off stride, a reality now bedeviling the U.S.

A slew of soft economic reports in recent days has led Wall Street analysts to again reduce their estimates of U.S. growth. It now looks possible U.S. output will nearly be flat for the first half of 2015, and might even contract on average over the first half. J.P. Morgan economists see a growth rate of just 0.5% for the first half.

This softness, which is likely to constrain the Federal Reserve as it eyes when to raise short-term interest rates, is befuddling many economists who just months ago pointed to signs the U.S. economy was kicking into a higher gear. Many of the economy’s underlying fundamentals still look strong: companies are hiring, and incomes and wealth are rising. Interest rates are low and supportive of growth while government fiscal policy—a drag early in the recovery—has become neutral.

A variety of indicators, though, tell a different story. The Federal Reserve on Friday reported U.S. industrial production contracted in April for the fifth straight month, down a seasonally adjusted 0.3% from the month before. A University of Michigan index of consumer sentiment also droppedSoft April retail-sales data and dismal trade numbers, both on Wednesday, had already led analysts to reduce their estimates of growth.

“Economies, like bicycles, are more stable when growing at moderate speed than when growing slowly,” said Lawrence Summers, a Harvard University economics professor and former Obama administration economics adviser, in an interview. A slow-growing economy “is one moderate sized shock away from recession.”

……………………………………………………………………

The U.S. economy has actually been less volatile than normal since the recession ended in mid-2009, according to James Stock, a Harvard University economics professor who coined the term “Great Moderation” to describe the steady growth rates of previous decades.

Deviations in growth from one quarter to another have been no larger in this recovery than they were in the three recoveries preceding the past recession, he said. Moreover, deviations in growth from one year to the next in this recovery have actually been half as large as they were during the three previous recoveries.

Yet he sees a risk if economic turbulence grows.

“If you are growing at a low level, you are going to be more vulnerable to those major shocks than you would be if you were growing at 3.5% or 4%,” he said. “This is a major challenge for policy.”

Because interest rates are already near zero—in part because of the slow growth rate—the Fed doesn’t have room to cut them in response to a downturn if one actually does occur.

The thing is that most talk about “Great Moderation” as something only pertaining to growth, forgetting about the associated level.

The chart below illustrates why the ongoing “Great Moderation” is consistent with a depressed economy. The chart describes in ‘phase space’ the degree to which growth ‘spreads out’ (is volatile).

Depressions´ Great Moderation_2

It is clear that real growth volatility is significantly lower during the ongoing ‘recovery’, than it was during the original “Great Moderation”. If you discard the low growth of the 2001 recession, real growth at present has been far lower than real growth in 1992 -07.

If you look at the first chart above, you see why we are in a depression. During the “Great Recession”, real output contracted and extremely low growth thereafter has not directed it back to trend.

The next chart describes in ‘phase space’ the behavior of nominal growth (NGDP or nominal spending growth). It is even more stable now than before, but note that at present, the growth rate is not much different from the nominal growth rate observed during the 2001 recession.

Depressions´ Great Moderation_3

The big question is; if the Fed has the ability (and note that for decades nominal growth was very volatile) to provide nominal growth stability (that translates into real growth stability), why can´t it also do it at a non-depressed level?

In other words, if it can keep nominal growth chugging along at a ‘constant’ rate, why can´t it temporarily increase that rate so that the economy will climb out of the ‘hole’ it´s in?

It´s certainly not because interest rates are at the ZLB. As Watson puts it, rates are near zero in part because (nominal) growth has been so low. For goodness sake, then, increase the nominal growth rate!

Unfortunately, Janet & Friends prefer to speak about “policy normalization”, meaning increasing the FF target rate. They would do much better if they switched to a target level for nominal spending.

The Inflation Target “two-step”. It sure isn´t one of the world´s wonders

Central bankers are proving to be the gang that can’t shoot straight.

A quarter of a century since New Zealand opened the era of inflation targeting, policy makers from the U.S., euro area, U.K. and Japan are all undershooting their consumer-price goals. Of the Group of Seven, only Canada is currently meeting its mandate.

Rather than lowering their sights to make things easier, the misses are fanning calls for targets to be increased from the 2 percent most aim for to perhaps as high as 4 percent.

While a similar idea was pitched five years ago by International Monetary Fund economists led by Olivier Blanchard, and endorsed by Nobel laureate Paul Krugman, this time around it may be the central-banking community itself proposing a rethink.

Former Federal Reserve Chair Ben S. Bernanke last month suggested he would be open to an increase in the U.S. Federal Reserve’s 2 percent goal, saying there is nothing “magical” about that number.

Fed Bank of Boston President Eric Rosengren said the same month it could be the case “inflation targets have been set too low.” His colleague from San Francisco, John Williams, told the New York Times that if the future is one of weaker growth because of demographics and productivity then it’s worth asking “is the 2 percent inflation goal sufficiently high in that kind of world?”

But if they can’t hit 2 percent, why lift the targets?

……………………………………………………….

A better solution would be for future central bankers to be as worried when targets undershoot as they have been when they overshoot, said David Lipton, the IMF’s No. 2 official.

Standard Life’s Lawson is unconvinced.

One wonders how many more years of failure it will take before the consensus surrounding current inflation targets begins to rupture and more radical policy objectives are considered,” he said.

Now consider this paper from the NY Fed that recently came out: “Inflation Expectations and Recovery from the Depression in 1933: Evidence from the Narrative Record”.

The abstract reads:

This paper uses the historical narrative record to determine whether inflation expectations shifted during the second quarter of 1933, precisely as the recovery from the Great Depression took hold. First, by examining the historical news record and the forecasts of contemporary business analysts, we show that inflation expectations increased dramatically. Second, using an event-studies approach, we identify the impact on financial markets of the key events that shifted inflation expectations. Third, we gather new evidence—both quantitative and narrative—that indicates that the shift in inflation expectations played a causal role in stimulating the recovery.

That´s a very sensible conclusion. Does that mean the Fed could increase inflation expectations today by announcing a higher inflation target? Given that inflation has been way below target for a long time, that´s quite unlikely.

What happened in early 1933 to change expectations?

1 FDR announced a price level target

2 To get the price level up, spending had to increase. To get spending to rise, monetary policy had to be expansionary. To make monetary policy expansionary, FDR delinked from gold and devalued the dollar.

The outcome:

No need for higher IT_1

Today, a more “radical” policy objective would be a NGDP – Level Target! At least the economy wouldn´t have remained “splashing” far underneath the “surface”!

No need for higher IT_2

HT Becky Hargrove

“Three coins in the fountain” of the monetary policy stance. Unanimously, they say interest rate does not define the stance!

First Milton Friedman:

The Federal Reserve cannot and does not control interest rates, though its actions clearly have an effect – but in a more complex way than would justify the identification of easy money with low interest rates and tight money with high interest rates.

Followed by Bernanke:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman  . . . nominal interest rates are not good indicators of the stance of policy . . .  The real short-term interest rate . . . is also imperfect . . .  Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

Then Mishkin:

What I’d like to spend some time on—because I feel this is sort of my swan song, but maybe because I’m a classy guy, I’ll call this my “valedictory remarks”—are three concerns that I have for this Committee going forward. I’m not going to be able to participate, but I have a chance now to lay them out.

The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policyThis is very dangerous. I want to talk about that.

So what best defines the stance of monetary policy? Let´s check Bernanke´s alternatives. The charts show NGDP relative to trend, Inflation and the FF target rate for different periods.

In 1992, Friedman wrote about monetary policy being tight with reference to money supply (M2) growth. Unfortunately, that´s not a good measure of the stance. He should have said monetary policy had been tight, because at that moment the Fed was just getting it right given NGDP was fast converging to trend, despite the falling/low FF target rate and falling inflation.

MP Stance_1

The 1993-97 period describes what a “perfect” monetary policy looks like.

MP Stance_2

NGDP hugged the trend, the FF target rate initially low, was subsequently raised (does that mean it was initially “easy” and then “tightened”?) and inflation fell throughout (does that mean the stance of policy was “tight”?).

The end of the decade describes what an “easy” stance of monetary policy looks like. Despite the increase in the FF target rate and inflation remaining below the “desired” (2%) level, the fact that NGDP rose above the trend level accurately describes the easy stance of monetary policy.

MP Stance_3

The subsequent period includes John Taylor´s “too low for two long” level of the FF target rate. According to the deviation of NGDP from trend, monetary policy was initially too tight, only becoming stimulative in the second half of 2003, when forward guidance was introduced, even though the FF target rate soon began to rise.

MP Stance_4

The following period accurately describes what a very tight monetary policy looks like, despite an initially constant and then falling FF target rate and inflation. Soon after taking the Fed´s helm, Bernanke proceeded to tighten monetary policy, and the “screws” turned until NGDP “crashed”! It looks like Lehman was a consequence and not the trigger.

MP Stance_5

And monetary policy, despite all the “highly accommodative” talk, has in fact remained pretty tight ever since!

A clear call for a higher NGDP level target

Robert Samuelson writes: “The investment bust (explained)”:

One of the great disappointments of the weak economic recovery has been the sluggish revival of business investment — spending on new buildings, factories, equipment and intellectual property (mainly research and development, and software). For the United States, this spending in 2014 was about 9 percent above its 2007 record high. Sounds good? It isn’t. The average annual gain is a bit more than 1 percent over the past seven years. It is only a small stretch to say that capital has gone on strike.

Why? Can anything be done about it?

We now have a new study from the International Monetary Fund (IMF) that suggests some not very encouraging answers. For starters, it confirms that the investment bust is a global phenomenon. It’s not just the United States but also Europe, Japan and most advanced countries. As important, the main cause of the investment slump is clear-cut: Businesses aren’t expanding because they can already meet most demand with existing capacity.

“Business investment has deviated little, if at all, from what could be expected given the weakness in economic activity in recent years,” the IMF concluded.

The result is a vicious cycle: A weak economy inspires lackluster investment, and lackluster investment perpetuates a weak economy.

Could we jolt business investment from its lethargy? The IMF suggests that more economic “stimulus” (a.k.a., bigger budget deficits) would boost business investment by shrinking excess capacity. Perhaps. But it’s also possible that temporary stimulus plans — as most are — wouldn’t generate much more private investment precisely because corporate managers would see them as fleeting. Why expand to serve demand that won’t last?

If that´s not a call for a higher target level of NGDP (aggregate demand) I don´t know what is!

Low Investment

A long-time Fed economist discusses NGDP favorably

Robert Hetzel, of the Richmond Fed writes “Nominal GDP: Target or Benchmark?”  I highlight two passages.

First:

Previous work by the author in 2008 and 2012 argues that former Fed chairmen Paul Volcker and Alan Greenspan followed a nonactivist rule during the period known as the Great Moderation, the years following the Volcker disinflation through the Greenspan era. Although the FOMC does not explain the rationale for its policy actions within the framework of a rule, since this era, policymakers have recognized the need to behave in a consistent, committed way to shape the expectations of financial markets.

The chart provides the view of NGDP growth and inflation for the last 60 years.

Hetzel Benchmark_1Hetzel Benchmark_2

Initially NGDP growth is highly volatile (but trendless). From the mid-60s to 1980, NGDP growth trends up, and so does inflation. The Volcker adjustment was a period when NGDP growth was strongly reduced with inflation being brought down significantly.

Note that from the start of Greenspan´s Great Moderation, NGDP growth is stable, but inflation continues to come down, only reaching the (implicit) 2% target in the mid-90s.

As Hetzel notes, the Fed, particularly Greenspan, never explained the rationale for its policy actions within the framework of a rule. As such, the Taylor-rule was an attempt by John Taylor to describe (guess, make-up) a “rule” that was consistent with what the Fed was doing. With time, given the highly successful monetary management of that period, Taylor and his followers want us to believe that the “rule” was responsible to the period´s success!

From the chart, it appears much more likely that the “success” (defined by inflation falling and remaining low and stable) was mainly due to NGDP growth remaining stable.

The chart on RGDP growth tends to corroborate that view.

Hetzel Benchmark_3

Throughout the 1954-2007 period, RGDP growth averaged 3.4% (we´ll see below that is true since 1870!). Before the mid-60s, the volatility of RGDP growth is due to the volatility of NGDP growth. During the “Great Inflation”, RGDP growth volatility derives from the inflation volatility of the period (caused by the rising and “chopped” growth in NGDP). During the “Great Moderation”, low NGDP growth volatility translates into low inflation and real growth volatility!

Which leads me to the second passage of Hetzel´s essay I want to highlight:

If trend real GDP growth is stable and policy is credible so that the expectation of inflation is aligned with the FOMC’s inflation target, as it was for most of the 1990s, these procedures translate into stable trend nominal GDP growth. Note, however, that this fact does not imply that the FOMC had a target for nominal GDP.

It would seem that a stable NGDP growth is the outcome, or result, not the driver! That´s the reason for him to suggest that NGDP may be a good benchmark (although not a target).

My first observation is that trend real growth has been stable since the 19th century! It´s not a characteristic of the 1990s. The top chart shows RGDP and trend from 1870 to 2011 (yearly data). Trend growth is 3.4%. The bottom chart, based on quarterly data from 1954 to 2014, shows that trend growth is also 3.4% (up to 2007). Note that following the Great Depression, RGDP reverted to trend. Will the post 2007 period become known in 50 years’ time as “the Bernanke Break”?

Hetzel Benchmark_4

Hetzel Benchmark_5

My second observation is that during the 1990s, since the US did not have an explicit inflation target, policy credibility cannot be defined as the “alignment of inflation expectations with the FOMC´s inflation target”. The FOMC´s “target” was “low” inflation, something vague. In the course of the 1990s, the Fed gained credibility because inflation remained “low”. My conjecture is that that´s the outcome of NGDP growth evolving stably along a level trend path.

The panel below indicates my conjecture has some validity. From the early 90s to early 2008, you could say the Fed “targeted” inflation, not at 2% but in a band of 1% – 2%. You could also say it targeted the price level (PLT) close to a 2% trend growth, but you could also say the Fed targeted NGDP along a 5.5% trend level path.

Hetzel Benchmark_6

The “Bernanke Break” serves to show that what “held everything together” was keeping NGDP evolving stably along a level path. In 2008 it wasn´t inflation or the price level that indicated something was wrong. The “dog that barked” was NGDP dropping significantly and “permanently” below the trend path!

But by all means, if there are reservations to a formal NGDP level targeting, use it as a benchmark. If the Fed had done so in 2008, things would be much less dire in 2014, and we would not be having ridiculous discussions about “GSG”, “SS” or about “June”, “September” or “whatever”! Or see things go topsy-turvy as suggested by this piece by Binyamin Appelbaum ( HT Peter Ireland):

At a hearing in February, Representative Scott Garrett, a New Jersey Republican, complained that Congress and the Federal Reservehad traded places.

During previous periods of high unemployment, members of Congress pressed the Fed to print more money even as the Fed remained wary of the inflationary consequences of such efforts.

After the Great Recession, by contrast, the loudest criticism has come from politicians demanding that the Fed shut down its printing press and raise interest rates.

Raise the banner! Oops, I mean the Inflation Target!

The higher IT idea has never died, and recently there has been a “great revival”. Cecchetti and Schoenholzt have a long post – Is 2% still the solution?” – but the conclusion comes on the third paragraph:

The debate over the appropriate level for a central bank’s inflation objective reminds us of a 40-year-old Sherlock Holmes movie called “The Seven-Per-Cent Solution.” Convinced that Holmes’ addiction to cocaine (the solution in the title) had made him delusional, Watson took the master sleuth to Vienna to be treated by Sigmund Freud.

Has the 2% solution for inflation targeting in advanced economies made central bankers similarly delusional? Are they stubbornly attached to an outdated target? That argument gained ground in recent years as policymakers in Europe, Japan, and the United States struggled to stimulate weak economies and stabilize prices with policy interest rates stuck at the zero bound.

Our view is that if policymakers could start from scratch, they might well choose a somewhat higher inflation target. Their rationale would be to avoid having to lower the policy rate to zero again in a future recession. But the cost of changing the policy framework now would be a substantial loss of credibility, so there seems little chance for a new regime with a higher inflation target.

Tony Yates, who has been pushing the “raise the banner” idea lately, comments on C&S:

On this central point [the credibility issue], I don’t think we can know.  This is the sort of thing central bankers and ex-central bankers [Steve being one!] say a lot.  But there isn’t any good theory or empirics of reputation formation and dissolution, so we are in the dark.  I remember thinking it rather wishful thinking that inflation targeting – simply promising to create the amount of inflation you wanted – would be believed, especially after a few decades of failed proper [read ‘intermediate’, ie exchange rate/monetary] targeting.

I would also like to re-emphasize a point I made in my earlier post, that worrying about credibility is the right thing to do, but might cause us to be concerned about the status quo.  If unconventional monetary policies are not as effective, or more costly to wield than interest rate policy, and if there are insurmountable political obstacles to using discretionary fiscal policy, then too-low inflation means more busts than we thought.  And a higher risk of being trapped forever at the zero bound.

Krugman, one who has never let go of the higher inflation target idea, comments on a very interesting series of posts by Mathew C. Klein on the 2009 FOMC Transcripts:

Matthew Klein has been going through Fed transcripts from 2009, and notes that the Fed was surprised at the persistence of inflation despite the Great Recession. Oddly, however, he seems to suggest that this episode weakens the case I and others have been making for a higher inflation target. Actually, it strengthens that case.

And concludes:

So the failure of inflation to fall as much as predicted in 2009 was part of a series of events that were trying to tell us that the initial inflation target was too low.

I think the “higher IT” debate is a complete waste of time and effort. Over many years, even decades in some cases, inflation was kept low and stable, both for countries formally targeting inflation, either point targeting at 2% or targeting within a narrow band centered at 2%, and for countries, like the US, who had no numerical target, just a concept of what “price stability” meant (according to Greenspan, it was a rate of inflation that didn´t affect people´s plans).

My conjecture is the “good times”, or “Great Moderation” experienced by many countries, many times beginning in the mid-1980s and extending to 2006-07, has mistakenly been credited to IT, even if it was, like in the US, only informal (or implicit). What was really behind the “good times” was the accomplishment, by many central banks, of nominal stability, a much more encompassing concept.

In fact, the IT idea emerged, “out of the blue”, in the late 1980s, when the New Zealand government was seeking to improve general government performance and began giving departments and agencies clear goals by which they could be appraised.  I can just imagine what went on in the head of the RBNZ Governor when asked how he should be evaluated. Seeing that inflation was falling after being in the two-digit range for many years, his quick answer must have been something like “keep inflation low”. Thus was born IT!

That doesn´t give IT a good “pedigree”. Nevertheless, academics were quick to develop theoretical and model-based frameworks that gave IT the “pedigree” it needed to flourish. So why is it that at present there´s so much discussion on “regime change”?

Great minds predicted this. More than a decade before IT “emerged”, Nobel Laureate James Meade in his 1977 Nobel Lecture called IT dangerous:

Earlier I spoke of ‘price stability’ as being one of the components of ‘internal balance’. Yet in the outline which I have just given of a possible distribution of responsibilities no one is directly responsible for price stability. To make price stability itself the objective of demand management would be very dangerous. If there were an upward pressure on prices because the prices of imports had risen or because indirect taxes had been raised, the maintenance of price stability would require an offsetting absolute reduction in domestic money wage costs; and who knows what levels of depression and unemployment it might be necessary consciously to engineer in order to achieve such a result? This particular danger might be avoided by choice of a price index for stabilisation which excluded both indirect taxes and the price of imports; but even so, the stabilisation of such a price index would be very dangerous. If any remodelled wage-fixing arrangements were not working perfectly, – and it would be foolhardy to assume a perfect performance – a very moderate excessive upward pressure on money wage rates and so on costs might cause a very great reduction in output and employment if there were no rise in selling prices so that the whole of the impact of the increased money costs was taken on profit margins. If, however, it was total money incomes which were stabilized, a much more moderate decline in employment combined with a moderate rise in prices would serve to maintain the uninflated total of money incomes.

Flash forward thirty years to 2007 and the “danger” materializes under Bernanke Chairmanship of the Fed. And this mostly happens because Bernanke was known as an ardent defender of inflation targeting and would likely act accordingly.

Later in the Lecture Meade proposes NGDP Level Targeting

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues which should certainly be the responsibility of the government rather than of any independent monetary authority. Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt. One would hope, of course, that there would be a suitable discussion of their plans and policies between the government and the monetary authority; but the latter would be given an ultimately independent duty and independent choice of monetary policy for keeping total money incomes on their target path.

Among the suggested “new regimes”, NGDP Level Targeting stands out. Why so much interest in NGDP Level Targeting?

To me, one important, maybe even defining, reason is that over the whole of the pre 2008-09 crisis “inflation targeting period”, including all the non-IT central banks, like the Federal Reserve, that nevertheless managed to keep inflation low and stable, all the “targets” (NGDP-LT, IT and PLT) were observationally equivalent.

To illustrate I look at Canada, an inflation targeter and the US, which did not target anything explicitly.

IT Banner_1

IT Banner_2

For both countries before the crisis, NGDP growth trend is 5.4% while both Headline and Core inflation are approximately 2% in the two countries.

Note that up to the moment the crisis hit, you wouldn´t be wrong to think, if you didn’t know otherwise, that both countries could be doing either IT, PLT or NGDP-LT. There´s no way to distinguish among the alternatives.

What the crisis showed is that inflation or price level targets are not robust, or dependable, “target rules”. If an NGDP-LT target had been explicitly pursued, both the Fed and the Bank of Canada (and many other central banks) would have heard the “dog bark” loud and clear! (Note that the IT and PLT “dogs” “barked up the wrong tree”!)

In fact, inflation targeting is not something that naturally defines central bank procedures. If you contrast New Zealand and Australia, for example, you´ll learn that macroeconomic outcomes other than inflation can be widely different even for inflation targeting central banks.

This adds to Ball and Sheridan´s findings in their 2003 article “Does Inflation Targeting Matter?” that since the early 1990s inflation has been lower and more stable in both IT and non-IT countries.

Ball and Sheridan´s findings are consistent with the idea of observational equivalence between IT, PLT and NGDP-LT that I illustrated using Canada and the U.S. From this, one could infer that low and stable inflation countries followed a de facto NGDP-LT targeting. The crisis had the effect of revealing the actual targeting regime.

A country such as Australia, where NGDP remained close to trend is more likely to have been following a NGDP-LT targeting regime than Canada or the U.S., where NGDP dropped well below trend.

Another inflation targeting country that the crisis revealed was de facto targeting NGDP is Israel. The contrast between Israel and the U.S. clearly brings out the danger of IT alluded to by James Meade. Although the U.S. was not formally an IT country, when Bernanke took the helm at the Fed in early 2006, it got much closer to being an IT country.

The different reaction of each Central Bank to the oil shock explains the different outcomes. While an oil shock (a negative supply shock) increases inflation and reduces growth, those effects tend to be temporary and the best monetary policy can do is to keep nominal spending close to trend. The charts show that by doing exactly that Israel avoided the real output contraction that befell the US and other de facto IT countries.

IT Banner_3

IT Banner_5

IT Banner_4

The German-centric ECB is arguably the most ardent IT central bank. For market monetarists, who strongly favor NGDP-LT, it is not surprising to observe the dramatic results, with the region going into deflation and real growth being close to zero and negative for some individual countries.

The chart below removes any doubt one may have on the dangers of inflation targeting in the face of supply shocks.

IT Banner_6

In the chart we observe the dramatic consequences of the ECB tightening in reaction to the rise in oil prices in 2008 and again in 2011.

Given the evidence I find Carl Walsh´s conclusion in his 2009 paper “Inflation Targeting: What Have we Learned?” depressing. To Walsh:

Financial meltdowns, such as the United States is experiencing at the time this is written, pose similar problems for IT and non-IT central banks. In that sense, they are irrelevant for the inflation targeting debate…

They certainly are not irrelevant. Countries, be them inflation targeters or not, that were on a de facto NGDP-LT regime fared much better than the de facto inflation targeters. And the reason is straightforward. NGDP-LT provides a much higher degree of nominal stability to the economy, and thus is much more effective in limiting the propagation of real shocks.

Therefore, instead of “suggesting” a higher target inflation, economists should try to help central banks “rediscover” nominal stability. For that, finding the appropriate level of nominal spending is required. It is not enough to just keep nominal spending growing at a stable rate, as the US has mostly done since emerging from the crisis.

PS An expanded version of this post can be found in “Which is more reliable” (PDF)